Illiquidity is a dangerous thing. Banks have failed because of it, and banking regulators have every reason to be concerned about it. Now that we all agree on that point, let’s talk about some of the recent regulatory comments, suggestions, requirements and mindsets concerning liquidity:
The Crystal Ball Fallacy: It seems that some regulators believe that if we work hard enough, we can create a crystal ball that will tell us whether we can survive the next liquidity crisis. The stress tests recently completed by the government on the nation’s top 19 banks seem to assume that the next worst case scenario can be described, even though no one was able to predict the current crisis. If banks had been running some flavor of stress testing or contingency funding model in August 2008, would it have been a reasonable indicator of the risks that they would face in September? Probably not, because we had never experienced a market meltdown like the one created by Lehman’s failure and the other events of that week. The significant problems we have cannot be solved at the same level of thinking with which we created them. (Einstein) No one has stepped forward to tell bankers how to stress liquidity or what measure is acceptable, but we must appear to be doing something…
Forward Looking Liquidity: Since the dawn of the FDIC Liquidity Ratio (which the FDIC has since disavowed), liquidity has been a point-in-time, slightly historical ratio. By the May board meeting, you would present and discuss the April 30 liquidity calculations and (perhaps) a historical liquidity trend. For most community banks, this was and still is sufficient, as most institutions don’t change rapidly and have plenty of time to detect liquidity trends and adjust funding plans accordingly. With the recent liquidity crisis, regulators have (correctly) observed that some banks have rapidly moving balance sheets that require additional forward-looking liquidity modeling. As with most regulatory thoughts, this one will now trickle down to all institutions, whether you need it or not.
Traditional accountants and CFOs like real (actual historical or current) numbers. Real numbers are accurate, can be balanced and don’t change. Many accountants get a bit squeamish when the annual planning process comes along, as it requires projections, estimations and significant uncertainty. Compared to the minor discomfort of annual budgeting or forecasting, forward liquidity calculations are downright gut wrenching. They require us to make assumptions about the most irrational and erratic of all creatures – humans. What will our loan originations and paydowns look like over the next 90 days? Will deposits increase or shrink? What will our competitors do to impact our market? Which securities will be called?
We have been developing a couple of forward liquidity models and have beta tested with a few clients. If you are scheduled for an exam soon, please let me know and we will help you get ready by deploying one of our models along with an updated Liquidity Policy.
Contingent Funding Planning (CFP) Policy: For those of you who don’t have enough policies to keep up with, here is another one that you will be expected to have in place for your next exam. Is liquidity during market disruptions important? Definitely. Can we identify, in general, the sources of liquidity that we have and which ones could go away at the worst possible time? Probably. Can we create a model that will address all possible events AND show that the bank will survive those events? No, because we can’t describe the next failure event any more accurately that we could have predicted the events of the last 18 months.
In the contingent funding modeling we have done thus far, the amount of data necessary to model reasonably and the assumptions required to come up with an answer make me question whether the output is worth (a) the effort and (b) the paper on which it is printed. We’ll keep working to come up with a simple model that provides reasonable outputs, but there is nothing simple about the combination of forward looking liquidity and hypothetical stress events. Like with #2 above, we intend to roll out our current CFP and model based on risk and exam schedules.
As Louisiana Office of Financial Institutions Chief Examiner Sid Seymour wrote recently, “We understand that some of our institutions are finding it somewhat difficult to perform comprehensive liquidity analysis and contingency planning as outlined in the expanded liquidity risk management guidance contained in Financial Institution Letter (FIL) 84-2008…” We have found that almost all banks are finding it hard to comply with FIL 84-2008, because it addresses complex issues that are changing rapidly. My best advice: read FIL 84-2008 (several times) and begin thinking about your exposures. Rest assured that we are working on a reasonable solution. I don’t want to rush anything, but I also don’t want you to go into your next exam without something in hand. Please let us know as soon as your next exam is scheduled so that we can help you prepare.
The Regulatory Mindset: The FDIC is scared. The deposit insurance fund is depleted, banks are failing faster than in previous economic contractions and Congress wants to know why the problems couldn’t have been averted. Where the FDIC once gave broad latitude to the OCC, OTS and state chartering agencies, now everyone else is expected to take a back seat to the almighty insurer. In the eyes of some field examiners (FDIC and others), anything abnormal is bad. If your bank is funded from nontraditional sources or invested in nontraditional assets, the presumption is that you have taken on excessive risk. Don’t let examiners make sweeping assumptions and penalize you for the way your bank is structured. Choose which battles are worth fighting, then stand up and defend your position. If the worst case is a 2 or 3 rating in liquidity and a composite 1 or 2, consider swallowing your medicine with a smile. If the concern might result in a composite 3 rating (and/or regulatory order) that you feel is undeserved, fight to the last man. You should know your bank better than someone who comes in for two weeks every 18 months. A disagreement, handled professionally, is an opportunity to show just how well you know how your bank behaves. We will be glad to join in your fight as appropriate, either on the front lines or behind the scenes.
