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How banks can manage liquidity risk in today’s interest rate environment

Mar 15, 2023

Banks are facing liquidity risk management challenges in today’s interest rate environment. Banks got comfortable with abundant and cheap liquidity over the past several years. Things have changed quickly, though.

Between March 14, 2022, and March 14, 2023, the two-year rate on the daily U.S. Treasury yield moved from 1.87% to 4.20% and from 2.14% to 3.64% on 10-year. The higher rates have had various impacts on bank balance sheets, including spoiling the cheap liquidity.

Competition for deposits is heating up, leaving some banks feeling a liquidity squeeze. As yields increased throughout 2022, banks were forced to increase deposit rates. The average rate that banks paid on money market accounts increased from 0.08% to 0.48% between February 2022 and February 2023. The increased rates put pressure on banks to pay up for deposits or see them walk out the door.

Another reality banks have faced is tougher economic conditions for customers — and the resulting impacts to liquidity. Bank customers may be dealing with increased loan payments on variable rate loans, decreased savings rates due to inflation and general uncertainty about economic conditions.

Aggregated call report data shows that deposit growth slowed substantially in 2022 after two years of unprecedented growth. At the same time, banks grew brokered deposits and FHLB advances to offset the slowing deposit growth.

Year-over-year bank growth trends

2016 2017 2018 2019 2020 2021 2022
Deposit growth
4.75% 4.63% 7.95% 24.38% 12.16% -0.55%
Brokered deposit growth
-5.4% 11.28% 14.36% 7.43% 2.36% -45.33% 55.70%
FHLB advances growth
16.25% 5.25% -0.73% -13.34% -50.78% -30.14% 284.20%
Securities growth
7.43% 2.28% 3.02% 9.20% 29.38% 23.92% -4.06%

Source: BankTrends

In 2020 and 2021, banks also grew securities that were susceptible to unrealized losses. Securities growth was 29.38% in 2020, and 23.92% in 2021. In 2021, securities repricing > three years grew from 73.03% to 77.56% of all securities.

As rates increase, these longer term securities are prone to unrealized losses. Banks may collect interest and principal from cash flows, but long-term securities with large unrealized losses are not typically sold. To do so would mean realizing a loss against net worth. The result is a lot of long-term investments on bank balance sheets that do not represent true accessible liquidity, except for by pledging the asset to a third-party at market value.

Percent of securities

2018 2019 2020 2021 2022
Securities repricing > 3 years
70.81% 70.90% 73.03% 77.56% 75.18%

Things changed quickly. And if you aren’t staying up on your liquidity monitoring, it can put your bank in a tough spot. So how can you manage these elevated risks? Here are five best practices:

1. Step up your liquidity monitoring

Your liquidity policy should specify the frequency of liquidity reporting. While the board may receive quarterly liquidity risk reports, management reporting should generally be more frequent, especially if you are dealing with decreasing liquidity. Consider moving to weekly or monthly management reporting.

In addition, monitoring the liquidity triggers from your contingency funding plan is an important element of liquidity management. When a crisis happens, there might not be a way to know right away — that’s why it’s important to frequently monitor liquidity triggers. Changing conditions could indicate increasing liquidity risks.

For example, a 2% outflow of nonmaturity deposits might be normal or “green,” while 5% might be outside normal business fluctuations or “yellow” and 10% might be a major crisis or “red.” If there was a 5% outflow of nonmaturity deposits, you don’t want to wait until month-end or quarter-end to discover the issue. 

2. Review pro-forma cash flow analysis, and stress test your cash flows

Regulatory guidance says that banks should have robust methods for projecting cash flows from their balance sheet. Pro-forma cash flow models are a critical liquidity tool, especially in uncertain times. Looking at your current balance sheet is not good enough; you need to develop realistic expectations of future liquidity.

In addition, the regulatory guidance says that banks should conduct stress tests regularly for a variety of institution-specific and market-wide events across multiple time horizons. The stress testing should be layered on top of the pro forma cash flow model, and management should develop plans to address any cash flow shortfalls. If you are dealing with decreasing liquidity, your liquidity stress testing may inform management’s tactics in addressing the situation.

3. Understand your funding risks

An important piece of managing liquidity risk is to understand how the bank is funding its balance sheet. Typically, banks will fund the balance sheet with a mix of core deposits, noncore deposits, other wholesale funding and equity. Management should understand concentration risks, including large depositors, concentrations to certain industries, concentrations of noninsured deposits or concentrations in certain types of wholesale funding. Part of the CFP should be potential responses to those concentration and funding risks.

A study of historic deposit behaviors can also help the bank understand the expected maturities on its deposits, or if the bank has surge deposits that it should expect to run off quicker than the rest of its deposit base. Understanding these risks is a critical piece of managing your liquidity position.

4. Review your contingency funding plan (CFP)

At its core, a CFP is a crisis management tool. The tool should set out the strategies management expects to use to address liquidity shortfalls. The requirements of a CFP are addressed in the Interagency Policy Statement on Funding and Liquidity Risk Management. If you are facing mounting liquidity pressure, it is a good time to review your CFP at your asset liability committee meeting and board meeting, as well as time to test the operational components of your plan.

5. Get an independent review of your liquidity risk management

Management should ensure an independent party reviews and evaluates your bank’s liquidity risk management processes. The reviews should evaluate the process and determine whether it complies with both supervisory guidance and industry sound practices.

How Wipfli can help

Wipfli offers a range of services to assist your bank in managing liquidity. Our complimentary strategic risk management consultation can pinpoint areas of risk in your institution and discuss how to mitigate that risk and strengthen your institution’s overall stability. 

Wipfli also performs full liquidity risk management validations to meet regulatory guidelines. Learn more about our ALM consulting services and our enterprise risk management services.

And because risk officers are such a critical position for financial institutions, especially during tumultuous times like today, we can also help you fill temporary gaps in staffing your risk team.

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Luke Soper, CPA
Senior Consultant
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