Must Know 6.1

Question 1

The definition of liquidity risk

Answer 1

Liquidity risk is the risk of not being able to obtain funds at a reasonable price within a reasonable time period to meet obligations as they become due.

Question 2

The four methods of increasing liquidity

Answer 2

The board of directors should understand the nature and level of the institution’s liquidity risk, establish the institution’s tolerance for liquidity risk, and approve significant policies related to liquidity management. The board, or a committee of board members, should also ensure that senior management takes the necessary steps to monitor and control liquidity risk, which include the following:
1. Establishing procedures, guidelines, internal controls and limits for managing and monitoring liquidity to ensure adequate liquidity is maintained at all times.
2. Preparing contingency funding plans.
3. Reviewing the institution’s liquidity position on a regular basis and monitoring internal and external factors and events that could have a bearing on the institution’s liquidity.
4. Reviewing periodically the institution’s liquidity strategies, policies, and procedures.
Regardless of the method or combination

Question 3

The Board of Directors’ responsibilities relating to liquidity

Answer 3

The board of directors should understand the nature and level of the institution’s liquidity risk, establish the institution’s tolerance for liquidity risk, and approve significant policies related to liquidity management. The board, or a committee of board members, should also ensure that senior management takes the necessary steps to monitor and control liquidity risk, which include the following:

1. Establishing procedures, guidelines, internal controls and limits for managing and monitoring liquidity to ensure adequate liquidity is maintained at all times.
2. Preparing contingency funding plans.
3. Reviewing the institution’s liquidity position on a regular basis and monitoring internal and external factors and events that could have a bearing on the institution’s liquidity.
4. Reviewing periodically the institution’s liquidity strategies, policies, and procedures.

Question 4

The 13 items found in a sound Liquidity/Funds Management policy

Answer 4

The following are examples of typical guidelines established by a sound liquidity and funds management policy:

1. Provides for the establishment of an asset/liability committee. Define who will be on the committee, what its responsibilities will be, how often it will meet, how it will obtain input from the board, how its results will be reported back to the board, and who has authority to make liquidity and funds management decisions.
2. Provides for the periodic review of the bank’s deposit structure. Include the volume and trend of total deposits and the volume and trend of the various types of deposits offered, the maturity distribution of time deposits, rates being paid on each type of deposit, rates being paid by trade area competition, caps on large time deposits, public funds, out-of-area deposits, and any other information needed.
3. Provides policies and procedures that address funding concentration in or excessive reliance on any single source or type of funding, such as brokered funds, deposits obtained through the Internet or other types of advertising, and other similar rate sensitive or credit sensitive deposits.
4. Provides a method of computing the bank’s cost of funds.
5. In conjunction with the bank’s investment policy, determines which types of investments are permitted, the desired mix among those investments, the maturity distribution and the amount of funds that will be available, and reviews pledging opportunities and requirements.
6. Conveys the board’s risk tolerance and establishes target liquidity ratios such as loan-to-deposit ratio, longer-term assets funded by less stable funding sources, individual and aggregate limits on borrowed funds by type and source, or a minimum limit on the amount of short-term investments.
7. Provides an adequate system of internal controls that ensures the independent and periodic review of the liquidity management process, and compliance with policies and procedures.
8. Ensures that senior management and the board are given the means to periodically review compliance with policy guidelines, such as compliance with established limits and legal reserve requirements, and verify that duties are properly segregated.
9. Includes a contingency plan that addresses alternative sources of funds if initial projections of funding sources and uses are incorrect or if a liquidity crisis arises. Establishes bank lines and periodically tests their use.
10. Establishes a process for measuring and monitoring liquidity, such as generating pro-forma cash flow projections or using models.
11. Defines approval procedures for exceptions to policies, limits, and authorizations.
12. Provides for tax planning.
13. Provides authority and procedures to access wholesale funding sources, and includes guidelines for the types and terms of each wholesale funding source permitted. Defines and establishes a process for measuring and monitoring unused borrowing capacity.

Question 5

The differences between Asset Management and Liability Management of liquidity – strategy, risks, and costs

Answer 5

Banks relying solely on asset management focus on adjusting the price and availability of credit and the level of liquid assets held to meet cash demands in response to changes in customer asset and liability preferences. As an alternative to using assets to satisfy liquidity needs, these needs may be met through liability sources. Although core deposits continue to be a key liability funding source, many insured depository institutions have experienced difficulty attracting core deposits and are increasingly looking to wholesale funding sources to satisfy funding and liability management needs.

Question 6

Asset sources of liquidity

Answer 6

Liquidity needs may be met by managing the bank’s asset structure through either the sale or planned pay-down of assets.

Question 7

Risks of asset-securitization

Answer 7

First, some securitizations have early amortization clauses to protect investors if the performance of the underlying assets does not meet pre-specified criteria. If an early amortization clause is triggered, the issuing institution must begin paying principal to bondholders earlier than originally anticipated and will have to fund new receivables that would have otherwise been transferred to the trust.
Second, if the issuing institution has a large concentration of residual assets, the institution’s overall cash flow might be dependent on the residual cash flows from the performance of the underlying assets. If the performance of the underlying assets is worse than projected, the institution’s overall cash flow will be less than anticipated.
Also, an issuer’s marketplace reputation is crucial to its ability to generate cash from future securitizations. If this reputation is damaged, issuers might not be able to economically securitize assets and generate cash from future sales of loans to the trust.
Finally, residual assets that the issuing institution retains are typically illiquid assets, for which there is no active market. Additionally, these assets are not acceptable collateral to pledge for borrowings

Question 8

Liability sources of liquidity

Answer 8

Core deposits and Wholesale funding sources include, but are not limited to, Federal funds, public funds, Federal Home Loan Bank advances, the Federal Reserve’s primary credit program, foreign deposits, brokered deposits, and deposits obtained through the Internet or CD listing services.

Question 9

The five components of an effective deposit management program

Answer 9

• A clearly defined marketing strategy.
• Projections for deposit growth and structure.
• Associated cost and interest rate scenarios.
• Procedures to compare results against projections.
• Steps to revise the plan when needed.

Question 10

Public Funds

Answer 10

2. Public funds are deposit accounts of public bodies, such as State or local municipalities. These types of deposits often must be secured and typically fluctuate on a seasonal basis due to timing differences between tax collections and expenditures. General economic conditions can also be a factor in assessing the volatility of such deposits, since public entities may experience revenue shortfalls in times of economic decline. Though regarded as generally volatile, these accounts can be reasonably stable over time, or their fluctuations quite predictable.

Question 11

Large Deposits

Answer 11

3. large deposits are defined as those concentrations of funds under one control, or payable to one entity, which aggregate 2% or more of the bank’s total deposits. By virtue of their size, such deposits are considered to be potentially volatile liabilities; however, examiners may determine that certain large deposits actually remain relatively stable for long periods.

Question 12

Negotiable certificates of deposits

Answer 12

4. Negotiable certificates of deposit (CDs) warrant special attention as a component of large deposits. They are usually issued by money center or large regional banks in denominations of $1,000,000 or more and may be issued at face value with a stated rate of interest or at a discount similar to U.S. Treasury Bills.

Question 13

Brokered Deposits

Answer 13

5. Deposit brokers have traditionally provided intermediary services for financial institutions and investors. However, the Internet, certificate of deposit listing services, and other automated services enable investors who focus on yield to easily identify high-yielding deposit sources. These are highly volitile funds.

Question 14

Secured and preferred deposits

Answer 14

6. Secured and preferred deposits impose pledging requirements upon banks.

Question 15

International Funding

Answer 15

7. As in the case of domestic sources of funds, international funding may exist in a number of forms. The most common is the Eurodollar market. Eurodollar deposits are dollar-denominated deposits taken by a bank’s overseas branch or its international banking facility (IBF).

Question 16

Fed Funds

Answer 16

8. Federal funds are funds deposited by banks at the Federal Reserve Banks and are designed to enable banks temporarily short of their reserve requirement to borrow reserves from banks having excess reserves.

Question 17

A Bank Investment Contract (BIC)

Answer 17

9. A Bank Investment Contract (BIC) is a deposit contract between a bank and its customer that permits the customer to deposit funds over a period of time and obligates the bank to repay the amounts deposited plus interest at a guaranteed rate to the end of the contract term. The contract term varies, and may range from six months to as long as ten years.

Question 18

Banks receiving Treasury Tax and Loan (TT&L)

Answer 18

10. Banks receiving Treasury Tax and Loan (TT&L) funds have the option of remitting those funds daily through a Federal Reserve Bank (remittance option) or maintaining those funds in an interest-bearing, demand account (note option). The note option permits banks to retain the TT&L funds as secured, purchased funds callable on demand.

Question 19

Borrowings

Answer 19

11. By managing borrowings in a coordinated fashion with asset liquidity needs, banks can tailor liabilities to fit their cash flow needs instead of apportioning asset types and amounts to a given liability base. Locking in term funding can also reduce liquidity risk, especially if the bank can extend the duration of its liability structure. Accessing wholesale funds allows banks to obtain funds quickly and efficiently.

Question 20

Repurchase Agreement

Answer 20

In a securities repurchase agreement (repo), an institution agrees to sell a security to a counterparty and simultaneously commits to repurchase the security at a mutually agreed upon future date. Instead of borrowing money and pledging securities as collateral, the party to a repo transaction sells the securities today, and simultaneously agrees to buy the same security at the same price (with interest) at some point in the future. As a result, in economic terms, a repurchase agreement is a form of secured borrowing.

Question 21

Dollar Repurchase Agreements

Answer 21

Dollar repurchase agreements, also known as dollar repos and dollar rolls, provide financial institutions with an alternative method of borrowing against securities owned. Unlike “standard” repurchase agreements, dollar repos require the buyer to return to the seller substantially similar, versus identical, securities. Dealers typically offer dollar roll financing to institutions as a means of covering short positions in particular securities.

Question 22

Federal Reserve Bank

Answer 22

The Federal Reserve Banks provide short-term collateralized credit to banks at the Federal Reserve’s discount window. The discount window is available to any insured depository institution that maintains deposits subject to reserve requirements. Banks must execute borrowing agreements and fully collateralize all borrowing to the satisfaction of the Federal Reserve.

Question 23

Which deposits qualify as core deposits

Answer 23

of demand deposits, all NOW and ATS accounts, MMDA savings, other savings deposits, and time deposits under $100,000.

Question 24

How to calculate and interpret the Net Noncore Funding Dependency ratio

Answer 24

Noncore liabilities, less short term investments divided by long term assets.

Question 25

Noncore liabilities

Answer 25

Noncore Liabilities ($000)
The sum of:
Total time deposits of $100M or more
\+
Other borrowed money (all maturities)
\+
Foreign offi ce deposits
\+
Securities sold under agreements to repurchase and federal funds purchased
\+
Insured brokered deposits issued in denominations of less than $100,000
\+
Demand notes issued to the U.S. Treasury (Not available from March 31, 2001 forward).

Question 26

Short term investments

Answer 26

The sum of: Interest-bearing bank balances
+
Federal funds sold and securities purchased under agreements to resell
+
Debt securities with a remaining maturity of one year or less
+
Acceptances of other banks (loans) prior to March 31, 2001.

Question 27

long term assets

Answer 27

Acceptances of other banks (loans) prior to March 31, 2001
+
Held-to-maturity securities
+
Available-for-sale securities
-
Debt securities with a remaining maturity of one year or less
+
Other real estate owned (non– investment).

Question 28

The definition of a large depositor

Answer 28

large deposits are defined as those concentrations of funds under one control, or payable to one entity, which aggregate 2% or more of the bank’s total deposits. By virtue of their size, such deposits are considered to be potentially volatile liabilities; however, examiners may determine that certain large deposits actually remain relatively stable for long periods.

Question 29

The five characteristics of negotiable CDs

Answer 29

1. They are usually issued by money center or large regional banks in denominations of $1,000,000 or more and may be issued at face value with a stated rate of interest or at a discount similar to U.S. Treasury Bills.
2. CDs of major banks are widely traded, may offer substantial liquidity, and are the underlying instruments for a market in financial futures.
3. They are instruments ordinarily used to fund reinvestment goals of issuing banks as opposed to solving liquidity crises.
4. Their cost and availability are closely related to overall market conditions.
5. .Any adverse publicity involving either a particular bank or banks in general can impact the CD market. These CDs have many features of borrowings and can be quite volatile.
6. Fundamentally, there is little to distinguish these accounts from borrowings, but negotiable CDs clearly are a form of purchased funds.

Question 30

Definition of a “deposit broker” and the four requirements a listing service has to meet in order not to be considered a deposit broker

Answer 30

The term “brokered deposit” means any deposit that is obtained from or through the mediation or assistance of a deposit broker. When determining if a listing service is a deposit broker under Section 337.6 of the FDIC Rules and regulations, “brokered deposits” do not include those deposits obtained by a listing service that meets the following criteria:

1. The person or entity providing the listing service is compensated solely by means of subscription fees (i.e., the fees paid by subscribers as payment for their opportunity to see the rates gathered by the listing service) and/or listing fees (i.e., the fees paid by depository institutions as payment for their opportunity to list or “post” their rates). The listing service does not require a depository institution to pay for other services offered by the listing service or its affiliates as a condition precedent to being listed.
2. The fees paid by depository institutions are flat fees: they are not calculated based on the number or dollar amount of deposits accepted by the depository institution as a result of the listing of the depository institution’s rates.
3. In exchange for fees, the listing service performs no service except the gathering and transmission of information concerning the availability of deposits. This information may include an insured depository institution’s name, address (including e-mail address), telephone number and interest rates. Except for providing this information, the listing service does not serve as a liaison between depositors and depository institutions. For example, the listing service does not pass information about a depositor to a depository institution.
4. The listing service is not involved in placing deposits or confirming the placement of deposits. Any funds to be invested in deposit accounts are remitted directly by the depositor to the insured depository institution and not, directly or indirectly, by or through the listing service.

Question 31

How to account for a repurchase agreement when the repo agreement requires the selling institution to repurchase the identical asset, versus when it does not require the institution to repurchase the identical asset

Answer 31

From an accounting standpoint, repurchase agreements involving securities are either reported as borrowings and loans or sales and repurchase commitments based on whether the selling institution maintains control over the future economic benefits associated with the underlying asset. If the repurchase agreement requires the selling institution to repurchase the identical asset sold, then, generally, the institution has retained control over the future economic benefits and should report the transaction as a borrowing. If the repurchase agreement does not require the bank to repurchase the identical security sold, the agreement is reported as a sale of the securities and a commitment to purchase securities. For accounting purposes, a reverse repurchase agreement, which requires the buying institution to sell back the identical asset purchased, is treated as a loan. If the reverse repurchase agreement does not require the institution to resell the identical security purchased, it is reported as a purchase of the securities and a commitment to sell securities.

Question 32

The characteristics of Dollar Repurchase agreements

Answer 32

Unlike “standard” repurchase agreements, dollar repos require the buyer to return to the seller substantially similar, versus identical, securities. Dealers typically offer dollar roll financing to institutions as a means of covering short positions in particular securities. Short positions arise when a dealer sells securities that it does not currently own for forward delivery. To avoid the costs associated with failing on a delivery, dealers are willing to offer attractive financing rates in exchange for the use of the institution’s securities in covering a short position

Question 33

Requirements for one Mortgage-Backed security to be considered “substantially similar” to another MBS

Answer 33

Mortgage pass-through securities repurchased are considered “substantially similar” to those sold if all of the following conditions are met. The securities must:
• Be collateralized with similar mortgages.
• Be issued by the same agency and be part of the same program.
• Have the same remaining weighted average maturity.
• Be priced to have similar market yields.
• Have identical coupon rates.
• Satisfy good delivery requirements.

Question 34

How long securities used in a dollar repo transaction must have been held in the seller’s investment portfolio prior to initiation of the contract

Answer 34

In addition, securities used in dollar repo transactions must have been held in the seller’s investment portfolio for a minimum of 35 consecutive days prior to the initiation of the contract.