bank liquidity and wholesale funding ii examination guidance and procedures

Bank Liquidity andBank Liquidity andWholesale Funding IIWholesale Funding IIBank Liquidity andBank Liquidity and

Wholesale Funding IIWholesale Funding II

Examination Guidance Examination Guidance and Proceduresand Procedures

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Examination Guidance and Procedures

Overview UBPR ratios Borrowings and Pledging Interest Rate Risk Capital and Earnings Examples

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RD Memo, Transmittal #2000-046

Issued August 22, 2000 In response to:

– Increase in FHLB membership– Increased complexity and short-term nature of

advances Discusses:

– Asset/liability management strategies that banks employ with the use of advances

– Framework for examining the effects of these strategies.

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Section 6.1 of the Manual of Examination Policies

Additional funding sources, such as: – Borrowings– Trust preferred securities– Asset securitization

Core versus non-core deposits Brokered and rate sensitive deposits Warning indicators for liquidity and contingency

planning Funding diversification versus cost Changes in UBPR ratio analysis

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RD Memo, Transmittal #2002-039

Issued August 28, 2002 FDIC does not discourage use of wholesale

funding sources when incorporated into well-managed funding program

Examiner comments/criticisms related to:– Degree of risk faced– Quality of bank management

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Supervisory Perspective

Risks associated with FHLB advance usage

Impact when managing:– Liquidity– IRR– Earnings– Capital

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Liquidity Implications

Historically - liquidity ratings were driven by balance sheet ratios

Now - possible for banks to operate with fewer liquid assets

Examiners – consider bank's access to wholesale funding sources

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Examination Guidance and Procedures

Overview UBPR ratios Borrowings and Pledging Interest Rate Risk Capital and Earnings Examples

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Advance Usage and UBPR Liquidity Ratios

Advances categorized as non-core funding Use can increase non-core funding

dependence ratios

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Caution

Be careful when determining institution's core funding sources.– Classified as core – may not be– Not classified as core – may be– Advances can increase the loans/deposits

ratio

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When Assessing Liquidity…

Traditional liquidity ratios may not present accurate picture

Follow existing exam guidance – consider:– UBPR ratios– Stability of FHLB advances– Institutions unused borrowing capacity

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Examination Guidance and Procedures

OverviewUBPR ratios Borrowings and Pledging Interest Rate Risk Capital and Earnings Examples

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Secured Borrowings – Disadvantages

Require collateral to be pledged Removes these assets as possible liquid

sources Concern is partially mitigated – FHLB

accepts assets not normally considered liquid

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Ramifications of FHLB Advances

Banks should understand ramifications FHLB can curtail advances if collateral

quality deteriorates below standards Banks should have backup plan Banks should understand risks associated

with Option-Advance Programs

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Funds Management Policies

Should discuss use of non-core funding sources

Limits and types should be outlined Discuss how these funds should be used Consistent with bank's strategic plan Board should understand risks/rewards

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Red Flag

Rapid growth funded by advances Strategy driven by consultant's

recommendation more than board/management strategic plan

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Examination Guidance and Procedures

OverviewUBPR ratiosBorrowings and Pledging Interest Rate Risk Capital and Earnings Examples

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FHLB Advances and IRR

Second area where FHLB advances should be evaluated

Advances can reduce or increase a bank's IRR exposure

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IRR Measurement System

Management measurement system Capture effect advances and assets funded

by advance has on the bank's IRR exposure

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Advance Containing Options

Pay special attention to these Rise in interest rates – FHLB probably

would exercise its option Examiners – determine if bank's IRR

measurement system accounts for terms of FHLB advances

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Examination Guidance and Procedures

OverviewUBPR ratiosBorrowings and PledgingInterest Rate Risk Capital and Earnings Examples

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Purchasing Earning Assets

Some banks use advances to purchase earning assets

May cause increased IRR and credit risk May cause a decline in the NIM and ROA Monitor this risk/reward tradeoff

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Advances and Growth Strategy

Advances used as part of growth strategy require controls

Examiners – determine if institution has controls in place

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Projections

Projections should be made for:– Cash flows– Profits– Balance sheet composition– Resulting increase in risk

Examiners – review this activity

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Examination Guidance and Procedures

OverviewUBPR ratiosBorrowings and PledgingInterest Rate RiskCapital and Earnings Examples

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Wholesale Funding Transaction

Jan. 15, 2004 – Bank obtained FHLB advance and purchased FNMA note

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Wholesale Funding Transaction (continued)

Funding– $10 Million FHLB advance at 2.95%

• 121 bp less than a traditional 5-year, fixed-rate advance

• 31 bp less than a traditional 1-year, fixed-rate advance

– 5-year /1-year option

Investment– $10 Million FNMA note at 4.11%

Matures on 1/15/2009

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Transaction Performance

How did this strategy work?

Date Note Advance Spread

1/2004 4.11% 2.95% 116 bp

On 2/15/2005 advance was called and replaced with a fixed rate, non-callable advance at 4.20% for a 3.75 year term.

2/2005 - Present

4.11% 4.20% (9 bp)

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Replacement Funding

New advance Spread on transaction changes

dramatically – is negative Initial low advance rate - attractive Many institutions do not consider

repercussions

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Risk Associated with Callable Advances

Option will be exercised to benefit FHLB Detriment to the borrowing institution Examiners may see this scenario

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Examiners – Consider These Questions

Does management understand characteristics/risks?

Is transaction consistent with bank's strategic plan?

Does transaction comply with bank's policy requirements?

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Also Consider…

Was management’s selection process of components carefully considered?

Prior to executing transaction – did management evaluate risk/reward tradeoffs?

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Finally, consider these questions…

Is the bank’s IRR measurement system capable of accurately modeling both the asset and liability components of the transaction?

What is the transaction’s effect on the bank’s overall IRR exposure?

What is the impact on the bank’s liquidity?

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Wholesale Funding Transaction

Proposed Transaction Investment

– $10 Million FNMA 5:0% CMO (Accretion Directed, TAC)

– Average Life: 5 years– Yield: 4:98%

Funding– $10 Million FHLB Amortizing Advance– Maturity: 5 years– Rate: 3.09%

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Wholesale Funding Transaction

Bank Balance Sheet: Before Transaction

Total Assets $100 Million Liabilities $90 Million

Capital $10 Million

Tier 1 Capital Ratio: 10%

Bank Balance Sheet: Before Transaction

Total Assets $110 Million Liabilities $100 Million

Capital $10 Million

Tier 1 Capital Ratio: 9.1%

Projected Spread: 1.89%

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Funds Management Policies

Leveraging with FHLB advances easily attained in large quantities allows for rapid growth

Banks need sound funds management policies

Growth should be planned and well-managed

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Questions Examiners Might Ask

Asset quality Economic conditions Overall risk profile

With the decline in the bank's capital ratio, is the bank's capital position expected to remain satisfactory when considering trends in:

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A Growing Source of Funding

Growth in traditional core deposit products lag increases in non-core funding

Wholesale funding – secondary source of support for community banks

Yet, this funding source is growing

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Depositor Behavior

Influenced by several factors Depositors more inclined to invest in

shorter-term, highly liquid deposit products Bank customers do not want to tie up

dollars for extended periods of time

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We Might Ask:

Are these funds actually 'core' deposits? How 'sticky' are these 'core' deposits?

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Higher Yields

Depositors investing funds longer-term utilizing higher yielding deposit products (i.e. brokered, jumbo CDs)

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Wholesale Funding Trend

Due to various factors – wholesale funding plays prominent role in banking strategies

Trend likely to continue

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