The “Proposed Interagency Guidance – Funding and Interest Rate Risk Management” provides guidance on a very crucial issue – liquidity risk management. I believe the guidance addresses many critical issues institutions should deal with when developing a liquidity strategy, liquidity policy statement, and contingency funding plan. Hopefully the final version will be better organized and reduce some of the redundancy within the document.
In the review I see two major gaps that need to be addressed.
- Development and documentation of core deposit strategies, both as a normal part of a liquidity plan and as an important component of a contingency funding plan, and
- Guidance on the risk/risk relationships between liquidity risk, interest rate risk, capital risk, operations risk, reputation risk, and credit risk, along with a discussion about the relationships between risk and return
Of these two, I consider the core deposit strategies gap to be the more significant.
Core Deposit Strategies
I think we all agree that core deposits are the most important and desirable source of funds available to insured financial institutions when meeting liquidity needs. Yet, when you read through the guidance document, the majority of the non-framework content is focused on alternative sources of funding and asset based liquidity. There is little mention of management of the core deposit base.
Looking back over the last few decades, it is obvious that portfolio loans have outgrown core deposits across the industry. Much of that growth mismatch is a byproduct of an aging certificate of deposit base. In most shops, balance weighted age of CD holders in well into their 70s. As that wealth transfers to Gen X, Gen Y and Boomers, it is not likely to go into financial institution CDs. They are the mutual fund generations, and are much more likely to invest in the mutual fund industry than in financial institution CDs. To the extent loans outgrew deposits in the last two decades, the gap was funded by reducing the size of the investment portfolio, through securitization and sale of loans, and by increasing the use of non-core funding, particularly that from alternative funding sources like the FHLB and brokered CDs. All of these tactics raise liquidity issues.
While asset-based liquidity is stronger in most financial institutions today than a few years ago, the strengthening is primarily a byproduct of lessening demand for quality loans and an infusion of ‘flight to safety’ funds into deposit accounts – both brought on by the current recession.
When the economy rebounds, loan demand will strengthen and it is likely much of the ‘flight to safety funding’ will return to the markets. We’ll be back in the same liquidity crunch we experienced a few years ago. At the present time there is tremendous regulatory pressure being placed on institutions to reduce their reliance on brokered CDs and FHLB advances, which are the two largest sources of alternative funding to the industry. I understand where regulators are coming from in applying this pressure. The question is, “Where will institutions find core funding to replace non-core funding resources?” Across the industry there is some potential for addressing this problem over the short-term as core deposits have been outgrowing loans during the current recession. But I’m much more pessimistic about the ability of the industry to reduce its reliance on non-core funding over the long haul.
Now let’s take this issue down to the individual financial institution level, the level at which the guidance is directed. Individual institutions need to do a much better job in developing and implementing core deposit growth and acquisition strategies than they have in the past. While the industry may suffer from a lack of core funding growth, individual institutions with best practices funding processes may not. Those institutions wishing to implement upgraded core deposit acquisition and retention strategies need to focus on three key components:
- Implementation of a deposit pricing and acquisition process, as opposed to the prevalent current practice of “sticking your head out the window, looking up and down the street at competitive rates, and pricing off your competition.” These processes are a combination of upgrading product offerings and developing effective deposit pricing strategies. Pricing is the most powerful ALCO tool at an institution’s disposal as it affects more earning assets and non-capital funding than any other component of the balance sheet. Core funding strategies need to have a strategic component that ties into the ALCO process (quarterly?). In addition, strategies need to have a tactical component (weekly?) in which pricing decisions are made based on the strategy developed at the ALCO committee level. That framework does not exist in the majority of financial institutions in this country today.
- Use of the correct analytics in choosing between strategies. There are three key analytic tools that should be in place. (1) A good set of benchmark rates that can be used in determining whether the institution’s and competitor’s products are well or poorly priced relative to non-core funding alternatives. (2) The use of marginal cost analysis (rather than average cost) in choosing between alternative deposit pricing strategies. (3) The implementation of systems that track pricing decisions made and the effect on demand. Tracking the relationship between pricing and demand leads to (1) better pricing decisions, (2) more realistic budgets, (3) more realistic interest rate risk analysis, and, yes, (4) improved liquidity management strategies for normal environments, and when triggers require execution of contingency strategies.
- Development of segmentation strategies designed to allow the institution to compete aggressively for rate sensitive funds without destroying their cost of funds in the process. These strategies need to be defined and documented to the extent they are being deployed to meet normal liquidity needs, or when core deposit acquisition strategies are an important component in dealing with events addressed in the contingency funding plan.
To my knowledge no guidance is delivered in this ‘guidance document’ or in any other regulatory document I’ve reviewed on the development of core deposit growth and retention strategies. There is some discussion in the guidance document of the need to develop contingency plans should a non-normal or non-contractual outflow of core funds occur as a result of a liquidity event. But there is little guidance as to what constitutes a core deposit funding strategy or a core deposit contingency plan. The core deposit gap in this guidance needs to be plugged. As someone that spends most of his time working with institutions on core deposit strategies and has spent most of my podium time in the last few years speaking to this issue, I’d be happy to help out.
Risk/Risk and Risks/Return Relationships
The Proposed Interagency Guidance – “Funding and Liquidity Management” places liquidity risk into a silo. There are also regulatory silos in place for dealing with capital risk, operations risk, interest rate risk, etc. Yet we all know actions taken to address liquidity risk may impact on credit risk, interest rate risk, capital risk, and create operations risk issues. At certain points of the interagency document, credit risk, operations risk, and capital risk problems are identified as triggers for liquidity risk problems and events. Yet there is little discussion as to the potential effect of liquidity risk solutions on other forms of risk as well as return. For example, a decision to extend FHLB Advance or Brokered CD terms to improve liquidity may make an asset sensitive institution even more asset sensitive. The decision to convert loans to investments, to shorten investments, or to make the investment portfolio more liquid to meet asset-based liquidity needs is likely to have a negative effect on return. Diminished returns lead to less accumulation of capital which could lead to larger capital risk issues.
I expected to see more discussion of these issues in this document. You might respond by saying that those tradeoffs should be obvious. Yet the unaddressed tradeoffs raise a number of issues in the document’s discussion of tools and decision making frameworks for liquidity risk management.
I applaud the interagency players for significant movements away from static measures of liquidity in the form of balance sheet ratios (loans/deposits, dependency ratios, etc.) and toward a framework that primarily focuses on sources and uses of funds and contingency funding plans. There is a very strong undercurrent in this document that liquidity risk comes from a combination of current balance sheet structure, the institution’s proposed business strategy, and unanticipated events that trigger liquidity issues. Your framework for dealing with liquidity risk has moved from the static approach of years past to the dynamic approach needed in the future.
Yet the framework regulatory guidance suggests for interest rate risk management is still biased in the direction of static measures of interest rate risk. Regulatory guidance states that value at risk testing of fluctuations in EVE, NPV, and NEV is to be performed on existing balance sheets. Yes, the interest rate risk guidance documents I reviewed in preparing this comment letter suggest the institution might consider modeling income at risk based on business strategy. Yet, many field examiners are still asking to see income at risk analysis performed by holding the current balance sheet constant over the 1-2 year horizon commonly used for measuring income at risk. Much of the regulatory interest rate risk guidance hasn’t been updated in a number of years by the agencies involved in the development of this interagency document. After having been a contract IRR instructor to FSLIC then OTS all through the thrift crisis, I became more than familiar with the disconnect that often exists between what regulatory policy makers say an institution should be doing and what examiners are asking for in the field.
It is time to move interest rate risk guidance forward to match what the interagency document does to liquidity guidance.
- Institutions should be modeling income at risk using gradual rate moves rather than shocks and the moves should involve non-parallel rather parallel shifts in the curve. The regulatory accepted practice of using immediate and permanent shocks in income at risk analysis removes the ability for the institution to model risk/return trade offs in alternative strategies as the shock hits before the strategy even begins to be implemented.
- Base rate scenarios and some of the other scenarios modeled should be based on economic forecasts rather than flat rate environments and institution constructed rate tests that often do not adequately consider current interest rate conditions. At the extremes, best and worst case rate environments might move to the top rates and bottom rates seen in the last few decades and incorporate the yield curves that existed at the time.
- Because the rate environments should be gradual rather than immediate and permanent, income at risk horizons need to be extended to three years to fully measure the effect of gradual rate moves on income.
- The focus in income at risk analysis should shift from fluctuations net interest income to net income for two reasons:
- There is significant potential in many shops for fluctuations in fee income (mortgage banking) as rates change.
- Boards understand measures of risk much better when they are framed as a fluctuation in commonly used measures of return (ROE, ROA, earnings per share). All three have net income in the numerator.
- Balance sheet assumptions should be based on the institution’s business strategy rather than on an assumption of a static balance sheet (an event that has a near 0% probability of actually happening in the real world). Doing so would allow liquidity and interest rate risk analysis to be performed concurrently using the same strategy and during the same modeling run.
- Contingency liquidity funding plans should be modeled through the same rate environments used for interest rate risk modeling, as cash flows on both sides of the balance sheet will be different in different rate environments, especially for institutions with significant embedded options in investments, loans, core deposits, and borrowings.
- An institution might also be asked to develop contingency interest rate risk plans that articulate changes in strategy that might be implemented to address interest rate issues brought on by changing interest rate environments.
- Value at risk stress tests should be applied to both the current balance sheet and at least the forecast base case balance sheet that exists at the end of the income at risk tests. Without doing so, the long-term effect of the business strategy being executed on interest rate risk is not assessed. Doing so converts value at risk analysis from being solely static to a combination of static and dynamic.
All this brings me to the second issue not addressed in the guidance document. It fails to suggest a framework for evaluating the tradeoffs in risk/risk and risk/return tradeoffs. Maybe it is inappropriate for a regulator to provide such guidance. The recent increase in interest rate risk analysis outsourcing by financial institutions to firms that perform static analysis testing to satisfy minimal regulatory requirements removes from the institution the ability to model the impact of alternative strategies on risk versus return. I’ll admit that most small to medium sized institutions fail to effectively use models in this way, even when the model is in house. However, lack of regulatory guidance in this area encourages institutions to take minimalist approaches to measuring and managing interest rate risk. That in turn sub-optimizes the relationship between the institution’s risk and return.
I realize that most of the modifications suggested in this document will add to ‘regulatory burden’, although placing liquidity risk and interest rate risk modeling in the same strategy framework would have some offsetting effects. But leaving the core funding strategies and risk/risk/return discussion out of the picture turns this document into what will primarily be perceived as a cost of regulatory compliance. Yet if institutions were asked to actually develop and implement core funding strategies, and if they were encouraged to adopt frameworks that allow them to continually evaluate the relationship between risk and return, we’d have financial institutions that have a better chance of recovering their compliance costs through better performance.
I would think this document would better serve both regulatory and industry needs if it at least suggested a framework for improved decision making and plugged the obvious hole in the rather sparse material on the role of core deposit strategies in liquidity risk management.
