Let Market Strategies Define Liquidity Policies
I don’t even think about regulatory liquidity anymore; it’s
just not relevant.
Of course, we all must adhere to the regulation, but a five percent
liquidity requirement is so low that most institutions have no problem
meeting it. And, while regulatory liquidity may include some assets not
usually counted on to provide cash on demand, it excludes other assets
that can be quickly liquidated. Furthermore, regulatory liquidity gives
no credit for a healthy institution’s most effective guarantor
of cash availability—its borrowing power.
Any debate about the rewriting and updating of liquidity regulations
may be moot. Perhaps regulators will get around to changing their regulation
and perhaps not. But, given the extent to which the securitization of
mortgage assets and the development of the secondary market have progressed,
institutions and regulators may be better served by another approach.
An Economic Definition
Why not allow an institution’s liquidity to be driven by market
forces? Why not develop an economic definition of liquidity and allow
that to drive an institution’s liquidity policy?
After all, the stated purpose of liquidity regulations is to help ensure
the availability of funding for loans “...in periods of credit
stringency.” For all practical purposes, developments in the capital
markets since the regulations were written have made the asset-based
definition of regulatory liquidity at financial institutions vestigial.
Even the evolution of a “mark-to-market” philosophy within
the accounting profession changes the way institutions manage and regulators
view investment portfolios.
The reason we have deposit insurance and a Federal Reserve window is
that no individual institution could ever afford the liquidity to fund
a run on its deposits.
Aside from government regulations setting minimum requirements for
liquidity, each institution should set its liquidity goals by examining
its operating
characteristics and management policies in conjunction with the complete
cash-generating capacity of its balance sheet. Depending on the investment
alternatives that are sacrificed for the sake of liquidity, it can be
expensive to maintain cash and near-cash assets to satisfy liquidity
requirements. I’m not sure that an institution’s need for
liquidity demands this kind of sacrifice.
Purposes for Liquidity
An institution’s need for liquidity generally is driven by management
policy, not by economic accident. Liquidity usually is defined as the
capability of an institution to generate cash when it needs it, without
suffering an inordinate loss in market value. Cash is often needed when
loan originations are funded, other assets are acquired, and withdrawals
are made from accounts.
Funding Loan Originations
Loan demand can vary cyclically, depending on the regional distribution
of an institution’s loan origination offices. It can also vary
with the competitiveness of an institution’s mix and pricing of
loan products.
When an institution books every loan it originates, it’s constantly
aware of the amount of cash on hand to absorb those loans. But its capacity
to sell loans into the secondary market disassociates the institution’s
liquidity position from its ability to originate loans within its market.
The liquidity risk of the portfolio lender is replaced by the pipeline
risk of the mortgage banking function. And, as many financial institutions
discovered in the spring of 1994, effectively managing a loan pipeline
requires ready access to sources of liquidity.
For institutions that portfolio most of the loans they originate, for
philosophical or competitive reasons, volatility of loan demand is an
important source of liquidity risk.
Funding Asset Acquisitions
In a changing interest rate environment, institutions may require liquidity
to reposition the duration of assets on its balance sheet. Most financial
managers who brag about their liquidity positions are using near-cash
assets to take advantage of investment opportunities that materialize
as interest rates rise. (Or, perhaps they’re just putting up a
brave front in the face of poor loan-to-deposit ratios.) Such a purpose
for liquidity is subjective and completely determined by management policy.
Regulators and management should evaluate its value in the context of
market related factors.
Offsetting Withdrawals
How does an institution use liquidity to offset the risk of deposit
withdrawals? Are deposit withdrawals a function of conscious management
policy? By
and large, yes. The exceptions are areas where regulatory considerations
may play a role.
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Ensuring against system-wide runs on depository
institutions or regional panics is the proper province of government.
Maintaining liquidity to cover withdrawals in such situations cannot
and, in my opinion, should not be a governed by management policy. |
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In the past, a more troublesome situation occurred
when a financial institution, managed under regulatory supervision,
engaged in predatory pricing policies. Funding deposit runoffs in
the face of normal competition may be one of the most important purposes
for liquidity. |
Apart from these instances, an institution’s deposit pricing
policies determine the amount of liquidity needed to offset potential
withdrawals.
During the latter half of 1994 and the first half of 1995, the average
cost of funds at most financial institutions lagged far behind the marginal
cost of funds in both retail and wholesale markets. During such periods,
even the conservative pricing policies of commercial bankers are upset
when aggressive CD pricing tactics are implemented to retain retail deposits.
The failure of an institution to creatively develop retail-pricing strategies
may result in deposit withdrawals. In addition, insufficient withdrawal
penalties may contribute to deposit withdrawals during periods of sharply
rising interest rates. Of course, an institution that has a store of
very rate-sensitive jumbo deposits must be especially aware of its liquidity
position to anticipate any change in pricing policy.
In the increasingly competitive retail-banking environment, the uses
for liquidity demand consideration of alternative sources of liquidity,
especially liability-based sources.
Expanding Liquidity Sources
Institutions and regulators typically measure an institution’s
liquidity by its ability to generate cash from the asset side of the
balance sheet; this is known as “asset-based liquidity.”
For most regulators, the list of liquid assets includes the book value
of assets possessing acceptable degrees of credit risk. Intermediate-term
liquidity has a term to maturity of less than five years, and short-term
liquidity has terms to maturity of less than one year.
Many reasons may explain why regulatory liquidity is defined this way.
Since most institutions hold investments to maturity and do not follow
mark-to-market accounting, book value and term-to-maturity are used to
define liquid assets. Regulators give some weight to credit risk (i.e.,
the probability that the asset is convertible to cash upon maturity).
But, SFAS 115 impacts considerably the extent to which investment securities
may be considered liquid. While it is true that any security accounted
for as “held-to-maturity” qualifies as liquid, based on its
maturing cash flows, it is the only way these securities qualify as such.
Traditionally, investments for which market values exceeded book values
were considered liquid. But this can no longer be assumed for held-to-maturity
investments. In the not-too-distant future, EITF 03-1 will likely apply
similar logic to “available-for-sale” securities that
institutions designate as having the “ability and intent to hold.” (See
What
Counts, October
2004).
Only if a security is accounted for as available-for-sale (albeit “non-ability
and intent to hold”) can it be considered liquid. Similarly if
an institution is forced to factor the unrecognized gains and losses
on their available-for-sale portfolio to measure GAAP capital, why shouldn’t
it be able to include a substantial portion of the available-for-sale
portfolio as liquidity?
Probably for the same reason that institutions have always recognized
that only the market value of an asset is convertible to cash. Therefore,
regardless of their regulatory or accounting status, institutions are
unlikely to consider assets with market values below book values to
be liquid assets with the potential to fund normal demands for cash.
The
plain truth is that many institutions avoid using their income statement
to mark to market losses on their securities portfolio (although EITF
03-01 may do some of this for them). To generate liquidity, any institution
would be much more likely to use assets with a market value in excess
of book value, regardless of term-to-maturity.
Basic Tips for Liquidity Management
Maybe There’s Room for Compromise
The dollar amount of the available-for-sale portfolio could be liquidated,
although the transaction could be subject to some constraints on the
resulting loss in market value. For instance, if $100 million of the
available-for-sale portfolio could be liquidated without causing more
than two percent loss of market value, then the entire $100 million
would be counted as liquidity. As rates change, more or less of this
portfolio would be considered liquid. The amount would be dependent
on the dollar amount of securities that could be sold subject to the
two percent constraint. The constraint used by the institution to limit
market value losses is a function of the size of the available-for-sale
portfolio, relative to the institution’s total assets and
capital-to-asset ratio.
Furthermore, our expanded definition of liquidity permits the consideration
of the collateralized borrowing power of the institution as a source
of cash.
Borrowing Power
With the development of the secondary mortgage market, financial institutions
are increasingly accepting mortgages and mortgage-backed securities
as collateral for borrowing. True, certain speculative trading strategies
may have led to the abuse of tools, such as the reverse repurchase
agreement.
A financial institution has a variety of ways it can use the bulk of
its balance sheet to raise cash in the debt markets to substantially
enhance short-term and intermediate-term liquidity.
The opening of the Federal Home Loan Bank’s advance window to banks
has introduced the reality of “liability-based” liquidity
to a vastly increased number of financial institutions and to hordes
of bank regulators not conditioned to the use of borrowing power as part
of an institution’s liquidity policy. There can be no question
that the ability to borrow funds is an essential component of liquidity
for contemporary financial institutions.
Large and growing bank holding companies made aggressive use of wholesale
funds to meet their strategic goals of growth, feeding the ROE beast,
and managing their exposure to interest rate risk. The competitive environment
will force smaller financial institutions to use wholesale funding to
supplement retail deposits. Asset acquisition strategies of community
banks at the margin may be driven by these funding restrictions, since
the availability of funding from the FHLBank System is tied to mortgage-related
collateral.
The level of capitalization and even the extent of interest rate risk
that characterizes a particular savings institution’s balance sheet
may be easier to ascertain than the institution’s uses for and
sources of liquidity.
The determination of the proper level of liquidity is clearly and inextricably
entwined with both the strategic and tactical management policies of
an institution. A regulatory definition is absolutely the last measuring
rod that I would use for such an important function as liquidity.
Tom
Parliment is Managing Director of Farin & Associates.
Development
of liquidity policies is one of the topics discussed at the Seattle Bank’s
regularly scheduled Strategies for Success Workshops. The intensive two-and-a-half-day
workshops are
facilitated by Tom Parliment and include: an assessment of your institution’s
liquidity, capitalization, and interest rate strategies; pricing of assets
and liabilities using
marginal
cost analysis; and gauging the impact of asset and capital substitution
strategies. Sophisticated financial modeling is also used to assist you
in constructing strategies for increased profitability, ROE, and market
share.
For more information on the Strategies for Success Workshops, please
contact John Biestman or David Kidd.
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