FDIC Liquidity Analysis

The following are excerpts from a report by the FDIC in their publication called Supervisory Insights.  Supervisory Insights is published by the Division of Supervision and Consumer Protection of the Federal Deposit Insurance Corporation to promote sound principles and best practices for bank supervision.  This report was a review on an overview of problems that can emerge from the use of different asset and liability liquidity sources.  The report is intended for the interest of examiners, bankers and supervisors.   

In the current challenging environment, bank liquidity planning is becoming paramount. Although many banks have traditional contingency credit lines, established liquidity sources can quickly disappear when funding is most needed; in the worst cases, the result may be bank failure.  Further, even if an institution can weather a liquidity storm, ineffective funds management decisions could irreparably impair earnings.  A comprehensive, well-designed liquidity contingency plan can help bank management effectively navigate a liquidity crisis.

The report is designed to assist bank managers on how to understand their markets and quickly identify irregular deposit trends.  The article evaluates how a bank’s liquidity position can be adversely affected by deteriorating financial conditions and offers suggestions for developing an effective liquidity contingency plan.  This article builds on those concepts by highlighting in detail some of the unique features and risks associated with various liquidity sources.  The article describes how problems on the asset side of a bank’s balance sheet can cascade to a liquidity run and discusses some steps that institutions can take to anticipate and mitigate liquidity risks.

Bank failures that have occurred during the past year, along with media coverage about perceived weaknesses in the financial system, have heightened the public’s awareness of the existence of deposit insurance coverage and the need to monitor deposit balances. Community banks that are not experiencing liquidity pressures are now more aware of the importance of preparing in advance for the possibility of a liquidity run.  As a result, the development and implementation of a contingency funding plan (CFP) is critical for all financial institutions.

During the past ten years, the nation’s community banks have benefited from stable credit markets and relatively easy access to sources of liquidity.  However, recent disruptions in the credit and capital markets have increased the challenges of liquidity planning for many institutions.  Negative media coverage has heightened concerns among some bank customers about the safety of deposits.  Emerging liquidity problems are particularly problematic for FDIC-insured institutions that rely on liability and off-balance sheet liquidity sources.

As part of the analysis the FDIC provides a liquidity run example.  The example is designed for bank management review but provides and interesting and educational source for consumers as well.  The scenario laid out is titled, “Time Line of a Liquidity Run”.  Per the FDIC the case study, is based on several actual examples and shows how quickly an institution’s liquidity situation can deteriorate.  Here are the details of the hypothetical example.

Day 1. 

A rapidly growing community bank, with $750 million in total assets and several branches, holds a significant concentration in acquisition and development loans.  A large local real estate developer, associated with hundreds of loans at the bank, declares bankruptcy.  The bank’s publicly traded holding company makes a Significant Event filing with the SEC. 

Day 2. 

Local media outlets cover the SEC filing, noting the severe downturn in the area real estate market and the considerable impact on local builders.  The holding company stock drops 25 percent, and branch level deposits decline $11 million.  Two senior lending officers are placed on administrative leave pending an investigation.

Day 3.

Branch level deposits drop another $13 million, and the largest depositor notifies
management it intends to withdraw funds.  The bank draws $12 million from its borrowing line with the Federal Home Loan Bank (FHLB).

Day 4.

Branch level deposits drop another $8 million, and the bank draws $8 million from the FHLB.  A correspondent bank requires the bank to pledge securities to a $5 million line that was previously unsecured.  The bank reactivates an agreement with an Internet listing service to attract additional deposits.  The board of directors engages a consultant to advise on strategic options.  A review of borrowing line contracts confirms that all have material change clauses that would allow funded balances to be called. 

Day 5.

Branch level deposits drop another $14 million, and the bank draws the last $17 million from the FHLB line.  A correspondent bank informs the bank that it will no longer process the cash letter.  The bank is informed that the Federal Reserve Bank (FRB) will likely impose a zero daylight overdraft.  A local newspaper runs a story on high-risk and potentially fraudulent transactions involving real estate investors, brokers, and the bank.

Day 6.

Branch level deposits drop another $7 million.  Another correspondent agrees to take over the cash letter activities, and the bank draws $4 million from this correspondent.  Further, the bank obtains $3 million in higher rate CDs through the Internet listing service.  The bank’s largest depositor has withdrawn the majority of its funds.  Another SEC filing details the severity of the loan problems and management’s actions to address the issue.  Remaining liquidity is estimated at $35 million.  A line of credit with the FRB is not pursued as the bank has not identified collateral that is available to pledge.  The bank reaches an agreement to obtain substantial deposits, but those funds likely will not be available for two more business days.  The potential to sell loans is evaluated, but no loan sales are imminent.  Loss on the asset situation is initially estimated at $5–$10 million.  The loss will cause the bank’s capital level to fall to the point at which a brokered deposit waiver from the FDIC will be required to obtain or renew brokered deposits. 

Days 7–9.

Over the next three days, branch level deposits drop another $18 million.  The bank draws $41 million from the correspondent and obtains $9 million in Internet listing CDs. A full scope regulatory examination has begun, media coverage continues to scrutinize the asset issue, and the bank has virtually exhausted all credit lines. 

Day 10.

The bank completes the arrangement with an outside party and receives $99 million in higher cost deposits to avert a liquidity failure.  Thus, as the result of a single (albeit substantial) lending issue, the bank lost $73 million in deposits over ten business days, had a correspondent bank cease its agreement to process the cash letter, and nearly failed, as all ready sources of liquidity were exhausted.  Although it survived the short term liquidity crisis, the bank now faces an extremely narrow net interest margin because of the higher cost deposits.

Since the recent liquidity events in the bank and credit markets, federal programs have been implemented to bolster consumer confidence in the banking system and the marketplace. The Emergency Economic Stabilization Act of 2008, which temporarily raises the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor.  The legislation did not increase coverage for retirement accounts; this limit remains at $250,000.  The legislation provides that the basic deposit insurance limit will return to $100,000 after December 31, 2009.  The temporary increases solidifies the government insurance program by promoting the existence of the insurance with FDIC member banks and prevents uninsured deposit amounts that fell under the lower limits from being pulled form banks and being reallocated.

In addition, on October 14, 2008, the FDIC announced the creation of the Temporary Liquidity Guarantee Program (TLGP) as part of a broader government effort to strengthen confidence and encourage liquidity in the nation’s banking system.  The TLGP has two components.  One guarantees newly issued senior unsecured debt of the participating organizations, within limits, issued between October 14, 2008, and June 30, 2009.  The TLGP also provides full coverage for non-interest-bearing transaction deposit accounts, regardless of dollar amount, until December 31,2009.  Institutions may opt out of one or both programs.  These programs were designed to add security to interbank lending and again to help avoid withdrawals from banks on non interest bearing deposits that would have exceeded the insurance limit previously in place.

These recent policy initiatives reflect the importance liquidity issues have assumed in the current banking environment.

This entry was posted on Saturday, December 20th, 2008 at 2:25 pm and is filed under Money Rates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.