The Liquidity Spectrum 2.0

You may recall last quarter; my article was titled: “The Liquidity Spectrum”. Given the notable events in early March of this year, I felt it was appropriate to continue the conversation about Liquidity and the current state of the banking industry. In the previous column, I didn’t know how timely or significant the discussion on Liquidity would become and now it seems that Liquidity will continue to dominate the headlines for our industry in the foreseeable future. There has been a series of significant responses to the current Liquidity environment. Most institutions were able to maintain ample levels of on-balance sheet Liquidity in the months following the height of the pandemic and today we are seeing Liquidity positions negatively impact some institutions. However, the need for real-time Liquidity, not just available, or contingent sources of Liquidity, can occur in an instant and it seems certainly true of the two recent bank failures as reported by the media. Thankfully, it has been many years since our country has witnessed a true “run on deposits at an institution”. Although it appears there is some uneasiness within the system, I am optimistic that we will continue to see stability return across the sector.

Bank failures are unfortunate, and the two recent Liquidity failures have been extremely alarming, particularly because of the timing of these failures occurring either mid-day or not associated with a planned regulatory closure. The responsive actions taken by the federal regulators to the events give some indication that we are in a different environment than in previous periods of banking history. I have also continued to see and hear the comments about a “banking crisis” but I do not believe that is an accurate description or appropriate language to use at this point. However, we may continue to see a period of decline, some economic uncertainty, and the potential for further impacts to customers and our industry.

The influx of money into the economy and specifically to individuals and businesses over the past two years was unique. This occurred during a prolonged period of record low interest rates and was coupled with lower levels of loan demand across the banking sector. Some banks sought alternatives other than loans to bolster income and deploy the excess funds. Although yields in the bond markets were often not the most desirable, increasing securities portfolios seemed to be the best option for many institutions. However, monetary policy changes led to rapid increases in interest rates which immediately and significantly impacted bonds prices and valuations of banks investment portfolios; thus, diminishing the value or ability to use the investments for normal liquidity needs. These negative events when coupled with certain business sectors’ need to access funds and exercise their lending commitments led to the worst outcome for some institutions.

In the coming weeks and months, we will continue to see and hear more commentary around the circumstances and causes that led to these recent events. I will share my belief that diversification is key to sound banking practices and can be a contributing factor to managing risk. My annual list of “Hot Topics” this year, includes Concentration Risk as one of the topics for 2023. Concentration Risk should be identified, measured, monitored, and controlled for all institutions. Concentration Risk can occur on both sides of the balance sheet and that is especially true based on shared comments and observations of the bank failures this year. In the Post 2008 banking crisis, we have spent much time focused on Commercial Real Estate concentrations. While we witnessed the impact that can occur with deterioration of that business sector, we must continue to closely monitor the trends and market indicators that incorporates enhanced oversight of any balance sheet concentrations including funding sources and demands. We should also assess the potential for loss and exposure if there is weakening within a customer base or category. This is especially true for new or emerging markets or lines of business. Second, rapid growth can be an indicator of increased risk within a balance sheet. Many times, rapid growth can occur without well developed or enhanced risk management practices in place. Furthermore, the absence of strong risk management practices or risk mitigants, can often result in exposure and loss for an institution.

As I noted in the previous column, diversification of funding sources, robust Contingency Funding Plans that are tested, and appropriate internal stress testing of asset and liability classes are all examples of strong risk management practices. Today, more than ever, we see how necessary it is that we are prepared for that one day when Liquidity matters the most!