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Liquidity and the Winds of Change
by Jeff Bagby, Regional Examiner, Oklahoma State Banking Department
Change will happen whether the powers that be are willing or not, but it is nice to consider that there are regulators who are acknowledging and maybe even embracing evident change. It's kind of like finding out that creative tax deduction you've taken the last four years is actually legal. You were going to do it anyway, and now it has the government's blessing.
For as long as I have been examining banks, liquidity has been a ratio driven analysis. The ratio was the result of a page long calculation carefully crafted by now deceased regulators and handed down to the community of bankers who were looking for some method to satisfy regulators that adequate liquidity was available. The bank would take their assets and liabilities, insert them into the formula of liquid assets and core liabilities and generate a ratio. Over the years, this ratio has given regulators great comfort when it was high and consternation when it was low.
What exposure to great loss and possible failure is imminent if that ratio is not improved? I don't know Mr./Ms. Banker, but it needs to be higher. Although this approach has worked historically with little opposition from bankers, the archaic regulatory approach is starting to show some rust.
More and more bankers are developing alternative means to get where they are going and the added risk is almost imperceptible. And it's coming from outside the core deposit realm of the balance sheet. The concept is reasonable, but so far, it doesn't fit in the regulator's time honored method of assessing liquidity. When considering the regulatory calculation for liquidity, the ancient way of evaluating it has very little accommodation for managing liquidity from the liability side. The new and unusual culprits are FHLBank borrowings and certificates of deposit from non-brokered wholesalers.
Consequently, when bankers stray from the conventional and obtain funding beyond the typical sources, alarm bells sound off when their liquidity levels fall below the accepted limits. It has reached a point now, though, that regulators are going to have to address not only how bankers are erecting funding sources, but how they themselves are assessing liquidity.
Bankers are moving toward profitable operations and it is not in the their best interests and the industry as a whole for the regulatory community to stand idly by or force bankers to do business the customary way for no good reason other than it is the way it has always been done. The problem is regulators are unsure. They don't know what inherent risk is attached to liability side liquidity management. Until that monster shows itself, State and Federal regulators up the bureaucratic ladder will be hesitant at best to approve of widespread use of borrowing lines and out of territory deposits to satisfy funding needs.
The trend toward FHLBank borrowing and acquiring deposits through internet wholesalers is not new. Large regional banks have been managing liquidity through non-core funding for years. The change is that smaller community banks are beginning to catch on. And it has been mostly out of necessity. If community banks were able to match robust loan growth with similar deposit growth, alternative funding sources would not be an issue. In today's world, even the smaller banks are having difficulty gathering old fashioned deposits in their own market at a price that is competitive. They must either innovate or die.
Bankers will always incorporate a mixture of funding sources. They will continue to cultivate securities for liquidity and for added income, even though income possibilities are slim. Core deposits will continue to be a primary and positive funding source. But now, bankers will also go outside their trade area to purchase deposits through clearing house entities largely through the internet. The ongoing availability of these funds should reduce the concern regulators have over "hot" money. When one matures, there are a dozen more waiting to take its place. The only thing that will affect the institution in question will be what interest rate the bank has to pay for replacement funds because these rates will be driven by the national markets. The luxury of artificially depressing deposit rates for the good of the bank's bottom line is only for banks in out of the way communities with a customer base that is too lazy to shop their money.
Because of their consistency and availability, actively used FHLBank lines of credit are poised to become the norm rather than the exception in liquidity strategies. Going forward, excluding a bank's existing credit line(s) when evaluating their liquidity posture will be incomplete and inaccurate. There are now consultants who recommend that a bank's liquidity policy include available FHLBank borrowing lines as a part of their primary analysis rather than sequestering it to a secondary source.
This regulator is a believer. Supervisory converts to this line of reasoning may come slowly, or at least slower than bankers' conversion rate. Much of the time, bankers are put in a position of trying to understand and get up to speed on the latest regulatory "innovation" (read: rule change). This time, bankers are breaking new ground and finding their way, and the regulators are giving chase. Unfortunately, the most difficult part of the entire process for bankers may be the time lag of waiting on the regulators to catch up to where they already are.
Jeff Bagby is a Regional Examiner with the Oklahoma State Banking Department. He has spent nearly 20 years in bank regulation which includes a wide spectrum of knowledge and experience. In the early part of his career, the banking industry in the central region of the United States endured its most devastating era since the FDIC was established bringing with it numerous bank closures. In addition to writing examination reports and working with bank management, Jeff teaches Loan Officer Seminars which is aimed at revealing to bank lenders how and what an examiner looks for when reviewing loans.
Jeff received a B.B.A. from the University of Oklahoma in 1985 and is a graduate of the Conn Graduate School of Community Banking.
First published on BankersOnline.com 04/04/05
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