Liquidity Management. 158 Route 206 Gladstone, NJ P: (908) Home FinPro, Inc.

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1 Liquidity Management 158 Route 206 Gladstone, NJ P: (908)

2 Liquidity: you always have too much until you need it!! 1

3 Banks must take a holistic view of its funding risks... Interest Rate Risk On Balance Sheet Liquidity Dependency on Volatile Funding 2

4 Table of Contents... Section: Topic: Page Number: Section 1: Why Should Banks Have Liquidity Risk Concerns? 02 Section 2: What Are The Regulators Saying? 07 Section 3: What Should Banks Be Doing? 14 Section 4: Strategies For Additional Funding 26 3

5 Section 1: Why Should Banks Have Liquidity Risk Concerns? 4

6 Liquidity risk is increasing due to four major factors Competitive Pressure: Most community banks have started to increase rates on core deposits Customers are becoming increasingly demanding for rate Most strategic plans are now focusing on deposit growth as opposed to loan originations Banks that are growing deposits are often paying up for them 2. Alternative Funding Risk: Listing service deposits are now above the national rate cap Borrowing costs continue to rise Banks have utilized portions of their contingent funding sources 3. Funding Concentrations: High levels of money market accounts Increasing levels of high average balance accounts Concentration of municipal deposits Other hot money concentrations 4. Interest Rate and Economic Risk: Fed Funds increases will have a material impact on Beta values Funding mix shift towards CDs and higher cost funding Disintermediation of deposits Unwinding of Quantitative Easing 5

7 The Federal Reserve plan to unwind Quantitative Easing should result in declining liquidity within the industry... 6

8 However, when looking at the third quartile of community banks by region, some alarming trends are occurring regarding loan to deposit and loan to asset... The loan/deposit and loan/asset ratio has increased in all regions of the country. The regulators are concerned this trend may be a result of management reaching for credit. Source: SNL (Banks, Savings Banks, and Savings Institutions with Assets less than $10 B in MRQ) Note: data represents the third quartile 7

9 Third quartile regional trends also show increased utilization of wholesale as well as increased money market accounts and deposits over $250 thousand... The Borrowings + Listing Service + Brokered / Deposit ratio is increasing in all regions and is above 20% in the NE region for 3rd quartile banks Money market accounts levels are high and increasing as are deposits > $250k Source: SNL (Banks, Savings Banks, and Savings Institutions with Assets less than $10 B in MRQ) Note: data represents the third quartile 8

10 Section 2: What Are The Regulators Saying? The preeminent document the regulators are referencing is: FDIC Supervisory Insights Vol. 14 Issue 1 Summer

11 The regulators defined funding as core, non-core, and wholesale... Core Funding - these deposits are generally stable, lower-cost, and tend to re-price in a more favorable manner than other instruments when bank-specific conditions or market conditions change. Non-Core Funding may include, but is not limited to, borrowed money such as Federal Loan Bank (FHLB) advances, short-term correspondent loans, and other credit facilities, as well as brokered certificates of deposit (CDs) and CDs larger than $250,000. Wholesale Funding - includes, but is not limited to, brokered deposits, Internet deposits, deposits obtained through listing services, foreign deposits, public funds, Federal funds purchased (FFP), FHLB advances, correspondent credit lines, and other borrowings. Note: High-rate and uninsured deposit accounts are also potentially volatile in certain cases and may have characteristics similar to non-core or wholesale funding. Source: FDIC Supervisory Insights Vol. 14 Issue 1 Summer

12 The regulators also discussed liability and funding considerations... Brokered Deposits: - Rapid asset growth funded by brokered deposits has been directly associated with problem banks and failures. - Brokered deposits can have increased rate sensitivity and substantial run-off risk after maturity. - If the bank becomes less than well capitalized, brokered deposit restrictions can severely limit the bank s ability to access, retain, or rollover deposits. Listing Service Deposits: - Funds gathered from listing services can have rate sensitivity characteristics similar to other non-core deposits. - The customers often have no other relationship with the institution and solely are seeking to maximize return. Other Potentially Rate-Sensitive Deposits: - Deposits above the national rate cap (internet deposits / CDs, etc ). Borrowings: - Institutions with asset quality or capital problems may encounter issues with borrowings when collateral requirements or reduced borrowing capacity affects liquidity. Source: FDIC Supervisory Insights Vol. 14 Issue 1 Summer

13 Additionally, regulators identified unencumbered liquid assets as pillars of strength in crisis... The first line of defense for responding to a liquidity event is a cushion of unencumbered liquid assets (i.e., assets free from legal, regulatory, or operational impediments). Insufficient levels of unencumbered liquid assets can compound liquidity troubles. The most marketable and liquid assets typically consist of U.S. Treasury and agency securities, short-term, investment-quality, money market instruments, and Federal Reserve or correspondent deposits. As such, make sure on balance sheet liquidity is above 10% Source: FDIC Supervisory Insights Vol. 14 Issue 1 Summer

14 On-hand liquidity is our initial focus... 13

15 In basic terms, we are measuring C&DF plus unpledged securities in relation to total liabilities... 14

16 Minimum on-hand liquidity threshold is typically 10% while the Canary report triggers at 15%... 15

17 Management should have a comprehensive analysis to explain the low level of on-hand liquidity... 16

18 Let s review some key liquidity ratios within the context of the Canary Report... 17

19 The bank has consistently triggered Canary Report red flags... 18

20 Start by assessing whether your bank has a high loan-to-deposit ratio... 19

21 There is significant regulatory focus on the use of non-core funding to support long term assets... 20

22 The bank must assess its risk within this dependency ratio... 21

23 There is also significant regulatory focus on the use of wholesale funds... 22

24 An excessive reliance on wholesale funding will cause regulatory scrutiny... 23

25 What questions are the regulators asking Can capital levels absorb losses from the forced liquidation of assets at a discount from current values? Are non-core funding limits appropriate given base-case and stress cash-flow projections? Is a PCA category downgrade appropriately incorporated into the stress scenario regarding brokered and high-rate deposit restrictions? Are off-balance sheet exposures incorporated into the analysis, and do they have a liquidity impact? Are back-up borrowing lines sufficient relative to potential cash flow needs during a significant adverse event? Is the volume of encumbered assets consistent with management s goals regarding a balance between reliance on liquid assets and contingent funding availability? How liquid are the various securities in the investment portfolio, and can they be relied upon as a primary source of funding during significant cash outflows? How reliable are rate-sensitive liabilities and committed contingency funding lines in stress? Source: FDIC Supervisory Insights Vol. 14 Issue 1 Summer

26 Section 3: What Should Banks Be Doing? As a result, regulators are scrutinizing liquidity stress testing, contingency funding plans, and concentration risk analytics. Liquidity Risk has become the new Regulatory hot button! So much so that they are conducting interim exams on it. 25

27 FinPro recommends a more robust approach to liquidity risk management Create detailed funding concentration risk analytics Stratify funding using the Liquidity Matrix Conduct a Deposit Loyalty Study Determine the Local Rate Cap by funding product Conduct forward looking Stress Tests Tie assumptions to the results of the Liquidity Matrix Create realistic contingency funding strategies Train board members Update liquidity policy and contingency funding plan to reflect the above process 26

28 Anatomy of a Liquidity Analysis... Non Maturity Maturity Internet Deposit assessment is critical Non Maturity Deposits > $250k Non Maturity Maturity Deposits < $250k Long term volatile High Cost Deposit Calculation is critical Valid high cost deposits Valid internet deposits Stable Funding 100% Loyalty Score 0-25% Loyalty Score 25-50% Loyalty Score % Maturity 0-3 months Maturity 3-12 months Maturity 12+ months Municipal Deposits Large Depositors Brokered Deposits Listing Service FHLB Borrowings Maturity Wholesale Funding Non-Core Funding Core Funding Short term volatile 27

29 The regulators define high rate deposits as those above the national rate cap. It is imperative that banks understand the calculation... Definitions National rates are calculated based on a simple average of rates paid (uses annual percentage yield) by all insured depository institutions and branches for which data are available. Savings and interest checking account rates are based on the $2,500 product tier while money market and certificate of deposit are based on the $10,000 and $100,000 product tiers for non-jumbo and jumbo accounts, respectively. Account types and maturities published in these tables are those most commonly offered by the banks and branches for which we have data - no fewer than 46,000 locations and as many as 82,000 locations reported. The deposit rates of credit unions are not included in the calculation. Questions for Discussion Are Bank of America s 4,565 branches included as one institution or 4,565 institutions? How can this micro sample be indicative of current rates in the market when banks are offering specials that are not within the Rate Cap selection? These categories should not be so narrowly defined. Theses may be the ones most commonly offered by the institutions. The top 20 banks represent 33,800 branches, the law of averages is misrepresenting the average rate of community banks. How can you exclude rates paid by credit unions and deem that this is the market rate? The market rate should be all inclusive of rates offered in the market! 28

30 Current National Rate Caps as of December 31, 2017 are shown below... The top 100 QwickRate offer rates for CDs are all above the national rate cap (and borrowing rates are even higher). Make sure to understand that a waiver can be requested but takes time for the regulators to process (60 90 days). 29

31 As seen in the Liquidity Matrix, it is imperative each bank determines and understands their Local Rate Cap Identify banks within local proximity to branch network Remove banks with assets greater than $50 billion Calculate average by deposit product Add 75 bps to the calculated average to determine the Local Rate Cap 30

32 Depositor Loyalty Analysis 31

33 A deposit Propensity to Renew study is the key link between reporting historical information and maximizing success in the future... Banks often analyze the stability of the deposit base using historical information However, assuming the past will predict the future often results in a flawed analysis A deposit loyalty study assesses the bank s customer base utilizing six factors that FinPro has identified as being they key indicators of stable deposits Relationship Transactions Price Geography Tenure (age) Size Digital Footprint 32

34 The Loyalty Analysis scores the entire portfolio on an account basis to assess the stability of deposits... Data is collected from the Bank for each of the Propensity to Renew factors 1. Relationship (number of accounts/services) 2. Transactions (number of transactions a month) 3. Price (above/below market rate) 4. Geography (within/outside market area) 5. Tenure (age of account) 6. Size (balance of account) 7. Digital Footprint (technology dependency) Each Loyalty factor is scored based on FinPro proprietary bands and coefficients that can be statistically customized to each Bank While the process is complicated, the end result is that all accounts have Loyalty scores ranging from 0% to 100% that easily reflect their relationship with the Bank Note: When data is missing an average score for that factor is applied. This does not penalize the portfolio, but does hurt the accuracy of segregating loyal and non-loyal accounts. As more data that is received the better the accuracy of the scoring. 33

35 Scoring the individual accounts allows the Bank to isolate accounts with a lower Loyalty scores (i.e., potentially more volatile)... Less Loyal Customers Highly Loyal Customers 34

36 The true benefit of this study is that it allows the bank to determine its strategic options for pricing and funding in the current rate environment and also in rising rates... High Rate Savings has a stronger propensity to renew than the typical money market or savings account. 35

37 Conduct detailed forward looking stress tests that are specifically developed for your institution... Defendable assumptions that are used for each scenario based upon the Liquidity Matrix Stress testing conducted on forward projections (i.e. budgeted financials) not point in time. Stress testing of high probability/low impact scenarios all the way up to low probability/high impact scenarios Other items to be stressed should include: removal of brokered capacity, increase in unfunded loan commitments, removal of unsecured funding, increase in problem assets, reduction in borrowing capacity, reduction in high money market concentrations. Mitigation Strategies: Stress Tests: 1) 2) 3) Stage 1: Shorter-term risk situation testing A. 5.19% deposit shock run-off over a 3 month time frame Stage 2: Moderate risk situation testing B % deposit shock run-off over a 6 month time frame C. 25% decline in borrowing capacity over a 6 month time frame D. 50% draw down on all unfunded loan commitments over a 6 month time frame Stage 3: Distressed/Severe Risk (long-term) situation testing E % Deposit shock run-off over a 12 month time frame F. 100% loss of access to borrowing lines (other than the FRB) over a 12 month time frame G. 100% draw down on all unfunded loan commitments over a 12 month time frame H. 100% loss of access to brokered deposits 1) 2) 3) Stage 1: Shorter-term risk situation testing A. Draw down fed funds and cash position B. Increase utilization of brokered deposits C. Utilize borrowings at the FHLB Stage 2: Moderate risk situation testing D. Draw down fed funds and cash position E. Increase utilization of brokered deposits F. Utilize borrowings at the FHLB Stage 3: Distressed/Severe Risk (long-term) situation testing G. Draw down fed funds and cash position H. Borrow at FRB I. Sell unpledged investments J. Pledge additional loans at the FRB for additional borrowings, sell unpledged loans, or stop originating loans. Additional possible action not shown in the liquidity stress test table: Raise deposit rates, while maintaining the rates below FDIC rate caps, to bring in additional deposits or utilize listing service deposits. 36

38 Create realistic contingency funding strategies... Banks must understand that a decrease in loans doesn t necessarily mean the sale of loans. Stopping or slowing loan origination would result in a declining loan portfolio due to payoffs and amortization. Make sure you can quantify your loan cash flow going forward. 37

39 Train Board Members on Liquidity... Measuring liquidity, the 2/10/20 Rule Primary cash liquidity, on balance sheet liquidity and on balance sheet + borrowing capacity liquidity ratios. Holding more liquidity is MUCH cheaper than paying additional FDIC insurance costs, professional fees and legal fees associated with regulatory order. Be careful about window dressing liquidity at quarter end. Regulators are on to it and conducting interim analyses. 38

40 Update the liquidity policy and contingency funding plan to reflect the above process... Have in place a well written and sound liquidity policy - The Board of Directors has the ultimate responsibility for the adequacy of liquidity policies and procedures - Senior management has responsibility for policy design Set appropriate policy limits for wholesale funding Maintain a diversity of liquidity sources (including the Federal Reserve) Ensure most effective utilization of collateral Pledge loans first for borrowing capacity, utilize securities as collateral of last resort Test liquidity sources at least annually Have in place a sound Contingency Funding Plan that has been tested Responsibilities throughout organization under varying levels of stress Proper data systems Identifiable trigger events that could cause liquidity strains on banks Management must understand real responses to liquidity stress and have diversified sources available and tested 39

41 Section 4: Strategies For Additional Funding 40

42 From a strategic planning perspective, banks should focus on the following potential strategies to improve long term core funding... Strategic Opportunities: Utilize spheres of influence Customer segmentation analysis to drive both wallet and market share Differentiated pricing based on geography Hold lenders accountable for deposit generation Create not for profit accounts to attract both the not for profit as well as their constituents. Utilize special deposit products and off term CDs to minimize incremental cost of funds impact Refocus on business development instead of traditional branch managers and expand electronic media outlets and delivery Municipal deposit accounts from real relationships Acquire a Bank with a low loan to deposit ratio and/or purchase branches of other financial institutions Note: FinPro has a list of strategies that have worked for our clients over the past 30 years. 41

43 Utilize spheres of influence... People do not come to branches anymore They want information and advice Find the Spheres of Influence for each segment you want to And will be your best serve. salesperson, or your worst! 42

44 Customer segmentation analysis to drive both wallet and market share... The Wealth Market Online Living Asset Management Auto Loans Prestige Savings Accounts Personal Relationship Online Living The Wealth Market HELOC Online/Mobile Banking and Bill Pay Convenience Credit Cards and Lines of Credit Residential Mortgages Credit Cards and Lines of Credit Banks must win customers and build relationships, not focus on products and transactions 43

45 Differentiated pricing based on geography... Market Area 1 Market Area 2 Market Area 3 44

46 Hold lenders accountable for deposit generation... 45

47 Create not for profit accounts to attract both the not for profit as well as their constituents... 46

48 Utilize special deposit products and off term CDs to minimize incremental cost of funds impact... If a Bank has a 40% beta value, MMDA accounts would increase by 40 bps in a 100 bps rate move, resulting in $650k of MMDA annual expense vs $250k Another alternative to rising rates is to create a promotional deposit account and allow the other deposits to run off The key is to understand the break even rate for potential deposit disintermediation or runoff 47

49 Municipal deposit accounts from real relationships and understand what portions of balances are likely at risk... Banks also need to use letters of credit for their municipal deposits to free up their securities so that they are not pledged as collateral. 48

50 Acquire a bank with a low loan to deposit ratio and/or purchase branches of other financial institutions... Buyer s loan to deposit ratio pre-deal is nearly 105%, but post deal declines to approximately 95% and provides new markets and customers to grow the buyer s funding base 49

51 Conclusions 50

52 With liquidity risk increasing, community banks need to focus on both regulatory and business strategies... Regulatory Strategies: Business Strategies: Create detailed funding Utilize spheres of influence concentration risk analytics Customer segmentation analysis to drive both - Stratify funding using the wallet and market share Liquidity Matrix Differentiated pricing based on geography - Conduct a Deposit Loyalty Hold lenders accountable for deposit generation Study Create not for profit accounts to attract both the - Determine the Local Rate Cap not for profit as well as their constituents. by funding product Utilize special deposit products and off term CDs Conduct forward looking Stress to minimize incremental cost of funds impact Tests Refocus on business development instead of - Tie assumptions to the results traditional branch managers and expand of the Liquidity Matrix electronic media outlets and delivery - Create realistic contingency Municipal deposit accounts from real relationships funding strategies Expansion of electronic media outlets and delivery Train board members Acquire a bank with a low loan to deposit ratio Update liquidity policy and and/or purchase branches of other financial contingency funding plan to reflect institutions the above process 51

53 Thank you for participating in today s conference... For more information, please contact us directly at: Donald Musso, President Scott Polakoff, Executive Vice President Scott Hein, Director Tim Koch, Director dmusso@finpro.us spolakoff@finpro.us 2016 FinPro, Inc. 52