Throughout the first half of 2022, many institutions have seen liquidity tighten due to increased loan demand and slower deposit growth. This has caused depository leaders to look for alternative ways to fund their balance sheet growth.
Determine How Much Liquidity is Needed
The first step in liquidity management is determining the appropriate level of on-balance sheet liquidity necessary for daily business functions. When working with our clients, we suggest using a Liquidity Coverage Ratio, which measures the institution’s ability to meet short-term financial obligations given current liquid assets. The calculation is measured as High-Quality Liquid Assets, which are assets that can quickly and easily be converted into cash, divided by the net cash outflow over the next 30 days. Typically, 100% is the minimum requirement for this ratio, and many manage to 125%. Since High-Quality Liquid Assets includes not just cash accounts but also the stored liquidity in a high-quality investment portfolio, you may be surprised by how little cash you need on hand for liquidity management at a target threshold of 100-125%.
Consider Potential Funding Sources Carefully
After assessing the liquidity position and determining if cash is needed, it’s important to closely evaluate the cost of each funding source and choose the cheapest option. Many institutions identify their primary core liquidity source as deposit funding raised via strategies such as deposit pricing specials or core deposit rate changes, or sales from their securities portfolio. However, other non-deposit funding sources like the FHLB or capital markets alternatives, such as repurchase agreements and Agency MBS dollar rolls, should also be considered as strategic funding solutions and not simply reserved for unanticipated liquidity needs. As you put various funding options in comp, your cost evaluation should be tuned according to the source (i.e. marginal funding cost of raising core deposits, market yield of selling assets) and benchmarked versus a market index such as swaps or US Treasury yields in order to help compare sources with different terms.
Ensure Your Credit Union Is Pricing Loans Correctly
When evaluating the cost of varying funding sources, it is equally important to evaluate the asset being funded. Since there is a finite amount of room on the balance sheet to add assets, it is crucial to ensure a positive risk-adjusted spread over funding costs. Also important is pricing appropriately to market expectations for risk and funding costs, rather than to your institution’s current cost of funds. This helps strengthen the anticipated financial performance of the asset as well as its liquidity profile if the credit union needs to sell the asset in the future.
If considering selling one asset to fund another, it is paramount to evaluate each asset in a risk-adjusted return on capital (RAROC) model. This accounts for the unique elements of risk associated within each asset as well as their capital requirements in a risk-based capital (RBC) framework, allowing for a more even comparison. Take for example the sale of an agency-backed floating rate security to fund auto lending. An auto loan has a higher market value sensitivity to changes in interest rates (aka. duration) and increased exposure to credit risk, whereas a monthly-floating agency investment has minimal exposure to either of these risks. In addition to added risk exposure and a greater capital requirement, auto lending also comes with servicing expenses and possible origination costs, like indirect fees. When accounting for the various risk and operational costs, often our clients find that an agency security generates a higher risk-adjusted ROE than highly competitive auto lending.
As we assess paths to increase liquidity, it’s imperative to critically evaluate the funding sources, choose the cheapest option, and ensure there is a spread to the asset being funded. Consistent use of a well-tuned pricing model is a strong complement to a modernized liquidity management approach, helping to generate stronger financial performance and a healthier balance sheet.
ALM First’s team of experienced professionals is here to assist with liquidity management, asset pricing and all aspects of your balance sheet strategy. Contact us today to discuss your institution’s financial performance goals in more detail.