Liquidity Has Two Faces – Don’t Get Burned by the One You Haven’t Seen for a Long Time
April 3, 2020
7 minute read – We are having numerous discussions with CEOs and CFOs regarding liquidity and while none of them are exactly the same, there are two common themes. One is a great concern for a liquidity crunch and the other is a concern for flight to safety.
Since the industry has more recent experience in managing through a flight to safety, we are going to discuss some of the questions and considerations to be thought through, now, should a liquidity crunch in the credit union industry become widespread.
We recognize that decision-makers are swamped and brains are taxed. However, it is important to understand how your liquidity holds up if there is an extended liquidity crunch.
An unchecked liquidity crunch can rapidly become a crisis and move like wildfire through an industry. Your level of preparedness is directly linked to the preparedness of all others in the industry, including those providing the liquidity.
The following can help guide you to determine how in-depth your liquidity analysis and contingency preparation needs to be. This is a terrific time to beef up data analytics and establish baselines.
Questions/considerations to work through with your team:
Lending
- What could be the impact of our loan deferment program and for how long?
- Loss of cash flow from principal and interest income
- Escrow payments
- How are our members using their lines of credit? What are the liquidity implications of a significant increase in members drawing on their lines of credit? How do we need to enhance our business intelligence to ensure we are positioned to be proactive should we start to see material changes in member behavior?
- What is our strategic position on extending or reducing lines of credit in light of balancing helping members and potential increases in credit risk?
- What percent of our loan portfolio could we defer, and for how long, and not put undue stress on liquidity?
- How does this change if most of the deferments are in mortgages?
- As a mortgage servicer, what do we need to know and/or do right now to be crystal clear on the exact ramifications of deferments for loans we do not hold in portfolio? Under what circumstances, if any, are we at risk of needing to front deferred principal/interest payments and/or escrow as we are helping members?
- What percent of people who are requesting that their loan be deferred are also taking large draws on their lines of credit and/or spending more on credit cards? What changes, if any, are we seeing with their direct deposits?
- How could our mortgage pipeline impact our liquidity needs? What changes do we need to implement, if any, given our volume?
- What are potential liquidity implications from our business lending and related services? It is important to reach out soon to assess the situation and see how you can help.
- What do we need to do to be ready to ensure we can efficiently pledge less liquid loans, for example auto loans, to support our borrowing lines, especially in our remote working environment?
- How could a sustained downturn impact our members and their families, and our communities? Different from the Great Recession, job losses have been swift, severe, and across almost every sector. Consider testing the impact on liquidity of a moderate and a high-stressed credit risk scenario.
Investments
- What changes should we consider in our investment strategy to support our liquidity and cash on hand needs? How does this impact earnings?
- Which investments are pledged for borrowings? If we are considering selling investments to book some gains or to address cash needs, what is the impact on our borrowing capacity?
- How might cash flows in our investments, such as mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs), contract or extend as a result of unprecedented refis and on the other side loan deferments?
- How might changes in the credit environment impact our investments including valuations and liquidity? For example, Munis, Corporate Bonds, Private-label MBS, etc.
Deposits
- Dig deeper into who is depositing what. While initially, overall deposit levels might not change much because of tax payments and government assistance kicking in, it is important to establish your baselines now.
- Consider prioritizing ramping up daily watches on deposits. For example:
- Evaluate direct deposits post the start of COVID-19 pandemic compared to patterns over the last year.
- Watch for big withdrawals or transfers and have a process to jump on them to understand why the member is moving so much money at this time.
- Link big draws on lines of credit and corresponding increases in deposits from the same members, then keep a close eye on what happens with the money.
- Watch for changes in behavior and develop triggers and levers to pull should you need to do so.
- Again, reach out to your business depositors – consider enhancing your monitoring of their cash flow.
Borrowings
- Reconfirm your borrowing capacity. If you haven’t borrowed recently, test your operational process to ensure it is flawless so that if you need to borrow in a hurry you are ready.
- How might it be impacted by your employees working remotely?
- Who can execute the borrowings and should it be expanded in case key people become sick?
- Assess and test how your borrowing capacity could change as credit risk conditions evolve.
- What could happen to the value of your loan collateral?
- Will the lender adjust the amount of collateral required?
- Consider lining up new sources of borrowings now, even if you don’t think you will need it. Remember, it is not just about what you think you will need. Your needs can be directly impacted by what others need or think they need.
- Evaluate the pros and cons of borrowing now, even if you do not need it. Model the financial implications under various environments.
- Brush up on your sources of borrowings and your Contingency Funding Plan (CFP) so that you understand how lines of credit could be cut if a systemic issue arises.
- Model the impacts of having your lines of credit cut.
- What would it take to work yourself out of a liquidity crunch with only internal sources of liquidity? Include potential impacts to the value and/or salability of your investments.
- Same question as above, layering in only having access to the Fed Discount Window.
Contingency Funding Plan and Preparation
- Read and update it from a different perspective. COVID-19 has turned a riveting fiction novel into reality. Decision-makers’ views and lenses must expand and be multidimensional.
- Test your plan, just like you test your business continuity plans, make sure it is efficient when most people are working remotely.
- Beef up the frequency of modeling liquidity scenarios and their financial impacts.
- Keep your board informed and don’t sugarcoat the severity of the situation, should that be the case.
- Develop and monitor triggers before you are in a liquidity crunch. Based on up-to-date information, agree which levers need to be pulled and when.
- Be crystal clear who is responsible for monitoring and communicating liquidity and triggers at agreed upon intervals to ensure timely awareness.
Again, we understand the level of pressure decision-makers are under. We offer these suggestions so you can be better prepared if external forces deal another blow. It is proven that this type of critical thinking results in better, more timely decisions.
While we did not discuss a flight to safety, it is still necessary to explore potential business model implications of a flight to safety, as this is very different in an environment where long-term rates are extremely low (and could go lower) and credit risk could heat up – putting pressure on earnings and net worth ratios.
We have experience working with over 600 financial institutions, including 25% of the credit unions over $100 million in assets and 50% of the credit unions over $1 billion in assets.
We can appreciate how recent events are impacting the normal course of business and are happy to schedule time outside of normal business hours – early in the morning, late at night, or on the weekend, as needed.
You can reach us at 800.238.7475 | 602.840.0606 or email smay@cmyers.com.
