Pub. 6 2015 Issue 3

www.wvbankers.org 10 West Virginia Banker Liquidity and Investment Management The Bank as a System A bank is a system of interrelated func- tions. No single part of the balance sheet should be analyzed in complete isolation as the output of one decision serves as the input for another. This idea is partic- ularly applicable to questions of liquidity and marketability of securities. You can always buy bonds with higher yield, but only if you are willing to accept greater credit risk, more cash flow volatility, or less liquidity. This fundamental tradeoff is not negotiable. Investments and Liquidity Bank portfolio managers should think of the investment portfolio as a store- house of liquidity and safety, and as a tool for managing interest rate risk in the balance sheet. The portfolio should contain highly marketable bonds, such as those backed by the US treasury, government-sponsored enterprises, or high-grade municipals. These bonds are widely traded in liquid secondary markets. Bonds with private label names, exotic collateral, or complex structure, and those that “trade by appointment” should be avoided. At some point these may cause the frustration of illiquidity and the unpleasantness of major price deterioration. In addition to marketability, selection of bonds and bond types that provide reasonably consistent and predictable cash flow is critical. When purchasing a bond or considering alternatives, portfo- lio managers should take a hard look at the cash flow uncertainty or optionality as well as the underlying price sensitiv- ity. Some bonds have well-defined cash flow because they return principal in one lump sum on the maturity date; how- ever, they yield less because they have perfectly predictable cash flow. Other bonds have uncertain and dynamic cash flow that ebb and flow with different conditions. These bonds will yield more to compensate for that uncertainty of cash flow. What’s essential, however, is that banks have good interest rate risk modeling or asset/liability reporting tools for monitoring the dynamics of investment cash flow across a variety of scenarios. A good system will allow for modeling of multiple rate scenarios and curve shift environments, and the report- ing of impact on liquidity. It is also important to understand that the degree of price sensitivity tends to vary directly with the degree of cash flow uncertainty, assuming bonds of comparable credit. In other words, as cash flow volatility increases, the mar- ket value of the portfolio will become increasingly volatile as well. A portfo- lio consisting entirely of bullet bonds will have a level of price sensitivity or duration that is more or less constant and predictable. It may be high or low, but it will not experience much varia- tion. Bonds with a high degree of cash flow uncertainty, on the other hand, will also carry a good deal of variable price sensitivity, and this price sensitivity is a liquidity consideration. Conclusion Liquidity comes in several forms. It is a stream of stable and predictable cash flow. It is the ability to quickly convert marketable assets to cash. It is the ability to monetize or borrow against assets, which in turn requires the underlying value of those assets to be known and measurable. These aspects of liquidity should be well measured, monitored, and reported, particularly the dynam- ics of balance sheet or portfolio cash flow. At the end of the day, all aspects of liquidity risk management should be governed by asset/liability policies and prudent investment strategies designed to keep the individual system that is the bank profitable and sound. n Jeffrey F. Caughron, Chief Operating Officer/Managing Director of The Baker Group LP, has worked banking, investments, and interest-rate risk management since 1985 and currently serves as a market analyst and portfo- lio strategist. Contact: 800-937-2257, jcaughron@GoBaker.com. By Jeffrey F. Caughron, The Baker Group LP