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Liquidity – Evaluating And Understanding Your Contracts

Most liquidity concerns today revolve around having too much liquidity without viable investment opportunities. However, after the recent (and sustained) flight to safety, some credit unions are beginning to consider the potential impact of liquidity leaving insured financial institutions.

In the short-term, a liquidity event may be significant deposit run-off or draws on unfunded loan commitments (i.e. HELOCs or credit cards). Responses to such events may include reducing member lines of credit, increasing borrowings, selling AFS investments, or some combination of the above. However, prior to relying on these actions, management teams should evaluate their contractual ability to exercise certain options. Some important considerations include:

  1. Can unfunded loan commitments be revoked? If so, what are notice or disclosure requirements? If the loan is business-purposed, are there any special considerations needed?
  2. If an unfunded loan commitment can be reduced, are there limiting conditions? For example, some real estate-backed lines of credit may be reduced without advance notice only if the collateral value has declined since the approval of the loan. If home values have appreciated, the credit union may not be able to reduce lines.
  3. What AFS investments, if any, are encumbered through line of credit contracts with a correspondent financial institution?
  4. If the credit union’s safekeeper also provides a committed secured line of credit, what operational concerns are there if the credit union advances funds through the line and also plans to sell investments?
  5. What is the cutoff time or advance notice requirement for drawing on a committed credit facility? Does the cutoff time or advance notice requirement change based upon the terms under which the credit union is requesting funds, even if through the same correspondent financial institution (i.e. repurchase agreement vs. term borrowing)?

Many credit unions may have materially more considerations to make than those noted above. Every credit union should evaluate liquidity options and understand potential courses of action well before they are needed.

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Hot Money In Waiting

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Many credit unions continue to see higher levels of deposit growth despite lowering rates—and even a rising stock market—as members choose safety and certainty over return.  While the flight to safety has been discussed at length, the gradual shift from CDs to share products has received less attention.

Over the past 6 to 12 months, many credit unions have seen decreases in CD balances with a corresponding increase in share balances, in addition to the increase in overall deposit balances.  Such a trend suggests that members are willing to park their money in a lower-paying share account rather than lock their money up in a higher-paying CD in order to have the flexibility to reinvest their money when a better alternative presents itself.  As a result, these balances could be hot money in waiting.

Credit unions should evaluate the change in their liability mix over the last year and consider how any shifts might affect their liquidity concerns, product needs and cost of funds going forward—especially in different rate environments.  Likewise, it would be prudent for institutions to incorporate this additional rate sensitivity into their modeling, particularly if a clear shift can be identified.  Modeling the hot money as 30-50% more sensitive than other share balances is a good place to start.

Whether the impact is large or small, the credit union will be better positioned to handle the reinvestment of hot money should it occur.

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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.