Post on 18-Dec-2015
Building Partnerships. Serving Communities.
Maximizing Liquidity at Minimum CostMaximizing Liquidity at Minimum Cost
2005 CUNA CFO Council2005 CUNA CFO Council
May 16, 2005May 16, 2005
Presented by:
James B. Eibel, CFA
Vice President
FHLB-Indianapolis
(317) 465-0423
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Building Partnerships. Serving Communities.
Goals
1. An interactive discussion of strategic liquidity management
2. Be provocative
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Building Partnerships. Serving Communities.
Presentation Outline
1. What is liquidity risk?
2. Liquidity and opportunity cost
3. ALM and liquidity management
4. Case study and discussion
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Building Partnerships. Serving Communities.
Liquidity
1. The text book says…
2. Your regulators say…
3. Your board says…
4. You and your management team say…
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Building Partnerships. Serving Communities.
“If the members want a product, we need to find
a way to offer it. We are in the risk management
business.”
Credit Union CFO
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Building Partnerships. Serving Communities.
“Credit unions should consider the potential risk
exposure as they explore opportunities to better
serve their members.”
NCUA Letter 03-CU-11
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Building Partnerships. Serving Communities.
Liquidity Risk
“Liquidity risk is the funding risk that, due to a
lack of sufficient stable sources of funds, a credit
union will be unable to continue meeting
member demands for share withdrawals and/or
new loans.”
NCUA Letter 00-CU-13
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Building Partnerships. Serving Communities.
Deconstructing Liquidity Risk
1. “Funding risk”
2. Caused by a “lack of sufficient stable sources of funds”
3. Resulting in inability to meet “member demands for share withdrawals and/or new loans.”
NCUA Letter 00-CU-13
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Building Partnerships. Serving Communities.
Sources of Liquidity
• Primary liquidity– Cash and short term investments– Projected cash flow from loans and securities– Deposit growth
• Alternative liquidity sources– Borrowing lines– Sales, securitization, and participations
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Building Partnerships. Serving Communities.
Cash/Total AssetsInstitutions >$100 Million Assets
0%
2%
4%
6%
8%
10%
12%
14%
Cas
h/A
sset
s
10th 20th 30th 40th 50th 60th 70th 80th 90th
Percentile
Credit Unions Banks
As of 3rd Quarter 2004, averages were 6.9% and 2.9% respectively for credit unions and banks.
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Building Partnerships. Serving Communities.
Liquidity is Not a Free Good
• Primary liquidity has an opportunity cost
• Alternative sources of liquidity may have operational costs (fees, systems, and staff time)
Goal: Minimize cost while maintaining funding reliability for all
contingencies
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Building Partnerships. Serving Communities.
Opportunity Cost of Primary Liquidity
24
68
4
8
12
16
6
12
18
24
8
16
24
32
10
20
30
40
0
5
10
15
20
25
30
35
40
RO
A R
educ
tion
(bps
)
2% 4% 6% 8% 10%
Excess Liquidity
1%
2%
3%
4%
Yield Pick-up
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Building Partnerships. Serving Communities.
ALM and Liquidity Management
• Liquidity management is a subset of ALM
• Effective liquidity management requires the use of dynamic scenario analysis
– Cash flow projections by scenario– Contingency funding plans by scenario
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Building Partnerships. Serving Communities.
Contingency Funding Policies and PracticesThe Importance of “Fire Drills”
• Test & documents borrowing lines
• Test & document loan sales and/or participations
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Building Partnerships. Serving Communities.
Asset Composition and LiquidityKey Issues
• Cash flow certainty
• Collateral value
• SEG concentration
• Marketability– Sale– Securitization– Participation
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Building Partnerships. Serving Communities.
Callable BondsAgencies, Corporates, MBS, & CMOs
• Cash flow certainty is exchanged for a higher initial yield
– Amortizing vs. bullet structures
• FHLB collateral value is 85%-95% of market value for agencies, MBS, and CMOs
• Marketability issues:– Price volatility of bullet structures– Bid/ask spreads for thinly traded issues (beware of the Hotel
California)
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Building Partnerships. Serving Communities.
Investment CDs
• Cash flow certainty is high, unless CD has an embedded call option
• FHLB cannot use CDs for collateral
• CDs are illiquid, but withdrawal option is often cheap relative to fair market value
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Building Partnerships. Serving Communities.
Car Loans
• Cash flow certainty is relatively high even for longer-term loans (40% turnover)
• FHLB cannot use for collateral
• Can be packaged and sold, but execution may be an issue
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Building Partnerships. Serving Communities.
Home Equity Loans
• Cash flow volatility may be an issue – Unextended HELOCs (approximately 50%)– Closed-end loans similar to comparable duration
mortgages
• FHLB collateral value 50%-70%
• Can be packaged and sold
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Building Partnerships. Serving Communities.
Mortgages
• Cash flow can be unpredictable– Portfolios generally turnover 10%-20%, unless
rates fall
• FHLB collateral value approximately 80% of market value
• Can be sold, securitized, or participated
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Building Partnerships. Serving Communities.
Average Lives for Mortgage Products(Data in Years)
0
2
4
6
8
10
12
Years
5 yr. balloon 1.8 3.3 4
7 yr. balloon 1.9 4.0 5.2
10 Year 2 3.2 4.3
15 Year 2 4.2 6.1
30 Year 2.2 5.9 10.1
Down 1% Flat Rates Up 3%
Data based on Wall Street dealer prepayment estimates for agency mortgage-backed securities
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Building Partnerships. Serving Communities.
Member Business Loans
• Cash flow may be an issue with credit lines
• Some MBLs have collateral value– SBA guaranteed portions– Commercial real estate– Ag loans
• May be participated
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Building Partnerships. Serving Communities.
Liability Composition and LiquidityKey Issues
• Optionality– Impact on term structure– Impact on rates paid
• Reliability
• SEG Concentration
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Building Partnerships. Serving Communities.
Non-maturity Deposits
“It is not possible to predict with any certainty
what the future balances in non-maturity
accounts will be, how long they will remain
open, or what future rates will be paid to
members on these accounts.”
NCUA Letter 03-CU-11
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Building Partnerships. Serving Communities.
Non-maturity Deposit Issue
• Shares, drafts, and money market accounts represent a significant portion of credit union funding
• NMDs are relatively insensitive to interest rates and can be priced accordingly
– Term structure depends on pricing policies and customer behavior
Do you have the liquidity capacity to withstanddisintermediation if rates rise?
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Building Partnerships. Serving Communities.
Non-maturity Deposit AssumptionsWhat Qualifies as Conservative?
Increasing term structure
Value at Par/Floating Rate
McGuire Performance Solutions
ExampleChecking account average life estimates can vary from 1 day to 10 years.
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Building Partnerships. Serving Communities.
Time Deposits
• Largely rate driven– Funds can generally be attracted for a price– Rate sensitivity tends to increase with term
length
• Early withdrawal option– With interest rates near historic lows, withdrawal
penalties are as well
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Building Partnerships. Serving Communities.
CD Interest Penalty AnalysisHow far out-of-the-money is the option?
0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.25% 2.50% 2.75%
1 year
2 years
3 years
4 years
5 years
CD
Ter
m
6 Month Interest Penalty Break-even
5.00%
4.00%
3.00%
2.00%
Based on immediate change in rates
Offer Rate
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Building Partnerships. Serving Communities.
FHLB Advances
• History of reliability (9/11 and S&L Crisis)
• Clout in global debt markets
• Customized to match individual needs
• Optionality controlled by borrower
• Requires collateral
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Building Partnerships. Serving Communities.
Corporate Credit Union Lines
• Lack of history and market access
• May lend against collateral FHLB cannot
• More competitive on overnight and short borrowings
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Building Partnerships. Serving Communities.
Brokered CDs
• Product offerings may be limited
• Withdrawal option generally limited
• Does not require collateral
• Tend to be most expensive wholesale option
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Building Partnerships. Serving Communities.
Repurchase Agreements
• Generally short term
• Secured by high quality security collateral
• Counterparty risk
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Building Partnerships. Serving Communities.
Federal Reserve Window
• Reliable, but “The Lender of Last Resort”
• Catastrophic liquidity backstop
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Building Partnerships. Serving Communities.
Putting it All Together
• Cash flow budgeting
• Contingency funding (beyond cash flow)– Deposit pricing strategies– Saleable assets– Borrowings
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Building Partnerships. Serving Communities.
Congratulations!You are the new CFO at Lending Community CU
• Previous CFO has “Left to pursue other interests”– She was unable to persuade board and regulators that she
could manage the organization’s liquidity position
• LCCU pays well and recognized your talent• You were hired to:
– Formulate a liquidity plan consistent with their mission (“Lend, lend, and lend some more”)
– Articulate liquidity plan to management, board, and regulators– Implement the plan
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Building Partnerships. Serving Communities.
Your New Assignment as CFO:LCCU
AssetsCash and short term: $80 million
First mortgages: $400 million
HELOCs (50% extended):$50 million
Car loans: $320 million
SBA loans: $100 million
P, P & E: $50 million
Total Assets $1 billion
LiabilitiesMoney market: $200 million
Shares: $200 million
Share drafts: $200 million
Retail CDs: $175 million
FHLB borrowings: $100 million
Brokered CDs $15 million
Corporate CU overnight: $10 million
Total Liabilities $900 million
Equity $100 million
Liabilities & Equity $1 billion
RatiosROA: 1.2%ROE: 12%Net Worth: 10%Loan/shares: 112%Loans/assets: 87%Borrowings/assets: 12.5%Projected loan growth: 12%Projected deposit growth: 10%
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Building Partnerships. Serving Communities.
Liquidity Risk Questions
1. Does LCCU have “funding risk?”
2. Does LCCU have a “lack of sufficient stable sources of funds?”
3. Is LCCU unable to meet “member demands for share withdrawals and/or new loans?”
From NCUA Letter 00-CU-13
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Building Partnerships. Serving Communities.
Liquidity Management is a Strategic Competency
• Risk/reward optimization
• Improved decision-making & resource allocation
• Improved budgeting and forecasts
• Improved management of regulatory risk