What is Liquidity? Ability and ease with which assets can be converted to cash to meet shortterm obligations, without incurring unacceptable losses Me

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1 Fundamentals of Liquidity Management Chris Shipman, CFP Advisor Catalyst Strategic Solutions Overview Define Risks Measurement Planning Policy Review 1

2 What is Liquidity? Ability and ease with which assets can be converted to cash to meet shortterm obligations, without incurring unacceptable losses Measurement of cash flow mismatches between sources and uses of cash on a credit union s balance sheet The fundamental role of credit unions in transforming short-term deposits into longer-term loans (or investments) makes the credit union vulnerable to liquidity risk. Liquidity is Not Liquidity is different than capital or net worth High capital or net worth does not ensure liquidity High capital or net worth does not ensure access to borrowed funds Low capital or net worth will reduce access to borrowed funds Liquidity is different than Solvency Liquidity is the ability to meet short-term financial obligations Solvency is the ability to meet long-term financial obligations 2

3 Liquidity Sources Primary Sources Cash (in excess of regulatory or operational requirements) Loan and Investment cash flow Non-term Shares Term Shares Secondary Sources Sale of Loans and/or Investments Borrowings Federal Home Loan Bank (FHLB) Non-Member Deposits Federal Sources Fed Discount Window Central Liquidity Facility (CLP) Liquidity Sources Primary Sources Secondary Sources Federal Sources Lowest cost Retain servicing revenue US government backed Pros Minimal Impact on cost of funds Potential gain on sale Structured amortizing borrowing Lenient credit requirements Challenges Cyclical Lack of control on timing and duration Reduced interest revenue Market value volatility Temporarily leverages balance sheet and dilutes capital Typically available for short-term liquidity needs Subject to collateral requirements 3

4 Liquidity Risk Liquidity is there Until it is not Liquidity Risk Risk effecting Liquidity Operational Operational Risk Market Risk Credit Risk Credit Liquidity Risk Concentration Concentration Risk Market 4

5 Liquidity Risk Factors impacting liquidity Change in balance sheet Higher reliance on indirect lending High allocation to non-conforming RE loans Rising use of leverage Reduces funding amounts Pledges liquid assets for collateral Membership Trends and Demographics Deposit trends Age distribution of membership Liquidity Risk Warning signs Rapid growth in Loansor Deposits Deterioration in credit quality Concentrated positions Heavy reliance on secondary funding (excessive leverage) 5

6 Liquidity Measurement Primary Criteria 1. Cash & ST Investments/Total Assets 2. Loans/Total Assets 3. Loans/Total Shares & Deposits 4. Liquidity Ratio (Uses/Sources) Recommendations 10% < 80% < 90% < 95% Liquidity Measurement Supplemental Criteria 1. Net LT Assets/Total Assets 2. Borrowings & NMD/Total Shares & Liabilities 3. Pledged Assets/Total Assets 4. Unfunded Liabilities/Cash & Investments 5. Unfunded Liabilities/ Borrowing Capacity Recommendations < 40% < 15% < 50% < 150% < 125% 6

7 Liquidity vs Profitability Too much liquidity sacrifices profitability Maintaining an ultra short investment or loan portfolio sacrifices yield, but improves liquidity Higher deposit rates retain shares but lowers earnings (increases cost-of-funds) 7

8 The Liquidity Three Step Plan* Step 1: Calculate/Review/Compare current and historical liquidity metrics Step 2: Forecast liquidity needs for the next 12 and 24 months Step 3: Monitor actual results versus forecast *ALCO members are responsible for reviewing and forecasting deposit and loan growth, ensuring adequate liquidity is available to meet any potential future needs. Step 1: Calculate/Review/Compare liquidity metrics Calculate and Review current and historical Primary Supplemental Various time horizons Compare Trends Various time periods Anomalies 8

9 Step 2: Forecast liquidity metrics for the next 12 and 24 months Use historical growth rates for each segment (Step #1) to build forecast Based on current numbers Adjust growth rate higher or lower Step 3: Monitor actual results versus forecast How accurate were the forecasts? What adjustments could be made to the forecasts? Primary Liquidity Metrics Forecasted Actual Difference Q Q Q Q Q Q Q Q Q Q Q Q Cash & ST Inv-to-Total Assets 12.00% 12.50% 13.00% 12.00% 14.03% 13.57% 15.81% 11.82% 2.03% 1.07% 2.81% -0.18% Loans-to-Total Assets 65.00% 65.00% 70.00% 70.00% 65.73% 65.85% 64.38% 66.70% 0.73% 0.85% -5.62% -3.30% Loans-to-Total Shares & Deposits 75.00% 75.00% 74.00% 74.00% 75.03% 75.18% 73.41% 76.31% 0.03% 0.18% -0.59% 2.31% Liquidity Ratio 85.00% 87.00% 87.00% 87.00% 89.30% 88.00% 86.00% 90.00% 4.30% 1.00% -1.00% 3.00% Net LT Assets-to-Total Assets 35.00% 35.00% 35.00% 35.00% 36.53% 35.63% 34.70% 34.47% 1.53% 0.63% -0.30% -0.53% 9

10 The Contingent Funding Plan NCUA 12 CFR Credit Unions less than $50MM in assets need a basic, written liquidity policy. Includes: Goals and limits for liquidity management Primary and secondary liquidity sources Credit Unions with $50MM+ in assets must establish a Contingency Funding Plan (CFP). Includes: Process to forecast, analyze and manage liquidity-stress events Early warning indicators Identify specific liquidity sources Identify responsibilities and thresholds Testing frequency 10

11 Contingent Funding Plan Establishes guidelines for management Assists in strategic planning direction Provides a road map response to stress events in advance - Contingency Funding Plan Example Policy: Maintain Cash & Short-Term Ratio above 10% Normal Conditions: If the ratio is above 10% Credit union is not seeking bids on loans or investments Access to external funding remains in-tact Loan and deposit rates are adjusted under normal conditions Business as usual 11

12 - Contingency Funding Plan Example Policy: Maintain Cash & Short-Term Ratio above 10% Moderate Liquidity Strain: If the ratio falls below 6% Sell marketing securities with gains Sell all 1st mortgage originations Raise indirect auto loan rates by 25 bps and direct rates by 10 bps Raise term deposit rates by 5 bps above local peer average - Contingency Funding Plan Example Policy: Maintain Cash & Short-Term Ratio above 10% Elevated Liquidity Strain: If the ratio falls below 5% Sell marketing securities with losses less than 5% Raise mortgage rates by 50 bps Raise indirect auto loan rates by 50 bps and direct rates by 25 bps Raise term deposit rates by 15 bps above local peer average Raise non-term deposit rates by 5 bps above local peer average Raise non-member deposits with a 24 month or greater term 12

13 - Contingency Funding Plan Example Policy: Maintain Cash & Short-Term Ratio above 10% Severe Liquidity Strain: If the ratio falls below 3% Sell all marketable securities Raise mortgage rates by 50 bps, limit originations to only those that can be sold immediately Raise indirect auto loan rates by 100 bps and direct rates by 100 bps Raise term deposit rates by 25 bps and non-term by 10 bps above local peer average Access secondary term borrowings with a 24 month or greater term Liquidity Management Last Thoughts: Liquidity management is vital to a credit union Understand the factors that can impact liquidity Watch out for early warning signs, act accordingly Review liquidity plan annually 13

14 Questions Chris Shipman, CFP Advisor, Catalyst Strategic Solutions