Liquidity – How Much is Enough? by Stephen Curry

Liquidity is a critical component of a bank's financial stability, impacting its ability to meet short-term financial obligations and weather unforeseen economic challenges. The ideal level of liquidity for a bank is influenced by a multitude of factors, including its size, business model, risk tolerance, and regulatory obligations. This article explores the dynamic world of bank liquidity and the key ratios that regulators and financial institutions closely monitor to ensure sound financial management.

Traditionally, banks have relied on local retail deposits (transaction and savings accounts) to support asset growth. Funding dynamics at all banks – community, midsize, and large banks – however, have evolved rapidly in the last few years and are the most interest rate and event sensitive since the 1980s. In the last year, funding dynamics and counterparty risks have evolved significantly, emphasizing the importance of robust liquidity management.

Today, bank regulators are focusing on sources of liquidity, coverage of forecasted cash flows, quality of liquid assets to meet operating risk, and a bank’s ability to generate liquidity to cover event risks such as unplanned deposit outflows and other high impact stress scenarios. The high cost of deposit funding, and the difficulties of accessing long-term debt and equity markets is driving the scrutiny of on-balance sheet liquidity.

Two key liquidity calculations are the current focus of regulators:

1) The Liquidity Coverage Ratio (LCR) measures a bank's ability to cover liquidity needs as time passes. It compares High-Quality Liquid Assets (HQLA) to projected Total Net Cash Outflows over 30 days. Maintaining an LCR of at least 110% is recommended, with values below 100% triggering Contingency Funding Plan actions.

LCR = HQLA / Total Net Cash Outflows

Best practices is to maintain a ratio of 110%; less than 100% should trigger a Contingency Funding Plan action.

Cash flow modeling is complex, and we have taken a very high-level approach here just to highlight how this should work. Basel III guidance for banks with assets greater than $100 billion stipulate uniform assumptions about cash outflow rates for major deposit categories and require capping inflows at 75% of forecasted cash outflows to ensure a minimum HQLA buffer is available to cover some outflows (thereby maintaining a 25% of the forecasted net cash outflow as a “buffer”). Cash inflows only include contractual inflows, including principal and interest payments, from exposures that are fully performing and for which the bank has no reason to expect a default within the 30-day time horizon. Contingent inflows are not included in total net cash inflows.

For smaller banks less than $100 billion in total assets, simulating liquidity coverage and the availability of high-quality liquid assets can be accomplished through stress testing of cash outflow scenarios. One such example especially pertinent after the collapse of larger banks includes stressing liquidity levels and coverage with discrete cash outflow scenarios such as accelerated decay (or run-off rates) of non-maturity deposits, particularly uninsured deposits, and large depositor balances. Liquidity levels and stress scenarios for cash inflows should include a forced sale of AFS securities and the resulting estimated proceeds when this action is required from triggering an action in the Contingency Funding Plan and to meet cash outflows.

2) On Hand Liquidity Ratio: This point-in-time ratio, often called the Primary Liquidity Ratio, assesses a bank's ability to satisfy liabilities with on-balance sheet high-quality liquid assets (HQLA). A minimum of 25% is recommended, with less than 15% warranting a Contingency Funding Plan action.

Components of HQLA: HQLA includes cash in interest-bearing accounts, fed funds sold, reverse repos, and select investment portfolio securities. Note that not all securities are considered HQLA.

On Hand Liquidity Ratio = HQLA/Total Liabilities

HQLA (sometimes referred to as net liquid assets) is comprised primarily of the sum of cash in interest bearing accounts + fed funds sold + reverse repos + securities (available for sale securities at market value) - fed funds purchased - repos - pledged securities. Essentially, a bank should have the ability to calculate all of its collateral positions, including the value of assets currently pledged relative to the amount of security required and unencumbered assets available to be pledged. Fundamentally, the cash flow volatility of assets and how quickly they can be converted to cash without incurring unacceptable loss form the basis for evaluating the liquidity contained in a bank’s asset base.

When evaluating your liquidity, the asset type is critical and often a subject of confusion amongst many banks. For example, net High Quality Liquid Assets should not include securities that have been classified as Held to Maturity (HTM) unless first reclassified to Available for Sale and marked to market (if HTM securities are included, there is a significant risk of tainting the HTM accounting at book value election). Securities that have been pledged, either to the Federal Reserve’s BTFP or Cash Window, or pledged to the FHLB also cannot count. There are also subtleties for certain other securities – ex: agency securities like Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Farm Credit System, and FHLB are considered Level 2A securities (per Basel III) and are discounted by 15%. Investment grade corporate debt and investment grade municipal obligations are haircut 50%.

Off balance sheet, liquidity like undrawn lines do not count towards the Liquidity Ratio but are instead considered Contingent Funding Sources. These are secondary sources of liquidity, thus not included in the primary liquidity ratio.

Cash can be complex too; vault cash to meet daily operating needs does not count, but excess vault cash can. Balances which are temporary and essentially “Due To” balances, such as intraday settlement and clearing balances and cash and coin in transit to clients, do not count toward liquidity either.

Two key funding ratios also bear on how liquidity can be raised:

1) Net Non-Core Funding Dependence Ratio ($250K): This is measure of a bank’s non-core liabilities less short-term investments compared to its long-term assets. Defined using deposit insurance limits for time deposits.

Non-core liabilities comprised of time deposits >$250K + other borrowed money + foreign office deposits + repos + fed funds purchased + brokered deposits (to the extent not already added-in).

Short-term investments comprised of interest-bearing bank balances + fed funds sold + reverse repos + debt securities with a remaining maturity of one year or less.

Long-term assets comprised of net loans and leases (both held for investment and held for sale) + securities (AFS and HTM, but with remaining maturity >1 year) + other real estate owned (non-investment).

Best practices is to maintain a dependency ratio of less than 20%. Greater than 20% should trigger action to diversify funding sources and/or increase short term investments.

2) Reliance on Wholesale Funding Ratio: This ratio measures the percentage of a bank’s total funding from wholesale sources.

Wholesale Funding is defined as the sum of brokered deposits, fed funds, repos, and other borrowed money which includes FHLB advances.

Brokered deposits have been the subject of controversy given the regulatory treatment. Many believe they should be treated as core deposits. However, the primary concern from the regulators is not simply that these deposits are transient and rate sensitive, but also that the brokered market is becoming volatile and event sensitive. Brokered deposits may not be readily available at a reasonable price when the bank needs them most. Also, brokered deposits and wholesale funding are sensitive to the financial and regulatory condition of the bank. Thus, regulators are limiting reliance on brokered deposits and other types of wholesale funding.

This ratio is defined as brokered deposits + borrowed money divided by total funding sources which is borrowed money plus total deposits.

Best practices is to maintain a ratio under 15%, and a hard limit of 30%.

In conclusion, while there's no universal formula for determining the right level of liquidity for banks, these guidelines are crucial for managing liquidity effectively. Banks must consider their unique circumstances, business models, and counterparties to maintain financial stability during times of uncertainty when liquidity is at a premium.

This has been a topic that has generated extensive regulatory criticisms in many recent bank examinations, a trend which is likely to accelerate in 2023. Expect to see continued regulatory actions in the form of MRIAs, MRBAs, MOUs and Consent Orders in both 2023 and 2024. An experienced advisory firm like ours can help you tackle these challenges.

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