LIQUIDITY AND FUNDS MANAGEMENT

Transcription

1 LIQUIDITY AND FUNDS MANAGEMENT STRATEGIC TOPIC INTERSESSION PROJECT by: Brian Heim

2 LIQUIDITY AND FUNDS MANAGEMENT TABLE OF CONTENTS INTRODUCTION 1 PART I: LIQUIDITY GUIDANCE AND TRENDS 2 PART II: FUNDS MANAGEMENT PRACTICES AT BANK 9 PART III: LIQUIDITY RISK AT BANK 16 PART IV: RECOMMENDATIONS 19 EXHIBIT A: INTEREST RATE RISK AND ASSET/LIABILITY MANAGEMENT POLICY 21 EXHIBIT B: ALCO PACKET FROM APRIL 14, EXHIBIT C: PROPOSED NEW CASH FLOW REPORT 59

3 LIQUIDITY AND FUNDS MANAGEMENT INTRODUCTION The Board of Directors of Bank has requested a formal review of the Bank s liquidity and funds management practices. This document will serve as a liquidity plan in response to that request. The objective of this document is to identify potential improvements in Bank s liquidity and funds management practices. Evaluation of potential improvements will be based on FDIC examination policies and more recent liquidity-related guidance. Section 6.1 of the FDIC Risk Management Manual of Examination Policies outlines the criteria for well-developed funds management practices. Additional guidance on liquidity risk management was released by the FDIC in Financial Institution Letters dated August 26, Most recently, an article titled The Changing Liquidity Landscape was issued in the Winter 2008 edition of Supervisory Insights, which is published by the Division of Supervision and Consumer Protection of the FDIC. While this publication has an explicit disclaimer that the views should not be construed as definitive regulatory or supervisory guidance, the article may be used as a supplemental resource due to its timeliness. This document is divided into four parts. Part I will review and summarize current liquidity guidance and industry trends. Part II will examine the liquidity levels and funds management practices at Bank. Part III will evaluate the current liquidity risks specific to Bank. Part IV will propose recommendations for improving Bank s liquidity and funds management practices. In order to make the analysis as relevant at possible, most figures will be from the end of the first quarter of GSBC 1 of 59

4 LIQUIDITY GUIDANCE AND TRENDS The FDIC Risk Management Manual of Examination Policies was last updated on April 6, It identifies liquidity management among the most important activities that a bank conducts. Liquidity and funds management are separated into the following eight sections: Introduction Liquidity Management Warning Indicators and Contingency Liquidity Plan Funding Sources: Assets Funding Sources: Liabilities The Role of Capital and the Bank Holding Company Evaluation of a Bank s Liquidity Rating the Liquidity Factor The introduction defines liquidity and liquidity risk, emphasizes the importance of effective liquidity management, and states that the adequacy of a bank s liquidity is variable at different banks and at different times. Determining the adequacy of a bank s liquidity requires an analysis of the current liquidity position, present and anticipated asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs, and options for reducing funding needs or obtaining additional funds. The introduction outlines the major elements of liquidity as follows: To provide funds to satisfy liquidity needs, one or a combination of the following must occur: Disposal of assets. Increase in short-term borrowings and/or issuance of additional short-term deposit and depositlike liabilities Increase in long-term liabilities Increase in capital through earnings, capital injection, stock issuance, or issuance of other capital instruments In terms of a balance sheet, these four events can be simplified to (i) decrease assets, (ii) increase deposits, (iii) increase borrowings, or (iv) increase capital. The complicating factor is that liquidity must be provided without incurring an unreasonable cost. The section on liquidity management provides specific requirements for board and senior management oversight, policies and procedures, management information systems, and internal controls. The section on warning indicators and contingency liquidity planning provides specific requirements for these areas. The guidance from these two sections will be outlined in Part II of this document in order to compare specific FDIC requirements to funds management practices at Bank. GSBC 2 of 59

5 The three sections titled Funding Sources: Assets, Funding Sources: Liabilities, and The Role of Capital and the Bank Holding Company describe asset, liability, and capital liquidity elements in greater detail. Asset-based liquidity involves meeting liquidity needs by managing the bank s asset structure through either the sale or planned pay-down of assets. The amount of liquid assets that a bank should maintain is a function of the stability of its funding structure and projections for loan growth. If a bank has a stable funding base, predictable loan demand, and sufficient available borrowings for unexpected fluctuations, a lower level of liquidity is required. Traditional asset-based liquidity involves building a balanced investment portfolio during times of excess liquidity to use as a funding source when loan demand increases or deposit levels decrease. Problems with this liquidity strategy emerge when assets normally considered liquid are not easily or profitably liquidated. Losses can occur during liquidation if credit quality deteriorates within the investment portfolio, demand for a particular asset class declines, or interest rate changes reduce the sale price of investments. Factors that may indicate that a higher allowance for liquidity is required include: The competitive environment is such that bank customers can invest in alternative instruments (reducing demand for bank deposits). Recent trends show substantial reduction in large liability accounts. Substantial deposits are short-term municipal special assessment-type accounts. A substantial portion of the loan portfolio consists of large problem credits with little likelihood of reduction or marketability. A substantial portion of the loan portfolio consists of non-marketable loans. The bank expects customers to draw upon unused lines of credit or commitments in the near future. A concentration of credits has been extended to an industry with present or anticipated financial problems. A close relationship exists between individual demand accounts and principal employers in the trade area who have financial problems. A significant portion of assets is pledged to support wholesale borrowings. Access to the capital markets is impaired. As an alternative to selling assets to meet liquidity needs, funding requirements may be met through liability sources, in the form of customer deposits or wholesale funding. The primary source of funding should be customer deposits and the FDIC maintains the importance of implementing programs to retain and, in most instances, expand the deposit base and of monitoring the nature and volatility of the deposit structure. At a minimum, banks should have a deposit management program that includes the following information: A clearly defined marketing strategy. Projections for deposit growth and structure. Associated cost and interest rate scenarios. GSBC 3 of 59

6 Procedures to compare results against projections. Steps to revise the plan when needed. The program should incorporate an understanding of the make-up of the market area economy, including local and national economic conditions; the potential for investing deposits at acceptable margins, management competence, the adequacy of bank operations, the location and size of facilities, the nature and degree of bank and non-bank competition, and the effect of monetary and fiscal policies of the Federal government on the bank s service area and money and capital markets in general. Wholesale funding is generally used in a liability-based liquidity strategy to meet funding needs as required. Wholesale funding sources include Fed Funds, public funds, FHLB advances, FRB loans, brokered deposits, and deposits obtained through the Internet or CD listing services. The use and risk of such funding sources varies widely depending on the circumstances of individual financial institutions. When the terms and conditions of such funding sources are well understood and managed, wholesale funding can facilitate an institution s ability to meet liquidity needs. Controlling liquidity risk typically becomes more challenging with greater use of nontraditional funding sources and requires enhanced funds management. Related items, such as contingency planning, capital management, and reputation risk also become more significant. The following are potential red flags that may require enhanced liquidity risk management with regard to brokered deposits: management: Ineffective management or the absence of appropriate expertise. Newly chartered institution with few relationship deposits and an aggressive growth strategy. Inadequate internal audit coverage. Inadequate information systems or controls. Identified or suspected fraud. High on- or off-balance sheet growth rates. Use of rate sensitive funds not in keeping with the bank s strategy. Inadequate consideration of risk, with management focused exclusively on rates. Significant funding shifts from traditional funding sources. The absence of adequate policy limitations on these kinds of funding sources. High delinquency rate or deterioration in other asset quality indicators. Deterioration in the general financial condition of the institution. Other conditions or circumstances warranting the need for administrative actions. The following are risks associated with borrowed funds that may require enhanced liquidity risk Secured borrowings can impact a bank s liquidity profile by pledging high quality assets, lessening the availability of such assets for contingent liquidity demands. GSBC 4 of 59

7 If the institution s condition or the economic climate deteriorates, it will be more difficult to borrow funds economically, if at all, when needed most. Change in market conditions can make it difficult for the bank to secure funds and to manage its funding maturity structure. Due to rate competition, a bank may incur relatively high costs in obtaining funds and may lower credit quality standards in order to invest in higher yielding loans and securities. If a bank is purchasing liabilities to support assets already on its books, the high cost of borrowings may result in a negative yield spread. Preoccupation with obtaining funds at the lowest possible cost, without proper consideration given to diversification and to maturity distribution, intensifies a bank s exposure to funding concentrations and the risk of interest rate fluctuations, respectively. Management might not fully understand the terms of the particular borrowings. Some borrowings have embedded options that make their maturity of future interest rate uncertain. This uncertainty can increase the complexity of liquidity management and, under certain circumstances, may increase cost of funding. The fourth major element of liquidity, in addition to assets, deposits, and borrowings, is capital. Capital can be viewed as a funding source, but that is not its main purpose. Used strictly as a funding source, capital does not provide an adequate return on investment and dilutes existing shareholders. It must be leveraged with deposits and borrowings to support earning assets at a profitable margin. Capital issued to banks from bank holding companies may produce a negative effect on liquidity. Trust Preferred Securities and TARP Capital Purchase Program capital, for example, require quarterly payments of a fixed amount by the bank holding company. A typical holding company has no source of revenue, no liquid assets, and a leveraged balance sheet. The holding company generally depends on dividends from bank subsidiaries for funding to service the payments. Issuing new equity is a relatively slow and costly way to raise funds from a liquidity perspective and should not be viewed as an immediate or direct source of liquidity. The following two paragraphs are excerpts from the FDIC Risk Management Manual of Examination Policies regarding the evaluation of a bank s liquidity: Perhaps more than any of the other component ratings, except the management component, the liquidity component should be assigned in the context of other financial factors. Banks with very strong capital positions and earnings fundamentals are likely to be able to easily fund ongoing operations and have no difficulty raising liquidity for even unforeseen events. Conversely, banks with low levels of capital, weak earnings, or asset deterioration, may find financing to be more expensive or borrowing line maturities reduced. Under the Uniform Financial Institutions Rating System, in evaluating the adequacy of a financial institution s liquidity position, consideration should be given to the current level and prospective sources of liquidity compared to funding needs, as well as to the adequacy of funds management practices relative to the institution s size, complexity, and risk profile. In general, funds management practices should ensure that an institution is able to maintain a level of liquidity sufficient to meet its financial obligations in a timely manner and to fulfill the legitimate banking needs of its community. Practices should reflect the ability of the institution to manage unplanned changes in funding sources, as GSBC 5 of 59

8 well as react to changes in market conditions that affect the ability to quickly liquidate assets with minimal loss. In addition, funds management practices should ensure that liquidity is not maintained at a high cost, or through undue reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. The following paragraphs are excerpts from the FDIC Risk Management Manual of Examination Policies describing the criteria for rating the liquidity factor: A rating of 1 indicates strong liquidity levels and well-developed funds management practices. The institution has reliable access to sufficient sources of funds on favorable terms to meet present and anticipated liquidity needs. A rating of 2 indicates satisfactory liquidity levels and funds management practices. The institution has access to sufficient sources of funds on acceptable terms to meet present and anticipated liquidity needs. Modest weakness may be evident in funds management practices. A rating of 3 indicates deficient liquidity levels or funds management practices in need of improvement. Institutions rated 3 may lack ready access to funds on reasonable terms or may evidence significant weaknesses in funds management practices. A rating of 4 indicates deficient liquidity levels or inadequate funds management practices. Institutions rated 4 may not have or be able to obtain a sufficient volume of funds on reasonable terms to meet liquidity needs. A rating of 5 indicates liquidity levels or funds management practices so critically deficient that the continued viability of the institution is threatened. Institutions rated 5 require immediate external financial assistance to meet maturing obligations or other liquidity needs. Liquidity is rated 1 through 5 with respect to the following: Volatility of deposits Reliance on interest-sensitive funds and frequency and level of borrowings Unused borrowing capacity The capability of management to properly identify, measure, monitor, and control the institution s liquidity position, including the effectiveness of funds management strategies, liquidity policies, management information systems, and contingency funding plans Level and diversification of funding sources Ability to securitize assets Availability of assets readily convertible into cash Ability to pledge assets Impact of holding company and affiliates Access to money markets The institution s earnings performance The institution s capital position The nature, volume, and anticipated usage of the institution s credit commitments Some of the more common ratios that examiners use are: Net Short-Term Non Core Funding Dependence Net Non-Core Funding Dependence Net Loans and Leases to Deposits Net Loans and Leases to Total Assets GSBC 6 of 59

9 Short-Term Assets to Short-Term Liabilities Pledged Securities to Total Securities Brokered Deposits to Deposits Core Deposits to Total Assets Examiners should recognize that UBPR liquidity ratio analysis might not provide an accurate picture of the institution s liquidity position. Characteristics and behavior of asset and liability accounts should be scrutinized prior to analyzing liquidity ratios. Loans, securities, deposits, and borrowings should be evaluated before using UBPR ratios to draw conclusions concerning the liquidity position. The FDIC Risk Management Manual of Examination Policies references the Uniform Financial Institutions Rating System, dated December 19, 1996, which contains a short directive on liquidity evaluation, as stated above. The major factors listed for evaluation are similar, but stated another way, as follows: The adequacy of liquidity sources compared to present and future needs and the ability of the institution to meet liquidity needs without adversely affecting its operations or condition. The availability of assets readily convertible to cash without undue loss. Access to money markets and other sources of funding. The level of diversification of funding sources, both on- and off- balance sheet. The degree of reliance on short-term, volatile sources of funds, including borrowings and brokered deposits, to fund longer term assets. The trend and stability of deposits. The ability to securitize and sell certain pools of assets. The capability of management to properly identify, measure, monitor, and control the institution s liquidity position, including the effectiveness of funds management strategies, liquidity policies, management information systems, and contingency funding plans. The most recent formal guidance on liquidity and funds management from the FDIC was released in Financial Institution Letters dated August 26, The guidance addresses elevated liquidity risk trends of some institutions that have shifted from asset-based liquidity strategies (i.e., maintaining pools of highly liquid and marketable securities to meet unexpected funding needs) to liability-based liquidity strategies (i.e., funding partly through securitization, brokered/internet deposits, or borrowings) and highlights the importance of a forward looking approach to liquidity planning. The following excerpt summarizes the guidance: For banks using liability-based or off-balance sheet liquidity strategies, traditional measures of liquidity, such as the ratio of loans to deposits or non-core funding dependency, may not provide an accurate view of the institution s true liquidity position. Such institutions should augment traditional liquidity risk measures with pro forma cash flow and scenario analysis, and should have realistic contingency funding plans that are responsive to changes in liquidity risk exposure. The FDIC expects institutions to use liquidity measurement tools that match their funds management strategies and that provide a comprehensive view of an institution s liquidity risk. Risk limits should be approved by an institution s board of directors and should be consistent with the measurement tools used. Some institutions have underestimated the difficulty of obtaining or retaining funding sources during times of financial stress. The terms associated with wholesale borrowings (both secured and unsecured) can become more restrictive when an institution faces either real or perceived financial difficulties. GSBC 7 of 59

10 Institutions that become less than well capitalized may face limits on the ability to accept, renew, or roll over brokered or high-cost deposits. The guidance from the Financial Institution Letters on Liquidity Risk Management dated August 26, 2008 addresses specific requirements for pro forma cash flows analysis, contingency funding, and liquidity risk limits and guidelines. The requirements from this guidance will be outlined further in Part II of this document in order to compare specific FDIC requirements to funds management practices at Bank. Institutions using liability-based funding strategies that have a significant exposure to cash flows resulting from the choices of customers should use pro forma cash flow statements as part of their liquidity analysis. Pro forma cash flow analysis shows the institution s projected sources and uses of funds. The analysis should incorporate scenarios that evaluate the general and unique risks faced by the institution, commensurate with the complexity of the institution s liquidity risk profile. Contingency funding events include the unplanned inability to fund asset growth, difficulty renewing or replacing funding as it matures, the exercise of options by customers to withdraw deposits or to draw down lines of credit, legal or operational risks, the demise of a business line, and market disruptions. A contingency funding plan should be developed according to the specific liquidity risk profile of an institution and identify the types of events which may cause a contingency funding event. The planning should incorporate the limitations set forth in Part of the FDIC s Rules and Regulations for both brokered and high-rate deposits, specifically that these limits can result in deposit run-off should an institution become less than adequately capitalized. In addition, all institutions that are less than well capitalized are prohibited from offering deposit rates that are significantly higher than the prevailing rates in the institution s market area. The final section of the FDIC s most recent liquidity guidance addresses liquidity risk limits and guidelines. Risk tolerances or limits should be appropriate for the complexity and liquidity risk profile of the institution and include both quantitative and qualitative guidelines. The sections states: Institutions may use other risk indicators in specifying risk tolerances. These may include, for example, ratios such as loans to deposits, loans to equity capital, purchased funds to total assets, and other common measures and ratios. However, in developing and using such measures, management should be fully aware that some measures may not appropriately assess the time dimension and specific characteristics of the institution s liquidity risk profile. Static balance sheet measures may not reveal significant liquidity risk that may exist under either normal or adverse business conditions and generally should not be the sole measures institutions use to monitor and manage liquidity. GSBC 8 of 59

11 The scope and frequency of a bank s internal liquidity risk management reports will vary according to the complexity of the institution s operations and risk profile. FUNDS MANAGEMENT PRACTICES AT BANK Liquidity management at Bank will be rated based on two factors including (i) actual liquidity levels and (ii) funds management practices. This section will focus on funds management practices at bank compared to guidance issued by the FDIC. Actual liquidity levels will be discussed in the context of funds management practices, when applicable. Two exhibits are attached to this document to demonstrate Bank s primary board-level methods to identify, measure, monitor, and control liquidity risk. Exhibit A is the Bank s Interest Rate Risk and Asset/Liability Management Policy (IRR/ALM Policy). Exhibit B is the Asset/Liability Committee (ALCO) Packet distributed for the regularly scheduled meeting held on April 14, Liquidity management guidance is clearly listed in Section 6.1 of the FDIC Risk Management Manual of Examination Policies. The guidance requires board-approved written policies and procedures for the day-today management of liquidity. Appropriate board and senior management oversight is required and liquidity levels must be reviewed regularly by the board, or a committee of board members. Proper oversight of liquidity risk includes the following, which Bank meets through ALCO and the annually updated IRR/ALM Policy (check marks indicate compliance with FDIC liquidity management guidance): Establishing procedures, guidelines, internal controls and limits for managing and monitoring liquidity to ensure adequate liquidity is maintained at all times. Preparing contingency funding plans. Reviewing the institution s liquidity position on a regular basis and monitoring internal and external factors and events that could have a bearing on the institution s liquidity. Reviewing periodically the institution s liquidity strategies, policies, and procedures. The FDIC details typical guidelines established by a sound liquidity and funds management policy and procedures (comments in italics are added to describe specific Bank practices; check marks indicate compliance with listed guidelines): Provides for the establishment of an asset/liability committee. Define who will be on the committee, what its responsibilities will be, how often it will meet, how it will obtain input from the board, how its results will be reported back to the board, and who has authority to make liquidity and funds management decisions. GSBC 9 of 59

12 An asset/liability committee is formally established by Bank s ALCO charter. ALCO meets monthly in practice and holds special meetings from time to time. The ALCO Chair gives a formal report to the board of directors monthly. Provides for the periodic review of the bank s deposit structure. Include the volume and trend of total deposits and the volume and trend of total the various types of deposits offered, the maturity distribution of time deposits, rates being paid on each type of deposit, rates being paid by trade area competition, caps on large time deposits, public funds, out-of-area deposits, and any other information needed. This periodic review takes place formally at the board-level in monthly ALCO meetings. The primary reports containing this information are located in the ALCO Packet titled Deposit Fluctuation & Decay Report (Avg Bal) and Deposit Fluctuation & Decay Report (# of Accounts). Rates can be found in the Net Interest Margin Analysis report. Maturities can be found in the GAP Review report (since Bank does not have variable rate CD products) and the Wholesale Funding Maturity Schedule. Provides policies and procedures that address funding concentration in or excessive reliance on any single source or type of funding, such as brokered funds, deposits obtained through the internet, public funds, out-of-area deposits, and any other information needed. Bank has internally classified its deposits as core, customer, and brokered. Brokered deposits identify both DTC CDs and any other deposits obtained by a third-party, which are typically out-of-area (OOA). Levels of wholesale funding, including brokered deposits and borrowings, are detailed on the Secondary Liquidity Report. At the bottom of this report, the deposit balances of the Bank s largest depositor are listed for the prior three months in order to evaluate the current level and trends. Provides a method of computing the bank s cost of funds. The Bank s funding costs are reported in several areas, but are most detailed in the Net Interest Margin Analysis report. In conjunction with the bank s investment policy, determines which types of investments are permitted, the desired mix among those investments, the maturity distribution and the amounts of funds that will be available, and reviews pledging opportunities and requirements. Permitted investments, mix, and duration guidelines are established in Bank s Investment Policy. ALCO reviews pledging opportunities and requirements frequently and has elected not to pledge securities in the investment portfolio in order to provide a potential source of unencumbered liquidity. The bank also has a correspondent bank willing to extend funds on a secured basis at a slight collateral discount from market values. This would allow the bank to access liquidity in the investment portfolio, including municipal bonds, without liquidating the securities, potentially at a loss. Conveys the board s risk tolerance and establishes target liquidity ratios such as loan-to-deposit ratio, longer-term assets funded by less stable funding sources, individual and aggregate limits on borrowed funds by type and source, or a minimum limit on the amount of short-term investments. Note: Financial Institution Letters dated August 26, 2008 provide additional guidance as follows: GSBC 10 of 59

13 Liquidity risk tolerances or limits should be appropriate for the complexity and liquidity risk profile of the institution and should employ both quantitative targets and qualitative guidelines. These limits, tolerances and guidelines may include items such as: Discrete or cumulative cash flow mismatches or gaps (sources and uses of funds) over specified future short- or long-term time horizons under both expected and adverse business conditions. Target amounts of unpledged liquid asset reserves expressed as aggregate amounts or as ratios. Asset concentrations, especially with respect to more complex exposures that are illiquid or difficult to value. Funding concentrations that address diversification issues, such as dependency on a few large depositors or sources of borrowed funds. Contingent liability metrics, such as amounts of unfunded loan commitments and lines of credit relative to available funding. The potential funding of contingent liabilities, such as credit card lines and commercial back-stop lending agreements, should also be appropriately modeled and compared to policy limits. Institutions may use other risk indicators in specifying risk tolerances. These may include, for example, ratios such as loan to deposits, loans to equity capital, purchased funds to total assets, and other common measures and ratios. However, in developing and using such measures, management should be fully aware that some measures may not appropriately assess the time dimension and specific characteristics of the institution s liquidity risk profile. Static balance sheet measures may not reveal significant liquidity risk that may exist under either normal or adverse business conditions and generally should not be the sole measures institutions use to monitor and manage liquidity. The scope and frequency of a bank s internal liquidity risk management reports will vary according to the complexity of the institution s operations and risk profile. Reportable items may include, but are not limited to: Cash flow gaps Assets and funding concentrations Critical assumptions used in cash flow projections Key early warning or risk indicators Funding availability Status of contingent funding sources Collateral usage A summary of actual liquidity performance compared to IRR/ALM Policy limits is detailed in the Interest Rate Risk and Asset/Liability Management Policy Ratios Summary report. This report also details the change from the prior month or quarter and assesses a risk rating, direction of risk, and action plan for each item. ALCO monitors numerous liquidity measurements on a monthly basis, including those not listed in the summary report. The IRR/ALM Policy ratios related directly to liquidity management establish both targets and limits and include: Net Free Liquid Assets to Total Assets Net Liquid Assets to Total Assets Investments to Total Assets Wholesale Funding to Total Assets Customer Deposits to Total Assets GSBC 11 of 59

14 Provides an adequate system of internal controls that ensures the independent and periodic review of the liquidity management process, and compliance with policies and procedures. Responsibility for independent and periodic review is an Audit Committee function. Third-party internal auditor (Eide Bailly) periodically reviews the liquidity management process and compliance with policies and procedures. Ensures that senior management and the board are given the means to periodically review compliance with policy guidelines, such as compliance with established limits and legal reserve requirements, and verify that the duties are properly segregated. Senior management and the board review compliance with liquidity guidelines on a monthly basis in ALCO. Daily liquidity management takes place in the Accounting Department, with actual transactions (i.e. - wires) executed in the Operations Department. Includes a contingency plan that addresses alternative sources of funds in initial projections of funding sources and uses are incorrect or if a liquidity crisis arises. Establishes bank lines and periodically tests their use. Bank s contingency funding plan is located on page 3 of the IRR/ALM Policy. Further methods to satisfy liquidity needs are itemized on page 7 under the category Liquidity. Available alternative sources of funds are reviewed monthly in the ALCO Packet in the Secondary Liquidity Report. Establishes a process for measuring and monitoring liquidity, such as generating pro-forma cash flow projections or using models. Note: More recent guidance in Financial Institution Letters dated August 26, 2008 requires additional forward-looking measuring and monitoring for institutions using liability-based funding strategies. Pro forma cash flow analysis must show the projected sources and uses of funds under various liquidity scenarios. Such analysis should be commensurate with the complexity of the institution s liquidity risk profile. Management must consider the general and unique liquidity risks faced in multiple scenarios. ALCO uses several methods of measuring and monitoring future liquidity needs. A Stressed Cash Flow Report is included in the ALCO Packet each month. This report clearly lists the assumptions used to estimate the sources and uses of funds and considers the impact of wholesale funding sources becoming unavailable. A variance report called the Stressed Cash Flow Backtest is then prepared the following month to test the assumptions and included in the ALCO Packet for review. It is important that this report produces a positive variance each month, indicating that stressed levels were not reached. The variance has been positive in each of the past 12 months and assumptions were adjusted from time to time over that period. Additionally, ALCO is responsible for reviewing financial projections and presenting an annual budget to the board of directors. Each year a formal budget is approved by the board of directors and forecasted liquidity ratios are presented. Each of the past two years (2008 and 2009), long-term projections were created and presented with the annual budget to illustrate expected earnings, capital, and liquidity levels over a 4-year period. Recently, given the economic volatility, management has produced interim projections to highlight expected future budget variances and provide updated expected earnings, capital, and liquidity levels for the current fiscal year. Defines approval procedures for exceptions to policies, limits, and authorizations. GSBC 12 of 59

15 Exceptions to policy must be reported to the board of directors, usually through ALCO for liquidity-related exceptions. Generally, management will prepare a recommendation for rectifying the condition. Recently two liquidity ratios have remained out of compliance Customer Deposits to Total Assets and Wholesale Funding to Total Assets. Significant discussion in both ALCO and board meetings resulted in a mandate to increase customer deposits. Various programs have been implemented as a result, including a detailed 2009 Deposit Strategy (December 2008), deposit product overhaul (February 2009), enrollment in the CDARS network (February 2009), creation of a new sweep deposit product (April 2009), and a formal plan to require a deposit relationship for all borrowers (pending). Provides for tax planning. Tax planning as pertains to the investment portfolio is listed as a responsibility of ALCO in the ALCO Charter. General tax planning is assigned to the Audit Committee since the Audit Chair is a tax professional and interacts more frequently with the Bank s tax firm. Provides authority and procedures to access wholesale funding sources, and includes guidelines for the types and terms of wholesale funding source permitted. Defines and establishes a process for measuring and monitoring unused borrowing capacity. Targets and limits on wholesale funding are outlined in the IRR/ALM Policy on page 8. Authority to access wholesale funding sources is listed in the section titled Liquidity on page 7. Typically, borrowing arrangements also require a board resolution to designate access to authorized individuals. The FDIC guidance on liquidity management specifically indicates the characteristics of management information systems and report formats it considers sound, as follows (check marks indicate compliance with FDIC guidance through the ALCO Packet or Pricing Committee materials): Liquidity needs and the sources of funds available to meet these needs over various time horizons and scenarios. The maturity distribution of assets and liabilities and expected funding of commitments would prove useful in preparing this report. List of large funds providers. Asset yields, liability costs, net interest margins and variations both from the prior month and budget. Such reports should be detailed enough to permit an analysis of the cause of interest margin variations. Longer-term interest margin trends. Any exceptions to policy guidelines. Economic conditions in the bank s trade area, interest rate projections, and any anticipated deviations from original plan/budget. Information concerning non-relationship or higher-cost funding programs. At a minimum, this information should include a listing of public funds obtained through each significant program, rates paid on each instrument, and an average per program. Information on maturity of the instruments, and concentrations or other limit monitoring and reporting. The final discussion item concerning specific FDIC guidance and requirements involves contingency funding. This topic is covered in great detail in the FDIC Risk Management Manual of Examination Policies and further in the Financial Institution Letters dated August 26, Early warning indicators, while not GSBC 13 of 59

16 necessarily requiring drastic corrective measures, may prompt management and the board to enhance monitoring. Examples of these indicators include the following: Rapid asset growth funded by potentially volatile liabilities. Real or perceived negative publicity. A decline in asset quality. A decline in earnings performance or projections. Downgrades or announcements of potential downgrades of the institution s credit rating by rating agencies. Cancellation of loan commitments and/or not renewing maturing loans. Wider secondary spreads on the bank s senior and subordinated debt, and increasing trading of the institution s debt. Counterparties increase collateral requirements or demand collateral for accepting credit exposure to the institution. Correspondent banks decrease or eliminate credit line availability. Counterparties and brokers are unwilling to deal in unsecured or longer-term transactions. Indicators that the institution potentially may have a serious liquidity problem include the following: Volume of turndowns in the brokered markets is unusually large, forcing the institution to deal directly with fewer counterparties. Rating sensitive providers, such as money mangers and public entities, abandon the bank. The institution receives requests from depositors for early withdrawal of their funds, or the bank has to repurchase its paper in the market. Transaction sizes are decreasing, and some counterparties are even unwilling to enter into shortdated transactions. An increasing spread paid on deposits relative to local competitors, or national or regional composites. The guidance requirements in the FDIC Risk Management Manual of Examination Policies for a bank s liquidity contingency plan are specific. Recent guidance in Financial Institution Letters dated August 26, 2008 reiterate, nearly word-for-word, four of the specific requirements and add one additional bullet point. The guidance states that a contingency funding plan is even more critical for banks that have an increasing reliance on alternative funding sources. The updated liquidity guidance emphasizes five items that are particularly important for institutions using liability-based liquidity strategies. Given that very little changed in the updated liquidity guidance regarding contingency funding, it is clear the FDIC is sending a message of the heightened importance of such plans. Bank s contingency funding plan is currently incorporated into its IRR/ALM Policy. The plan meets the requirements of the original guidance, but may need to be updated following the more recent guidance and considering current levels of wholesale funding. The following list uses check marks to indicate that a requirement is met in the current contingency funding plan or funds management practices. Boxes are used to indicate a requirement that may be met, but should be improved. One of the GSBC 14 of 59

17 recommendations in the final section of this document is to extract and expand upon Bank s current contingency funding plan and create a formal board approved Contingency Funding Plan. Requirements listed in bold font indicate guidance contained in both the FDIC Risk Management Manual of Examination Policies and Financial Institution Letters dated August 26, The final requirement is the one new requirement from the most recent guidance. The FDIC expects that a bank s contingency funding plan is updated on a regular basis and: Define the responsibilities and decision-making authority so that all personnel understand their role during a problem-funding situation. Include an assessment of the possible liquidity events that an institution might encounter. The types of potential liquidity events considered should range from high-probability/lowimpact events that can occur in day-to-day operations, to low-probability/high-impact events that can arise through institution-specific, systemic market, or operational circumstances. As an example: Consider the impact that a credit rating downgrade or the general perception of a loss of creditworthiness would have on liquidity. Assess the potential for erosion (magnitude and rate of outflow) by funding source under optimistic, pessimistic, and status quo scenarios. Assess the potential liquidity risk posed by other activities such as asset sales and securitization programs. Analyze and make quantitative projections of all significant on- and off-balance sheet fund flows and their related effects. Match potential sources and uses of funds. Establish indicators that alert management to a predetermined level of potential risks. Identify and assess the adequacy of contingent funding sources. The plan should identify any back-up facilities (lines of credit), the conditions related to their use and the circumstances where the institution might use them. Management should understand the various conditions, such as notice periods, that could affect access to back-up lines and test the institution s ability to borrow from established backup line facilities. Identify the sequence in which sources of funds will be used for contingent needs. The uncertainty of the magnitude and timing of available resources may call for different priorities in different situations. Assess the potential for triggering legal restrictions on the bank s access to brokered deposits under PCA standards and the effect on the bank s liability structure. Accelerate the timeframes for reporting, such as daily cash flow schedules, in a problem liquidity situation. Address procedures to ensure funds will meet the overnight cash letter. GSBC 15 of 59

18 Include an asset tracking system that monitors which assets are immediately available for pledging or sale and how much a cash sale of these assets will generate. New August 26, 2008: Details how management will monitor for liquidity events, typically through stress testing of various scenarios in a pro forma cash flow format. LIQUIDITY RISK AT BANK Liquidity risk is a combination of (i) actual liquidity levels and (ii) funds management practices. Poor liquidity levels may be identified, managed, and improved with strong funds management practices. Conversely, excellent liquidity levels can deteriorate quickly in the absence of strong funds management practices. The adequacy of liquidity levels and funds management practices should be determined by the complexity and liquidity risk profile of each institution. Bank is considered a non-complex institution in terms of the financial products and funding types. Earning assets are primarily composed of liquid securities and commercial, real estate, and consumer loans. Funding is primarily composed of traditional deposit products (checking, savings, money markets, and certificates of deposit), wholesale funding, and capital. The liquidity characteristics of a significant portion of Bank s balance sheet are dependent on customer behavior, but there are very few financial instruments with complex structures such as continuous-call bonds, CMO s, PAC s, prepayable FHLB advances, callable brokered CD s, or convertible debt. Although the Bank has strong capital levels, significant available borrowings, and an active ALCO, the liquidity risk profile of Bank is elevated due to actual liquidity levels and a liability-based liquidity strategy. Bank has grown nearly $100 million (50%) since the end of 2006 as a result of a formal growth initiative that included the addition of two new full-service branches and a residential construction loan production office. Projections indicated that wholesale funding would be required to fund the initial loan growth, followed by steady, sustained deposit growth. Multiple scenarios were forecasted, including a projection for aggressive loan growth and zero deposit growth. This scenario was the expected worst case in terms of liquidity, which was an acceptable level of risk compared to the benefits of earnings, asset, and franchise growth. As economic conditions deteriorated in the following months, Bank suffered unexpected credit deterioration. In 2008, the Bank had net charge-offs of $6.3 million and non-accrual loans and other real estate reached $25.2 million. The charge-offs and funding requirements for non-earning assets GSBC 16 of 59

19 accelerated earnings losses, which reduced capital. As the entire banking industry struggled, many competitors offered unreasonably high interest rates on deposits. This further strained Bank s liquidity by significantly impeding deposit growth and increasing funding costs, which reduced capital. Wholesale funding totaled $104.9 million (36.2% of total assets) at the end of 2008 in order to satisfy liquidity needs. In dollars, this level of wholesale funding was $3.6 million above the policy limit of 35% of total assets and $61.5 million above the policy target of 15% of total assets. In order to reduce these high wholesale funding levels, Bank would need to decrease assets, increase deposits, or increase capital. Deposit growth has been a major focus of Bank since the formal growth initiative due to the projected need for funding. Customer deposits must be the Bank s primary source of funding. In 2008, as liquidity needs increased, the Bank implemented a 2008 Deposit Strategy and enhanced an incentive plan to reward line-level employees for deposit growth and cross-selling at their respective branches. Work began on a complete overhaul of the Bank s deposit products. Significant progress towards the IRR/ALM Policy targets was not achieved and board directives intensified. Several new programs have been implemented more recently including a comprehensive Deposit Retention and Growth Strategy (December 2008). This strategy promotes a stronger sales and marketing mentality in the branches and provides timely measuring, tracking, reporting, and follow-up. An overhaul of checking and money market accounts simplified the product menu, provided incentives for multiple deposit relationships, and eliminated per item fees on business checking products (February 2009). Enrollment in the CDARS Reciprocal program allowed Bank to offer unlimited FDIC insurance on CD products to its customers (February 2009). CDARS deposits are expected to be less volatile than traditional brokered deposits because the program is designed to obtain funds from customers the Bank has or wishes to have a direct and ongoing relationship. Placing the full CD investment for each CDARS customer into the program allows Bank to focus on the primary deposit relationship with these customers and offer FDIC insurance up to $250,000. Creation of a new on-balance sheet sweep deposit product will allow the Bank to offer more competitive rates on sweep investments and recognize those funds as money market balances (April 2009). A formal plan to require a deposit relationship for all borrowers is in the development process. Each of these programs emphasizes relationship banking and avoids promotional rate- GSBC 17 of 59

20 based campaigns due to poor historical retention rates. Management is careful to construct a customer funding base with minimal volatility. Remaining at maximum wholesale funding limits creates many challenges for management. During the rate cycle over the past four months, Bank remained above its targeted 75 th percentile deposit rate pricing compared to local peers in order to retain deposits. This was particularly concerning due to the fact that local retail deposit pricing was significantly higher than alternative funding. CD specials in the area were up to 100 basis points higher than brokered CD rates of similar terms. If the Bank s wholesale funding levels had been near the target amount, offering rates on retail products could have been reduced at a faster pace compared to local trends. Deposit levels may have decreased, but the remaining balances would likely be much less rate sensitive. In a liability-based liquidity strategy, funding needs would have been met with low cost borrowings and overall funding costs would have decreased at a faster pace. At maximum wholesale funding levels, deposit pricing needed to remain high enough to retain virtually all deposit balances. Promotional, high-rate CD maturities exacerbated this pressure on rates since many of these customers were attracted by high rates and placed little value on service. Wholesale funding levels at the end of the first quarter of 2009 equaled the limit of 35% of total assets established in the IRR/ALM Policy. Even at that level, available wholesale borrowings totaled $78.8 million, equal to more than half of the Bank s customer deposit base. The outstanding amounts were diversified in order to limit exposure to any one source. For example, if the FHLB cancelled its credit line with Bank, the $16.0 million could be absorbed by available borrowings at the Federal Reserve Bank and vice versa. If brokered CD s were no longer available for issuance, the entire outstanding balance could be absorbed by available other borrowings. One of the most significant liquidity risks that Bank currently faces is a change in borrowing terms. Changes in borrowing terms could occur in several forms. A third-party rating agency downgrade could significantly increase pricing requirements to obtain brokered CD s. If capital deteriorated below well capitalized, the brokered markets may not be available at all. Borrowing lines with the FHLB and Federal Reserve Bank are secured by collateral, but terms can be changed easily by modifying collateral requirements or increasing borrowing rates. Recently the Federal Reserve Bank reduced borrowing capacity on commercial and construction loans from 75% of the collateral value to 65%. It could also increase GSBC 18 of 59