FHLBInsider

By Jeff Sanders, CFA, senior financial consultant.

Who can forget George Bailey’s heroic effort to resolve the liquidity crisis in "It’s a Wonderful Life?" Now the fear of a crowd of angry depositors has been replaced by the fear of angry stockholders demanding higher earnings. The chart below suggests many institutions retain high levels of liquid assets, relieving the fear of a run on deposits at the expense of potential earnings.

Part of the reason for high liquidity levels may be two common adequacy measures: the loans to deposits ratio and the volatile liability dependence measure. Liquidity decisions based on these two measures may be contrary to decisions from a risk/reward perspective. The following sections will describe weaknesses of the two measures and demonstrate a better framework for managing liquidity levels.

Liquid asset ratios by peer group

Loans to deposits

The loans to deposits ratio is commonly used to limit a bank’s investment in loans to a fraction of deposits. In theory, a lower ratio of loans to deposits (higher cash and investments) reduces the risk that a sudden loss of substantial deposits would compromise the ability to maintain the funding of the loan portfolio. Establishing an appropriate target ratio is a function of management judgment and experience.

This measure loses its reliability when wholesale funds are available. In general, banks can promptly replace lost deposits with borrowings or brokered CDs. Wholesale funding alleviates the concern about maintaining a particular level of deposits to cover the loan portfolio.

Volatile liabilities

A volatile liability dependence measure compares a bank’s level of short-term investment securities to volatile liabilities. Volatile liabilities are defined as short-term borrowed funds plus jumbo deposits. Presumably, a bank with more short-term securities than volatile liabilities minimizes the risk that the loss of volatile liabilities at maturity will deplete liquid assets.

The problem with this measure is that it assumes wholesale funds are a less reliable long-run funding source than retail CDs and core deposits. In this era of fierce competition for local deposits, seemingly stable core deposits might actually be where the risk of outflows is highest. The problem is magnified when deposits at promotional rates are excluded from the volatile liability side of the formula. Conversely, secured borrowings maturing within one year are considered volatile. Since renewing these borrowings depends on the collateral rather than on local depositor behavior, they are usually less volatile.

The decision process

The essence of liquidity management is the trade-off between adequate funds to cover predictable and unanticipated needs versus the opportunity cost of carrying lower yielding liquid assets. Decisions based on these traditional measures fail to consider other essential elements: expected cash inflows, other marketable assets, and borrowing capacity. Neglecting these will lead to overestimation of the funds needed to cover potential cash needs and thus reduce profitability.

A dynamic cash budgeting process, not just meeting ratios, should be the focus of liquidity management. Effective cash budgeting begins with projecting and balancing certain and probable cash flows. A contingency strategy must be adopted to address unexpected cash needs. Review of the cash budget and the contingency plan should help determine the minimum amount of liquid assets needed. Critical to success are identification of marketable assets and an estimation of funds available through external sources.

The FHLBI provides borrowing capacity reports to help our members estimate available funding. Also, the High Performance Tracking Report compares a member's liquidity position to that of highly profitable peers. Both reports are available on Member Link.

Profitability opportunities

Institutions with excess liquidity and excess loan demand can fund loans, reduce liquid assets, and boost earnings without changing the capital ratio. For example, an institution with 25% of its assets in securities could use better cash budgeting to safely reduce the balance to 10%. The table below illustrates the benefit of this strategy for an institution replacing securities at 6.0% with loans at 8.0%, assuming an 8.0% capital ratio and a 40% tax rate.

It may seem that funding excess loan demand with borrowings would be more profitable than liquidating securities. If the cost of borrowing exceeds the yield on the security being replaced, it is more profitable to liquidate the investments than to borrow. Borrowing becomes profitable once all excess securities with yields below the borrowing rate have been used. However, growth-related issues, such as capital adequacy, emerge at this point.

Institutions carrying additional liquid assets throughout the year to cover seasonal outflows may replace the additional securities with loans and borrow to cover the periodic additional cash need. The benefit of this strategy depends on investment yields, borrowing costs, the duration of the seasonal need, and the capacity for additional assets.

Conclusion

Average liquidity ratios suggest that some members may be carrying unneeded low-yielding assets, perhaps at the expense of stockholders. Unlike George Bailey, these institutions do not have Hollywood script writers to formulate a "happily ever after" ending. However, the staff of the FHLBI can discuss the role of advances in improving the earning power of your balance sheet.

Copyright 1999, Federal Home Loan Bank of Indianapolis