Liquidity Risk Managing an Effective Program Session #2. Course Agenda

Transcription

1 Liquidity Risk Managing an Effective Program Session #2 David Koch Chief Operating Officer x Course Agenda Understanding Nature of Liquidity Asset based vs. Total Liquidity How to Classify Sources and Uses Causes of Liquidity Risk in FI s Regulatory Actions and Expectations Building a Measurement Framework Monitoring Ratios (Triggers) vs. Limits Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Liquidity Gap (Sources & Uses) Role of the Contingency Funding Plan (CFP) What is contingency planning? How does scenario planning differ from contingency planning? Stress Testing Liquidity What are Liquidity Stress Tests General Considerations for Testing Current Priorities Assumption Sensitivity Developing the necessary buffer for liquidity risk How much do you need in savings vs. secondary liquidity? 2 1

2 A Practical Approach to Liquidity MEASURING CASH FLOW BASED LIQUIDITY 3 Liquidity Gap Report Pro forma cash flow analysis: Projected sources and uses of funds over various scenarios Like rate movements or what-if plans Show exposures to variables and report to board and establish contingencies What sources change and why (optionality, credit risk, performance risk) What uses change and why (loan demand, potential deposit outflow, etc.) Assumptions should be reasonable and appropriate. Institutions with reliance on securitization and sale for cash should consider impact of conditions that may effect availability of funds. 4 2

3 Liquidity Gap Report Liquidity Gap Report Summary of Cash Flow sources and uses impact on liquidity Use a forecast (Plan) for growth assumptions Use starting cash flows to project inflows and outflows Allows for Assessment of Contingency Funding Plan Stress Tests to Determine Liquidity needs Impact of missing deposit growth by 10% What if loan repayments accelerate or slow? What happens to total ratio if access to key funding sources is gone? Brokered CDs FHLB 5 Asset Sources/Uses First two of forecast show Assets are a net drain of funds in years 1 & 2: $25.7 million Investments are providing sources of funds to fund loan growth $3.8 million over 2 years Loans using $29 million in funding by end of Yr

4 Liability Sources/Uses Non-maturity funding providing $2.7 million over 2 years CDs expected to provide $6.9 million. Equity growth from earnings also contributing (not shown) Remainder is borrowed by model. Sources MUST = USES 7 Sources/Uses Summary Cumulative Cash Flow Based Liquidity Gap No borrowings, securities, or OBS commitments 2. Adjustment to Liquidity Available securities, borrowings, and potential customer draws on liquidity 3. Cumulative Liquidity Gap/Assets our primary measure of long-term liquidity includes adjustments for investments, borrowings & OBS commitments 8 4

5 Sources/Uses Summary Cumulative Cash Flow Based Liquidity Gap No borrowings, securities, or OBS commitments 2. Adjustment to Liquidity Available securities, borrowings, and potential customer draws on liquidity 3. Cumulative Liquidity Gap/Assets our primary measure of long-term liquidity includes adjustments for investments, borrowings & OBS commitments 9 Sources/Uses Summary Test passed because of wholesale and investments available for liquidity, NOT CASH FLOW. Determining Adequacy of limits by applying realistic stress tests and deciding how low you can go. 10 5

6 Using Liquidity Gap Advantages Dynamic measure derived from business plan Considers sources and uses of funds Gap between sources and uses is liquidity buffer Buffer includes cash flow mismatch, asset based buffer (LCR), and liability based buffer (unused borrowing capacity) Liquidity gap/assets can be used as control ratio Can be stress tested Recommendation Primary long-term measure of liquidity in policy statement Limits set on pre- and poststress ratios 11 A Practical Approach to ALCO COMBINING LIQUIDITY AND INTEREST RATE RISK TESTING 12 6

7 FDIC Definition of Stress Testing Credit Risk Stress Testing Advisory Summer 2012 Stress testing is a forward-looking quantitative evaluation of stress scenarios that could impact financial condition and capital adequacy. These risk assessments are based on assumptions about potential adverse external events. Stress tests are most useful when customized to reflect the characteristics particular to the institution and its market area, and can be used to evaluate credit risk in the overall loan portfolio, segments of portfolios, or individual loans. Stress tests also can be used to evaluate whether existing financial (such as capital and liquidity) and operational (such as staffing and internal systems) resources are sufficient to withstand an economic downturn or unexpected event. Inter-relationships OCC Community Bank Stress Testing Issued 10/18/2012 Lays Out Supervisory Expectations Primarily focused on Credit Stress Testing Generally Stress Tests Should Lay Out Plausible What If Questions Assess Impact of What-If Incorporate Results into Institution Risk Management Process If Major Problems are Uncovered at the Basic Level, Additional Detailed Analysis May be Necessary 14 7

8 Stress Test Objective Test whether an institution has sufficient capital to remain Well Capitalized after a severe stress Says to us: New capital regulations will set minimums Stress tests will define cushions Recently verbalized regulatory approach Stress tests not a requirement for community banks Simple enough to be done in a spreadsheet Excel or Lotus Maybe?? 15 Stress Testing Liquidity Scenarios: Make them realistic but severe Tailored to your specific areas of risk for your business model Objective: Will your institution have enough sources of liquidity (primary & secondary) to withstand stress events Note that financial condition factors will impact this assessment Capital levels drive liquidity sources Liquidity levels drive earnings and capital 16 8

9 Scenario Management Scenarios effect the entire institution not just one risk area Key Challenge: translating scenarios into enterprise-wide measures Balance sheet and income statement Cash flow impact Key ratio analysis Individual risk limits Secondary Challenge: Once we run, how much insurance do you buy? How does the likelihood of the scenario impact? 17 Stress Tests Typical Community Bank Lender Scenario: Large balances in liquid assets Excess cash invested into agency bonds and MBS in Bonds purchased at 3-6% premiums Economy Forecasted to Recover early 2013 Projecting increase in loan balances funded by excess cash and investment repayment Deposit costs rising and potential loss of deposits to higher rate products (NOT STATIC) or disintermediation Stress test: Deposits leave at faster rate or greater % move to higher rate sector Bonds sold at discount (market value) and premium write-down to fund loan commitments and fund withdrawals Increased use of Wholesale funding to meet needs 18 9

10 Stress Tests Midwest Ag Lender Scenario: Primary Clients:: farmers in grain markets and Corn prices have been at all-time highs. Concern over future prices and borrowers reliance on pricing Risks to Cash Flow: Grain price fluctuations, Crop damage due to weather, Spikes in production costs Potential Impacts: Credit and Liquidity Risks if prices drop Stress Tests: Individual Borrowers (Loan level)) for impact of price changes Liquidity (cash flow) and earnings implications on capital 19 Economic Scenarios Base Case Key Forecast Assumptions (60%) Fiscal Policy: Automatic Spending Cuts and the Bush Tax Cuts. do not expect the automatic spending cuts now scheduled to begin in January 2013 to take effect assume new Congress and president will produce a package of spending cuts and tax increases including cuts in Medicare, Medicaid, and Social Security, and increases in income tax. Begin in January 2014; assume Bush tax cuts extended for Oil Prices Resilient. Expect refiners acquisition cost for crude oil to average $113/ barrel in Corresponds to average price for Brent oil $120/barrel in

11 Economic Scenarios Base Case Key Forecast Assumptions (60%) Federal Reserve to Hold Rates Near Zero Until late The Fed has said that it expects to keep its federal funds target in the % range until at least late We assume that the Fed will start to hike rates in November of Global Growth Slowing. expect GDP growth in the United States major-currency trading partners to weaken to 1.1% in 2012, from 1.8% in This mainly reflects a recession in the Eurozone, where we expect GDP to contract around 0.5%. GDP growth for other important trading partners is projected to slow to 4.3% in 2012, from 5.3% in Economic Scenarios High Rate Key Forecast Assumptions (20%) Better news from Europe and the Middle East boost stock markets. Oil prices fall and US economic growth accelerates, leading the Fed to raise interest rates in late 2013 (instead of 2014). Safe-haven demand falls, sending the US dollar lower against major currencies and driving long-term interest rates higher. Impact: Fast loan growth pressures liquidity Rising cost of funds squeezes margins Capital management under double pressure Rapid denominator growth Slower earnings growth 22 11

12 Economic Scenarios Low Rate Key Forecast Assumptions (20%) Oil and Europe combine to tip the economy back into recession. Spanish borrowing costs rise to unsustainable levels leading to a default. Credit markets freeze in Europe and lead to much tighter credit conditions worldwide. Panic settles upon financial markets as stock prices plummet and investors race to the safety of US Treasuries. Fading economic growth and disinflation push the Fed to keep interest rates near zero through 2015 & expand balance sheet further. Long-term interest rates stay low for longer. Impact: Slow loan growth, yield compression, credit risks rise, more deposit growth (flight to safety) 23 Economic Scenarios General Economic Forecasts Base Case Key Forecast Assumptions (60%) Fiscal Policy Assumptions: Discretionary Spending. real nondefense federal government spending falls 1.7% in calendar 2012 and 2.6% in 2013 as budget cuts bite. Fiscal Policy: Expiring Stimulus. assume 2% payroll tax cut and emergency unemployment insurance benefits are extended for 2013, and phased out over several years, rather than disappearing overnight. Oil Prices Housing Demand Add in relevant parts to your planning Institution Assumptions Asset Growth Assumed at 2-3% Loan Growth sluggish 3-5% Net Deposits growing to replace maturing Institution Capital Plan Goals Maintain > 7% Capital/Asset Increase ROA

13 Liquidity Issues to Address Economic Recovery Erodes Cash Flow Loans growing faster than deposits ($125 million) Deposits running out to higher returns (35-40 million) Existing Borrowing Capacity Consumed to meet loan demand ALCO must develop funding plan to raise deposits or, manage asset growth What other risks are raised with this potential scenario? Interest Rate & Credit Risk Capital compliance & Earnings? 25 Alternative Scenarios Recovery Scenario Rates increase in 6-12 months dramatically Loan growth jumps 25% Deposit runoff increases to 10% Double Dip Long term rates remain below 2% for another 18 months Planned loan originations decline 50% Prepayments slow by 75% Customers increase draws on existing Lines of Credit by 25% 26 13

14 2 Yr.. Forecast Liquidity Comparison Base Plan Economic Recovery 27 2 Yr.. Forecast Liquidity Comparison Base Plan Economic Recovery 28 14

15 Stress Test Comparison Over 1 Yr.. Level of HQLA under Stress Increases, causing LCR levels to Rise ALCO must document assumptions behind stress test Loan payments decline 25% and prepayments 50% Loan originations planned to drop 50% to offset loss of flow, resulting in lower total assets Investment purchases set to 0 in stress 29 Stress Test Comparison Table helps pinpoint changes between base and stress scenarios 30 15

16 Stress Test and Borrowing Capacity Institutions total capacity to borrow offers 3 uses: Strategic Management ALCO Uses for managing earnings ALCO Uses for matching risks Short-term buffer Unanticipated growth requiring funding. Unanticipated runoff of large depositor or deposits Long-term buffer The savings under the mattress in case of emergency Major Question: How much capacity do we need to keep available in case of a liquidity need? 31 Determining Long Term Funding Needs Base Cash Flow Gap 1 Yr.: -1.1 Million + Unencumber Liquid Assets 1 Yr Million Stress Test Results: -50% Loan Repayments -50 Million -20% Deposit Runoff -35 Million -20% Increase in Line Draws - 6 Million Total Change in Stress Test -91 Million Net Position B4 Management Action -66 Million 32 16

17 Determining Long Term Funding Needs Net Position Before Management Action Management Actions: -66 Million 25% Decrease in Loan Origination 38 Million Net Need for Long Term Liquidity -28 Million Total Borrowing Capacity $125 Million Reserve between 28 & 66 Mil of capacity for liquidity risk Minimum Reserve Maximum Reserve Total Borrowing Capacity to Retain for Liquidity 22% 53% 33 Stress Tests & The Liquidity Gap Ratio Modify Base Plan with Stress Assumptions Changes the projected sources & uses cash flows Impact shows on income statement & ratio reports Establishing Section 2: Adjustments Limit Available Borrowing Capacity to Amount Above the Limit Allows for ratio to show if you are dipping in to the reserves Limit is to maintain a positive total liquidity gap We have enough without hitting reserve If you use total capacity, adjust policy limits to address need for floor amounts Make sure you are including remaining available securities (asset based) liquidity in forecast analysis 34 17

18 Liquidity Gap Comparison Stress test total liquidity gap in yellow zone for 8 Qtrs then recovery begins 35 Examining Earnings at Risk Overall 1 Yr.. Projected Earnings Higher in Economic Recovery vs. Base Volatility in earnings higher but not outside limits 36 18

19 Forecast Capital Position Capital remains above the 7% in all scenarios except in the Recovery with GI High Rates (high probability) All recovery scenarios put pressure from increase asset growth on capital levels. 37 Forecast Net Interest Margin Levels No major swings in margin over 2 year forecast but trends show downward pressure in recovery Funding costs 38 19

20 Installing Dynamic Liquidity Management Our Belief in Best Practice: Design stress tests to correspond to economic conditions (consistent with other ALCO risks) Update quarterly as economic conditions change Run doomsday scenario annually Helps identify possible funding risks Helps set capital planning priorities Integrate key measurement assumptions across all risk areas Core deposit studies help define at risk funds Cash flow projections identify ALCO model risks 39 Contingency Funding Plans (CFP) ROLE OF THE CFP 40 20

21 Genesis of the CFP Intended to set boundaries on various funding activities Acting like a liability concentration policy Outlines primary and secondary funding sources Identifies when institution will use various sources Assigns responsibilities for managing events Defines Crisis Events and Stress Tests Short Term 3 Month projection of cash flows Normal plan 10% and 20% deposit runoff Long Term 12 Month projections Assumes cut off from many wholesale sources How much would you have to raise to survive? 41 Genesis of CFP Issues in initial approach Liquidity events are defined in a vacuum No consideration for other impacts of the stress test Income Capital Short term (< 12 months) Current ALCO guidance looks at minimum of 24 months for earnings at risk Applies big bank approaches to community institutions Result: Institutions carry more assets to cover loss of wholesale funding that may or may not occur

22 Contingency Funding Plan Many Banks developed separate CFP During the crisis regulators asked for CFP Little integration with liquidity policy Traditional CFP Identifies Non & Near Core Funding Limits Funding Sources Capital Plan Goals In the Liquidity Policy Early Warning Signs (Trigger Ratios) Many can roll CFP items into new Liquidity Framework Consider combining Liquidity with IRR Policy to form an ALM policy? Lead with Capital Planning Process 43 CFP for Capital Failure Numbers 3, 5, and 6 are already in base business plan Number 4 and further implementation of 5 are in stress scenario 44 22

23 CFP for Cascading Events These items are all implemented as capital failure scenario continues to unwind. 45 CFP for Economic Recovery Even though the numbers are in the base business plan, we need to put together a plan to deal with this scenario as it unwinds. Note that while in base business plan these Actions deal with Events as they unwind

24 CFP for Market Dislocation Even though we are saying that the LCR test serves as a more severe test than what is likely to happen in this scenario, we still need a CFP containing Actions to deal with Events as they unwind. 47 CFP for Payment Disruption Even though we are saying that the LCR test serves as a more severe test than what is likely to happen in this scenario, we still need a CFP containing Actions to deal with Events as they unwind

25 Sound Liquidity Practices Governance BOD and management Appropriate strategies, policies, procedures Cash flow oriented measurement systems Intraday collateral and liquidity management Diverse mix of present and potential funding sources Adequate levels of highly liquid marketable securities Comprehensive contingency funding plans addressing adverse events Internal controls and `audit requirements 49 Liquidity Policy Framework Many Banks have Separate Policies Interest Rate Risk Investment/Liquidity Evolving Framework is Single ALCO Policy Recognized Interdependence of risks Consistent with Capital Plan Allows for evaluation of concentration risks in single policy 50 25

26 Liquidity Policy Framework Main Sections Purpose Statement Governance Liquidity Strategies Funding Sources Measurement and Reporting Systems Limits Contingency Funding Plan Liquidity Stress Events 51 Liquidity Policy Framework Governance Board is ultimately responsible for liquidity levels Management Assumes responsibility for Execution of Board policies, procedures and strategies Development of policies, procedures & measures Development of CFP & Stress Events Internal Controls Management runs back tests 52 26

27 Liquidity Policy Framework Strategies Describe how liquidity risk fits in context of capital plan and other ALM risks Set general strategy considerations for meeting liquidity needs. For example: Identify the primary sources of funding Provide for alternative responses to business scenarios Deal with temporary, short-term and long-term liquidity disruptions Operate within liquidity risk tolerance levels Incorporate periodic review of assumptions used in liquidity projections Utilize cash flow projections 53 Liquidity Policy Framework Funding Sources Outline Available Funding Sources Set Source Role Base (Primary) Funding: Used to meet business plan needs. Contingent Funding: Available in times of stress to meet unanticipated needs. Acts as a reserve source Typically set limits here on general mix of Non & Near Core Source Usage in normal operating conditions In times of stress, the goal is survival. Extension beyond limits may be only option 54 27

28 Funding Source Identification 55 Liquidity Needs Analogy Approach Bank Liquidity Needs As You Would Personal Financial Management: Base or Primary Liquidity Is a Savings Balance Target: 3 months of savings to cover monthly expenses Secondary Liquidity from Saleable Assets & Secondary Sources Keep at least 6 months of monthly expenses available on credit sources Third Level Management Actions What will I Do to Lessen Impact on Liquidity Needs while meeting market demands? Goal: Maintain enough primary and secondary liquidity to manage at least 12 months of liquidity need

29 Issues in Setting Limits Gradient Limits (Red, Yellow, Green) must relate to individual bank : When operating at or below this level the bank finds itself unable to meet demands. Requires immediate and possibly drastic actions : Liquidity levels are below idea but are not jeopardizing operations. Actions should be taken but measured for impact on all other capital plan and risk issues : Liquidity levels are at or above levels seen as normal and low risk for the bank. No major actions are required. 57 Policy Limits Primary Policy Limits Liquidity Coverage Ratio Establishes a measure of required short term liquidity Cash flow Marketable securities Set ranges for performance 58 29

30 Policy Limits Intermediate term liquidity Cumulative Liquidity Gap Indicates how operating plan is impacting future liquidity levels. Assesses risk in context of bank actions, prospectively 59 Policy Limits Near-Core & Non-Core Funding/Total Assets Threat Level < 35% Green Light 35% - 40% Yellow Light > 40% Red Light Policy Limit Funding Mix Is the bank maintaining its proper mix of funding sources Goal is to prevent rapid changes in mix to less reliable funding sources Consistency with capital plan Note that this type of analysis could/should extend into measurement of all Asset/Liability Risks 60 30

31 Policy Limits Stressed Liquidity Limit Liquidity Gap with Stress events applied Can the bank withstand the potential threats to liquidity? Used to set the level of required contingent funding sources Note that this type of analysis could/should extend into measurement of all Asset/Liability Risks 61 Reporting Define Frequency What do we watch on monthly/quarterly basis? Monthly Reporting Use Early Warning or Trigger Ratios to Monitor Changing Trends When triggers move or limits are in Yellow or Red levels, more frequent reporting kicks in Quarterly Reporting Risk Levels vs. Limits Liquidity Coverage Ratio Liquidity Gap Report Funding Mix Liquidity Gap with Stress Events 62 31

32 Reporting By Risk Type Intra-Day Liquidity Reporting Daily Reporting of cash position by CFO/Controller Cash letters ACH activity and clearings Wire transfers Securities transactions Other items affecting the bank s cash position Not typically reported at ALCO or to board review unless insufficient levels exist 63 Reporting Suggested Reporting By Risk Type Short Term Asset Based Liquidity Needs Primary Policy Limit: Liquidity Coverage Ratio Trigger Ratios: Early Warning Indicator Report Available High Quality Liquid Asset Levels Deposit & Asset Growth Rates Contingent Funding Source Status Report Outlines each contingent source, availability and status Performance Variance Trends Comparison of past 4 quarters vs. policy Minutes must explain any variances 64 32

33 Monthly Reporting XYZ Bank Monthly Report of Liquidity Trigger Ratios Balance Sheet Trigger Ratios Dec- 10 Nov- 10 Oct- 10 Sep- 10 Rapid Asset Growth? % % 2.15% % Deposit Decline? % 4.60% 1.76% 4.60% Capital Triggers Have Earnings been Negative for past 3 Mo? No No No No Is Capital/Assets > Well Capitalized Target? No Yes Yes Yes Asset based Liquidity Trigger Ratios Highly Liquid, Marketable Securities/Total Assets 14.78% 12.55% 10.48% 12.55% Emerging Credit Risk Triggers Non- Performing Assets/Total Assets 3.50% 2.28% 2.00% 2.28% Net Charge Offs/Total Assets 1.78% 1.50% 1.10% 1.50% 65 Quarterly Reporting XYZ Bank Quarterly Report of Liquidity Policy Measurements & Limits Primary Policy Limits Dec- 10 Sep- 10 Jun- 10 Mar- 10 Liquidity Coverage Ratio 78.70% 82.60% 78.70% 78.70% Cumulative Liquidity GAP Ratio (1 yr) 15.00% 17.00% 21.00% 22.50% Stressed Cumulative Liquidity Gap Ratio (1 yr) 7.20% 9.20% 12.00% 15.00% Near & Non- Core Funding /Total Assets 14.78% 14.78% 14.78% 14.78% Balance Sheet Trigger Ratios Rapid Asset Growth? % % 2.15% 4.40% Deposit Decline? % 4.60% 1.76% % Capital Triggers Have Earnings been Negative for past 3 Mo? No No No No Is Capital/Assets > Well Capitalized Target? No Yes Yes Yes Asset based Liquidity Trigger Ratios Highly Liquid, Marketable Securities/Total Assets 14.78% 12.55% 10.48% 7.70% Emerging Credit Risk Triggers Non- Performing Assets/Total Assets 3.50% 2.28% 2.00% 1.54% Net Charge Offs/Total Assets 1.78% 1.50% 1.10% 0.76% 66 33

34 Reporting Suggested Reporting By Risk Type Additional Supplemental Quarterly Reporting Pledged to Total Security Ratios Market Value of Pledged Securities with Trends Available Collateral Calculation for Non-Core Sources Results of pledging/collateral tests for contingent sources 67 34