For most of this year, banks have been building cash and liquid assets, as deposit inflows exceed loan outflows. Adding to this structural shift, bankers are also reacting to regulatory pressure to build capital and increase liquidity, by aggressively shrinking the balance sheet to build liquidity pools. The longer economic recovery takes and regulatory pressure continues; the longer banks will be inclined to shrink balance sheets and increase cash as a percent of total assets. As of the end 2009 compared to 2Ys earlier, financial institutions have doubled the percent of assets held in cash (to 8%) and increased by 27% the percentage of securities to assets (to over 19% of assets). Liquidity has clearly jumped in importance for institutions throughout the country.
As one can see above, cash and securities, as a percent of assets, are one way to measure bank liquidity. The problem occurs when you get into the nuances of liquidity, however, because as it is with most things liquid, improper handling can cause leaks. Let's examine the latest FFIEC Interagency Policy Statement on Funding and Liquidity Risk Management that was released on March 17.
The purpose of the policy statement per the document itself is to provide "consistent interagency expectations on sound practices for managing funding and liquidity risk." Importantly, the policy ties to concepts issued by the Basel Committee recently, in an effort to ensure a level playing field with international banks. Given the extreme importance of this subject and the fact that some of the information is new to bankers, we will spend the next few days exploring this 51 page regulatory thesis.
While the policy statement establishes practices for funding and liquidity risk, it also points out that liquidity risk management in many banks "needs improvement." It indicates that banks do not hold sufficient levels of liquid assets; have funded risky or illiquid assets with volatile short-term liabilities; lack meaningful cash flow projections and have weak or nonexistent liquidity funding plans. It is time to grab a pen and a clip board and start walking around the bank to address these issues. If not, prepare for things to potentially get ugly, because it is clear the regulatory agencies are going to insist banks take action to address these areas sooner rather than later (and in conjunction with global banking regulators).
Specifically, regulators will be looking for banks to utilize cash flow projections, diversify funding sources, apply stress testing to liquidity and have a cushion of liquid assets. Banks will also need to have a formal, well developed contingency funding plan at the ready and available for regulators. The overarching goal is that banks need a robust process to identify, measure, monitor and control both funding and liquidity risk. As part of this process, banks may even end up having to upgrade analytics models or core systems, depending on complexity, risk profile, etc.
Few things are more irritating than having a leak you don't know about, so consider yourself warned in advance. Having the right tools, plenty of duct tape and remaining patient throughout the process should help, as you work to repair any potential liquidity leaks your bank may have before examiners next arrive.