Liquidity CAPITAL ASSET QUALITY MANAGEMENT EARNINGS LIQUIDITY SENSITIVITY TO MARKET RISK

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1 represents a financial institution s ability to accommodate expected and unexpected withdrawals in deposits, decreases in other liabilities, and increases in assets. The stronger an institution s liquidity, the more efficiently and economically it can accommodate these changes in existing balance sheet structure, and fund future growth. CAPITAL ASSET QUALITY MANAGEMENT EARNINGS LIQUIDITY SENSITIVITY TO MARKET RISK Contents Contents... 1 Objectives... 2 Resources... 2 Icons... 2 Chapter 1: Introduction to... 3 A Practical Example of... 3 Why Do Banks Need?... 4 Sources and Uses of Funds... 5 Stability vs. Volatility: Core vs. Non-Core Impact of Other Components on Analyzing Chapter 2: Offsite Analysis Review the Balance Sheet Structure Review and Analyze the Securities Portfolio Identify and Assess Funding Concentrations Identify the Types and Levels of Off-Balance Sheet Items Analyzing the Levels and Trends of Key Ratios Offsite Analysis Summary Chapter 3: Onsite Analysis Determine the Institution s Funding Requirements Determine the Institution s Sources of Funds Review the Management Program Assign a Rating and Prepare a Supporting Comment Onsite Analysis Summary September 2015 Page 1

2 Financial Institution Analysis School Objectives After completing this topic, you will be able to: Identify factors that affect liquidity. Identify balance sheet structure information related to liquidity. Identify key UBPR ratios used to analyze liquidity. Identify areas to review in assessing the institution s funding requirements, deposit stability, and funding sources. Resources The following resources are available in the FIAS Independent Study. The Expert Model for Assessing, which serves as a consolidated job aid for key ratios and considerations and may be used for analysis activities. A link to the Uniform Financial Institutions Rating System composite ratings and component ratings from FDIC Statements of Policy, Uniform Financial Institutions Rating System. A link to the Risk Management Manual of Examination Policies, which contains a comprehensive list of items that should be included in an institution s risk management policies. Icons Icons used in this document: Directs you to open an example from the topic screen. Directs you to open an exercise from the topic screen. Directs you to open a document or go to a Web site. Page 2 September 2015

3 Financial Institution Analysis School Chapter 1: Introduction to Analyzing an institution s liquidity helps examiners assess the bank s ability to meet changing market conditions and needs, both now and in the future. As an examiner, you must assess a bank s ability to obtain sufficient funds at a reasonable cost and within a reasonable time period to meet obligations as they become due. Examiners assess the bank s ability to obtain sufficient funds at a reasonable cost and within a reasonable time period. A Practical Example of The level of a bank s liquidity is analogous to your current personal financial environment. Your wallet likely includes some cash or a way to access cash through an automated teller machine. This is an example of instant liquidity. Banks also have some amount of cash on hand to accommodate immediate requests. Your checkbook (physical or online) is the way you pay your debts by writing checks out against what you have in the account. Banks also pay debts in this way. You may have a credit card that enables you to obtain money or pay for things on credit. Similarly, a bank may borrow against an unsecured Federal funds line at set interest rates. You may have a home equity line of credit (HELOC), which represents your secured borrowing line. You are able to obtain liquidity by borrowing against this line. Banks can usually borrow in this manner, such as through the secured Federal Home Loan Bank (FHLB) line or the Federal Reserve Discount Window. Overall, you have several means for obtaining money when you need it to purchase goods, invest and save for future needs, and pay down debt. Each of these means can be thought of as a source for managing the outflow of money at required instances. risk occurs when one does not have enough incoming sources, obtained at reasonable prices, to meet the outflow of funds. No bank has enough liquidity to cover all required outflows if we block all sources for an extended period. In fact, most banks could not withstand an extended period when the pace of cash outflows greatly exceeds the pace of cash inflows. September 2015 Page 3

4 Financial Institution Analysis School By contrast, in an increasingly competitive environment, few banks can be profitable when drowning in liquidity; they must implement plans to use their liquidity effectively. Day-to-day operating liquidity is important, and liquidity managers are rightly concerned with profitable, efficient operations in normal economic environments. The best liquidity managers, however, will also spend time evaluating the impact of stressful, low-probability liquidity events. They plan for these events to ensure that they can access sufficient funding sources in a reasonable time period and at reasonable costs in an emergency situation, thus minimizing liquidity risk. Fundamentally, sound liquidity management involves optimizing the level of liquidity by: Identifying a variety of sources to add cash flow when liquidity gets tight. Developing strategies to reduce the liquidity drains during times of rapid outflow. Why Do Banks Need? Banks need liquidity for a number of reasons, including: Withdrawals of core deposits Withdrawals of time deposits more than $250,000 and other non-core funds Replacing maturing borrowings Loan growth Operational needs (e.g. payroll, utilities, legal fees, and other expenses associated with operating a bank) Core deposits are defined as checking, savings, and money market deposit accounts, as well as certificates of deposit less than $250,000. Non-core funding generally consists of large time deposits (greater than $250,000), borrowings, brokered deposits, federal funds purchased, repurchase agreements, and foreign deposits. A bank s liquidity needs are situation-specific. That is, different circumstances under non-crisis situations will cause a bank s operating liquidity needs to differ over time. For example, loan and deposit growth or demand is driven by customer needs and competition. Page 4 September 2015

5 Financial Institution Analysis School A bank with low liquidity may be subjecting itself to loss of customer confidence if it cannot pay its depositors on demand. This could lead to greater deposit withdrawals and closing of the bank. One example of a bank that suffered a liquidity crisis is IndyMac Bank, which in 2008 was taken over by FDIC. The following article provides an overview of the failure, particularly the liquidity crisis faced by the bank. The Seattle Times; Monday, July 14, 2008; IndyMac bank crisis signals new takeover era Sources and Uses of Funds To understand a bank s liquidity position, you must understand the concept of sources and uses of funds. The way in which management administers the bank s funding sources and requirements is an important aspect of its liquidity program. When considered from the perspective of the bank s balance sheet and income statement, sources and uses of funds might be illustrated as: Sources Balance Sheet Perspective: Decrease assets OR increase liabilities Increase capital through a capital injection Income Statement Perspective: Increase income (e.g., charge higher fees) Decrease expenses (e.g., reduce operating costs) Uses Balance Sheet Perspective: Increase assets OR decrease liabilities Decrease capital through a payment of dividends Income Statement Perspective: Increase expenses Decrease income For example, think of a banker who is considering sources to fund planned loan growth. From a balance sheet perspective, the banker could sell or reduce assets, or increase liabilities such as deposits or borrowings. Or, from an income statement perspective, the banker could create cash flow by increasing income perhaps by charging higher fees or by reducing operating costs or overhead expenses. September 2015 Page 5

6 Financial Institution Analysis School This example assumed that loan growth was the primary use of funds. More generally, uses include any increase in assets or any decrease in liabilities or capital. So while the need for liquidity to fund asset growth may be obvious, it is less intuitive to think that reducing liabilities is also a use of funds. Think about it in terms of your personal liquidity: paying down your debt is a use of your funds. Or, from an income statement perspective, an increase in personal expenses or a decline in income uses funds that would otherwise be available. Uses of Funds Uses include any increase in assets or any decrease in liabilities or capital. When analyzing liquidity, you must consider all potential uses of funds, both on the asset side of the balance sheet, and also on the liability side of the balance sheet. Uses of funds on the asset side of the balance sheet typically include the following: Planned/budgeted asset growth. Planned and budgeted growth is most commonly found in the loan portfolio, as management attempts to boost bank earnings. Ideally, examiners would like to see these needs met with increases in core deposits. The strategy of funding loan portfolio expansion with traditional liquid assets (e.g., Federal funds sold or investment portfolio) results in an immediate reduction in on-balance sheet asset liquidity, as liquid assets are replaced with relatively illiquid loans. Unfunded loan commitments. These commitments can be revocable or irrevocable, as well as contractual or non-contractual. Commitments that are irrevocable and contractual represent an unconditional guarantee by the bank to lend when called upon to do so by the customer, as long as the customer complies with the contract (or agreement). These commitments can be under a line of credit or under commitments to fund new loans. In many instances, commitments are conditioned on the maintenance of a satisfactory financial standing by the customer and the absence of default in other covenants. It is important that management review all unfunded commitments and assess their likelihood of funding. Securities portfolio growth. Although less common, asset growth can occur in the securities portfolio. Occasionally, bank management will use excess funds obtained from deposit-gathering activities to invest in securities. Depending upon the liquidity of these securities, and the stability of the deposits used to purchase the securities, this use of funds may have a neutral or positive net effect on the bank s liquidity position. Page 6 September 2015

7 Financial Institution Analysis School Fixed asset expansion. This typically represents an insignificant draw on liquidity for most banks, but can be more significant in smaller institutions. Uses of funds on the liability side of the balance sheet typically include the following: Withdrawals of promotional deposits. Deposit withdrawals can occur in any deposit type, but are most pronounced in time deposits and in any promotional deposits. Any non-maturity deposit or CD that was originated under a deposit promotion should receive closer review. For example, a bank that runs a high-rate money market deposit account (MMDA) promotion may actually be raising funds that are more volatile than other deposits that are typically considered non-core. Maintaining these deposits may require paying continued high interest rates, which is detrimental to earnings. Because liquidity is a function of raising sufficient funds at a reasonable cost, the overuse of such funds can be detrimental to liquidity and should be cause for concern. Withdrawal of brokered deposits. These deposits are typically considered less stable, as a bank must pay market rates, or higher, to retain these funds upon maturity. Depending upon the circumstances, these market rates might not be offered at a reasonable cost. In addition, regulatory restrictions can significantly affect a bank s ability to accept, renew, or roll over these deposits. As such, a bank that has high levels of brokered deposits could be faced with a need to replace or fund maturing balances by using other nonbrokered deposit or borrowing sources. Sources of Funds In addition to uses of funds, your liquidity analysis involves looking at the historical and future sources of funds. Sources of funds on the asset side of the balance sheet most typically include the following: Excess cash and due from balances. Cash and due from balances are many times thought of as the most liquid of assets. In a bank, however, cash and due from balances are typically not available for general liquidity needs because most institutions keep only September 2015 Page 7

8 Financial Institution Analysis School enough funds in these accounts to cover their outgoing cash letter and conduct normal business transactions. Because this is typically the case, only cash and due from balances in excess of those balances needed for normal operational needs should be considered a liquid asset. Federal funds sold. Federal funds sold are typically one of the most liquid sources of funds on the asset side of the balance sheet. Because these funds mature daily, they can be easily converted to cash when needed. Interest bearing bank balances. These balances are usually easy to convert to cash, but pre-payment penalties may apply if the accounts are time deposits. Available-for-Sale (AFS) Securities. These securities are typically the largest class of liquid assets in most banks. Most securities can be sold and converted to cash, pledged to secure borrowing lines, or used in a repurchase agreement to provide funding for the bank. Although these securities can provide a significant source of funding, the liquidity provided by the portfolio is heavily affected by the contractual and structural features of the individual securities. The resulting credit quality, remaining term, and expected cash flow of each security will significantly affect that security s ability to be converted into cash by sale or be pledged for borrowing availability. In addition, the breadth and depth of existing markets can affect its salability. Any of these factors may result in market depreciation, which may make management reluctant to sell these investments for liquidity purposes. To determine the true liquidity of this portfolio, a detailed review of the entire portfolio must be completed. Held-to-Maturity (HTM) Securities. Due to the accounting designation (ASC 320) of this portfolio, sale of these securities should not be considered a primary source of liquidity for most banks. However, depending upon the individual characteristics of each security (same as those noted for AFS securities), these assets can likely be pledged to secure borrowing lines of credit. In addition, funds from maturing HTM securities can be used for liquidity purposes. It should be noted that while there are potential adverse accounting consequences to selling such securities, bank management may decide to Page 8 September 2015

9 Financial Institution Analysis School sell such securities, and endure the consequences, when other options are undesirable. Loans. Although this asset class is typically one of the least liquid, some loan types can be readily sold in the secondary market (e.g., 1-4 family residential mortgages). Though less common, high-quality loan participations can also sometimes be sold to other institutions, thereby producing additional liquidity. Many loans can also be pledged to secure borrowing lines, thereby producing liquidity even if the asset cannot be readily sold. Although this is possible, pledging discounts (commonly called haircuts), are usually higher with these assets. These discounts (the counterparty may give less credit for this type of collateral) can result in only a marginal increase in borrowing availability. Sources of funds can also be found on the liability and capital side of the balance sheet. The act of increasing a liability or capital account results in the bank obtaining cash or other liquid assets that can be used to meet funding requirements. Sources of funds on the liability and capital side of the balance sheet most typically include the following: Sources of funds include any act of increasing a liability or capital account to obtain cash or liquid assets. Federal funds purchased. Federal funds can be purchased for short-term funding needs if the purchasing bank is creditworthy. If the bank is not deemed to be creditworthy by the correspondent bank, these unsecured lines of credit can be revoked immediately. Core deposits. Although these deposits typically represent the least costly and most stable liability category, additional deposits are difficult to raise quickly due to intense market competition. As a result, existing amounts on the bank s balance sheet can be quite stable, but increases in these deposits as a future funding source is limited. Non-core deposits. These deposits are relatively easy to obtain if the bank s financial condition is satisfactory. However, these deposits are usually more expensive than other deposit types and are more sensitive to market conditions, since these deposits are not relationship-driven. FHLB borrowings. Funds are readily available for most institutions, as the borrowing line is pre-established and is secured by bank assets. These funds can also be less expensive than deposit balances and can be obtained in a variety of terms to reduce a bank s interest rate risk position. However, if the bank s credit quality declines, collateral pledging discounts will increase, reducing the bank s available line of credit. September 2015 Page 9

10 Financial Institution Analysis School Capital. Capital injections are generally not made for the purpose of providing liquidity, but they can provide additional cash, which benefits liquidity. Also, capital injections can improve a bank s financial condition, leading to an enhanced ability to attract and retain funds. When analyzing a bank s sources and uses of funds, it is important to assess the effect of external factors. Common external factors that can affect the bank s liquidity include: Economic conditions. Economic conditions can affect the stability and availability of deposits, both positively and negatively. In times of declining stock prices or market uncertainty, customers may flee to the safety of bank accounts and insured deposits. Conversely, if the stock market is booming, depositors may withdraw funds. Additionally, if customers lose confidence in the banking system, or in a particular bank, liquidity risk may be heightened. Seasonality. This is many times dependent upon the bank s market area and specific circumstances. For instance, in agricultural markets, banks typically have tight liquidity in the spring months, as farmers withdraw deposits or request loans to obtain funds to plant crops. In the fall months, however, liquidity is typically ample in these banks, as farmers repay loans and deposit excess funds obtained from the sale of harvested crops. Stability vs. Volatility: Core vs. Non-Core As we have already noted, one of the primary uses of funds is a decline in deposit balances. This is particularly problematic in those instances where deposit outflows cannot be easily predicted. You know from your work on examinations that the volatility of funding sources is denoted in the Uniform Bank Performance Report (UBPR) by the use of two general categories of funding sources: core and non-core. Knowing that examiners often think of core deposits as a bank s primary funding source, it s important to keep in mind that funding sources usually don t fit neatly into one category of core or non-core, or stable or volatile. All core deposits are not created equally. All core deposits are not created equal. They differ in stability. Page 10 September 2015

11 Financial Institution Analysis School Typical Core Deposits Core deposits often have these typical characteristics: Demand Deposit Accounts (DDA), and Negotiable Order of Withdrawal (NOW) accounts. These accounts are generally considered to be a stable source of funds and are low-cost in terms of interest expense. Customers typically maintain these deposits to access the payment system, and they are transaction-oriented. Some banks offer incentives such as free checking giveaways to attract these accounts. These funds also tend to be more stable due to difficulties in moving these accounts to other institutions, including a change in bill pay, direct deposit, and checks. Savings accounts. Savings accounts tend to pay lower rates and are generally more stable. Typically, customers open these accounts to save for specific purposes, and tend to leave them open for longer periods of time. Money Market Deposit Accounts (MMDAs). MMDAs tend to be more ratesensitive and can cost more than savings accounts. Often rate specials are run on this type of account so they are not always core. Sometimes the rates paid on these accounts are tied to market rates. Customer attraction to these accounts is often a higher rate and the ability to write a few checks. Bank attraction is that these often have lower transaction volume than checking accounts. September 2015 Page 11

12 Financial Institution Analysis School Retail CDs. These are usually insured and tend to be viewed as stable. Keep in mind, however, that rates paid, competition, promotions, and other factors could influence the level of stability of these deposits. Public funds. Public funds are often invested in CDs, but can also be in any of the other deposit categories. Even if management argues that the relationship is stable and that the municipality has been a long-time customer, this does not mean that the entire balance at any given time is stable. Public fund balances frequently have dramatic fluctuations over the course of the year as tax revenues are generally received at one or two times during the year, and then balances are run down as expenses are paid throughout the year. As such, even for what appears to be stable relationship public funds, it is critical to assess balance history and anticipated levels/funding needs. Management of balance fluctuations and knowledge of balances is important. Internet Deposits. Most times, CDs obtained from Internet listing services do not qualify as brokered deposits, as the listing service does not ultimately place the funds in an institution. Although these deposits may not be categorized as brokered, you should determine the extent of these deposits in the bank s funding base, since they many times contain many of the same risk characteristics as brokered deposits. These deposits can also be relatively expensive depending upon the interest rate environment, making renewal of such funds undesirable in the future. Typical Non-Core Funding Sources Just as the stability of core deposits can range widely based upon the specific characteristics of the product and the depositor, the stability of non-core funding sources can also range widely based on several characteristics. In general, longer-term, secured funding sources will be more stable, while shorter-term, unsecured funding sources are the least stable. The general characteristics of each non-core funding source follow: FHLB borrowings. There are different types of FHLB borrowings based upon term (overnight, short-term, and long-term), but all FHLB borrowings are secured. To determine appropriate collateral margins for each bank, the FHLB reviews an institution s credit risk profile on an ongoing basis. If the bank s financial condition deteriorates, and thus risk of repayment increases, the FHLB may raise collateral requirements, reduce funding lines, and require physical delivery of collateral. Although rare, the FHLB could also refuse to renew advances upon maturity or accelerate repayment of advances due to a covenant breach in extreme situations. Page 12 September 2015

13 Financial Institution Analysis School Repurchase agreements (Repos). Like other non-core funding sources, the term and collateralization of the repurchase agreement will determine the stability of these funds. Because most repurchase agreements mature daily, they are generally less stable than most FHLB borrowings. However, because they are fully collateralized by marketable securities, these borrowings can typically be renewed upon maturity. As with FHLB borrowings, the counterparty to a repurchase agreement may raise collateral requirements if the bank s financial condition deteriorates. Brokered CDs. Brokered CDs have historically been less stable and more rate-sensitive because, by their nature, these are funds for which individuals or businesses are looking to obtain the highest rate of return, rather than investing in their local bank. In addition, Part 337 of the FDIC s Rules and Regulations can significantly reduce or eliminate a bank s ability to accept, renew, or rollover these deposits if they are considered less than Well Capitalized. CDs above $250,000. The stability of these deposits can vary widely, based upon the composition of this deposit portfolio. In general, these deposits are considered less stable, and more sensitive to market rate conditions, since the balances exceeding $250,000 are generally not insured. However, in some situations, a portion of these deposits may well be considered more stable based upon historical retention and customer relationship. Federal funds purchased (FFP). Because Federal funds purchased mature daily and are unsecured, these funds are typically the least stable of the noncore funding sources. Many community banks cash flow projections involve the use of back-up correspondent bank Federal funds lines of credit. These back-up lines may be a viable option under normal business conditions; however, many Federal fund credit agreements contain a material adverse change clause that allows the correspondent bank to terminate or reduce the lines at the first sign of trouble. As such, these borrowing lines cannot be relied upon when the bank s condition deteriorates. Impact of Other Components on As you can see from the previous descriptions, a bank s level of liquidity must be considered in the context of the institution s risk profile. An increase in any of the other risks, particularly credit, operational, and/or reputational risk, will increase liquidity risk as well. From a CAMELS perspective, deterioration in other components can strain liquidity. September 2015 Page 13

14 Financial Institution Analysis School For example, asset quality problems increase operating liquidity needs (such as loan workout costs and legal fees) and can result in reduced cash flow if the borrower does not make the scheduled payments. In addition, asset quality problems can reduce the availability of credit from the FHLB or other lenders. Asset Quality problems Increase liquidity needs May reduce cash flow If focused on Earnings..... may reduce liquidity. There is an inverse relationship between liquidity and earnings. If a bank is highly focused on maximizing earnings, it may be tempted to reduce its level of liquidity to hit the budget goals. Inversely, having a liquidity cushion will put a drag on earnings. When reviewing the liquidity position during your offsite and your onsite analyses, you must consider the effects of the bank s risk profile, and other examination findings, when assessing the bank s liquidity. Analyzing To understand an institution s exposure to liquidity risk, you will need to analyze all of a bank s sources and uses of funds. To do this, you will collect and analyze: Offsite information, including the UBPR, to identify balance sheet composition and trends regarding historical sources and uses of funds. Onsite information, including the institution s monitoring tools and information obtained from management, to gain insight into current and future sources and uses of funds, and the bank s overall funds management program. Page 14 September 2015

15 Financial Institution Analysis School Chapter 2: Offsite Analysis Offsite liquidity analysis provides useful information to begin your assessment of the bank s historical sources and uses of funds, as well as potential sources and uses of funds in the future. The results of the offsite analysis should identify any concerns or issues that need to be addressed through onsite follow up. Completing the offsite analysis involves a review of: Previously identified liquidity deficiencies as noted in prior Reports of Examination (ROEs), prior examination work papers, and file correspondence. The UBPR to: Review the bank s balance sheet structure. Review and analyze the securities portfolio. Identify and assess funding concentrations. Identify the types and levels of off-balance sheet items. Analyze the level and trend of key ratios. These items will be discussed in more detail on the following pages. Review the Balance Sheet Structure A review of historical balance sheet information offers insights related to past funding needs and how those needs were met. You can review historical balance sheet information in the UBPR to understand this history and the potential amount needed to meet future funding requirements. For example, review of a bank s historical balance sheets may show an increase in certain asset categories over time, which would likely mean a use of funds, or a funding requirement. A decrease in asset accounts likely means they were a source of funds during these time periods. Additionally, an increase in liability accounts likely means they were a source of funds during these periods. By evaluating how funding needs were met in the past, you can gain perspective on how they will be met in the future. For example, loans may have increased, and this funding was met by an increase in borrowings. While this does not tell you that future growth will be funded in the same manner, it provides an indication that management may have some difficulties raising core deposits. September 2015 Page 15

16 Financial Institution Analysis School Review of the balance sheet also provides us with information on available sources of funds, including Federal funds sold or interest bearing balances. Review the following UBPR pages for balance sheet structure information: Page 4, Balance Sheet $ Page 6, Balance Sheet Percentage Composition Reviewing the bank s balance sheet composition will give you a preliminary view of the bank s: Historical sources and uses of funds. UBPR Pages 4 and 6 help you identify significant changes in asset and liability categories, and therefore help you estimate sources and uses of funds. To estimate, compare the most recent balance sheet to the prior year s balance sheet, and subtract to determine balance changes. Then, classify the changes as a source or use. Decreases in asset accounts indicate that these resources were likely used to meet funding requirements; increases in liability accounts (generally deposits or borrowings) indicate that management has used deposits or borrowings to meet funding requirements. Continue this review with prior periods to obtain a more comprehensive view of historical sources and uses of funds over time. Future sources of funds. Review UBPR Pages 4 and 6 to obtain information regarding future liquidity sources, including: Federal funds sold or marketable securities. Generally, an abundance of, or increasing level of, Federal funds sold or marketable securities indicates that a bank has liquid assets available to meet its immediate funding requirements. Loans held for sale. These loans are generally marketable and will, in the normal course of business, be sold. These sales will be a future source of funds. Deposits or borrowings. For liabilities, the existence of deposits or borrowings does not indicate a future liquidity source; rather, the lack of deposits or borrowings indicates a potential area that can be exploited in the future to provide a source of liquidity. It is important to remember that, even if the historical information seems very clear, you should not to jump to conclusions before you have further follow-up with management while on site. Remember that the supply of liquidity by Page 16 September 2015

17 Financial Institution Analysis School creditors or depositors fluctuates given different situations. For creditors, the credit quality of the bank and overall economic conditions are important determining factors in supply decisions. For depositors, competitors interest rates, a bank s reputation, and local economic conditions (e.g., unemployment and business growth) are important factors that can affect the flow of funds. Therefore, review of historical sources and uses of funds can provide valuable background information, but the bank s liquidity dynamics may change frequently and historical information may not be completely relevant for the current review. You must use your examiner perception and decision-making abilities to weigh these considerations appropriately. Review and Analyze the Securities Portfolio As part of your offsite balance sheet review, you should begin to analyze the securities portfolio for liquidity considerations. Securities are fundamental to a bank s liquidity because they provide a dependable stream of interest income, can be sold to provide immediate funding, or pledged to acquire borrowings or public funds. Some securities, such as mortgage-backed securities (MBSs), also provide enhanced cash flow, as each payment typically consists of both principal and interest payments garnered from the underlying mortgages. In your analysis of a bank s securities portfolio, you should consider: Marketability. Securities that are more easily marketed provide a better source of funds. Shorter-term securities are typically more marketable than longer-term securities. You should review maturity information in the securities trial balance to obtain this information, as detailed maturity information is not found in the UBPR. Some categories or types of securities are more marketable than others. In general, the categories of securities listed on UBPR Page 10A are listed from more marketable (e.g., U.S. Treasury and Agency securities) to less marketable (e.g., foreign debt securities). Accounting designations. UBPR Pages 4 and 6 provide information on the volume and percentage of HTM and AFS securities. In general, AFS securities are more frequently used than HTM securities as sources of funds. However, it is also important to note that funds invested in short-term HTM securities will become available as funding sources when these securities reach their ultimate maturity. September 2015 Page 17

18 Financial Institution Analysis School Pledging information. While off site, you should review the bank s pledged securities report to ascertain which securities are pledged, and what they are pledged for. In addition, you should review the Pledged Securities to Total Securities ratio found on UBPR Page 10A for information on the aggregate level of such pledgings. This ratio provides an indication of the securities that are available as funding sources. A lower ratio indicates that a greater proportion of the portfolio is available as a funding source. The following example provides UBPR Pages 4, 6, and 10A with an expert analysis of the bank s securities profile. Securities Profile Example Identify and Assess Funding Concentrations Any funding concentrations should be identified and assessed pursuant to Transmittal Number RMS (Revised Concentrations Page and Instructions for the Risk Management Report of Examination), which was issued on November 7, This memorandum indicates that a funding concentration should be included in the Report of Examination when either of the following conditions exists: A single funding source represents 10% or more of Total Assets. Potentially volatile funding sources, when combined, represent 25% of more of total Assets. These sources may include: Brokered deposits Large deposits (deposits representing 2% or more of Total Deposits) High-rate deposits(typically refers to deposits receiving interest rates 75 basis points above the national average for similar deposits, as included in FIL ) Uninsured deposits Internet-Listing-Service deposits Other potentially volatile deposits Federal Funds Purchased Page 18 September 2015

19 Financial Institution Analysis School Borrowings Any funding concentrations should be thoroughly assessed during the onsite portion of the examination and discussed with management. A writeup for each, including the composition and any unique risks or management controls for that particular concentration, should be included on the Concentrations page of the Report of Examination. Identify the Types and Levels of Off-Balance Sheet Items Off-balance sheet items, found on UBPR Page 5, represent potential future funding needs of the bank. The primary off-balance sheet items affecting your liquidity assessment include the following: Loan commitments. UBPR Page 5 contains both dollar amounts, and percentage composition, of unfunded commitments by loan type. These commitments can be extended under a line of credit, or under written commitments to fund new loans. In many instances, commitments are conditioned on the maintenance of a satisfactory financial standing by the customer and the absence of default in other covenants. It is important to analyze these commitments by loan type, since some loan commitments (e.g., unused construction lines of credit) are much more likely to be funded than others (e.g., home equity lines of credit). Although this review can provide you with useful information regarding potential future funding needs, you should discuss these lines with management to ensure that you fully understand the future funding needs of the bank. Letters of credit. A letter of credit is a document issued by a bank on behalf of its customer that authorizes a third party to draw drafts on the bank up to a stipulated amount and with specified terms and conditions. The letter of credit is a conditional commitment on the bank's part to provide payment on drafts drawn in accordance with the document terms. The most typical letters of credit are commercial and standby: A commercial letter of credit is issued specifically to facilitate trade or commerce. Generally, drafts will be drawn when the underlying transaction is consummated as intended. A standby letter of credit (SBLC) is an irrevocable commitment on the part of the issuing bank to make payment to a designated beneficiary. It obligates the bank to guarantee, or stand as surety, for the benefit of a third party. An SBLC is not, generally, expected to be funded unless the account party defaults in meeting an obligation to the beneficiary. September 2015 Page 19

20 Financial Institution Analysis School In the following example, review the balance sheet structure and off-balance sheet items to determine the bank s risk profile. This example includes UBPR Pages 4, 5, and 6 and an expert analysis of the data. Balance Sheet/Off-Balance Sheet Example Analyzing the Levels and Trends of Key Ratios Offsite analysis also involves reviewing the levels and trends of key liquidity ratios. Although ratio analysis cannot fully depict all of the intricacies of a bank s liquidity function, it is a very important step in offsite analysis. This review can point out areas that need detailed review and analysis when onsite. The following liquidity ratios are found on UBPR Pages 1, 10, and 10A. Summary Ratios, UBPR Page 1 There are two liquidity-related summary ratios on UBPR Page 1 that provide additional insight into the bank s funding sources and loan mix. Remember that these ratios provide a starting point for analysis and are part of the larger picture of the bank s liquidity strengths and weaknesses. Net Non-Core Funding Dependence New $250M This ratio measures the degree to which a bank uses non-core liabilities to fund long-term assets. It is calculated as: Non-core liabilities short-term investments Long-term assets This ratio is also included on UBPR Page 10, under the heading of /Funding Ratios. UBPR Page 10 provides an alternate calculation of this ratio, using a $100M cutoff for large CDs (the first version uses $250M as the cutoff for large CDs). Both ratios can provide useful insights into a bank s balance sheet structure, since they relate the net position of typical non-core funding sources to the long-term assets they are financing. When reviewing this ratio, consider the: Level. A negative ratio means that the bank does not rely upon non-core sources to fund long-term assets, as the amount of short-term investments more than offsets the amount of non-core funding sources employed. This suggests that bank management can liquidate short-term investments, or use Page 20 September 2015

21 Financial Institution Analysis School funds from maturing short-term investments, to retire all non-core funding sources used. A low ratio indicates that the bank should be able to adapt to an unfavorable non-core funding situation with the liquidity available in short-term investments. A high positive ratio: Indicates that the bank may need to convert other assets in addition to short-term investments to satisfy the possible retirement of non-core liabilities that need to be paid. May also indicate that the bank is not investing in short-term investments or is not able to increase its core deposit base. Depending on the makeup of other assets, this may or may not be a concern. Trend. If this ratio has been negative and there is a significant increase, or if the ratio has been positive and there is a significant adverse change to an even greater positive ratio, further onsite investigation is warranted. Net Loans and Leases to Assets This ratio depicts the percentage of a bank s total assets that are invested in loans. It is calculated as: Net loans and leases Total assets When reviewing this ratio, consider the: Level. A higher ratio typically indicates less balance sheet liquidity because more of the bank's assets consist of loans, which are less liquid than other types of assets, such as securities and Federal funds sold. If this ratio is high, further analysis of loan composition should be completed to determine if any portions of the loan portfolio could provide liquidity to the bank, either through sale or through pledging for borrowing availability. Trend. A significant increase in ratios reported in prior periods warrants further onsite investigation. September 2015 Page 21

22 Financial Institution Analysis School The following example compares the summary ratios data for two banks. Bank A Non-Core Liabilities Time deposits Above Insurance Limit Federal funds purchased Bank B Non-Core Liabilities 18,265,000 Time deposits Above Insurance Limit 5,360,000 4,155,000 Federal funds purchased 10,900,000 Other borrowings 13,000,000 Other borrowings 18,004,000 Total $35,420,000 Total $34,264,000 Short-Term Investments Interest-bearing bank balances Short-Term Investments 100,000 Interest-bearing bank balances 1,750,000 Fed funds sold 65,000 Fed funds sold 0 Total $165,000 Total $1,750,000 Long-Term Assets Long-Term Assets Net loans and leases 125,048,000 Net loans and leases 71,105,000 AFS securities 21,386,000 AFS securities 46,146,000 Total $146,434,000 Total $117,251,000 Total Assets $156,130,000 Total Assets $139,422,000 Net Non-Core Funding Dependence New $250M 24.08% Net Loans and Leases to Total Assets 80.00% Net Non-Core Funding Dependence New $250M 27.73% Net Loans and Leases to Total Assets 51.00% Example Analysis Both banks have about the same dollar amount of non-core liability. However, Bank A has less short-term investments and more long-term assets. In addition, a greater percentage of Bank A's long-term assets are loans. Although the net non-core funding dependence ratio is lower for Bank A, Bank B is probably in a better position to react to adverse changes in the non-core funding environment because it has more short-term assets and more long-term assets in securities. Although the Net Non-Core Funding Dependence New $250M ratio can be very helpful, you cannot draw conclusions about a bank s liquidity based solely on this ratio. Page 22 September 2015

23 Financial Institution Analysis School In the following exercise, you will analyze the summary ratios on UBPR Page 1 and determine if they raise any liquidity concerns. Summary Ratios Exercise and Funding Ratios, UBPR Page 10 Key ratios related to the bank s balance sheet structure are depicted on UBPR Page 10 under the heading /Funding Ratios. Core Deposits (to Total Assets) This ratio indicates how much of the asset base is funded with core deposits. It is calculated as: Core deposits Total assets When reviewing this ratio, consider the: Level. A higher ratio indicates less liquidity risk because more of the asset base is funded with core deposits, which are typically lower-cost and more stable. Conversely, a low ratio indicates potentially higher liquidity risk because more of the asset base is being financed with non-core funds, which are less likely to remain at the bank long term and at reasonable rates. When these non-core funds are invested in loans, which are less liquid than securities, the bank may encounter a liquidity problem if the holders of the non-core deposits decide to transfer their funds out of the institution. Trend. A stable or increasing trend is desirable. Short-Term Investments to Short-Term Non-Core Funding This ratio indicates how well the bank has matched the time horizons of its shortterm investments to its short-term non-core funding sources. It is calculated as: Short-term investments Total short-term non-core funding September 2015 Page 23

24 Financial Institution Analysis School When reviewing this ratio, consider the: Level. A ratio near or exceeding 100 percent indicates that the bank's short-term investments will be sufficient to fund short-term non-core funds at the time of maturity. A low ratio (e.g., well below 100 percent) indicates that the bank does not have sufficient short-term investments to pay off short-term non-core funds, if they are withdrawn or need to be repaid upon maturity. A low ratio does not necessarily mean the bank is experiencing a severe liquidity crisis; however, when the ratio is low, you need to follow up with management during the onsite analysis to determine their strategy for addressing this potential problem. Trend. A stable or increasing trend is desirable, but this ratio can fluctuate considerably from period to period depending upon the timing of investment and non-core funding maturities. If this ratio has fluctuated considerably, assess the composition of short-term investments and short-term non-core funding sources to determine the level of concern. Net Short-Term Liabilities to Assets This ratio depicts the net position of all short-term liabilities (including all time deposits maturing within one year, whether core or non-core) and short-term assets of the bank, in relation to the bank s total asset base. It is calculated as: Short-term liabilities short-term assets Total assets When reviewing this ratio, consider the: Level. A negative ratio means that the volume of the bank s short-term assets exceeds the volume of short-term liabilities. In some cases, this means that there should be a sufficient volume of short-term liquid funds to fund all liabilities maturing within one year. However, this ratio should be closely scrutinized, as short-term assets includes all loans and leases maturing within 1 year. If these loans simply mature and are renewed by management, no cash is generated. In this case, the ratio may be negative, but there still may be insufficient liquid funds to fund all maturing liabilities within the 1 year time horizon. A positive, but low, ratio indicates that management should be able to retire the majority of short-term liabilities with funds obtained from short-term assets, if needed. Again, composition of the short-term assets should be assessed to ascertain the liquidity provided by these assets. Page 24 September 2015

25 Financial Institution Analysis School A high positive ratio indicates that management may need to convert other longer-term assets in addition to short-term assets, to satisfy the possible retirement of short-term liabilities. A high positive ratio may also indicate the need for management to renew or roll over a significant volume of short-term liabilities, since funds obtained from maturing short-term assets is insufficient to retire these liabilities. The level of concern over this ratio depends upon the makeup of short-term assets and liquidity of longer-term assets, as well as management s ability to renew short-term funds at reasonable costs. Trend. If this ratio has been negative and there is a significant increase, or if the ratio has been positive and there is a significant adverse change to an even greater positive ratio, further onsite investigation is warranted. In all cases, review of the composition of short-term assets, and the liquidity provided by such assets, must be assessed. Net Loans and Leases to Deposits This ratio indicates the percentage of loans and leases that is funded by deposits, versus other liabilities such as FHLB borrowings. It is calculated as: Net loans and leases Total deposits When reviewing this ratio, consider the: Level. A ratio that exceeds 100 percent signifies the bank's reliance on funding sources other than deposits to satisfy loan demand. When net loans exceed deposits, investigate the bank's liability structure more closely to determine the level of concern. Trend. The trend should be relatively stable. If the ratio has increased or decreased significantly, discuss these changes with bank management. Significant changes may be the result of a change in strategic direction, either in lending or funds management, which may affect future liquidity levels. Net Loans and Leases to Core Deposits This ratio indicates the percentage of loans and leases that is funded by core deposits. It is calculated as: Net loans and leases Total core deposits September 2015 Page 25