Ever wander around your house late at night? If so, you have probably also accidentally kicking a piece of furniture at some point. As your big toe swelled up in pain, you probably grabbed the hurt foot, pulled it up to your chest, hopped around on the other foot and howled in pain. Sometimes working in community banking can feel like the kind of pain one endures after stubbing a big toe.
If you are one of the banks that have not yet been examined by regulators, there is still time to focus on some key issues before they come knocking. If you have already been examined, you know the focus is more targeted on credit, liquidity and risk management.
While very important, in the essence of space constraints, we will skip over credit and risk management components this morning and focus our energies on the liquidity aspect of the examination in particular.
When it comes to liquidity risk, we suggest bankers take a moment and review the FRB's Trading and Capital Markets Activities Manual (Section 3005-1). Brushed up in late 2006 (right before the CRE concentration guidance officially came out), the 34-page manual compiles and expands on previous guidance. It also gives bankers a good road map as to where examiners are likely to focus efforts in upcoming examinations. In addition, the publication provides a great tool to ensure your bank is up to date when it comes to liquidity risk.
As an overview, the manual starts by defining what "liquidity" really is - a financial institution's capacity to meet its cash and collateral obligations without incurring unacceptable losses. It is clear from recent FRB actions to maintain banking system liquidity that Bear Stears did not have a good handle on this risk.
The manual indicates that liquidity management can be broken down into 3 main elements. The 1st is assessing the need for funds to meet current and future obligations at the appropriate time, the 2nd is providing an adequate cushion to meet unanticipated funding needs and the 3rd is balancing adequate liquidity with the cost of such liquidity. This makes sense, but it is much harder in practice to do, particularly since each bank is different from the next.
To ensure adequate risk management when it comes to liquidity, bankers have to take into account changes in interest rates, economic conditions, credit risk exposures and many other risks (such as operational, legal, reputational, etc.). In order to be effective, the liquidity plan must also be fully integrated into the bank's overall enterprise-wide risk management process.
Specifically, community banks should ensure there is adequate corporate governance around liquidity risk. Now would be a good time to update the board to ensure they are knowledgeable about liquidity activities. Bankers should also make sure they have strategies, policies, procedures and limits in place to manage such risk; adequate systems and processes to measure, manage and report on liquidity risk; and a contingency funding plan in place (and tested) to handle emergency cash flow needs in an adverse situation.
Other topics outlined in the manual include specifics as to how the examiners view the role of the board and senior management; how to set policies; what to measure and how to measure liquidity; how to assess funding needs and sources of liquidity; what regulators will look for as part of their scope; what to have in the ALCO minutes; sample liquidity worksheets and even a chart on the use of brokered CDs (such as how and when banks may accept brokered deposits as conditions change).
The manual is dry reading, but it is also very good information. At the very least, it will certainly help you avoid kicking the furniture during your next examination. Get a copy of this updated liquidity risk manual, read it and take the time to revitalize your liquidity polices, procedures and processes. Bankers that do so are well on their way to a clean examination when it comes to the "L" in CAMELS.