The Mentor Journal
Asset-Liability Management | Portfolio Management | Risk Management
The Return of Liquidity Management
Dollar bills falling to illustrate liquidity management
By Chris Nelson
July 25, 2022
Reading Time: 7 minutes

Lately, I’ve been having more and more conversations with clients and community bankers about liquidity and liquidity management.  This is a topic that has been off the radar for the past couple of years. 

Actually, it’s not that the topic disappeared.  Instead, the focus was on figuring out what to do with excess liquidity due to the pandemic, the PPP program, and the considerable deposit growth that all financial institutions experienced.

Lately, however, community financial institutions have seen continued loan growth, while deposit growth has leveled off or shrunk a little.  Excess cash on the balance sheet has dried up, and they’re now beginning to borrow wholesale funding again in some cases. 

In addition, regulators are focusing more on bank and credit union liquidity and how institutions are managing it.  This is especially true given the loss in market value that investment portfolios experienced in the past few months, which has reduced the amount of liquidity available through the sale of investments if needed.

In some ways, this is one of those “back to the future” moments.  What I’ve been sharing with clients and other community bankers is that it’s time to dust off the practices and procedures we were using before the pandemic because we’re heading back to liquidity management as we once knew it.

Table of Contents

3 Factors to Liquidity Management Success

So given these circumstances, what should you be doing now to ensure your liquidity house is in order?  And what steps can we take with the investment portfolio to help out?  Here are three factors that are key to successful liquidity management for your institution.

Factor #1: Make sure you have multiple diversified sources of funding

The investment portfolio is one of these sources, but they also the Federal Home Loan Bank (FHLB), the Federal Reserve, brokered deposits, and other wholesale funding sources.  We’ll talk about the investment portfolio in more detail shortly, but let’s talk about the other types of funding I mentioned. 

FHLB Funding – Every financial institution has access to the FHLB system and can use its advances to help fund the balance sheet.  The source of the institution’s available borrowing capacity is based on the loans and securities pledged to them as collateral.  The more you have pledged to FHLB, the larger the borrowing capacity. 

As a result, you’ll want to be sure that you have pledged everything that’s eligible to them.  It’s worth checking with your FHLB rep to see if there are options for increasing your collateral and, therefore, the amount you can borrow from them.

Federal Reserve – The Federal Reserve is also a potential funding source through its Discount Window programs.  If you haven’t yet set up a borrower-in-custody (BIC) line with your local Fed bank, I recommend checking into it.  It takes a little time to get things in place and establish the Fed relationship, and you don’t want to wait until you absolutely need it to start the process.  You can learn more about setting up a line at your local Fed.

Brokered Deposits – Brokered deposits are another great source of funding.  There are different ways of raising funds through the brokered deposit markets that are beyond what we’re covering here.  But taking the time to establish the channels for tapping brokered deposits is time well spent.

Finally, you could also establish additional wholesale funding sources using Fed funds lines through correspondent and bankers’ banks and utilizing repurchase agreements. 

As I said, the key is having multiple and diversified sources available so that you have liquidity management options and flexibility.  Once those resources are in place, it’s a good practice to test them at least annually.

“It’s time to dust off the practices and procedures we were using before the pandemic because we’re heading back to liquidity management as we once knew it.”

Factor #2: Make sure you have sound policies, procedures, and tracking of your institution’s liquidity position

I know that everyone has a liquidity policy.  But when was the last time you really sat down and read it?  You might find that the policy needs updating or revising.  Your policy forms the foundation for your liquidity management efforts, so it’s worth checking it to be sure it’s structured the way you need it to be.

In addition, you want to be sure that you’ve established metrics and scorecards to know how your liquidity position is doing.  You don’t want to find out you have a liquidity problem after it’s already started and you’re forced into more of a reaction mode.  Establishing liquidity guidelines that show whether things are good, becoming a challenge, or have hit a critical level is essential. 

In addition, you want to be sure that you’re checking these metrics and scorecards regularly, sometimes even monthly.  You don’t need to have dozens of measurements in place, but you want to make sure you’ve covered your bases with enough monitoring that’s robust and helps you easily understand what’s happening on the liquidity front.

Factor #3: Conduct regular what-if and stress test scenarios

If you have a robust liquidity management reporting system in place, you’ll know where you are at any given moment.  But it’s also important to consider how changing conditions might affect your liquidity position.  That’s why it’s good to test the system and its underlying assumptions periodically. 

For example, what would happen if asset growth or deposit runoff is more aggressive than you thought?  What if you were to lose one or more of your wholesale funding sources?  These are all ways you can develop scenarios that push the boundaries of your liquidity management plan.  It’s not about trying to break the system; it’s about ensuring that the institution can weather more severe storms, whether they occur internally or systemically. 

In conjunction with a regular what-if scenario routine, you’ll want to make sure you’ve developed a solid liquidity contingency plan so that you’ll know what to do when the stuff hits the fan.  Again, you don’t want to wait until liquidity pressures emerge to decide on a response.  It’s also a good practice to occasionally test the contingency plan.

The Investment Portfolio as Part of Liquidity Management

Now that we’ve covered the three factors to managing liquidity successfully, let’s talk about how the investment portfolio fits into the liquidity management plan.  The investment portfolio is essential in managing a community financial institution’s liquidity.  There are two ways to utilize the portfolio for liquidity risk management.

Image of money bags and woman at desk with money falling to illustrate investment liquidity management concept

Option #1: Selling unencumbered liquid assets

Regulators usually consider selling investments the first line of defense in liquidity management.  It is the basis for the liquidity coverage ratio, which requires banks to hold sufficient amounts of high-quality liquid assets.  By raising cash through the sale of investments, a bank can produce a source of liquidity that it can use to offset changes in asset growth or liability runoff. 

With the recent sharp rise in interest rates and the related fall in market value, banks and credit unions have less available market value to liquidate to raise cash.  This is a major reason liquidity is getting more attention from regulators and bank examiners nowadays.  It’s also why investment liquidity in the portfolio becomes a more important consideration. 

What do I mean by investment liquidity?  I’m talking about the ease of selling a security in the market and converting it to cash.  Some securities, like US Treasuries, are highly liquid and can be easily sold.  Other securities are less liquid and may be harder to liquidate quickly depending on market conditions. 

Understanding the relative liquidity of investments in the portfolio is an integral part of managing the institution’s liquidity risk, especially if investment sales need to be involved.  Now, I’m not saying you need to concentrate your portfolio in highly liquid investments like Treasury securities; I’m saying that you’ll want to understand how liquid your existing holdings are.

Generating liquidity through investment sales does have two downsides right now.  First, if you had to liquidate investments today after the recent market selloff, you’d have to realize those losses.  In addition, one downside of selling investment securities for liquidity purposes is the loss of investment income.  Securities sold are earning assets that are no longer on the books.  The sale of investments raises cash immediately but comes at the expense of future interest income.

Option #2: Structuring Investments to Manage Cash Flow

This means building a portfolio that produces a steady stream of principal payments on a regular basis.  Unlike the first option, it does not require selling any assets. 

An investment portfolio with regular cash flow provides an ongoing and stable source of funds to meet liquidity needs on either side of the balance sheet.  If the funds are not needed when they’re received, they can simply be reinvested.  Simply put, managing investment cash flow is the foundation for good liquidity management. 

There are different ways to structure an institution’s investment portfolio to manage this cash flow.  If the portfolio is composed of traditional bonds, it could be structured to provide regular principal payments by building a bond ladder, which provides a series of staggered principal maturities.  Another way to create portfolio cash flow capability is to use mortgage-backed securities, which generate monthly principal payments.

The investment portfolio plays a significant role in liquidity management, whether by helping to mitigate liquidity risk on the balance sheet or as a means to manage excess liquidity.  By managing the underlying mix of investments and their cash flows, you can build an effective liquidity tool for your community financial institution.

Related Articles

Mentoring for Community Bankers

Take your professional development to the next level! A 1-on-1 mentoring relationship provides highly tailored and individualized training for community financial institution executives.  Imagine working closely with a seasoned professional who will show you the way!  You’ll be more knowledgeable, feel more confident, and be more effective in your job role.

Send this to a friend