Studies show every home foreclosure within 1/8th of a mile radius will cause a 1% drop in price to the values of surrounding homes. We bring this up because it highlights one problem among many that has surfaced during the recent credit crisis.
As with home price erosion, we have also learned much about the value of liquidity. While we have touched on this value before, it surfaces again following a recent FRB analysis of the crisis. As part of its research, the FRB compared financial companies that did well during the crisis for the period ended 2007, with those companies that did not fare as well (i.e. Bear Stearns, etc.). The FRB did this in order to surface what actions top companies may have taken in order to ensure they had enough liquidity and that resulted in them having the least issues. As it turns out, these companies were more than just lucky.
In its analysis, the FRB found that companies that managed their liquidity and funding needs on a proactive basis performed well. Those that did best encouraged individual business lines to assess and communicate their funding needs to a central treasury team. The treasury group then funded each business unit based on actual market conditions and charged each one accordingly. By staying close and in continual contact during the crisis, these top performers were able to react faster to changing conditions and evolve their funding mix.
Also of interest, the FRB found companies that did not perform well did not have adequate plans to increase liquidity. The FRB analysis also found even companies with sophisticated risk management systems failed to properly assess contingent liability exposure, which further strained liquidity. As a result, these companies found themselves scrambling to raise liquidity in a very difficult environment.
Another key finding from the review was that the best funding managers had flexible tools that allowed them to quickly monitor and manage their liquidity position across business lines and to shift rapidly to changing market conditions. Strong technology, robust reporting and integrated systems were all critical components that helped this group outperform peers.
Companies that proactively solicited senior manager input, pooled their skills and tapped into their experience, generally performed well. In fact, some companies that performed well built up liquidity reserves in advance of the crisis because they were beginning to see deterioration and projected they might lose flexibility. These companies also typically incorporated liquidity stress testing to anticipate funding needs in advance of the crisis.
Finally, even though top performing companies were better prepared, they still could have done better with their contingency planning. Each one failed to fully anticipate the severity and length of market stresses and every one said they planned to improve their contingency plans based on what they had learned.
While the extent and severity of such a credit and liquidity crisis may not hit community banks as hard as a home in foreclosure, it does serve as a sobering reminder. Banks must be better prepared for market turmoil, while staying abreast of the valuation and behavior of new products and market sectors. No matter how well we all model or prepare, judgment remains a critical component. Proactive communication among senior management teams is a significant success factor when responding to shifting market conditions that place unexpected stresses on the organization.