a newtwork of opportunties
Optimize Your Liquidity Position by Identifying Your Risk Capacity
key words: risk capacity, uses and sources of funds, liquidity coverage ratio, contingency funding plan quantitative assessment
THC Asset-Liability Management (ALM) Insight
Your liquidity adequacy depends upon many factors, including commitments to lend, loan prepayments (run-
off), and/or unanticipated withdrawal of deposits. There are also many liquidity measures, including ST
Investments/Total Assets, Net Loans/Total Assets, Net Loans/Total Deposits. How do you determine the
optimal liquidity position with multiple requirements and metrics?
Last issue, I discussed the use of Duration to measure your Interest Rate Risk Capacity. Is there a key liquidity
measure that can be used to monitor the Liquidity Risk Capacity of the balance sheet? Do you have a liquidity
measure that you trust?
Re-Examine Your Risk Culture
An institution’s risk culture may be driven by the historical experience and professional background of
management. The S&L crisis of the 1980’s and the financial crisis of 2009 experiences have greatly reduced
some banks’ perceived Risk Capacity. Historically, liquidity has been a key metric used by the examiners when
determining the safety and soundness of a bank. Bankers should be aware of liquidity risks such as a run on
the bank, inability to access Federal Home Loan Bank advances, slowing prepayments, and the inability to
sell investments. Failure to consider these and other potential liquidity risks can lead to insolvency.
As I mentioned in Issue 1, there is a sea change in the risk management culture as banks are adopting new
ways to measure, monitor and manage risk. This change is broad based and fundamental, a change that
cannot be detected by anecdotal cases nor by several trend analyses but by sharing ALM views with banks
across the country. Determining the Liquidity Risk Capacity is no exception. Banks tend to converge on using
one key measure, Liquidity Coverage Ratio (LCR).
Modeling the Sources and Uses of Funds and Determining the Liquidity Coverage Ratio (LCR)
The Comptroller Handbook Liquidity June 2012 describes the LCR in detail. ST Investments/Total Assets, Net
Loans/Total Assets, Net Loans/Total Deposits are considered Static Liquidity Ratios. These ratios do not
identify your ability to meet your future cash requirements. To address the limited relevance of the static
liquidity ratios, the Handbook suggests using a Dynamic Liquidity Ratio.
The Handbook suggests that you use your interest rate risk model to project the monthly interest and
principal payments of both assets and liabilities. The ratio of the inflow of funds to the outflow of funds is
called the Liquidity Coverage ratio (LCR). Appendix B of the Handbook provides an example worksheet of
how to calculate the LCR as shown below.