Loan growth in financial institutions is robust. The most recent FDIC Quarterly report noted loan growth in community banks is up 2.3% in just the last quarter (June 2018 to March 2018) and 7% in the past twelve months. Taking a deeper dive into those numbers, the largest increases in lending were in nonfarm, nonresidential loans (8.4%), commercial and industrial (7.9%), construction and development loans (11.6%), and multifamily residential loans (9.4%). This translates into higher net interest income for financial institutions as excess liquidity has been deployed into higher earning assets and bank management has lagged in raising deposit interest rates. Net income is also up, contributing to strong capital ratios.
But—and there is always a but—the expansion of your loan portfolio does not come without increased stress on your funding sources and your liquidity risk management processes. Certain loan types do not provide consistent cash flow and are not able to be turned into cash quickly. Deposits in community banks increased at a slower pace than loan growth; FHLB advances increased 10.9% on a year-to-year basis. As a result, now is not the time to be complacent in your liquidity risk management processes, and perhaps it is time to dust off and update your liquidity strategies and contingency funding plans and perform a bit of stress testing.
Interagency Guidance including Financial Institution Letters FIL-13-2010 (Funding and Liquidity Risk Management) and FIL-84-2008 (Liquidity Risk Management) are at the core of any strong liquidity management program. Your bank’s program and processes should at a minimum include the following:
- Effective corporate governance by your Board and management. While the responsibility of this rests with the Board, it can and usually is delegated to the ALCO committee.
- Appropriate strategies, policies, procedures, and limits. There is not a one-size-fits-all strategy for financial institutions. There should be thoughtful and deliberate discussion over what is reasonable for liquidity limits based on your size, balance sheet makeup, capital levels, and risks to ensure alignment with both your strategic plan and risk appetite.
- Comprehensive liquidity risk measurement and monitoring systems. Many of your interest rate risk models include liquidity risk systems. However, depending on your situation, utilizing Excel or similar tools is adequate. They should also be a regular part of your ALCO meetings.
- Active management of intraday liquidity and collateral that supports your funding options.Consider a dashboard approach to reviewing daily liquidity data.
- An appropriately diverse mix of sources of funding, both existing and potential. Finding sources when there is a crisis is not good risk management. Talk with your correspondent bankers, the FHLB, listing services, and deposit brokers and be ready. And test the availability.
- Adequate levels of highly liquid marketable securities free of legal, regulatory, or operational impediments. The regulators have noticed an increase in municipal holdings. While these holdings are liquid, they are not as liquid as U.S. Treasury, Government, and Agency securities. Thoughtful review of the investment portfolio and its makeup is imperative to provide strong liquidity for your bank. Many financial institutions also maintain public deposits, which can impact liquidity due to pledging requirements. Discuss other options with your FHLB representative such as utilizing letters of credit.
- Comprehensive contingency funding plans that sufficiently address adverse liquidity events. In the “Great Recession,” stress testing was frequently performed. As the economy recovered and tight liquidity became a thing of the past, resources were directed elsewhere. It may be time to discuss this with your ALCO committee and increase your stress testing frequencies.
- Internal controls. These are designed to determine whether the liquidity process is adhering to policies and procedures and risks are adequately identified, reported, and addressed. Regulatory guidance also requires an independent review of your liquidity risk management process. Consider having this done with your periodic interest rate risk validation service.
No one wants a repeat of the liquidity crisis that occurred ten years ago. Having a thoughtful, thorough approach to liquidity will give you a sound platform to continue providing all the services that your customers need and a good return for your shareholders. Contact your Wipfli client relationship executive for an evaluation or validation of your liquidity process or for assistance with liquidity stress testing.