Liquidity
Category: Corporate Governance
When evaluating liquidity, members of Council compare the current level of liquidity, plus liquidity that would likely be available from other sources, with funding needs, and they determine whether funds management practices are adequate. Bank management should be able to manage unplanned changes in funding sources, as well as react to changes in market conditions that could hinder the bank’s ability to quickly liquidate assets with minimal loss. Funds management practices should ensure that the bank does not maintain liquidity at too high a cost or by relying unduly on wholesale or credit-sensitive funding sources. These funding sources may not be available in times of financial stress or when market conditions are adverse. It is important to maintain an adequate level of liquid assets and a stable base of deposits and other funding sources.
Supervisory Council members should regularly review the following liquidity leading indicators for signs of increasing liquidity risk.
Net loans/deposits —indicates the extent to which a bank’s deposit structure funds the loan portfolio. The higher the ratio the more reliance that a bank has on non-deposit sources to fund the loan portfolio.
Net short-term liabilities / total assets —calculated by taking the difference in short-term assets from short-term liabilities and dividing by total assets. The ratio indicates the degree of exposure assumed by funding assets with short-term liabilities, also referred to as rollover risk. Generally, the higher the number, the more vulnerable the bank is to funding sources rolling out. This requires the bank to find new funding sources for existing assets.
On-hand liquidity / total liabilities —calculated by dividing net liquid assets by total liabilities. This ratio measures the bank’s ability to meet liquidity needs from on-hand liquid assets. The lower the ratio, the greater the likelihood that the bank will need to sell less liquid assets or use market funding sources to meet incremental liquidity needs.
Reliance on wholesale funding —calculated by dividing all wholesale funding by total funding. This measures the portion of the bank’s total funds that are from wholesale sources. Banks with high volumes of wholesale funding need to make sure they have up-to-date contingency funding plans.
Liquidity Red Flags:
Significant increases in reliance on wholesale funding.
Significant increases in large certificates of deposit or deposits with interest rates higher than the market.
Mismatched funding —funding long-term assets with short-term liabilities or short-term assets with long-term liabilities.
Significant increases in borrowings.
Significant increases in dependence on funding sources other than core deposits.
Reduction in borrowing lines by correspondent banks.
Increases in cost of funds.
Declines in levels of core deposits.
Significant decreases in short-term investments.