Managing Liquidity Risk in a Near-Zero Environment

New Focus on Liquidity Risk
The regulatory authorities have made clear their intention to highlight liquidity risk management as a point of focus in the wake of financial market turmoil. The FDIC states that “Recent disruptions in the credit and capital markets have exposed weaknesses in liquidity risk measurement and management systems.” Among other things, specific mention is made of banks that rely on “liability-based” funding strategies or those that have “other complex liquidity risk exposures.” These institutions should use dynamic cash flow analysis to monitor their liquidity exposures and should have contingency funding plans. Considering the fact that most banks today rely at least in part on wholesale sources of funding, this is an important development indeed. Moreover, in the new market environment where deflation is a threat and near-zero fed funds are the policy, how should banks view liquidity risk and what strategies should they pursue?

Pro forma Cash Flows and a Contingency Funding Plan (CFP)
Liability-based funding strategies and reliance on wholesale sources of deposits potentially raise the balance sheet risk profile of banks that do not have adequate tools for monitoring scenario cash flows. These banks need cash flow analyses that simulate multiple scenarios in order to show an institution's projected exposures and potential funding shortfalls or gaps. A good asset/liability management reporting system should incorporate these simulations. This sort of dynamic cash flow monitoring helps institutions develop forward-looking strategies that work to limit their liquidity exposures. Banks should also develop a contingency funding plan if they do not currently have one.

This is a plan which comports with the liquidity risk profile of the institution and lists potential liquidity events that could result in problems. These events could be market oriented and only indirectly related to the bank, or they may involve issues specific to the institutions.

Investments and Liquidity: Managing in a Near-Zero Environment
The current market environment calls for a reassessment of the investment portfolio and its purpose within the context of the overall balance sheet. Banks traditionally used the investment portfolio as a store of liquidity. In recent years though, banks were seduced by higher yielding bonds such as private label CDOs, CMOs, and the like. Many of those bonds are now suffering from a serious lack of marketability. It may make sense then for banks to revisit the role of the investment portfolio as a vehicle for managing liquidity. Banks should focus primarily on high grade bonds issued by the US Treasury, government sponsored enterprises, or municipalities. These bond types are highly marketable and provide the sort of flexibility that is needed to properly utilize the portfolio as a vehicle for managing overall liquidity.

Strategies for Deflation
An interesting development in the current environment is the prospect of deflation and the potential effects on portfolio dynamics. If in fact deflation is forthcoming, banks should keep investable assets deployed. They should not get “frozen in the headlights.” Deflation makes a fixed income yield rise in value... not in terms of price necessarily, but the real (deflation-adjusted) return rises as dollars gain purchasing power. In other words, whereas investors normally see their obligations cheapened in an inflationary environment, deflation does the opposite. Fixed-income cash flows, even at low nominal rates, are more valuable in a deflationary environment than during inflation. This is precisely when you want to own bonds. Banks should keep assets working, locking in yield on quality bonds. In our view, idle cash is a big mistake right now. Liquidity and marketability are important and must be managed within the context of optimal macro money-management. Right now that means banks should buy quality bonds and build a flexible portfolio that optimizes yield within a sound framework of liquidity risk management and balance sheet considerations.

Borrowings and Scenario Cash Flow Analysis
From a liquidity management standpoint, the ability to monitor the scenario dynamics of balance sheet cash flows is extremely important. Projected cash flows under the existing rate environment are a necessary starting point, but must be supplemented by additional projections for different rate scenarios. We know that portfolios that contain callable bonds and/or MBS will experience faster cash flows when rates fall and slower cash flows when rates rise. This asymmetry of cash flows and the degree to which those cash flows are uncertain needs to be calculated and reflected in an analytic reporting model. Similarly, borrowings such as Federal Home Loan Bank advances need to be accurately measured and reported within a scenario analysis, particularly if they contain options or amortization structures.

Liquidity risk management is obviously important in today’s environment from both a regulatory standpoint and from the perspective of prudent bank management. Having the right processes, tools, and management practices in place will help the bank maintain healthy performance and an optimal risk/reward profile.

Jeffrey F. Caughron is an associate partner at The Baker Group.