Regulatory Bootcamp Part 1: Liquidity – Preparing for your Next Exam

This Fall, we will be putting out a three-part series on key areas of focus for examinations based on a combination of regulatory guidance, risk management best practices, and actual exam feedback.  To lead off the series, we’ll take a look at the “L” in CAMELS and discuss some critical considerations as your financial institution preps for its next exam.

Liquidity has taken center stage as the top risk position for financial institutions as well as regulators, and rightfully so.  Over the past 6 months, the industry has witnessed three regional banks fail with over $525 billion in total assets, eclipsing the two highest years during the Great Financial Crisis combined!  It goes without saying that the primary cause of these failures was inadequate liquidity risk management and contingency funding planning, exacerbated by other imperfections in interest rate risk management.  As your institution prepares for the next regulatory exam, have you considered any of the following actions to bolster your ability to identify, measure, monitor and control liquidity risk? 

• Secured Borrowing Capacity, Secured Borrowing Capacity, Secured Borrowing Capacity – Its importance cannot be emphasized enough.  Examiners expect to see diversified access to secured borrowing sources, including the Federal Home Loan Bank and the Federal Reserve’s dual programs:  Discount Window and Bank Term Funding Program.  Identifying additional collateral to pledge to either source should be aggressively pursued.  Remember, examiners do NOT care if you can eventually pledge collateral; they care that you HAVE pledged collateral.
• Reciprocal Deposits – Reciprocal deposits remain an advantageous source of liquidity to collateralize uninsured non-public deposits, and more importantly to collateralize public fund deposits.  Migrating public funds away from liquidity negative sources (direct investment pledge and FHLB LOC) towards reciprocal creates liquidity!  This should be a priority for all institutions and considered as important as expanding secured borrowing capacity. 
• Uninsured Deposits – Measuring and monitoring uninsured deposits is not a precise science but is expected.  Monitoring the level of, trends in, and concentrations within uninsured deposits will be expected at your next exam.  Remember, this is just an estimate – recent guidance also emphasizes including pledges for public funds (FHLB LOC and direct investment pledges) as well as any affiliated Holding Company or related deposits.  The typical community financial institution ranges from 15-35% in uninsured deposits, a far cry from the 80%+ noted at the recent regional bank failures, but nonetheless, understanding/monitoring uninsured deposits is a key risk management exercise.
• Liquidity Timelines – How fast can you access liquidity?  How quickly can you garner 15%, 30%, 45% of the balance sheet in funding?  Same day?  Next day?  Same week?  Longer?  Do you have piping set up at secured borrowing sources?  Do you know the cutoff time for accessing a variety of same-day liquidity sources?  Have you tested them?  Mapping out your institution’s unique timeline of access to liquidity is another technique to document to examiners that CFP sources and timelines are defined and established. 

Taylor Advisors’ Take:  What have you done for me lately?  While not explicitly stated, examiners want/expect to know how your institution has proactively taken steps to bolster and solidify liquidity access and risk management practices in light of the current environment.  Chance favors the prepared.  Those institutions that have taken action to prepare for a more challenging liquidity and regulatory environment will fare far more favorably during their regulatory exam.  “Ratings Migration” is not a formal policy from the regulators but expect there to be a high potential for one-notch downgrades in the Liquidity rating absent proactive action to enhance identification, measurement, monitoring, and controlling of liquidity risk.  Liquidity component ratings may no longer range from 1-5, but rather 2-5, with other CAMELS components likely in a similar ratings band.  As the margin for error narrows, more emphasis must be placed on proactive risk management. 

Taylor Advisors’ helps executives by providing strategies and expertise to effectively manage balance sheet risks, including liquidity, and the Net Interest Margin.  Please visit our website for additional publications or to ask us a question about your balance sheet process and how we can help.