BID® Daily Newsletter
Apr 15, 2008

BID® Daily Newsletter

Apr 15, 2008

NOSTALGIC POLICIES


Anybody with an ounce of nostalgia has to appreciate the Cutler Mail Chute. The brass, copper and glass chute that runs from the top floor to the basement, used to be a staple in buildings throughout North America. We love ours so much that we have developed a tradition - you have to go out and rub the 1936 date whenever you are in need of good luck.
Similarly quaint are the policies of many banks. Unfortunately, many weren't any good to begin with, as they were given to the bank by a local consultant when the bank was formed. Many are as bland and generic as they come and do not provide much use. Other policies have been long outgrown as they applied to a bank that was 10Ys younger and $1B smaller. Still others were written with good intentions, but were never really thought through - so they act as more of a hindrance than a risk management tool.
Take deposits for example. Many banks have a hard limit on the amount of brokered CDs that can be used as a percentage of deposits. Brokered deposits shouldn't be any different than repo, Fed Funds or FHLB advances, in that they are all wholesale funds and subject to established lines of credit. Bankers should have unlimited flexibility to move between different wholesale sources, in order to take advantage of the lowest rate.
Setting limits on brokered CDs or wholesale funding as a percentage of total deposits makes little sense, but a majority of banks have limits written just that way. A better approach is to set a limit as a percentage of total assets, since that is what is being funded. The percentage of a particular type of deposits to total deposits is really irrelevant. For example, when you buy a house, you are not worried about your percentage of mortgage debt to other debt? No, since you are funding the house, financial institutions care about the percentage of debt to the total value of the house, since that is what is being funded. For that matter, loan-to-deposits is another worthless measure, and loan-to-assets is much better. You never really know how much capital is in play if you focus on the former.
Finally, for policy constraints, make sure you have targets and then limits to provide flexibility. Ratios depend on the market, composition of the bank and access to liquidity and are different for every bank. However, in our example above, a good wholesale funds-to-asset target might be 25% with a hard limit of 40%.
When it comes to setting policy targets or limits, make sure they are not self-limiting and self-defeating. For every ratio, whether it is capital, loans, liquidity or deposits; ask yourself why the ratio is there. What does it really tell me and am I going to manage off of it? If you don't have good answers for each question, go find your own mail chute to rub and then come back and revise your polices.
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