The “Proposed Interagency Guidance – Funding and Liquidity Risk” was issued by the FDIC, OCC, OTS, NCUA and the Federal Reserve on 7/6/09. The comment period ends on 9/4/09. With everything else going on in the industry, you may have not taken the time to read this proposal. It needs to be better organized and some of the redundancy needs to be cleaned up. I’ve provided a link to the document. Read it with a cup of coffee in the morning, rather than a cocktail in the evening. You need a sharp mind to work through this document.
It leads off by indicating that the proposed guidance represents a consolidation of material already issued by the individual agencies as well as some of the International Basel Committee work on the funds management and liquidity. I haven’t taken the time to cross check this document against already issued sources to verify that statement. But assuming it is what they say, we are likely to see it morph into a final guidance document relatively quickly. It will happen quickly because:
- Much of it is already out there in individual agency documents.
- It addresses some of the liquidity problems that exist in the industry brought on by contingency event triggers like falling below well capitalized minimums.
- It puts additional strength behind the field examiner push to reduce reliance on alternative funding sources like brokered CDs.
It is a very significant document in a number of other important ways:
It is the result of an interagency collaboration. It means that in liquidity risk management we will see a consistent approach being taken by all five regulatory agencies. As such, it is a sign of things to come. While we may not emerge from the current financial crisis with a single regulatory agency, we are likely to see consistent approaches to a variety of issues from the agencies.
I expect as the move in the direction of Basel II continues; we will see a consistent set of risk based capital regulations across all agencies. That is a sharp contrast to the current environment where credit union capital standards are significantly different than bank and thrift capital standards.
I expect the same to happen with interest rate risk measurement and management. Most of the regulations and guidance on interest rate risk from the individual agencies haven’t been updated for a while – and sorely need to be updated for reasons I’ll get into a bit later. Inconsistency is the norm here. For example, why does NCUA measure value at risk using NEV, while banks use EVE, and thrifts use NPV – when all three have the same fundamental meaning? Why are credit unions asked to consider ‘plausible changes in rates’ to be an immediate and permanent 300 bp shock, when banks and thrifts use a 200 bp shock?
I could take this discussion of inconsistencies a lot further, but I sense I’ve made my point. The Basel Committee was charged with providing a level playing field between financial institutions internationally. We haven’t even accomplished this goal in the U.S. between our own regulated financial institutions. But that, I feel, is about to change.
The document significantly raises the bar on liquidity risk management. Examinations of policies, procedures, authorities, software infrastructure, scenario testing, stress testing, assumptions, auditing, and support, are going to be as significant for liquidity risk, as what we are used to seeing with interest rate risk. It is going to cost you money and time to react.
But here’s possibly the most significant message; There is a very strong undercurrent in this document that liquidity risk is a byproduct of: (a) your current balance sheet structure, (b) the business strategy you are attempting to execute, and (c) events that you never expected to occur (both within your institution and in the economy) that trigger liquidity needs for not considered in your base business plan.
Let me put it a different way. The primary focus of liquidity management has moved forever away from static liquidity measures (loan/deposits, dependency ratios, etc.) and in the direction of dynamic tools like sources and uses of funds, funding gap analysis, and contingency funding plans. Along the way, the ball has been thrown directly into your side of the court to effectively measure and monitor liquidity in the context of your business plan, including unexpected contingencies.
Why is this so significant? Because the same thing is likely to happen (and needs to happen) with interest rate risk analysis. Currently, value at risk analysis (NEV, NPV, EVE) is performed by applying immediate and permanent shocks to existing balance sheets. Nowhere do the guidelines from the various agencies suggest the same stress tests should be performed on forecast balance sheets that exist at the end of a business planning period. So value at risk analysis is still firmly mired in the static analysis world.
Many of the individual agency guidelines suggest institutions might consider modeling business strategies through multiple rate environments to test the effect of changes in rates on income in the dynamics of a business plan. Yet in the field, many examiners are still asking for analysis of income at risk for 1-2 year horizons where the balance sheet is held constant throughout the forecast. So a potentially dynamic measure of income at risk analysis is reduced to a static analysis by holding the balance sheet constant.
Does it make sense to plan for and analyze liquidity risk in a dynamic world but continue to focus interest rate risk on static analysis? No it doesn’t, and that needs to change. And I expect that it will. In a separate blog post you will see the comment letter I wrote in response to the “Proposed Interagency Guidance – Funding and Liquidity Risk”. The comment letter specifically addresses this issue.
Aside from the inconsistency between guidance on interest rate risk and liquidity risk, does the Funding and Liquidity Risk Guidance touch all the bases? Should you use it as the complete framework for implementing your liquidity risk management program? I see one major hole in the document. That hole is also discussed in the comment letter and below.
I think everyone involved in banking would agree that core deposits are the most important and most desirable source of funds to a financial institution. Read through the funding and liquidity risk guidance document. If you ignore all the structural stuff – policy statements, lines of authority, measurement systems, reporting frequency, etc. – you will find the primary focus is on asset-based liquidity and the use of alternative funding sources. There is very little discussion of core deposit growth and retention strategies, core deposit analysis tools, and other aspects of using your most important funding source effectively both as part of your base liquidity program, and in response to the triggering events that throw you into contingency funding mode. If I was building a liquidity policy statement, management system, and reporting system, the most important component would be my plan for retaining and growing core deposits as well as how my behavior would change under different contingency events. My core deposit growth component of my liquidity plan would describe the structure of my core deposits and my product design process including the use of segmentation strategies. It would discuss the tools I use in making effective deposit pricing decisions including benchmark rates, marginal cost, and tracking systems. It would describe the process I use to evaluate the effectiveness of past strategies and how I modify those strategies in response to my financial condition, my needs for liquidity, market conditions, competitive initiatives, and the like. It would discuss the criteria I use in deciding whether to raise deposits or access wholesale funds.
I can hear it now, “Farin, what you are suggesting adds to a regulatory burden which is already too heavy to bear.” OK, I hear you. But in my experience, an effective core deposit growth and retention strategy is capable of doing some combination of two things. (1) It can increase the growth rate of core deposits without materially increasing average funding costs. (2) It can retain your existing core deposit base while lowering your average cost of funds 20-30 bp. Because many of you are currently in a no-growth mode, let’s examine the second option. 20 basis points on a $100 million institution is $200 thousand of expense reduction per year. On a $1 billion institution, the expense reduction is $2 million a year.
“But, Farin, would it save me that much?” Yes, in most cases. “Why?” Because almost none of the financial institutions I’ve visited have taken the time to develop an effective (retention and growth) and efficient (cost of funds management) core funding strategy.
That cost savings from an effective core deposit retention and growth strategy can cover a very significant regulatory compliance expense and leave plenty of money in your pocket. So even if the regulatory guidance doesn’t address core funding adequately, I’d incorporate a strong core deposit component in my liquidity policy and process which should lead to better performance, more than covering your compliance cost in the process. Of course, most of you will need to build the strategy before it is placed in your liquidity plan. We can help!
In addition to the cost savings from an effective core funding strategy, there is potential for additional net interest margin gains from an upgraded interest rate risk and liquidity management process. Static measures of interest rate risk fail to provide a framework for effectively evaluating risk/return tradeoffs between alternative interest rate risk strategies. A movement to a dynamic framework for managing both interest rate risk and liquidity risk would allow an institution to model a proposed strategy through multiple rate environments, concurrently evaluating the effect on interest rate risk, liquidity risk, capital risk, and return. By modeling additional strategies and comparing results, you will be able to more effectively optimize the relationships between various sources of risk and return. In the process, you have the potential to earn far more than your cost of compliance. Pile the risk/return cost savings on top of those gained through an effective core deposit strategy!
I didn’t see anything in regulatory guidance, existing or proposed, that prohibits you from upgrading interest rate risk measurement and management from static to dynamic to match the changes required by the emerging liquidity guidance. Yes, you may need to run some static income at risk and value at risk reports to satisfy your examiner over the short haul. But you are likely to get higher grades for your interest rate risk process if you are ahead of the game rather than at the minimum required by the game. Doing it for yourself will also help you gaining the insight to prepare a better business plan.
In the last decade, there has a significant movement in interest rate risk modeling away from in house models and in the direction of outsourced analysis and regulatory reporting. Farin offers both, so you might assume we are indifferent about which approach you take. The low-end outsource providers focus on providing analysis and reports that meet minimum regulatory requirements. Much of the analysis is static in nature. I can certainly understand from an operating expense standpoint why an institution might make that decision. I can hear some of you saying to me, “We did it to improve our efficiency ratio, Farin.”
I just taught Bank Performance Analysis to around 175 first year students at the Graduate School of Banking at Wisconsin. The BPA track included a discussion of the efficiency ratio which measures, “how much it costs us to make a buck.” The efficiency ratio is calculated by placing operating expenses in the numerator and the sum of non-interest income and net interest income in the denominator. If you can reduce operating expenses without affecting non-interest income or net interest income, your efficiency ratio will improve. However, if in the process of outsourcing interest rate risk analysis you lose the opportunity to optimize net interest income, the reduction in operating expense (numerator), could be more than offset by a reduction in net interest income (denominator). That could cause the efficiency ratio (“how much it costs us to make a buck”) to increase rather than decrease.
I have a feeling that when all the dust settles, the trend moving interest rate risk analysis in the direction of low cost outsource vendors will reverse itself. It will happen as CFOs and CEOs come to realize that their interest rate risk and liquidity processes need to be dynamic rather than static. It will happen when they tire of continuing to see erosion on the bread and butter source of profitability, net interest income. It will happen when they realize that the operating expense savings from a low cost outsource solution are a false economy.
The beneficiaries will be firms that offer in-house models, higher end outsource solutions that include consulting services and those that work with institutions on developing effective core deposit growth and retention strategies. Organizations that offer education on optimizing the relationship between risk and return will also see a growth in business. I like the position we are in as a firm when that trend begins to happen. Want to talk about it? Give us a call.
Of course, you can experience some of what we have to offer at no cost at all. In this blog we previously announced a series of three 90 minute webinars that kicks off with a free deposit webinar on September 28. Within 24 hours of announcing the deposit webinar we had over 70 registrations. You might want to check it out.
