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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  
Issue 2  
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.  
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However, this work sheet is deceptively simple. Many questions arise:  
How are the sources of funds from loan prepayments determined?  
The withdrawal of non-maturity accounts is a use of funds, but what is the withdrawal rate?  
Should we include the retention rate of time deposits?  
What reinvestment rates should be used?  
How is the cash based net income as a source of funds determined?  
Should CDs be classified as cash in the sources and uses of funds report as they are in the CALL report?  
What is the optimal LCR?  
Let me suggest some answers to the questions above. The prepayment speed of loans on the balance sheet  
depends on many factors: loan age (vintage), interest rate, remaining life and more. Likewise, the withdrawal  
rate also depends on multiple factors: deposit type, your customer base, your rate relative to your  
competitors’ and more. For these reasons, and by regulation, you have to conduct a prepayment and core  
deposit account study to justify these model assumptions. Therefore, the Uses and Sources of Funds report  
must be generated with your Interest Rate Risk Model to ensure consistency and accuracy of risk  
measurement.  
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Why is LCR an Effective Risk Capacity Measure?  
The LCR assumes that all net inflow funds are reinvested, making the metric more relevant to an operating  
financial institution. By way of contrast, the liquidity gap report, while commonly known, assumes the  
balance sheet is being run off, which is not realistic for management purposes. The uses and sources of funds  
can also be internally validated by cross checking the reasonableness to actual cash inflows and outflows to  
ensure model accuracy and usefulness. The report can identify your excess liquidity, a specific cash amount  
for your decision-making process. Furthermore, the LCR can be simulated under stress tests.  
The stress test results of the uses and sources of funds can be graphically presented. On the left, the chart  
depicts the inflow of funds and the outflow of funds, which are the bars above and below the x axis,  
respectively.  
When the positive bar exceeds the negative bar by a multiple of 2, then the LCR is higher than 2.  
The fluctuation of the bars represents the expected demand and supply of funds. Understanding the  
information contained in these fluctuations enables you to avoid possible cash short falls.  
If your target LCR is 2 and the results show that your LCR is 3, then the model suggests that you have  
excess cash by the amount of the total uses of funds, because your LCR exceeds your target by 1, the  
amount of the total uses of funds.  
The chart on the right side depicts the uses and sources of funds under different scenarios. This chart shows  
the uses and sources of funds under the Severe Scenario of the Contingency Funding Plan, or the scenario of  
alternative rate shocks. The uses and sources of funds report can meet the regulatory requirements for  
Contingency Funding Plan quantitative assessment. THC can model the assumptions of the Moderate, Severe  
and Crisis scenarios within the Uses and Sources of Funds framework in addition to calculating their  
respective LCRs.  
Numerical Illustration  
Let us consider at a high level the Uses and Sources of Funds report for a Board meeting using a hypothetical  
bank. Referring to the table below, the “Cash” represents the cash and cash equivalent items with a stated  
maturity of less than one month. The cash line item is also a plug, where the net cash flow of the previous  
month is reinvested as cash. Note that neither the total sources of funds nor the total uses of funds equal  
the sum of the subitems, since the purpose of the board report is to convey information that can lead to  
actionable decisions and not providing detail accounting.  
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The LCR in October (“1 mo” of the September report) is 1.26 (= 87,038/68,906) suggesting that the balance  
sheet has $1.26 inflow to cover every $1 outflow. Note that the LCR increases every month; the increase is  
the result of the assumption that the cash-based profits, not accounting profit, are always reinvested as  
cash.  
The LCR can be used for making the following actionable decisions:  
If the bank’s target LCR is 2.0, then one solution is to increase the cash position by $50,990 (= (2 –  
1.26)*$68,906).  
The table can also identify the liquidity needs for each projected month. If the LCR for a particular  
month falls below your minimum target, for example 1 mo, October, then the results would suggest  
that you should evaluate further the liquidity needs for that month.  
What is the Optimal LCR?  
Of course, the optimal LCR should be institution specific. The optimality will depend on your risk preference,  
the volatility of funds flow on the balance sheet, and diversification of your funding sources.  
Most banks have an LCR between 1.5 and 2.5. Banks with a higher LCR tend to be smaller. Banks with a lower  
LCR tend to be larger and have larger investment portfolios to augment balance sheet liquidity, as the  
investments can be used to support the adequacy measure of the Contingency Funding Plan quantitative  
assessment.  
The variance of LCRs among banks is significant. Typically, for smaller institutions below $1 billion, I suggest  
an LCR target of 2.0, with an internal policy limit of minimum 1.5. If a bank’s LCR is below 1.5, then some  
internal compliance static liquidity ratios would likely fail. If you want keep a low LCR, I suggest that you use  
the Contingency Funding Plan quantitative assessment report to ensure that you have sufficient liquidity in  
selling your liquid assets or drawing down your line of credit.  
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Summary:  
This THC Insights suggests that you examine your LCR to determine your risk capacity in utilizing your cash  
position to originate/purchase loans or deploy the cash for other application. When the LCR is low, then you  
should use the Contingency Funding Plan quantitative assessment report to ensure that you have an  
adequate liquidity buffer to withstand your severe and crisis scenarios.  
I have covered the measures for interest rate risk and liquidity risk in measuring the Risk Capacity of your  
balance sheet in this and the previous issues. Next issue, I will discuss the specifications of Credit Risk Capacity  
using the Current Expected Credit Loss (CECL).  
I welcome your comments.  
Regards,  
Tom Ho PhD  
President  
1-212-732-2878  
About THC  
THC is a financial technology company founded by Dr. Thomas Ho, a former professor at New York  
University, who introduced the first balance sheet valuation (Ho-Lee model 1986) called "option model" by  
regulators and key rate durations (1992), one of the most popular interest rate risk measures.  
THC was selected as the sole provider of the risk reporting to all regulated institutions under a federal bank  
regulator. THC continues to dedicate its research and resources to supporting community banks.  
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