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c. bit: Please don’t “Frankenstein” your Asset/Liability Management Policy

Over the years we have reviewed many credit union A/LM policies. One of the biggest issues we’ve found is that often the policies are “Frankensteined” from various sources. We are reminded of this currently as credit unions are writing policy with respect to liquidity management and contingency funding plans.

Why does this happen? Our theory is twofold.

First, nobody wants to reinvent the wheel when it comes to A/LM policy. Let’s face it – policy writing is tedious. An informal survey of CFOs showed that many would equate writing a policy to having a root canal.

Second, quite often people wait until the last minute to put the policy together. So what do they do? A web search or call their credit union friends and ask for a copy of their policies.

The result is a “Frankensteined” policy that often has many conflicts throughout. And, because people are in a hurry, they don’t really think critically about what they are committing to do in policy. This can result in a distasteful experience if an examiner reads the policy start to finish.

If you are reviewing your policies as part of your normal cycle or updating them to include liquidity management and a contingency funding plan – please take the time to thoroughly review your policy to help ensure it reflects the true tolerances of your board and that there are no conflicts.

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All Sources Of Liquidity Cost Something – But Which Impacts Net Worth Ratios The Least?

As credit unions develop contingent funding scenarios to test against contingency funding plans, the solution to a liquidity event is perhaps as important as ensuring the scenario is both realistic and rigorous.

In working with various credit unions, solutions to liquidity scenarios range from CD promotions to brokered (non-member) deposits to borrowings and lastly, to selling investments. If a contingent scenario also includes a change in interest rates, selling investments may seem unpalatable due to the loss. However, what is the decision driver that is being considered when evaluating alternatives? Is it focused on earnings or focused on net worth?

Take the example of two potential solutions below. Option A solves $10M of deposit run-off from the liability side of the balance sheet replacing the deposits with another liability – Promotional CDs. Option B solves the deposit run-off from the asset side of the balance sheet selling term investments at a loss.


Above, Option A impacts 1-year earnings ($175), all else being equal. Option B impacts 1-year earnings ($500). However, compare the resulting net worth ratios. Option A results in a ratio of 9.89%, which decreases from the beginning net worth ratio, but Option B results in a ratio of 10.39%, which increases from the beginning net worth ratio.

If the liquidity scenario cannot resolve itself through normal balance sheet runoff, which could be the case if the runoff occurred over a very short time horizon, any potential solution should consider not only earnings for the current period, but more importantly the impact to net worth. This is especially important if the loss of liquidity occurs as rates rise – “normal” balance sheet runoff may slow materially as rates rise and existing assets extend.

Remember, the NCUA has recently commented “Net worth is the reserve of funds available to absorb the risks of the credit union, and it is therefore the best measure against which to gauge the credit union’s risk.”

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NCUA Beefs Up Insurance Requirements with New Emergency Liquidity Rule

Approved at NCUA’s July 24th board meeting, the proposed rule on maintaining access to emergency liquidity will require credit unions to create/maintain various levels of liquidity planning based on asset sizes.

Under $10 million in assets:  Maintain a written policy approved by the board with a list of contingent liquidity sources.

$10 million or more in assets: Establish a formal contingency funding plan (CFP) that clearly defines strategies for addressing liquidity shortfalls under adverse circumstances.  The CFP must address, at a minimum, the following:

  1. The sufficiency of the institution’s liquidity sources to meet normal operating requirements as well as contingent events
  2. The identification of contingent liquidity sources
  3. Policies to manage a range of stress environments, identification of some possible stress events and identification of likely liquidity responses to such events
  4. Lines of responsibility within the institution to respond to liquidity events
  5. Management processes that include clear implementation and escalation procedures for liquidity events
  6. The frequency that the institution will test and update the plan

$100 million in assets: In addition to maintaining a CFP as described above, demonstrate access to at least one of the following three sources:  becoming a member of the CLF, becoming a CLF member through a CLF agent, or establishing borrowing access at the Federal Reserve Discount Window.

Required For Federal Insurance
Perhaps more interesting to note is the placement of this proposed rule under Part 741 of the NCUA rules and regulations, which outlines requirements for Federal insurance.  This is the same Part that was revised to require formal IRR programs/policies earlier this year.

Liquidity Contingency Planning
When approaching liquidity planning, c. myers provides its clients with no less than 2 “what-if” scenarios based on an actual liquidity forecast:

  • What-if #1:  What’s our bad-case liquidity environment? Consider heightened loan demand, increased competition for low-cost deposits and potential cuts in lines of credit in order to stress the credit union’s liquidity position
  • What-if #2:  How will we respond to our bad-case liquidity environment? When addressing the bad-case environment, consider triggers the credit union can pull to protect its liquidity position, including slowing down/stopping lending, selling investments, raising rates to attract “hot” money, etc.

Exploring these scenarios on a regular basis can help credit unions be prepared for potential liquidity risks—and in light of the new proposed rule—will also help satisfy regulatory requirements for federal insurance if the rule is realized.

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Liquidity: Another Thing to Worry About?

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Imagine a scenario where it is difficult to find deposits. Suppose the stock market is booming and members are taking funds out of your credit union. Even if you don’t have liquidity issues, what if your competitors do and deposit rates are higher as a result?

Is this hard to imagine given all the liquidity you have now? Consider the relationship between the change in the Dow Jones Industrial Average and credit union deposit growth. In the past, strong stock markets have typically been accompanied by reduced deposit growth. This pattern has yet to repeat in 2010, but what if it does? What would your liquidity position be if you lost the funds you have gained in the last year?

cu deposit growth and dow jones percent change

Also consider that this time your external sources of liquidity may not be available. What if a new corporate credit union structure included a reduced ability for corporates to lend funds? How about the FHLB? What if they are not able to lend funds at the level they have in the past?

The recently finalized Interagency Policy Statement on Funding and Liquidity Risk Management underscores this importance of liquidity planning. This policy statement specifically requires financial institutions have contingency funding plans (CFPs). We recommend you prepare for potential future periods of reduced liquidity now rather than wait for your regulator to request a CFP, or worse yet, to face a period of tight liquidity without a plan.