Communicator Archives: August 2001

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Communicating Liquidity Risk to Your Board

The financial services industry has become infinitely more complex over the past few decades making it imperative that directors have a clear understanding of the bank's risk position and the impact of that risk on bank performance.

A bank's board needs accurate and timely reports in order to manage risk to the institution. This article will focus on liquidity risk and what your board needs to know.

When evaluating liquidity, the board needs to look at the current level as well as contingency plans in order to determine if funding is adequate. What are the current sources of funding? Can the bank handle changes in funding sources? What is the cost associated with the current and contingent funding sources? Can the bank liquidate assets with minimal loss?

Directors need to review the following standardized liquidity ratios quarterly:
Loans/Deposits-To what extent does the bank rely on core deposits to fund loans? Demand and savings accounts, NOW accounts, money market accounts and time deposits of less than $100,000 are all considered "core deposits".

Short-Term Investments/Total Assets-Short-term investments are assets such as federal funds sold, repurchase agreements and debt securities with a remaining maturity of 1 year or less. This measurement gives a percentage of assets that can be readily converted into cash.

Volatile Liability Dependence, Non-core Funding Dependence and Short-Term Non-Core Funding Dependence-More specific measures to assess the degree of exposure to risk associated with funding long term assets with short tem liabilities.

Purchased Funds to Earning Assets-This ratio measures the bank's reliance on price sensitive markets.

With a clear understanding of what these figures represent, (specific calculations and definitions are given in A/L Benchmarks Board Report), directors need to be on the lookout for the following red flags in liquidity measures:

• Increases in reliance on non-core funding
• Increases in borrowings
• Funding mismatches (short-term liabilities funding long term assets or long-term liabilities funding short-term assets)
• Decline of core deposits
• Increases in cost of funds
• Decreases in short term investments

In summary, directors must have accurate and timely financial information in order to assume their fiduciary responsibility effectively. A/L Benchmarks Board Report was designed to assist directors in this task.

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Adams Financial Software
Allfirst Bank
Coastal Securities
Digital Visions, Inc. (PortPro)
Finser Corporation
First Tennessee
First National Banker's Bank (Baton Rouge, LA)
Griffin,Kubik,Stephens,& Thompson
Heber Fuger Wendin
Morgan Keegan & Company
National City
U.S. Bancorp Piper Jaffray
Vining Sparks

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A bank that is experiencing an influx of deposits needs to look at the types of new deposits. Are the new funds money market accounts that are extremely price sensitive or are they two plus year certificate of deposits that may lock the bank into an unattractive rate as rates are generally falling?

In addition, how are the new funds being used? If you match short-term deposits with short-term investments, you will see little to no spread. However, using long-term investments increases your risk in a rising rate environment. Management must balance the risk with the anticipated return and simultaneously be prepared for the new funds to be "called back" with relatively short notice.

In summary, while some community banks are experiencing an ease in short-term liquidity risk, one cannot neglect the possibility of increased risk to earnings, volatile interest rates, and the possibility that the short-term easing will be reversed.

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