Effective management of liquidity risk (i.e., the risk of not having sufficient liquid assets to meet short-term funding needs) requires close monitoring and modeling of short-term asset and funds flows.

Of the three major gauges of an institution’s financial statements—capitalization, interest-rate sensitivity, and liquidity—the latter is often the most difficult to quantify. In formulating their liquidity policies, management teams have typically relied on such generic indicators as:

• The relationship of liquid assets to volatile funds
• The proportion of liquid versus illiquid investments
• The ratio of loans to deposits

From the regulatory perspective, two key ratios have historically been used to assess liquidity. Both of these ratios are static and do not attempt to measure liquidity on a forward basis:

• A liquidity ratio compares the level of short-term funding to deposits and short-term liabilities. It is operationally defined as: (net cash + short-term and marketable assets + maturing loans) / (net deposits and short-term liabilities).
• A dependency ratio measures the extent of volatile liabilities within an institution’s funding base. It is operationally defined as: (volatile liabilities – short-term investments) / (total earning assets – short-term investments).

In this month’s issue of What Counts, we introduce the “liquidity risk ratio,” a new Tool for Success provided by Farin & Associates, Inc.

Rather than serving as a static measure of liquidity, the liquidity risk ratio is a forward-looking, cash flow-based projection of sources and uses of funds. Measured at three-, six-, nine-, and 12-month points in the future, the ratio is calculated by modeling the relationship of [maturing assets, scheduled and unscheduled loan/investment payments], and [unused borrowing capacity to deposit outflow, projected loan demand, and debt service].

We are pleased to provide links to various customized tools provided by Farin & Associates, which can assist in your effort to formulate an effective liquidity management policy:

• The detailed Liquidity Risk Management Model. The model produces three separate ratio calculations from the single input sheet. Inputs can easily be gathered from your institution’s call report or core system database. Detailed instructions are also included.
• A sample detailed Liquidity Management Policy that is tied to the information gathered from the Liquidity Risk Management Model.

Our Financial Advisory Services group is pleased to work with Seattle Bank members in formulating effective liquidity management policies. The subject of liquidity management is comprehensively addressed in our regular Strategies for Success workshops and in our ongoing work with members. Cash flow alignment and the laddering of liquid maturities are among the liquidity enhancement strategies that many of our members have implemented.

To evaluate your liquidity management policy, or assist you in using these liquidity management tools, feel free to contact John Biestman, 206.340.2473, or David Kidd, 206.340.2471.

John Biestman is assistant vice president, IMS consultative sales advisor, and David Kidd is assistant vice president, financial advisory services manager at the Federal Home Loan Bank of Seattle.

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