In the movie, “It’s a Wonderful Life,” George Bailey, building and loan executive, solves a liquidity crisis with an impassioned speech to depositors about the role of the local bank in the community. Deposits aren’t sitting in the vault, he tells the gathered savers. They’re in this house, and that development, and so forth. Bailey, as played by James Stewart, makes his case, and all but one grump return their deposits. Liquidity crisis averted.
 
In real life, liquidity contingencies have to be solved by preplanning and forethought, not clever oratory.

Liquidity’s evolution
Prior to Autumn  2008, the 2000s had been a prosperous decade for the nation’s financial institutions. There were loans to be made on every street corner. Communities were undergoing expansions and financial institution customers were looking for every avenue to enhance and leverage investments in those projects. 
 
To handle this growth, many banks needed to leverage their own balance sheets. They chose non-core capital options, including trust preferred, subordinated debt, and  holding company loans. Such capital structure leveraging has had a major impact on the health of balance sheets and liquidity management.
 
Many institutions shifted from the asset-based liquidity strategies of the past to liability-based funding strategies. They used a combination of FHLB advances and other borrowings, brokered deposits, and internet CDs not only as core funding sources but also as a backstop, should emergency funds become necessary.  Such techniques were previously used solely as liquidity sources of last resort. As they were used to leverage the balance sheet, a new set of issues has emerged regarding balance sheet management. Therein lie the reasons the  regulators have called for enhanced liquidity risk management through two Financial Institution Letters on Liquidity Risk Management.  While the guidance provided a framework for liquidity risk management, it does not provide much in the way of specifics.
 
Stress testing—much like the exercise performed on 19 megabanks earlier this year—is critical. A financial institution’s liquidity should be stressed to determine how senior management would manage through an event that results in a negative impact on a bank’s liquidity and funding strategies.
 
For a greater understanding of this risk management tool, let’s explore how a hypothetical banker named “Mike” worked through a liquidity stress test. Although the banker and bank are fabricated, the example is based on actual experiences.

Developing a methodology
Mike is CFO of “Quality Bank,” a $300 million bank holding company in a growing metro market in the Midwest. Quality Bank has experienced some challenges with asset quality over the past few years. This has led to employee turnover, new policies and procedures, and increased scrutiny from regulators. 
 
The bank identified the steps necessary for the development of a contingency funding plan:
 
• Identify the appropriate team to gather and analyze relevant liquidity and funding data.
• Discuss the institution’s funding philosophies and challenges.
• Populate a model with the bank’s current balance sheet and proforma cash flows.
• Discuss and document policy limitations and key ratios related to liquidity and balance sheet funding.
• Discuss stress events and model them.
• Discuss results of the stress events and determine how the institution would manage through such events.
• Document steps management would employ when dealing with a stressed liquidity event as part of a contingency funding plan.
• Determine how the institution will monitor the liquidity funding plan going forward. 
• Determine who is responsible for liquidity plan execution.
 
Because liquidity analysis is comprehensive to all areas of a bank,  Mike assembled a team of key senior managers who have the ability to effect change within Quality Bank’s balance sheet and who would ultimately play an active role in managing any liquidity crisis. To promote the team’s understanding of their institution’s current funding environment, as well as the risk tolerance and monitoring mechanisms already in place, they reviewed existing asset-liability, liquidity, and funding policies. 

Gathering information
Liquidity stress test models should look at a six- to twelve-month time horizon, so it is necessary to understand an institution’s budget and projections for growth; its available funding sources; projected commitments; potential for calls in the investment portfolio; monthly prepayment and principal amortization expectations in the loan and investment portfolios; and deposit concentrations. The bank’s core systems may make this information readily available, though to date it may not have typically been analyzed.
 
The inventory of funding sources is particularly important. Funding draws from a combination of on-balance-sheet and off-balance-sheet sources. On-balance-sheet sources might include unpledged securities, available liquid funds, loans held for sale, or loans with an active market. These assets could be readily converted to cash within a short period. Off-balance-sheet funding sources are typically liability-based in nature, such as access to borrowed funds, including Federal funds purchased lines, FHLB advances, correspondent bank lines of credit or term loans, brokered deposits, and accessibility to Federal Reserve sources. 

Funding philosophies and challenges
The next phase of the liquidity stress testing process is to understand how the institution has funded its balance sheet and what types of challenges it encountered.  Historically,  Quality Bank’s funding strategy had been very reactive. If funds were needed, an order for brokered deposits was placed, the funds were obtained, and management was off and running again. 
 
But more recently, like many banks, Quality’s management faced asset-quality issues. Under a regulatory order, accessibility to brokered deposits was limited. A waiver for brokered deposit funding had been obtained, but the process was awkward, as Quality Bank’s use of brokered deposits had to be explained to regulators. And the waiver solely granted the bank use of brokered deposits to the extent needed to replace maturing deposits—no increase was allowed.  The future of the waiver was in doubt, as well.
 
Thus, with Quality Bank’s main source of funding no longer available, alternative sources needed to be developed. One  option the institution developed as part of its contingency funding plan was the use of the balance sheet—the option of turning assets into cash. The easiest assets to turn into cash lie in the investment portfolio. As an alternative to liquidating investments, the investment portfolio can be pledged for off-balance-sheet sources.
 
This underscores the importance, in the development of contingency funding plans, of determining what types of investments, and what amounts, a bank will invest in. Investments that create the best return in earnings or tax advantages may not be the right securities to rely on for a source of liquidity. 
 
Similarly, while the loan portfolio can be a good source of liquidity, loans require a bit more planning to convert to cash. Planning for loan sales must occur long before liquidity concerns actually arise. Loans in an active market are the best source of liquidity, but require a working knowledge of loan brokers and pricing strategies, such as with Small Business Association loans or participation relationships. 
 
Turning to the liability side, local deposits have been and will continue to be the main source of funding for community banks. However, there are more challenges today for raising local funds.
 
Competition, pricing expectations, and seasonality are all factors that require management.
 
Quality Bank has been successful in attracting shorter-term, local deposits; however, the long-term options in the local market have been more of an issue. The bank had turned to the CDARS program (endorsed by ABA) and to internet CDs as alternatives for filling out the bank’s longer-term gap buckets.  CDARS has worked well for Quality Bank and the institution has been able to attract  larger depositors by using it. The one drawback is that CDARS deposits are considered brokered deposits. 
 
Internet CDs have been an excellent product as well. Typically, the national rates found through this source of funds has been below special CD rates in the local market and brokered deposit rates. Quality Bank has monitored the rates versus the local rates to ensure that they fall within the regulatory standards of 75 basis points. 

Don’t take Fed funds for granted
Quality Bank has used Federal Home Loan Bank advances and currently has availability in the program. The bank’s philosophy has been to maintain the current level of advances and use the rest as contingency funds. It is important to manage this source of funds as the FHLB has the ability to cut availability based on its assessment of risk in an organization. 
 
For many institutions, Federal funds purchased lines have been taken for granted as part of liquidity policies. Over recent months, however, the industry has experienced the volatility of relying on Fed funds lines as a funding source.
 
Historically, banks may have had two or three correspondent relationships, which provided a Fed funds line for short-term funding needs. The economic environment has prompted correspondent banks to evaluate the risks they were taking, causing many to reduce risks by eliminating or reducing Fed funds lines.
 
Both events occurred at Quality Bank. Given this current trend, institutions should be proactive in communicating with primary correspondents, particularly since new correspondent Fed funds arrangements will be significantly harder to set up than in the past.
 
Through its evaluation process, Quality Bank has explored other sources of liquidity including correspondent bank loans, brokered money market products, participation in the federal discount window, and others. As part of its liquidity stress test process, Quality Bank’s analysis of alternative funding sources became an action item.  

Addressing other challenges
The biggest challenge Mike presented was how to cost-effectively fund the balance sheet while managing liquidity and interest rate risks. In addition, Quality Bank monitors its top 20 customers. The percentage of its overall deposit base held by the top 20 depositors has been increasing in recent years. Reliance on these deposits is a real concern and was a major consideration in development of stressed situations. 
 
Aside from liquidity, the other chief concern for Quality Bank is capital. Leveraging capital typically provides the best return for shareholders, but it can be in direct conflict with safety and soundness when stress events occur.
 
Capital planning, therefore, has become critical to every institution and has a direct impact on access to liquidity.
 
Financial institutions with lower capital ratios may be forced into capping their access to brokered and other wholesale funding sources and may see federal funds purchased or borrowed fund lines reduced or pulled, particularly if asset quality issues arise. 

Finding a stress test that fits
Stress tests should be varied and tailored to the institution and its current and anticipated circumstances. Significant stress events may include deterioration of access to liability-based liquidity; a reduction in deposits (i.e., a “run” on the bank or loss of a large customer); negative press coverage; reduction of the bank’s CAMELS or investment rating; a severe decline in asset quality; or other events that may lead to an institution’s inability to meet its funding obligations. 
 
The effects of the stress tests should then be modeled; Quality Bank’s stress tests will come out differently than those performed on ABC Bank down the street. Mike chose to concentrate his stress tests on a loss of the bank’s larger depositors, further decreases in its available fed fund lines, limitations on brokered CDs, and a dramatic decline in asset quality. Three different scenarios were documented. 
 
Once each of the scenarios was documented, Mike analyzed the effects and developed potential responses for managing through the stress events.

Creating a contingency funding plan
The culmination of all the work is the development of a Contingency Funding Plan. Its purpose is to document the institution’s response, roles, and responsibilities that might be necessary in a liquidity stress event. Key aspects include:
• Defined roles and responsibilities.
• An assessment of likely liquidity events and how management will monitor them.
• Delineation of a bank’s funding options in the order they would be utilized, along with the benefits and risks of each.
 
Mike entered this process in a position not unlike many community banks—Quality Bank had developed a contingency funding plan using a sample that had been obtained from a third-party source. He had spent some time thinking through various events that might affect the bank, but had not supported the events with numerical data using a cash flow model. In addition, he spent little time analyzing potential trigger points. 
 
Having now developed a greater understanding, Mike was able to identify policy limits that act as trigger points in the stress test model. The limits became a direct link between the contingency plan and the liquidity monitoring mechanisms. 
 
The limits were then identified according to a Level 1, Level 2, and Level 3 stress test format. By laying out the policy limits in this format, Mike was able to directly link action plans in his contingency plan to the level that would be anticipated in the stress test scenarios. Action plans were designated as follows:
Base Level—Normal business.
Stress Level 1—Normal business with heightened liquidity concerns.
Stress Level 2—Possible or future liquidity crisis.
Stress Level 3—Actual liquidity crisis.
 
As stress events or actual performance are elevated, a greater degree of monitoring by team and the board is implemented, alongside corresponding action plans. 

Importance of monitoring
The policy limits developed as part of the contingency planning process become the base ratios to monitor on a monthly or quarterly basis. In addition, a liquidity report that incorporates all sources and uses of funding options, along with pro forma cash flows, is highly recommended.
 
The contingency funding plan and liquidity stress testing should be updated annually or as necessary. The institution’s implemented procedures should be incorporated as the final piece of the plan. 
 
As part of the development of Quality Bank’s plan and the liquidity stress test events, Mike identified gaps in his bank’s funding strategy. These gaps consisted of reviewing options with the Fed discount window, reviewing the portfolio for pledgeable securities, and developing additional correspondent relationships.
 
Action plans were developed to explore these alternatives. Action plans take time to research, understand, and implement. Now is the time to act. BJ
 
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