Pub. 7 2016 Issue 3

www.wvbankers.org 10 West Virginia Banker Asset/Liability Management: Modeling the Dynamics of Liquidity By Jeffrey F. Caughron, The Baker Group LP Overview Every banker knows that liquidity has a tendency to ebb and flow with changing market conditions. As a rule, liquidity rises and falls inversely with the general trend and direction of interest rates. The ability to reasonably project the behavior of balance sheet cash flows, and therefore liquidity, is critical to sound asset/ liability management processes. Some banks have relatively sim- ple balance sheets that experience very little cash flow volatility. Other institutions are much more active and dynamic, including off-balance sheet transactions and financial instruments with high degrees of optionality or cash flow uncertainty. In general, it is the magnitude of this cash flow volatility that can result in unde- sirable levels of liquidity risk and financial performance. Among other things, extreme variation in balance sheet cash flows can result in volatile measures of economic value of equity (EVE). Identifying the Need Three points of focus help to determine the degree to which institutions should have access to cash flow-level interest rate risk reports and simulation analysis: wholesale funding, off-balance sheet commitments, and options risk. Banks that make heavy use of wholesale funding sources including brokered deposits or advances, for example, and those that have a high percentage of “non-core” funding generally are certainly candidates for robust cash flow analysis and reporting. Also, off-balance sheet funding commitments would trigger a need for such tools. Perhaps the most notable characteristic that would call forth a need for such cash flow analysis is a high degree of options risk, particularly in assets. Options risk entails uncertainty with respect to cash flow. Cash flow projections and therefore liquidity forecasts become more difficult since you cannot know precisely when principal will return to the balance sheet for reinvestment or redeployment. In short, bank balance sheets that contain a high level of options risk should make a greater effort to analyze and monitor those cash flows. Measuring and Reporting A critical aspect of dynamic cash flow analysis is the develop- ment and modeling of assumptions. The analysis must project the response or behavior of cash flows to a variety of influences. Here the bank must make assumptions about future events. For the risk measurement system to be reliable, these assumptions must be reasonable given the characteristics of the bank and its balance sheet. The OCC identifies some common problems with regard to development of assumptions in the risk measurement process. These include: • Failing to address potential risk exposures over a sufficient- ly wide range of interest rate movements to identify vulner- abilities and stress points. • Failing to adequately modify or vary assumptions for prod- ucts with embedded options to be consistent with individu- al rate scenarios. • Basing assumptions solely on past customer behavior and performance without considering how the bank’s competi- tive market and customer base may change in the future. • Failing to periodically reassess the reasonableness and accuracy of assumptions. We should add to this list the failure to model non-parallel changes in the yield curve since some instruments have cash flows that are driven by changes in short-term rates, while others are sensitive to changes in the long end. In any case, it is impera- tive to have a comprehensive set of reasonable assumptions built into any model projecting scenario cash flow dynamics. Once we have meaningful cash flow projections, we can simulate with more precision the effect on earnings of different interest rate environments. This is more valuable than, for example, a call report-based system, which must rely on broad categories and average balances rather than actual dollars of reinvesting and/ or repricing cash flows. Again, banks with very simple balance sheets may not need the highest degree of precision, but they will want to assess the adequacy of their system in any case. Conclusion There are many considerations involved in the modeling of a bank’s interest rate risk and liquidity exposures. The regulatory authorities have told us in no uncertain terms that bank man- agement must be vigilant in its efforts to define, measure, and manage those exposures. In order to do this properly, we must look at the behavior of cash flows. The swirl of repricing balances and changing interest rates creates a good deal of uncertainty with respect to future earnings unless there is some meaningful way to model those dynamics. For banks that seek to upgrade and optimize their IRR processes, a good start is to review and assess the adequacy of their asset/liability reporting systems, particular- ly with respect to the ebbs and flows of liquidity. n Jeffrey F. Caughron, Chief Operating Officer/Managing Director of The Baker Group LP, has worked in the field of banking, investments, and interest-rate risk management since 1985. He currently serves as a market analyst and portfolio strategist.