Series: Ask ALM
On Wednesday, January 17, the NCUA released an Advisory letter on Liquidity Risk Management.
Liquidity remains a topic of discussion and increased focus given the reduction in on-balance sheet liquidity and competitive deposit environment the industry has experienced over the past 18 months. As such, many of our clients have reported increased focus on liquidity risk management during regulatory examinations.
The Advisory letter highlights the key pillars of liquidity risk management, all of which are already reflected in regulation and existing official regulatory guidance. Although no new regulatory requirements have been issued, ALM First considers this letter to be a useful resource for credit unions to reflect upon current liquidity risk management practices and correct any potential weaknesses. The letter covers the following topics:
- Cash flow forecasting and backtesting
- Asset composition
- Structure of liabilities
- Liquidity risk governance practices
- Funding sources
Although the Advisory letter primarily reiterates existing and generally well-established risk management practices, we wanted to highlight a few key areas for credit unions to consider when assessing existing liquidity risk management practices.
Asset Pricing
Asset and liability composition can be difficult to manage in an environment with consistent loan growth and competitive deposit markets. Asset composition can quickly change when credit unions do not properly assess relative value when making loan and investment decisions. Poorly priced loans can lead to excess growth, which can lead to liquidity pressure and concentrations of credit risk. Lending functions and treasury teams should continue to work together to assess relative value among available asset allocation opportunities with consideration given to strategic priorities for balance sheet composition.
Funding Evaluation
Assessing the relative cost of funding sources remains imperative, especially as competition in some markets has driven certificate rates above wholesale funding rates. Credit unions should ensure funding sources are diversified and the cost of incremental funding is evaluated prior to enacting a funding strategy.
Short-Term Cash Flow Forecasting
The Advisory letter points out the need to manage and forecast cash flows under normal and stressed conditions. ALM models can be leveraged for periodic stress testing of a credit union’s liquidity resilience; however, sources and uses of cash should be monitored more frequently and used to project short-term funding needs. Cash usage can be determined by combining loan pipelines, planned investment purchases, and projected funding decay or maturities. These projected cash uses can then be paired with projected cash inflows from loans and investments along with projected funding inflow or procurement to determine any short-term funding gaps over 30-, 60-, and 90-day time frames.
Backtesting
As with any financial model, backtesting is an important practice that is necessary to fine tune model performance and dependability for decision-making. Many clients have reported difficulties in obtaining actual cash flows from core systems but have been able to achieve sufficient backtesting by leveraging budget variance analyses.
There is no “one size fits all” approach to liquidity risk management and each credit union will need to incorporate the unique aspects of their business model to effectively manage risk. If you have questions or would like to discuss how the Advisory letter impacts your credit union, please reach out to your primary ALM First contact or send an inquiry to info@almfirst.com.
