“Success depends upon previous preparation, and without such preparation, there is sure to be failure.” – Confucius
This quote felt particularly relevant when considering recent discussions I’ve had with clients and colleagues on the liquidity front. Within the halls of DCG, the phrase “March Madness” has not only applied to the NCAA basketball tournament, but more specifically to the run on deposits and failure of Silicon Valley Bank (and ultimately others) that occurred in early 2023. We are now a year removed from the banking version of March Madness, and the ripple effects from those events are still being felt.
Liquidity was at the forefront of discussions then and remains a primary focus for management teams, boards, and especially regulators today. With another large bank in the recent headlines, questions regarding an institution’s ability to adequately fund itself are in focus once again. What if the issues this institution is experiencing (albeit credit-related) cascade into negative press and ultimately deposit runoff? Could this create systemic issues?
While we could debate the probability of this hypothetical scenario, the bigger question remains: is the industry prepared to handle what could potentially unfold?
Although institutions may not need the liquidity presently, understanding potential responses in a stressed environment, available sources of liquidity, and how quickly one may draw on them are all keys to successfully preparing for a liquidity event.
As with anything in life, preparation is foundational to success, and financial institutions must be prepared to tell their story.
From the Editor
Prior to the 2024 Masters golf tournament, Scottie Scheffler, the world’s number one ranked golfer and prohibitive favorite, was asked how he handles the pressure of playing in the preeminent event on the golfing calendar.
His response: “When I step up onto the tee at a tournament, my thought process is always about my preparation. I just remind myself: I’ve done the work. I’ve done everything I could. I’ve checked all the boxes.”
The comfort in knowing he has prepared his game for every type of shot Augusta National Golf Club requires of its champions actually “enhances his focus” (his words).
In many regards, Scheffler’s preparation is no different from successful financial institutions who have “teed” it up with depositors throughout this Federal Reserve hiking cycle. Those who were prepared for the influence of significantly higher interest rates on their liquidity profiles have “scored” better than those who instead tried to work out their approach on the “driving range” prior to their “round.”
In this month’s Bulletin, DCG Director Joe Bona writes about the critical importance of liquidity preparation. Specifically, Joe shares five discussions that should have already occurred during your ALCO meetings. Joe encourages management teams to have honest conversations about operating liquidity, additional funding resources, FHLB capacities, forecasting, and stress testing.
Ultimately, the success of your organization relies on the work you’re putting in now. Hopefully, Joe’s recommendations will enable your organization to “do everything it can” and “check all the liquidity boxes” during 2024.
Vinny Clevenger, Managing Director
Here are five liquidity discussions that should have already taken place within your organization.
1. Operational Liquidity versus Contingent Liquidity
Post March Madness, it seems as though the line between operational and contingent liquidity has been clouded. I encourage groups to work to re-establish that line.
What is the definition of operational liquidity? Some groups will refer to their loan-to-deposit or loan-to-asset ratios, while others utilize a collateral-based approach such as the Basic Surplus. How do you define it?
What resources would you consider using from an operational standpoint? How does your group view Federal Home Loan Bank (FHLB) Borrowings, Federal Reserve Bank (FRB) Borrowings, Brokered Deposits, and Listing Service Deposits?
What do your day-to-day business needs look like? Are you looking at expectations on a daily / weekly / monthly / quarterly horizon? How much cash should you be carrying on your balance sheet? DCG is hearing that most examiners are looking for policy minimum levels as in relation to on-balance sheet liquidity limits.
Your ability to answer these questions can provide guidance as you craft your definition of operational liquidity.
From a contingent liquidity perspective, what types of events would you classify as more stressful and trigger a heightened response? How does your overall liquidity position compare to uninsured deposit levels? What is a reasonable amount of contingent liquidity to have access to? How does that differ from an operational standpoint? Institutions should outline examples of events that would trigger a greater response in a Contingency Funding Plan.
2. Access to the Federal Reserve Bank
Has your team set up the ability to borrow from the Federal Reserve Bank? In July of 2023, an interagency release updated guidance around liquidity risks and contingency planning. The revised guidance encouraged groups to include the discount window in contingency funding plans, and recent dialogues have worked to “de-stigmatize” borrowing from the FRB.
The release also referenced the importance of periodically testing contingency funding sources and understanding the necessary steps to access the funding. This serves as a good reminder that this exercise isn’t about satisfying some regulatory requirement / best practice; instead, it’s about preparing your institution for a scenario in which funding may be needed quickly.
More and more groups have worked to gain access to borrow at the FRB, with a goal of diversifying their liquidity options. Having the ability to access the FRB is a key component of contingency funding, as noted by the regulators.
When reviewing whether it is worth going through the process of setting up access, consider a comparison to home insurance: homeowners want to have everything squared away and in place before there is a potential loss. It is not a flip of the switch to be set up at the FRB. It takes time, and the funding is something an institution may want to use on short notice.
3. Could there be changes on the horizon for the Federal Home Loan Bank System?
In November of 2023, the Federal Housing Finance Agency (FHFA) released its FHLBank System at 100: Focusing on the Future report, which describes a vision of the FHLB of the future while suggesting the potential for change.
The report highlights that due to operational and financing limitations, the FHLB does not intend to be the “lender of last resort.” Instead, the FHLB encourages members to set up capacity at the FRB. Perhaps the catalyst was the significant spike in borrowing levels from March Madness. At that time, institutions utilized the FHLB to add additional liquidity (insurance) in case the events unfolding turned out to be systemic (see FRED chart below highlighting borrowings at all commercial banks dating back to early 2023).
The report also highlighted that the FHLBanks’ model of providing liquidity in the future will be accompanied by a thorough and frequent credit evaluation.
While the FHLB has always been a foundational piece of the funding puzzle for banks and credit unions, the report emphasized the importance of collateral management and having multiple resources set up and available should the need arise from a liquidity standpoint (i.e., at a minimum, incorporating the FRB into liquidity management process).
DCG encourages all institutions to review the report and to reach out to your FHLB representative to discuss any questions.
4. Cash Flow Forecasting
Recent feedback from examiners has included changed expectations for liquidity forecasting and stress testing. Forecasting 90 days out is no longer sufficient.
Daily, weekly, monthly forecasts should replace (or augment) the traditional 30/60/90-day forecasts. Clearly, the period over which an institution needs to demonstrate an ability to meet funding demands has rapidly accelerated.
With forward outlooks, it is important to consider key components such as prepay/amortization amounts and upcoming maturities, and how these relate to new production/flows. Not only should institutions review positions under a “baseline” scenario, they should also consider stress testing on top of that. Incorporating this dialogue into ALCO discussion and minutes from meetings is critical.
The time to increase the frequency of liquidity forecasting (and more regularly review the assumption process) is now. The days of being able to “talk your way out of it” with regulators are over.
5. Stress Testing
The specific stress tests that institutions are running and reviewing have come under the microscope over the last year. Examiners are raising questions around the specific scenarios run and have asked what adaptations have been made to previous stress testing processes for liquidity positions. In response, many groups have worked to adjust the scenarios they run and review regularly.
Do you build in current balance sheet expectations for the coming year? What type of stress events are you incorporating? Are they relevant to the current environment and reasonable? Are you reviewing the impact of shifts/migration from the deposit base? What types of events would cause you to lose access to specific liquidity channels?
As highlighted in the July 2023 interagency guidance, contingency plans must account for a variety of stress scenarios. As current conditions continue to evolve, the scenarios need to be reviewed and altered as necessary. It is best practice to model out the stress scenario versus attempting to talk to it.
Lastly, the management team should create planned responses to potential stress scenarios. The responses should include the levers you would pull for relief, and document the anticipated repercussions to other metrics you closely track. Post-Silicon Valley Bank failure, the interconnectedness of Liquidity, Capital, and Interest Rate Risk management has been further magnified.
If you didn’t have the discussion “yesterday,” how about “tomorrow?”
When considering the initial quote from Confucius, in the face of a challenging situation or environment, it’s important to remember preparation’s role in success.
Although you may not need liquidity today, most institutions don’t exactly have much to spare either when it comes to their current liquidity profiles. The time to nail down these five discussion items was yesterday – or tomorrow!
For more insights from Darling Consulting Group, click here.
Joe Bona is a Director at Darling Consulting Group. In his role, he assists banks and credit unions of all sizes throughout the country with asset/liability management. He works with management teams to develop institution-specific strategies to improve financial performance while effectively managing interest rate risk, liquidity, and capital through the ever-changing economic and regulatory environment.
Joe began his career at DCG in 2015 as a financial analyst. He earned a B.S. in business administration from Bryant University.
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