FRISCO, Texas–Liquidity risk should never be discounted, according to one expert.
“Liquidity risk is real; it’s the first point I want to make,” said Jonathan Jackson. “It’s the primary risk that will shut a financial institution’s doors, or force it to merge when it doesn’t want to.”
Jackson, who works in Catalyst Strategic Solutions’ Advisory Services area, discussed the “ebb and flow” of liquidity along with how the process can be better managed to manage risk (but not eliminate it) during Catalyst Corporate’s Economic Forum here.
What is liquidity risk? Jackson ran his audience through some terminology:
- Sufficient liquidity. Jackson called “sufficient liquidity” a “vague concept that defines it is a useless experience. What we know is it typically appears to be in pretty good shape, until it’s not.”
- Liquidity risk: the risk of being unable to meet financial obligations.
- Liquidity management: balancing liquidity risk and profitability
- Liquidity (Non-) Management: Holding too much liquidity as a substitute for robust liquidity management.
Jackson cited a Basel Committee statement on managing risk as a reminder for credit unions: “The fundamental role in the maturity transformation of short-term deposits into long-term loans creates an inherent vulnerability to liquidity risk, both of an institution-specific nature and that which affects markets as a whole.”
The keys to maturity transformation are trust and competitive pricing, according to Jackson.
What Happened to One CU
As an example of the kind of liquidity risk a credit union can face, as well as the consequences, Jackson shared the example of a credit union that introduced rewards deposit account to bring in deposits and grow. Deposits flooded in, with 11% growth within one month, ultimately doubling in size in less than two years. The CU could not deploy funds effectively or efficiency, and attempted to book as many loans as quickly as they could, including entering into new areas. Delinquencies began to rise and provision expense eroded capital.
The CU then moved to immediately suspend its rewards program, which led to funds flowing out even faster than they had come in. Within three years it had been conserved by NCUA.
The Steps to Process
According to Jackson, a strong liquidity management process:
- Requires an organization-wide understanding of the liquidity risk management process including where the credit union will operate on the liquidity risk spectrum.
- Requires multiple business units to provide input.
- Includes well developed liquidity policies and contingency funding plans.
- Includes static ratios, dynamic forecasts, and stressed scenarios.
What liquidity management is not, stressed Jackson, is the elimination of risk.
Other Steps
In addition, Jackson told the meeting a strong liquidity management process:
- Balances the member value proposition, profitability, and balance sheet growth.
- Maximizes the use of assets.
- Optimizes the use of secondary liquidity options.
- Doesn’t substitute an overly conservative liquidity risk profile for a robust liquidity management program.
Jackson said there are red flags to look for in liquidity management, and the warning signs include:
- Rapid / unanticipated growth or decline in loans, deposits, or earnings.
- Concentrated positions.
- Deteriorating loan quality.
- High leverage (heavy reliance on external funding).
Jackson reminded several times during his remarks that while knowing a CU’s current liquidity position is critical, it is also a point-in-time measure that can change, sometimes dramatically.
Looking Forward
In looking to the future, especially with strategic planning season underway, Jackson noted forecasting remains the standard for a healthy liquidity risk management process. That forecast should typically include:
- Projections of expected cash flows for 12 months typically.
- Anticipation of potential periods of liquidity surpluses and deficiencies.
- Knowledge from historical cash flows.
- An accounting for share and loan growth expectations.
Stress Testing
Planning for the future must also include stress testing he reminded.
“Once the baseline is set, begin to alter future states,” he said. “Baseline projections rarely present truly adverse environments.”
He said stress tests should also identify which scenarios reveal significant difficulty and why; which scenarios cause liquidity ratios to be out of policy?; which scenarios cause catastrophic failure (scenarios shouldn’t always be “reasonable,” he stated), and, finally, should identify scenarios that drive failure to allow for proper planning.
What to Do Now
Finally, Jackson called on every credit union to build out an effective funding strategy by:
- Setting a growth target and a capital plan for the credit union.
- Establishing a funding strategy. “The strategy should be flexible to changing conditions,” he said.
- Tracking the progress. Remember to ask who is responsible and what are the right measurements?
“Be proactive not reactive,” said Jackson.