May 13, 2010

Credit Union Management’s Web-only “CFO Focus” column runs the second Thursday of every month.

On April 5, 2010, the National Credit Union Administration, Office of the Comptroller of Currency, Federal Deposit Insurance Corp., Federal Reserve and Office of Thrift Supervision published their “Interagency Guidance on Liquidity and Funds Management.”

In her speech to the ABA Convention on Oct. 26, FDIC Chairman Sheila Bair indicated that the majority of bank failures in 2008 and 2009 were related to liquidity risk rather than capital risk.

Why do her comments apply to your credit union? This interagency guidance is the combined effort of five different regulators, including NCUA. The vast majority of deposits in U.S.-insured financial institutions are covered by the FDIC. The banking industry regulators feel they need this guidance now. I don’t think the NCUA disagrees.

The guidance document accelerates the pace at which we’ve been moving away from ratio-based liquidity analysis and in the direction of sources and uses of funds and contingency funding plans. In addition, the guidance has a very strong undercurrent saying, “The industry needs to increase its level of asset-based liquidity and reduce its reliance on non-core funding.”

Developing an effective liquidity policy and strategy comprises five key steps:

1. Build a top level capital/liquidity plan that: (a) reconciles your credit union’s strategic goals for growth, earnings, and capital/assets, (b) balances strategic growth goals for shares, loans and capital, and (c) determines the strategic target mix of investments to loans, and core funding to non-core funding.

Then set annual goals leading to accomplishment of the strategic goals within a reasonable horizon (three to five years). This process is important as it sets up the goals you want to hit in each of the following steps, given challenges faced by the industry—such as asset quality, potential loss of overdraft protection income and narrowing net interest margins.

2. Using your goals for share growth as targets, develop and document your plan to grow core funding (shares). Most credit unions lack an effective core funding strategy. Core funding is the most favored, most valuable, least volatile, and lowest-cost source of funding to a credit union. Why focus on share growth when most credit unions are currently highly liquid? Because economic recovery will lead to “flight to safety” shares returning to the markets combined with acceleration in loan growth. With it will come tightening liquidity. Now is the time to begin building a share growth strategy that focuses on economic recovery combined with a rising rate environment.

3. Examine the alternative sources of non-core funding available to your credit union. Diversify your sources of non-core funding to reduce the risk in any particular funding source. Then set up schedules to periodically test the sources of non-core funding you may need, should an unanticipated liquidity stress event occur that significantly affects your sources and uses of funds. Based on the goals set in your top-level plan, set policy limits on overall concentration of non-core funding, along with limits on use of specific non-core funding sources.

4. Evaluate your sources of asset-based liquidity. How much cash flow is available from your loan portfolio and from amortizing and maturing investments? What loans could easily be securitized and sold? How much of your investment portfolio is in unpledged, highly liquid securities that can be relied on to provide liquidity should a liquidity stress event occur? Then using your top-level plan goals, set policy limits on maximum loan portfolio concentrations and minimum investment concentrations, especially for highly liquid, unpledged investments.

5. Develop a sources-and-uses-based base liquidity strategy as part of your budget or business plan. Set your policy limits for acceptable gaps between sources and uses of funds. Stress test your base liquidity strategy assumptions for highly probable high-impact events—such as loan growth significantly exceeding share growth as the economy recovers—to see whether unfavorable liquidity gaps develop that could take you outside your limits. Make sure your base strategy can deal with these stresses. Develop contingency funding plans for low probability, high impact events, such as falling below well-capitalized minimums or receiving prompt corrective action status downgrades. The contingency funding plan should lay out how you will deal with those events. Your liquidity management policy and strategy should be integrated into your asset/liability committee’s policy and strategy.

Follow these five steps and you will have a liquidity policy and strategy that will meet the test of time.

In addition, rethink how you are managing your ALCO process. Most spend most of their time looking back at what has happened. Not enough time is spent evaluating the risk-to-risk and risk-to-return tradeoffs in alternative solutions to your financial challenges. Without an effective structure for decision-making, you may end up adopting solutions that are well short of optimum, hurting the credit union and its members.

Tom Farin is president of Farin and Associates, Fitchburg, Wis.