Tool5

Tool 5:Building a Liquidity Policy Statement and Contingency Funding Plan

ABAToolb x on LiquidityABA Members Only

Dear Reader,Welcome to Tool 5 of the ABA Liquidity Toolbox. All the work in Tools 1 - 4 comes together here. We explore how liquidity planning fits in with the overall asset/liability committee (ALCO) process. Finally, we emerge from Tool 5 with structure, measurement systems, policy limits, a liquidity policy, and a contingency funding plan (CFP).

Many of the figures in Tool 5 are outputs from FARIN & Associates Foresight Asset-Liability model. (To learn more about Farin & Associates asset-liability services visit www.farin.com/ALM/.)

Many thanks to Dave Koch, Chief Operating Officer for FARIN & Associates for his assistance in preparing Tool 5.

Tom Farin, FARIN & Associates, Lead AuthorMr. Farin is the author of three separate books on financial institution asset-liability management, as well as a popular asset-liability newsletter. FARIN & Associates is best known for using technology and education to help community banks develop and implement retail strategies.

Dave Koch, FARIN & AssociatesMr. Koch is the Chief Operating Officer at FARIN & Associates. Dave consults regularly with community banks on the ALCO process, board education, strategy development, and safety and soundness compliance issues.

About American Bankers Association

The American Bankers Association represents banks of all sizes and charters and is the voice for the nation’s $13 trillion banking industry and its two million employees. The majority of ABA’s members are banks with less than $165 million in assets. ABA’s extensive resources enhance the success of the nation’s banks and strengthen America’s economy and communities.

© 2011 American Bankers Association, Washington, D.C.

This publication was paid for in part with the dues of ABA member financial institutions and is intended solely for their use. Please call 1-800-BANKERS if you have any questions about this resource, ABA membership or would like to copy or license any part of this publication.

This publication is designed to provide accurate information on the subject addressed. It is provided with the understanding that neither the authors, con-tributors nor the publisher is engaged in rendering legal, accounting, or other expert or professional services. If legal or other expert assistance is required, the services of a competent professional should be sought. This guide in no way intends or effectuates a restraint of trade or other illegal concerted action.

Banker Reviewers

Steven W. Corrie Senior Vice President Security National Bank Sioux City, Iowa

Phil Emma CFO Merrimack County Savings Bank Concord, New Hampshire

Troy K. Lewis, CPA Vice President Heritage Bank St. George, Utah

ABA Staff Contributors

Mary Frances Monroe

Deanne Johnson de Mariño

Susan Einfalt

Mark Tenhundfeld

James Chessen

Ryan Zagone

Mako Parker

Keith Leggett

Donna Fisher

Ellen Collier

Rachaell Davis

Lisa Gold Scheier

Robin Gordon

5

IntroIntroduction to the ABA Toolbox

on Liquidity

1Developing an

Effective Capital/Liquidity Plan

2Developing a Core Funding Strategy Through an Initial Strategic Review

3Integrating

Near-Core and Non-Core Sources Into Bank Funding

4Measuring Asset-based Liquidity

with the Liquidity Coverage Ratio

5Developing a Liquidity Plan

A Process for Dynamic Liquidity Management 1

Step 1: Define and Build a Base Liquidity Plan 3

Step 2: Stress Test the Base Liquidity Plan 23

Step 3: Develop and Test the Contingency Funding Plan 31

Step 4: Build Monitoring and Reporting Systems 40

Step 5: Create an Effective Policy Statement 46

Building a Liquidity Policy Statement

and Contingency Funding Plan

Glossary Asset-based liquidity buffer – The total of highly liquid unencumbered marketable (HLUM) securities plus cash and near-cash held as a reserve against a liquidity stress event

Asset-liability management(ALM) process – The process in which banks manage the relationship between risk and return

Contingency funding plan (CFP) – The portion of a liquidity policy devoted to outline lines of authority, contingent liquidity sources, and the series of steps management would take in responding to one or more liquidity stress events

Cumulative liquidity gap/asset ratio – A ratio that measures the cumulative size of the gap between sources and uses of funds, considering both the asset-based and liability-based liquidity buffers as a percentage of assets; usually over a one-year horizon

Dynamic liquidity management – The process of managing liquidity in the context of a business plan as opposed to merely focusing on a current balance sheet

Graduated policy limits – A set of policy limits that incorporate stepped threat level guidelines and define appropriate response at each step; e.g., red, yellow and green light ranges that represent increasing severity

Liability-based liquidity buffer – Total unused borrowing capacity constrained by sources and policy limits held as a reserve against liquidity stress events

Liquidity stress test – A test that measures the effect of a liquidity stress event on the relationship between sources and uses of funds

Net Stable Funding Ratio (NSFR) – A proposed Basel 3 liquidity ratio that measures the extent to which stable funding is available as a funding source for assets requiring stable funding, calculated over a 1 year stress horizon

Triggers and trigger ratios – Early warning indicators of a developing problem like a liquidity problem; when using ratios, it is helpful to see historical trends in the ratios as well as the forecast trends in the ratios under a business strategy

ABA Toolbox on Liquidity — Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan | 1

A Process for Dynamic Liquidity ManagementThe process of managing liquidity has become more integrated and dynamic than in the past. New ratios help to analyze overall liquidity, and stress tests help to consider unforeseen events. These raise the question of how liquidity risk management is to fit in with the management of other risks, such as interest rate risk and capital risk.

The asset/liability management (ALM) process is the place where banks manage the risk/return equation. Adding a new level of sophistication to the analysis, banks have expanded their focus to include liquidity risk. As we discussed in Tool 4, regulators are placing increased emphasis on holding higher levels of asset-based liquidity in the form of highly liquid unencumbered marketable (HLUM) securities. While increasing levels of HLUM securities mitigates liquidity risk, it may place pressure on earnings because of the low yields associated with HLUM securities. In addition, increased levels of liquidity may increase interest rate risk in an institution that is already asset sensitive. These trade-offs mean banks need to adopt a holistic approach to risk management in the ALM process that not only considers the effect of business plan strategies on risk levels of all kinds, but also measures the effect of these strategies on return.

Much has been written and discussed within the industry regarding the validation of ALM models for interest rate risk calculations. Incorporating the discipline of cash flow projections and review of maturing funds from the modeling software will help to spot problems with data and inaccurate projections. A regular review of these basic values will help to ensure that the management and board can build reliable strategies and have confidence in the risk levels projected. Too often the results of models are focused on the outputs being measured, and little attention is paid to how those measures are arrived at. An interesting byproduct of using an ALM model for liquidity analysis forces users to look at cash flows. Many times the review leads to discovery of and corrections applied to data being provided to the model. The critical items to measure a result like net income are issues such

2 | American Bankers Association

as volumes of assets and liabilities, rates offered, and speed of cash flow repayment, to name a few. By building our liquidity management system on the backbone of the interest rate risk and planning model, we are achieving several very important goals at once: validity in model data, single source for assumptions and outputs, and internal controls on values, to name a few.

Tool 5 will help to bring the pieces from the four previous tools together into a consistent and coherent liquidity plan and policy.

An effective liquidity plan considers how the changing projections on volumes of loans, investments, Core, Near-Core and Non-Core Funding will impact future availability of liquidity to meet business plan needs as well as to deal with events leading to liquidity stress. When ratio analyses, such as the liquidity coverage ratio (LCR) described in Tool 4, are combined with the analysis of sources and uses of funds, a complete picture develops.

Applying a sources and uses of funds analysis to a business plan or strategy and the development of a contingency funding plan (CFP) involves the following series of steps:

Step 1 Define and Build a Base Liquidity Plan

Step 2 Stress Test the Base Liquidity Plan

Step 3 Develop and Test the Contingency Funding Plan

Step 4 Build Monitoring and Reporting Systems

Step 5 Create an Effective Policy Statement

STEP 2Stress Testthe Base Liquidity Plan

STEP 4Build Monitoringand Reporting Systems

STEP 5Create an EffectivePolicy Statement

STEP 3Develop and TestContingency Funding Plan

STEP 1De�ne and Build a Base Liquidity Plan


STEP 1 Define and Build a Base Liquidity PlanA base liquidity plan is the liquidity component of a business plan or strategy and looks at the relationship between funding sources and funding uses – the cash flow. Measurement systems aimed at cash flow-based evaluation of liquidity consider an institution’s most recent balance sheet as well as its business plan or strategy.

As we move in the direction of cash flow-based measurement systems, you might wonder what happens to the traditional regulatory measures like loans/deposits and Non-Core Funding reliance. They still play a role in the future of liquidity measurement as “triggers,” early warning indicators that a liquidity problem may be developing and that action by management may be needed. While a sources and uses analysis cannot be derived using Call Report data alone, the traditional ratios and the new Basel III ratios certainly can.

Using the LCR to Set LimitsIn Tool 4 we introduced one of the new Basel III ratios, the Liquidity Coverage Ratio (LCR), which is aimed at identifying the quantity of short-term HLUM securities needed to meet liquidity needs in a 30-day stress test environment. The LCR is an excellent tool for measuring whether the institution has sufficient levels of HLUM securities and expected cash flow to cover a short-term liquidity crisis event covering 30 days.

The LCR can also be included within guidelines that outline the acceptable limits for the LCR and define actions to be taken when the LCR falls outside those limits. Limits such as these are usually established using graduated risk levels, which allow institutions to measure both the level of risk and the trends in risk. A common graduated system is one that reports the risk levels as a green, red, and yellow light zone limits for exposure reporting.







XYZ BANK CASE STUDy

LCR Limits at XYZ Bank

Green Light Zone The green light zone contains the range of potential exposures that the Board believes to be normal and acceptable operating behavior for liquidity levels. In a green light zone, normal liquidity assessment, and Board and asset-liability committee (ALCO) reporting requirements are in effect.

Red Light Zone The red light zone limit defines an institution’s absolute liquidity exposure compliance limit. Operation in the red light zone is not acceptable. Should the institution find itself in the red light zone, a comprehensive program of management and ALCO responses to address the excessive risk should be provided to the Board at its next meeting. In addition, special meetings and/or reporting might be presented to the ALCO and Board for as long as the red light zone situation continues.

XyZ is currently in the midst of an asset quality issue that is impacting loan repayments and loss of funds to other institutions. In Tool 4 we identified the LCR risk parameters we would use for the Basel III LCR 30-day stress test. The resulting LCR (Figure 5-1) shows XyZ to have inadequate HLUM securities to meet its stressed 30-day liquidity needs, falling short of target by approximately $3 million.

While the LCR was applied to XyZ’s current balance sheet, it could also be calculated for each month or quarter of XyZ’s business plan or strategy. Doing so would allow XyZ to monitor the how the business plan or strategy is affecting levels of asset-based liquidity and whether XyZ would pass this asset-based test in future periods, as the business plan evolves.

The business plan should incorporate strategies that will allow XyZ to plug its LCR shortfall of $3.0 million within a reasonable period of time.

In reviewing its current LCR levels, XyZ has established guidelines that outline the acceptable limits for the LCR and define actions to be taken as severity of the shortfall increases.

As figure 5-2 indicates, when the LCR is > 105%, it is in the green light range, meaning no short-term (30-day) liquidity threat exists. No additional reporting or measures are required, other than to monitor the projected LCR levels in the plan. Should the LCR drop to between 100% and 105%, the level of severity is raised to yellow. The yellow limit requires the ALCO to review and make modifications to the business plan with the objective of moving the

Figure 5-1 Liquidity Coverage Ratio

Liquidity Coverage Ratio 78.7% Target Ratio 100.0%Numerator (Net High Quality Liquid Assets) 11,177,770 Excess(Short) (3,026,629) Denominator (Net Cash Outflows) 14,204,399


Yellow Light Zone The yellow light zone is the range of liquidity exposures that falls below maximum allowable limits but is more than the normally acceptable liquidity risk levels.

The advantages of liquidity exposure zone limits are that they simultaneously define maximum, temporarily allowable, and normal exposure delimiting for liquidity risks. In the yellow light zone, they establish an early warning mechanism and mandate proactive corrective procedures for risk exposure should it move outside normal levels. An institution’s exposure zone limit definitions constitute a key and significant step forward in understanding, monitoring and controlling its liquidity-related risks and can be proactively assessed in relation to other risk areas such as capital, earnings, asset quality, and value.

LCR back to green light status within the following six months. In cases where the LCR is < 100% (red light status) as is the case in the example in figure 5-1, more immediate modifications to the business plan must be made to return to yellow levels within three months, and green within nine months*.

In the XyZ case, the strong possibility of failure of PCA well-capitalized minimums, as a result of asset quality problems and the resulting threat to its Non-Core, Near-Core, and Core Funding base, warrants tighter limits and faster actions, and makes the availability of asset-based liquidity crucial to its survival of a stress event.

Note: These timeframes are illustrative. your regulator may require faster action.

Figure 5-2 LCR Policy Limits

LCR Level Required Actions

> 105% Green Light No change in plans or actions

100-105% Yellow Light Demonstrate in the business plan the return to more stable levels in the coming 6 months, monitor and report quarterly on plan to actual

< 100% Red Light Immediate actions taken to return to yellow levels within 3 months and green within 9 months. Reporting to be communicated monthly until yellow level achieved.

12-Month Liquidity Gap/Asset Ratio Threat Level Actions

=> 15% Green Light No actions required, continue normal monitoring and reporting

>= 10% and <15% Yellow Light Develop options for asset or liability changes in plan to return to green within 6 months

< 10% Red Light

Immediate plan changes to be implemented and impact of CPF assessed for realistic stress events, monitoring monthly until return to yellow



>= 0% and <10% Yellow Light Frequency of updating CFP Strategies updated from annually to quarterly

< 0% Red Light

Pre-stress policy limits reviewed to determine whether they should be raised. Changes implemented to business plan to move this ratio into the yellow range within three months.


Using Other Triggers to Set LimitsManagement must monitor additional indicators of potential liquidity problems to determine in advance if there are approaching liquidity problems. These early warning indicators, or triggers, do not necessarily require an institution to take drastic corrective measures. Rather, they are used as a warning system to motivate management to take action in advance of a liquidity stress event actually appearing. Examples of trends that may point to the development of a liquidity stress event include:

• A decline in recent or projected earnings performance

• Credit rating agency downgrades or announcements of potential downgrades

• Rapid asset growth, especially when involving loan growth well in access of Core Funding growth

• Rapid growth in potentially volatile liabilities

• Negative publicity, real or perceived

• Overall decline in asset quality

• Maturing/renewing or committed loan offers cancelling and/or not renewing

• Higher collateral requirements on credit facilities

• Loss or restricted credit lines access from correspondent banks

• Inability to secure longer-term debt from counterparties and brokers

• Loss of brokered CD buyers, forcing the institution to deal directly with fewer willing counterparties

• A loss of rate sensitive buyers, such as money managers and public entities

• An increase in early withdrawal requests from depositors

• Decreasing transaction sizes, due to large deposits not renewing

• Having to pay a higher spread on deposits relative to local competitors or relative to national or regional composites to acquire or retain funds

Many of these events can be tracked using ratios the institution may already be producing to monitor earnings performance, asset quality, capital adequacy, etc.

Management must monitor additional indicators of potential liquidity problems to determine in advance if there are approaching liquidity problems.


The triggers selected will depend on the types of assets and liabilities on the balance sheet, market opportunities, and overall risk levels. All of the ratios you select can be calculated from an existing balance sheet and from balance sheets at the end of projected reporting periods in a business plan or strategy. That means you can not only look at the historical evolution of these ratios using progressively older balance sheets, they can also be calculated from projected balance sheets as part of your business plan or strategy.

Below are the trigger ratios that are considered to be most useful. Each represents a candidate for inclusion into your liquidity policy and reporting system. Each ratio’s calculation is defined and its role in the overall measurement and management process outlined for the following trigger ratios:

• Net Stable Funding Ratio (NSFR)

• Non-Core Funding Dependence

• Loans/Deposits Ratio

• Wholesale Brokered Deposits/Total Assets and Total Brokered Deposits/Total Assets

• Borrowings/Assets

• Noncurrent Loans/Gross Loans and Noncurrent Assets plus Other Real Estate Owned/ Total Assets

• Return on Assets

As with the LCR, these can also be used in conjunction with graduated risk levels. However, management should consider the potential implications of the overuse of threat level guidelines. It is possible make it difficult to reach the green zone in all your threat level guidelines. We recommend you pick the four or five triggers most important to your management team as early warning indicators of emerging liquidity problems and set threat level guidelines for those ratios.

Net Stable Funding RatioThe Net Stable Funding ratio (NSFR) is the second measurement introduced by the Basel III standards in December 2010 and helps to determine whether there is sufficient medium- and long-term funding to support an institution’s assets, should an extended, bank specific stress scenario occur. The ratio itself is a stress test run over a one-year horizon.

[The NSFR] is designed to act as a minimum enforcement mechanism to … reinforce other supervisory efforts by promoting structural changes in the liquidity risk profiles of institutions … toward more stable, longer-term funding of assets and business activities.


The philosophy behind the NSFR calculation is that an institution needs to have sufficient stable funding in an extended stress scenario to fund the portion of its asset base requiring stable funding. To perform the NSFR calculation, take an inventory of all available sources of stable funding (after stressed runoffs) as the numerator, and divide that by the amount of stable funding needs, both on- and off-balance sheet.

Non-Core Funding DependenceNon-Core Funding dependence is the difference between Non-Core liabilities and short-term investments, divided by long-term assets, and postulates that Non-Core liabilities are better suited to fund short-term investments than long-term assets. A lower ratio implies that an institution is better able to meet its liquidity needs.

Concerns with Non-Core Funding dependence as a measure of liquidity include the following:

• Highly stable funding items, such as long-term borrowings and long-standing large deposits, are considered Non-Core

• Highly volatile Internet deposits are considered Core deposits

• All loans regardless of time to expected repayment are considered long-term

The NSFR was designed to provide a more meaningful way to examine the relationship between stable funding and assets requiring stable funding. If you elect to use the NSFR in your policy, there is no need to develop threat level guidelines for the Non-Core Funding dependence ratio although you may want to track it in your measurement system, as regulators are likely to continue to monitor it. However, before beginning to use Non-Core Funding dependence, you may want to wait for U.S. regulators to address a number of issues in U.S. implementation.

Loans/Deposits RatioThe loans/deposits ratio was originally designed to measure how much of the institution’s stable funding (deposits) was committed to assets (loans) that could not easily be converted into cash. Shortcomings of the loans/deposits ratio are similar to those of the Non-Core dependency ratio.

Once again, the NSFR was designed to provide a more meaningful way to examine the relationship between stable funding and assets requiring stable funding. If you elect to use the NSFR in your policy, there is no need to develop threat level guidelines for the loans/deposits ratio although you may want to track loans/deposits in your measurement system, as regulators are likely to continue to monitor it.


Wholesale Brokered Deposits/Total Assets and Total Brokered Deposits/Total Assets Establishing limits around the total funding sources allowed by brokered deposits is a prudent trigger for management to employ. The difference between the two ratios above reflects what portion of the bank’s deposits come from reciprocal sources, which are usually relationship monies, meriting a higher threshold.

Institutions that rely on brokered deposits as part of their base liquidity strategy should set red/yellow/green levels along with discussion on the ALCO actions in each case. Establishing threat levels is especially important, because banks are usually prohibited from using wholesale brokered deposits if they become less than well-capitalized. Also, regulators tend to frown on the use of brokered deposits to grow a balance sheet of an institution with deteriorating asset quality.

Borrowings/AssetsTrends in borrowings/assets can be used as an indicator of unbridled asset growth without corresponding growth in Core deposits. In Tool 3 we set limits on both individual sources and on an overall basis. However, our overall policy limit included all sources of Near-Core and Non-Core Funding rather than just borrowings.

A set of red/yellow/green levels should be set for whatever measure you used in defining your policy limit, with discussion of the ALCO actions in each case. Institutions heavily involved in portfolio mortgage lending will often accept a higher level of borrowings than commercial lending firms.

Noncurrent Loans/Gross Loans and Noncurrent Assets plus Other Real Estate Owned/Total AssetsMeasuring the level of noncurrent loans/gross loans is an indicator of potential cash flow concerns on existing loans and the development of potential asset quality problems that could lead to ratings downgrades and capital concerns. A very similar measure to noncurrent loans/gross loans is noncurrent assets plus other real estate owned/total assets. By establishing either of these ratios as an early warning trigger for credit concerns affecting liquidity, the institution will be positioned to make changes in liquidity levels or assess contingency plans surrounding degrading credit and act proactively. A set of red/yellow/green levels should be set for noncurrent loans/gross loans, as well, with discussion of the ALCO actions in each case.


Return on AssetsPoor earnings may be an indicator of asset quality deterioration, leading to capital erosion, all of which can impact liquidity sources.

Using the Liquidity Gap Report to Set LimitsThe above ratios provide a good evaluation of the structure of the balance sheet, but to get a picture of current and prospective cash flows, you need to have a sources/uses approach. Sources and uses reports that measure liquidity gaps become the most important measurement tool for triggering action by the institution’s ALCO or Board.

To effectively measure liquidity risk and evaluate trade-offs between risk and return, it is critical to use ALM models, since they contain the data and assumptions needed to project cash flows from the existing balance sheet as well as the assets and liabilities added as part of a business plan.

Sources and uses reports that identify liquidity gaps provide a common framework for measuring liquidity risk in both the base business plan and in scenarios that stress an institution’s liquidity resources.

A sources and uses forecast measures the cash flows occurring within the institution’s plan in order to see the impact on the overall liquidity position. A sources and uses report generally looks at the cash flows month by month for at least three months and then quarterly over a specified time frame, usually 24-36 months. By reviewing the impacts resulting from strategy changes, an institution is better able to see how these strategies will impact future liquidity levels. Additionally, if a strategy is creating new liquidity as a result of the acquisition of new HLUM securities or by paying down existing borrowings, these sources of liquidity can be examined and incorporated into the projected liquidity levels.

We recommend a rolling approach to liquidity analysis, where the analysis is updated periodically. In a rolling environment the most intense focus should be on the next 12 months. However, it is worthwhile to look at liquidity gaps for periods longer than a year as trends in liquidity gaps become more apparent.

Sources and uses reports can be laid out in a variety of ways. A common approach is to group all the sources of funds in the top half of the report, with a total summing the sources. The uses are grouped in the bottom of the report with a sum of the total uses, so investments appear as a source of

Sources and uses reports measuring liquidity gaps are the most important measurement tool for triggering action by the institution’s ALCO or Board.


funds (maturities and cash flows from the investment portfolio) at the top of the report and as a use of funds (new investment purchases) at the bottom of the report. Because investment sources and uses are separated into the two halves of the report, it is somewhat difficult to determine whether, on a net basis, investments are a source or a use of funds.

In the analysis for Tool 5, we organize the report in a different way, by balance sheet category, displaying both sources and uses for each category, as well as the net impact on cash flow. Either approach will work as they will both lead to the same summary results.

Asset Sources and UsesIn considering asset sources, all anticipated payments – whether contractual or not – are considered a source of funds. Since a sources and uses report is generally run using the institution’s ALM model, monthly payments amounts, maturities, prepayments, and sales of assets prior to maturity all represent asset sources of funds.

ALM models often incorporate assumptions on the level of anticipated prepayments under differing rate forecasts, which can then be used to produce cash flow projections for liquidity analysis. Back-testing the prepayment assumptions in a plan and adjusting speeds based on the back-testing will lead to more accurate planning, liquidity, and interest rate risk projections. In addition to prepayment assumptions, assets may cause an inflow from call and put options. The trigger point for these options should also be assessed in the planned interest rate scenario. Any funds expected to be available should be included in the sources of funds.

In projecting asset uses, the liquidity gap ratio report lists the anticipated purchases, renewals, and originations of investments and loans. In addition, planned purchases of fixed or other assets or an increase in non-accrual loans represent a use of funds as they are removing cash from an available status. So, when an institution decides to plan for a new branch or computer system, the impact of higher non-earning assets will affect the amount of available funds for other uses.

The relationship between levels of asset sources and uses should move the institution in the direction of the asset balance sheet mix and loan growth goals laid out in the capital plan. It is unlikely that a business plan will be developed that hits the capital plan goals exactly. However, there should be a strong correlation between the general direction set forth in the capital plan goals and the progression in numbers in the business plan.


XYZ BANK CASE STUDy

Figure 5-8 Asset Goals from Capital Plan

Figure 5-9 Liquidity Gap Report – Base Forecast – Assets

Investments/ EndingYear Assets Investments

Dec-09 6.50% 19,513 Dec-10 9.00% 24,218 Dec-11 11.00% 28,734 Dec-12 12.00% 32,052 Dec-13 12.00% 33,724 Dec-14 12.00% 36,422

SFG 12.00%

0%

2%

4%

6%

8%

10%

12%

14%

2007 2008 2009 2010 2011 2012 2013 2014

NE Assets/ EndingYear Assets NE Assets

Dec-09 10.42% 31,266 Dec-10 9.50% 25,564 Dec-11 8.40% 21,942 Dec-12 7.60% 20,300 Dec-13 7.00% 19,672 Dec-14 7.00% 21,246

SFG 7.00%

0%

2%

4%

6%

8%

10%

12%

2007 2008 2009 2010 2011 2012 2013 2014

Loan Growth Ending Ending AssetYear Rate Loans Assets Growth

Dec-09 0.00% 249,218 300,000 0.00%Dec-10 -12.00% 219,312 269,094 -10.30%Dec-11 -4.00% 210,539 261,215 -2.93%Dec-12 2.00% 214,750 267,102 2.25%Dec-13 6.00% 227,635 281,031 5.21%Dec-14 8.00% 245,846 303,514 8.00%

SFG 8.00%

-15%-10%

-5%0%5%

10%15%20%25%

2007 2008 2009 2010 2011 2012 2013 2014

Liquidity Report Mar-2010 (Q) Jun-2010 (Q) Sep-2010 (Q) Dec-2010 (Q) Mar-2011 (Q) Jun-2011 (Q) Sep-2011 (Q) Dec-2011 (Q) Mar-2012 (Q) Jun-2012 (Q) Sep-2012 (Q) Dec-2012 (Q)(Dollars in Thousands)

Total Investments Inflow 611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 1,565,805 1,741,536 1,782,416 1,754,762 OutFlow 2,611,942 6,695,965 892,971 1,011,679 6,227,006 1,295,368 1,412,701 1,453,797 5,565,805 1,741,536 1,782,416 1,754,762 Net (2,000,000) (4,000,000) (0) 0 (5,000,000) (0) (0) 0 (4,000,000) 0 (0) (0) Cumulative by Year (6,000,000) (5,000,000) (4,000,000)Total Loans Inflow 33,917,376 33,653,818 18,610,665 28,752,329 28,178,424 35,243,455 19,636,360 31,910,144 32,384,283 34,078,720 20,069,053 27,066,217 OutFlow 25,564,993 26,371,358 11,544,495 21,896,029 25,946,004 33,033,285 17,448,220 29,743,814 35,166,466 36,517,452 21,567,195 28,712,610 Net 8,352,383 7,282,460 7,066,170 6,856,300 2,232,420 2,210,170 2,188,140 2,166,330 (1,077,740) (1,083,150) (1,088,570) (1,094,020) Cumulative by Year 29,557,314 8,797,060 (4,343,480)Non-Earning Assets Inflow 610,318 857,362 1,374,288 1,426,105 1,450,984 1,461,973 1,515,049 1,573,471 699,924 784,964 812,529 804,093 OutFlow - - - 271,115 432,221 455,510 520,526 590,538 - 63,436 108,407 104,266 Net 610,318 857,362 1,374,288 1,154,990 1,018,763 1,006,463 994,523 982,934 699,924 721,528 704,122 699,827 Cumulative by Year 3,996,957 4,002,682 2,825,401 TOTAL ASSETS Inflow 35,139,636 37,207,145 20,877,923 31,190,113 30,856,414 38,000,796 22,564,110 34,937,412 34,650,012 36,605,220 22,663,998 29,625,072 OutFlow 28,176,935 33,067,323 12,437,466 23,178,822 32,605,231 34,784,163 19,381,447 31,788,148 40,732,271 38,322,424 23,458,018 30,571,639 Net 6,962,701 4,139,822 8,440,458 8,011,290 (1,748,817) 3,216,633 3,182,663 3,149,264 (4,377,815) (361,622) (384,448) (394,194) Cumulative by Year 27,554,271 7,799,742 (5,518,078)

XYZ BankForecast Cash Flow Liquidity Report - Assets

Base Forecast - Capital Plan [Flat rates]


Asset Sources and Uses

Figure 5-8 reviews the capital plan goals for XyZ from Tool 1, which include annual targets as a percent of assets for investments and non-earning assets. It also includes annual goals for loan growth for each year of the five-year plan.

XyZ set goals to move investments from 6.5% to 9.0% of assets in year 1 of the plan. That means the business plan will need to incorporate levels of investment purchases sufficient to cover cash flows from the investment portfolio in year 1, plus those investment purchases needed to reach the investment portfolio mix goals set forth in the business plan. As a result, uses of funds for investments (purchases) would exceed sources (maturities and cash flows) by an amount sufficient to reach the investment goals at the end of year 1.

Figure 5-9 shows that XyZ plans to grow HLUM securities in its investment portfolio by $2 million in the first quarter of its business plan, another $4 million in the second quarter, an additional $5 million in the 5th quarter and a final $4 million in the 9th quarter of the plan.

XyZ’s capital plan calls for it to reduce the size of the loan portfolio by 12% in 2010. That means that in 2010, cash flows from the loan portfolio (liability sources) should exceed loan originations (liability uses) by an amount sufficient to reduce the loan portfolio by 12%. Cumulative loan sources exceed uses by $29.6 million in year 1 of the plan, and another $8.8 million in year 2. The major portion of the loan portfolio reduction is used to build HLUM securities in the investment portfolio and to shrink assets, which drop from $300 million to $271 million by the end of the 8th quarter of the plan. On the other hand, in the last four quarters of the plan, loans on a net basis turn into a use of funds, exceeding sources by $4.3 million. It is in year 3 that loan growth goes from negative to positive as called for in the capital plan.

Non-earning assets that accumulate as a result of XyZ’s asset quality problem are converted back to earning assets under its plan. In Figure 5-9, non-earning assets as a source of funds start in the range of $4 million per year in the first two years of the plan and decrease to $3 million in year 3.

Overall, asset sources exceed asset uses by $27.6 million in 2010 and $7.8 million in 2011, providing the cash to retire liabilities which will allow XyZ to shrink its balance sheet.

In 2012, asset sources fall short of asset uses of funds by $5.5 million, the difference driving the growth of the asset side of the balance sheet. The analysis of the asset side of the balance sheet fails to consider changes in overnight investments and cash and due. They will be taken into consideration a bit later.


Total Investments Inflow 611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 1,565,805 1,741,536 1,782,416 1,754,762 OutFlow 2,611,942 6,695,965 892,971 1,011,679 6,227,006 1,295,368 1,412,701 1,453,797 5,565,805 1,741,536 1,782,416 1,754,762 Net (2,000,000) (4,000,000) (0) 0 (5,000,000) (0) (0) 0 (4,000,000) 0 (0) (0) Cumulative by Year (6,000,000) (5,000,000) (4,000,000)Total Loans Inflow 33,917,376 33,653,818 18,610,665 28,752,329 28,178,424 35,243,455 19,636,360 31,910,144 32,384,283 34,078,720 20,069,053 27,066,217 OutFlow 25,564,993 26,371,358 11,544,495 21,896,029 25,946,004 33,033,285 17,448,220 29,743,814 35,166,466 36,517,452 21,567,195 28,712,610 Net 8,352,383 7,282,460 7,066,170 6,856,300 2,232,420 2,210,170 2,188,140 2,166,330 (1,077,740) (1,083,150) (1,088,570) (1,094,020) Cumulative by Year 29,557,314 8,797,060 (4,343,480)Non-Earning Assets Inflow 610,318 857,362 1,374,288 1,426,105 1,450,984 1,461,973 1,515,049 1,573,471 699,924 784,964 812,529 804,093 OutFlow - - - 271,115 432,221 455,510 520,526 590,538 - 63,436 108,407 104,266 Net 610,318 857,362 1,374,288 1,154,990 1,018,763 1,006,463 994,523 982,934 699,924 721,528 704,122 699,827 Cumulative by Year 3,996,957 4,002,682 2,825,401 TOTAL ASSETS Inflow 35,139,636 37,207,145 20,877,923 31,190,113 30,856,414 38,000,796 22,564,110 34,937,412 34,650,012 36,605,220 22,663,998 29,625,072 OutFlow 28,176,935 33,067,323 12,437,466 23,178,822 32,605,231 34,784,163 19,381,447 31,788,148 40,732,271 38,322,424 23,458,018 30,571,639 Net 6,962,701 4,139,822 8,440,458 8,011,290 (1,748,817) 3,216,633 3,182,663 3,149,264 (4,377,815) (361,622) (384,448) (394,194) Cumulative by Year 27,554,271 7,799,742 (5,518,078)

XYZ BankForecast Cash Flow Liquidity Report - Assets



Liability Sources and UsesLiability sources include the expected renewal of existing funds and the planned acquisition of new funds.

Non-maturity deposits are handled in a variety of different ways in a sources and uses report. Some models will assume the projected decay or runoff of existing non-maturity deposits as a monthly outflow offset by new non-maturity deposits being booked. Other models assume that in each period being analyzed, all funds are immediately available for outflow and inflow. A third method is to use the change in balances from period to period as either a source or use of funds. All three methods arrive at the same difference between sources and uses of funds in a period. However, the first or second analysis inflate the total cumulative sources and uses relative to the third method, since the assumed cash flows are counted each period as both a source of funds and a use of funds.

Term liability uses consist of outflows due to maturities including planned or unplanned runoff of funds. Embedded options on liabilities must be considered the same way we consider options on assets. Early CD withdrawals may be a concern for institutions with ineffective CD penalties, especially during stress events. The existence of wholesale contracts with call options held by an issuer like an FHLB might cause funding to leave prior to maturity, a possibility that should also be factored into the uses of funds.

In the capital account, retained earnings (income net of dividends) and any capital raised represent a source of funds. Capital retirement (stock repurchases, payoff of subordinated debt, preferred stock or TARP funds) as well as operating losses represent a use of funds to the extent they cause a reduction in retained earnings.

Non-maturity deposits are handled in a variety of different ways in a sources and uses reports. The method that uses the change in balances from period to period as either a source or use of funds does not inflate the total cumulative sources and uses, since the assumed cash flows are not counted each period as both a source of funds and a use of funds.


XYZ BANK CASE STUDy

Liability Sources and UsesOn the funding side of its balance sheet, as part of its capital plan, XyZ set a number of goals. One of the goals was to grow Core Funding by 2% in 2010 (Figure 5-10), followed with a 5% growth in 2011 and a 7% growth in 2012. At the same time, XyZ planned to reduce its reliance on Near-Core and Non-Core Funding from its current 35.9% level to 28.4% in 2010, 23.3% in 2011, and 20.1% in 2012. That reduction is consistent with its Near-Core and Non-Core Funding plan which sets the goal to reach a position where approximately half of its Near-Core and Non-Core Funding limit is utilized as part of its base business strategy with the other half available as a source of funding to deal with liquidity stress events. The methods XyZ will use to grow Core Funding were laid out in its Core Funding plan (Tool 2).

The 2010 $3.3 million projected Core Funding growth (Figure 5-11) is more than offset in year 1 by a reduction of $2.8 million in Near-Core Funding and $19.7 million on Non-Core Funding, allowing XyZ to shrink its balance sheet. In year 2 (2011), Core Funding is projected to grow by $10.4 million, offset by a reduction in Near-Core of $3.1 million and Non-Core of $13.1 million, allowing for additional balance sheet shrinkage. In 2012, projected Core Funding growth of $14.8 million is partially offset by a reduction in Near-Core Funding of $1.3 million and Non-Core Funding of $5.2 million, allowing overall funding growth to support a growing balance sheet.

In the capital plan, XyZ anticipated capital shrinkage of $2.845 million in 2010 (Figure 5-10) as a result of operating losses caused by its current asset quality problem. When XyZ actually built its business plan for 2010, the sum of the net equity outflows on the Liability Sources and Uses Report (Figure 5-11) shows a net equity outflow of $3.1 million due to projected operating losses, fairly close to the capital plan goals. Projected operating losses for 2011 in the business plan came in

at $784 thousand as opposed to $663 thousand in the capital plan. Projected net income of $696 thousand from the business plan in 2012 came up short of the $925 thousand projected in the capital plan.

Once again, it would be unreasonable to expect that the business plan will hit capital plan goals right on the head. But the results from the business plan should be in the same general range as the goals in the capital plan. So far, they are in roughly the same range of each other.

On an overall basis, Figure 5-11 shows that the business plan reduces XyZ’s liability and capital funding by $22.3 million in 2010 (a net use of funds), and $6.7 million in 2011. Once the growth rate turns around in 2012, the liability and capital side of the XyZ balance sheet becomes a net source of funds of $9.0 million, providing the funding to grow the XyZ balance sheet. Note that any overnight borrowings on the balance sheet are ignored in Figure 5-11.


XYZ BANK CASE STUDy

Figure 5-11 Liquidity Gap Report – Base Forecast – Liabilities

Figure 5-10 Liability and Capital Goals from Capital Plan

Oth Liab/ EndingYear Assets Oth Liab

Dec-09 0.20% 589 Dec-10 0.20% 538 Dec-11 0.20% 522 Dec-12 0.20% 534 Dec-13 0.20% 562 Dec-14 0.20% 607 Strat Goal 0.20%

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

2007 2008 2009 2010 2011 2012 2013 2014

Return on NetYear Assets Income

Dec-09 -1.00% (2,993) Dec-10 -1.00% (2,845) Dec-11 -0.25% (663) Dec-12 0.35% 925 Dec-13 0.80% 2,193 Dec-14 1.08% 3,157 Strat Goal 1.08%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2007 2008 2009 2010 2011 2012 2013 2014

Dividends/ Dividends New Captl EndingYear Income Paid (Buyback) Lev Capital

Dec-09 -13.33% 399 26,702 Dec-10 0.00% - 0 23,857 Dec-11 0.00% - 0 23,194 Dec-12 33.00% 305 0 23,813 Dec-13 33.00% 724 0 25,282 Dec-14 33.00% 1,042 0 27,397 Strat Goal 33.33%

-100%-80%-60%-40%-20%

0%20%40%60%

2007 2008 2009 2010 2011 2012 2013 2014

NonNr Core EndingAssets NonNr Fnd

Dec-09 35.91% 107,728 Dec-10 28.40% 76,420 Dec-11 23.28% 60,805 Dec-12 20.10% 53,693 Dec-13 18.15% 51,000 Dec-14 18.12% 54,987 Strat Goal 20.00%

Year

0%5%

10%15%20%25%30%35%40%

2007 2008 2009 2010 2011 2012 2013 2014

Core Growth EndingRate Core

Dec-09 2.00% 164,980 Dec-10 2.00% 168,280 Dec-11 5.00% 176,694 Dec-12 7.00% 189,062 Dec-13 8.00% 204,187 Dec-14 8.00% 220,522 Strat Goal 8.00%

Year

0%

2%

4%

6%

8%

10%

20142013201220112010200920082007

Liquidity Report Mar-2010 (Q) Jun-2010 (Q) Sep-2010 (Q) Dec-2010 (Q) Mar-2011 (Q) Jun-2011 (Q) Sep-2011 (Q) Dec-2011 (Q) Mar-2012 (Q) Jun-2012 (Q) Sep-2012 (Q) Dec-2012 (Q)

Core Funding Inflow 16,597,475 29,179,130 23,759,908 15,539,710 20,064,158 32,453,485 33,933,798 17,495,182 22,013,301 29,415,857 33,985,467 21,379,209 Outflow 15,771,201 28,348,719 22,925,338 14,700,959 17,526,869 29,877,947 31,319,433 14,841,405 18,415,611 25,745,732 30,241,449 17,559,811 Net 826,274 830,412 834,571 838,751 2,537,288 2,575,538 2,614,365 2,653,777 3,597,690 3,670,124 3,744,017 3,819,398 Cumulative by Year 3,330,007 10,380,968 14,831,230 Near-Core Funding Inflow 1,313,659 5,420,518 2,053,506 2,266,005 1,403,900 3,051,534 5,482,753 1,944,750 879,334 1,422,385 3,894,445 1,799,676 Outflow 1,699,948 6,583,405 2,749,961 2,809,915 1,754,597 5,172,609 5,862,276 2,225,447 1,159,084 1,570,289 4,599,058 1,981,692 Net (386,289) (1,162,887) (696,454) (543,909) (350,697) (2,121,075) (379,523) (280,697) (279,750) (147,904) (704,614) (182,016) Cumulative by Year (2,789,540) (3,131,992) (1,314,284) Non-Core Funding Inflow 6,966,473 14,384,826 10,158,890 5,631,989 10,285,272 8,938,388 8,616,906 5,007,097 12,197,125 11,447,464 11,895,453 3,396,590 Outflow 8,907,026 23,889,231 13,130,896 10,888,153 14,846,947 11,530,583 10,178,962 9,402,255 13,703,538 13,145,813 13,088,302 4,187,499 Net (1,940,554) (9,504,405) (2,972,007) (5,256,164) (4,561,675) (2,592,195) (1,562,056) (4,395,158) (1,506,413) (1,698,349) (1,192,849) (790,909) Cumulative by Year (19,673,130) (13,111,084) (5,188,520) Other Liab Inflow - - - - - - - - 3,000 3,000 3,000 3,000 Outflow 9,776 13,909 13,909 13,909 4,000 4,000 4,000 4,000 - - - - Net (9,776) (13,909) (13,909) (13,909) (4,000) (4,000) (4,000) (4,000) 3,000 3,000 3,000 3,000 Cumulative by Year (51,503) (16,000) 12,000 Capital Inflow - - - - - - - - 156,008 135,470 351,707 235,680 Outflow 689,653 752,928 826,644 841,560 235,456 291,715 132,162 124,553 - - - 182,552 Net (689,653) (752,928) (826,644) (841,560) (235,456) (291,715) (132,162) (124,553) 156,008 135,470 351,707 53,128

(3,110,785) (783,887) 696,313 Total Liab & Capital Inflow 24,877,606 48,984,475 35,972,305 23,437,704 31,753,329 44,443,407 48,033,457 24,447,029 35,248,767 42,424,175 50,130,071 26,814,155 Outflow 27,077,605 59,588,192 39,646,748 29,254,496 34,367,869 46,876,854 47,496,833 26,597,660 33,278,233 40,461,834 47,928,810 23,911,554 Net (2,199,999) (10,603,717) (3,674,443) (5,816,792) (2,614,540) (2,433,448) 536,624 (2,150,632) 1,970,534 1,962,341 2,201,262 2,902,602

(22,294,951) (6,661,995) 9,036,738

XYZ BankForecast Cash Flow Liquidity Report - Liabilities & Capital


(Dollars in Thousands)


Liquidity Report Mar-2010 (Q) Jun-2010 (Q) Sep-2010 (Q) Dec-2010 (Q) Mar-2011 (Q) Jun-2011 (Q) Sep-2011 (Q) Dec-2011 (Q) Mar-2012 (Q) Jun-2012 (Q) Sep-2012 (Q) Dec-2012 (Q)

Core Funding Inflow 16,597,475 29,179,130 23,759,908 15,539,710 20,064,158 32,453,485 33,933,798 17,495,182 22,013,301 29,415,857 33,985,467 21,379,209 Outflow 15,771,201 28,348,719 22,925,338 14,700,959 17,526,869 29,877,947 31,319,433 14,841,405 18,415,611 25,745,732 30,241,449 17,559,811 Net 826,274 830,412 834,571 838,751 2,537,288 2,575,538 2,614,365 2,653,777 3,597,690 3,670,124 3,744,017 3,819,398 Cumulative by Year 3,330,007 10,380,968 14,831,230 Near-Core Funding Inflow 1,313,659 5,420,518 2,053,506 2,266,005 1,403,900 3,051,534 5,482,753 1,944,750 879,334 1,422,385 3,894,445 1,799,676 Outflow 1,699,948 6,583,405 2,749,961 2,809,915 1,754,597 5,172,609 5,862,276 2,225,447 1,159,084 1,570,289 4,599,058 1,981,692 Net (386,289) (1,162,887) (696,454) (543,909) (350,697) (2,121,075) (379,523) (280,697) (279,750) (147,904) (704,614) (182,016) Cumulative by Year (2,789,540) (3,131,992) (1,314,284) Non-Core Funding Inflow 6,966,473 14,384,826 10,158,890 5,631,989 10,285,272 8,938,388 8,616,906 5,007,097 12,197,125 11,447,464 11,895,453 3,396,590 Outflow 8,907,026 23,889,231 13,130,896 10,888,153 14,846,947 11,530,583 10,178,962 9,402,255 13,703,538 13,145,813 13,088,302 4,187,499 Net (1,940,554) (9,504,405) (2,972,007) (5,256,164) (4,561,675) (2,592,195) (1,562,056) (4,395,158) (1,506,413) (1,698,349) (1,192,849) (790,909) Cumulative by Year (19,673,130) (13,111,084) (5,188,520) Other Liab Inflow - - - - - - - - 3,000 3,000 3,000 3,000 Outflow 9,776 13,909 13,909 13,909 4,000 4,000 4,000 4,000 - - - - Net (9,776) (13,909) (13,909) (13,909) (4,000) (4,000) (4,000) (4,000) 3,000 3,000 3,000 3,000 Cumulative by Year (51,503) (16,000) 12,000 Capital Inflow - - - - - - - - 156,008 135,470 351,707 235,680 Outflow 689,653 752,928 826,644 841,560 235,456 291,715 132,162 124,553 - - - 182,552 Net (689,653) (752,928) (826,644) (841,560) (235,456) (291,715) (132,162) (124,553) 156,008 135,470 351,707 53,128

(3,110,785) (783,887) 696,313 Total Liab & Capital Inflow 24,877,606 48,984,475 35,972,305 23,437,704 31,753,329 44,443,407 48,033,457 24,447,029 35,248,767 42,424,175 50,130,071 26,814,155 Outflow 27,077,605 59,588,192 39,646,748 29,254,496 34,367,869 46,876,854 47,496,833 26,597,660 33,278,233 40,461,834 47,928,810 23,911,554 Net (2,199,999) (10,603,717) (3,674,443) (5,816,792) (2,614,540) (2,433,448) 536,624 (2,150,632) 1,970,534 1,962,341 2,201,262 2,902,602

(22,294,951) (6,661,995) 9,036,738



(Dollars in Thousands)


Identifying Liquidity GapsThe Liquidity Gap section of a Sources and Uses report often begins by reviewing whether the net cash flows between assets and liabilities is adding to or reducing institution liquidity. To calculate cash flows coming from the balance sheet, sources are summed (asset and liability sources) and uses are summed (asset and liability uses). Sources are subtracted from uses to demonstrate the cash flow surplus or deficit. (On a financial institution balance sheet, total assets must equal the sum of total liabilities and capital. For that reason, total sources and uses of funds in any accounting period must be equal.)

The purpose of a sources and uses cash flow report, however, is more than merely explaining the changes to investments and borrowings from period to period. The primary reason for performing sources and uses analysis is to determine whether an institution has adequate liquidity to fund its business plan and to survive the effect of stress events.

Common measures of liquidity gap include dollar mismatches and ratios. Both can be calculated on a cumulative and non-cumulative basis. Of the ratios, the cumulative ratios are more important. Fluctuations in liquidity gaps between individual months and quarters may result from timing mismatches between incoming and outgoing cash flows. These timing issues are addressed with overnight investment and overnight borrowing transactions. These individual period mismatches are often neutralized by offsetting mismatches in prior or subsequent periods. On the other hand, a longer-term cumulative mismatch, especially when outflows exceed inflows, may cause erosion in an institution’s liquidity position by using up available borrowing capacity or eating into the institution’s stock of HLUM securities.

Setting Liquidity Gap Policy LimitsGraduated risk levels are also appropriate to use with liquidity gap analysis. Policy limits that focus on sources and uses analysis should reflect cash flows needed to allow an institution to survive liquidity stress events. The cumulative liquidity gap/assets ratio is the best measure for liquidity risk, within the sources and uses analysis. See page 22 for the case study on liquidity gap policy limits.

The cumulative ratios are the most important measures of liquidity gap.


XYZ BANK CASE STUDy

Identifying Liquidity Gaps at XYZ BankThe top portion of Figure 5-12 looks at the net cash flows coming from the balance sheet, ignoring cash and due from, overnight investments, and overnight borrowings. Totals appear on the top line of Figure 5-12. Line 2 shows the sources on a cumulative basis. Uses of funds (asset and liability sources) are summed and appear on Line 3 of the analysis. Cumulative uses of funds appear on Line 4. Sources are subtracted from uses on Line 5, which shows the cash flow surplus or deficit for the quarter. Cash flow surpluses or deficits are shown on a cumulative basis on Line 6. XyZ shows a cumulative cash flow surplus (sources less uses) of $5.89 million over the three years of its business plan.

XyZ’s 12/31/09 balance sheet contains $3.159 million in cash and due from and $2.083 million in overnight investments, a total of $5.243 million. Cash and due from are projected to remain at $3.159 million through the 12 quarters of the business plan. For that reason, changes in the total combined balance of $5.243 million that occur under the plan represent additions to or subtractions from overnight investments and overnight borrowings.

Figure 5-12 shows a cash flow surplus of $4.763 million for the first quarter of 2010. The surplus increases Cash

& Due From and Overnight Investments by $4.763 million (Figure 5-11 Section 2, Line 2). The $4.763 million increase in Cash, Due From, and Overnight investments is the offsetting use of funds that keeps the balance sheet in balance. The second quarter shows a cash flow deficit of $6.464 million (Section 1, Line 5). Cash, Due From, and Overnight Investments decreases by $6.464 million providing the funds needed to cover the cash flow deficit. However a portion of the cash flow deficit is due to the purchase of $4 million of HLUM securities in the second quarter (Figure 5-9) so only a portion of the deficit is a true reduction in asset-based liquidity. That net reduction in asset-based liquidity of $2.464 million can be seen can in Figure 5-12, Section 2, Line 3 as a reduction in available HLUM securities, cash and overnight funding from $15.873 million at the end of the first quarter to $13.409 million at the end of the second.

From the end of the second quarter through the end of the 12-quarter forecast, available HLUM securities, cash and overnight funding continue to build to a total of $30.003 million due to a combination of cash flow surpluses adding to the Fed Funds Sold position and additional purchases of HLUM securities, adding to XyZ’s asset-based liquidity.

Which Ratio is a Better Measure of Liquidity?

The issue of whether sources/uses is better than liquidity gap/assets as a measure of liquidity is similar to what played out in the early days of interest rate risk analysis and reporting built around repricing gaps. In those days institutions calculated the rate sensitive assets/rate sensitive liabilities (RSA/RSL) ratio in a nearly identical manner to the calculation of the sources/uses ratio. The RSA/RSL ratio was calculated on both a non-cumulative and cumulative basis. But users quickly identified that RSA/RSL really didn’t relate the size of the repricing mismatch to the size of the institution. So the industry changed its focus to the cumulative gap/asset ratio as the primary measure of interest rate risk in the gap analysis framework. In much the same way, we are focusing on the liquidity gap/asset ratio, as it relates the size of the liquidity buffer to the size of the institution.


XYZ BANK CASE STUDy

Identifying Liquidity Gaps at XYZ Bank, continued

Figure 5-12 Section 2 arrives at the total funds available for liquidity needs by bringing down the total inflows from Section 1, adding changes in the overnight position, adding HLUM securities (net of cash flows occurring in the quarter), and adding unused borrowing capacity.

The sum of the first four lines of Section 2 shows total available sources of liquidity on Line 5. Total outflows are then brought down from Section 1. Total liquidity gap for each period is calculated by subtracting outflows from total liquidity sources. The total liquidity sources/uses ratio is calculated by dividing total liquidity sources by outflows. The liquidity gap/assets ratio is calculated by

dividing the liquidity gap for the period by total assets at the end of the period.

Section 3 is identical to Section 2 except that inflows and outflows are on a cumulative basis. It is important in calculating cumulative ratios to only accumulate cash flows from Section 1, rather than making the mistake of calculating cumulative cash and due from, overnight investments, overnight borrowing, available HLUM securities, and available borrowing capacity. That is why these items are added in after the cumulative numbers are calculated.

Figure 5-12 Liquidity Gap Report – Base Forecast – Summary


Total Inflows 60,017,242 86,191,620 56,850,228 54,627,817 62,609,744 82,444,203 70,597,567 59,384,441 69,898,780 79,029,396 72,794,069 56,439,227 Cumulative Inflows 60,017,242 146,208,862 203,059,090 257,686,908 320,296,651 402,740,854 473,338,421 532,722,862 602,621,642 681,651,037 754,445,106 810,884,333 Total Outflows 55,254,540 92,655,515 52,084,214 52,433,319 66,973,100 81,661,017 66,878,280 58,385,809 74,010,504 78,784,258 71,386,828 54,483,192 Cumulative Outflows 55,254,540 147,910,055 199,994,268 252,427,587 319,400,688 401,061,705 467,939,985 526,325,794 600,336,298 679,120,556 750,507,384 804,990,577 Cash Flow Surplus (Deficit) 4,762,702 (6,463,894) 4,766,014 2,194,498 (4,363,357) 783,185 3,719,287 998,632 (4,111,725) 245,137 1,407,241 1,956,035 Cum Cash Flow Surplus (Deficit) 4,762,702 (1,701,193) 3,064,822 5,259,320 895,964 1,679,149 5,398,436 6,397,068 2,285,344 2,530,481 3,937,722 5,893,757

Total Inflows 60,017,242 86,191,620 56,850,228 54,627,817 62,609,744 82,444,203 70,597,567 59,384,441 69,898,780 79,029,396 72,794,069 56,439,227 Change in Overnight Position (4,762,702) 6,463,894 (4,766,014) (2,194,498) 4,363,357 (783,185) (3,719,287) (998,632) 4,111,725 (245,137) (1,407,241) (1,956,035) Avail HLUM Sec, Cash, Overnite 15,872,820 13,408,925 18,174,940 20,369,438 21,006,081 21,789,266 25,508,554 26,507,185 26,395,460 26,640,598 28,047,839 30,003,874 Unused Borrowing Capacity 13,717,820 20,143,612 22,342,316 25,815,670 29,682,234 33,422,104 35,578,346 39,383,940 42,468,326 44,599,502 47,377,476 49,511,436 Total Available for Liquidity 84,845,180 126,208,052 92,601,469 98,618,427 117,661,415 136,872,388 127,965,179 124,276,934 142,874,291 150,024,358 146,812,143 133,998,502 Total Outflows 55,254,540 92,655,515 52,084,214 52,433,319 66,973,100 81,661,017 66,878,280 58,385,809 74,010,504 78,784,258 71,386,828 54,483,192 Total Liquidity Gap 29,590,640 33,552,537 40,517,256 46,185,108 50,688,315 55,211,370 61,086,900 65,891,125 68,863,786 71,240,100 75,425,315 79,515,310 Total Liquidity Sources/Uses 153.55% 136.21% 177.79% 188.08% 175.68% 167.61% 191.34% 212.85% 193.05% 190.42% 205.66% 245.94% Total Liquidity Gap/Assets 9.94% 11.68% 14.29% 16.63% 18.43% 20.25% 22.36% 24.31% 25.22% 25.91% 27.21% 28.39%

Cumulative Inflows 60,017,242 146,208,862 203,059,090 257,686,908 320,296,651 402,740,854 473,338,421 532,722,862 602,621,642 681,651,037 754,445,106 810,884,333 Cum Change In Overnight Pos (4,762,702) 1,701,193 (3,064,822) (5,259,320) (895,964) (1,679,149) (5,398,436) (6,397,068) (2,285,344) (2,530,481) (3,937,722) (5,893,757) Avail HLUM Sec, Cash, Overnite 15,872,820 13,408,925 18,174,940 20,369,438 21,006,081 21,789,266 25,508,554 26,507,185 26,395,460 26,640,598 28,047,839 30,003,874 Unused Borrowing Capacity 13,717,820 20,143,612 22,342,316 25,815,670 29,682,234 33,422,104 35,578,346 39,383,940 42,468,326 44,599,502 47,377,476 49,511,436 Cumulative Available for Liquidity 84,845,180 181,462,592 240,511,524 298,612,695 370,089,003 456,273,076 529,026,885 592,216,919 669,200,085 750,360,656 825,932,699 884,505,886 Cumulative Outflows 55,254,540 147,910,055 199,994,268 252,427,587 319,400,688 401,061,705 467,939,985 526,325,794 600,336,298 679,120,556 750,507,384 804,990,577 Cumulative Liquidity Gap 29,590,640 33,552,537 40,517,256 46,185,108 50,688,315 55,211,370 61,086,900 65,891,125 68,863,786 71,240,100 75,425,315 79,515,310 Cum Liquidity Sources/Uses 153.55% 122.68% 120.26% 118.30% 115.87% 113.77% 113.05% 112.52% 111.47% 110.49% 110.05% 109.88% Cumulative Liquidity Gap/Assets 9.94% 11.68% 14.29% 16.63% 18.43% 20.25% 22.36% 24.31% 25.22% 25.91% 27.21% 28.39%


XYZ BankForecast Cash Flow Liquidity Report - Liquidity Gaps and Ratios


In XyZ’s case, there is a cash flow surplus for all months of the forecast, except in the quarters in which XyZ takes a portion of its Fed Funds Sold position and deploys it into the investment portfolio. At the same time, the business plan gradually reduces XyZ’s reliance on Near-Core and Non-Core Funding, building its unused borrowing capacity. you can see that occurring on Lines 4 and 5 of Section 2 of Figure 5-12.

Meanwhile cash and due from and overnight investments are cyclical, remaining somewhat constant as percentages of the balance sheet throughout the forecast. XyZ shows strong liquidity sources to uses ratios (Section 2) all through the forecast, with those ratios building over time from a low of 136% in June of 2010 to a high of 246% in December of 2012.

Because the cash flow numbers in both the numerator and denominator of the sources/uses rations in Section 3 are cumulative, they grow quickly in relation to the mismatch between sources and uses. This causes the cumulative liquidity sources/uses ratio to fall quickly, then more gradually throughout the forecast. Its decline would imply that liquidity worsens throughout the forecast. On the other hand, if the cumulative liquidity gap is calculated as a percent of assets, the upward trend in the cumulative liquidity gap/asset ratio much more accurately reflects the actual growing liquidity in the XyZ balance sheet due to growth in investments and the reduction in Near-Core and Non-Core Funding.

Section 1

Section 2

Section 3


Total Inflows 60,017,242 86,191,620 56,850,228 54,627,817 62,609,744 82,444,203 70,597,567 59,384,441 69,898,780 79,029,396 72,794,069 56,439,227 Cumulative Inflows 60,017,242 146,208,862 203,059,090 257,686,908 320,296,651 402,740,854 473,338,421 532,722,862 602,621,642 681,651,037 754,445,106 810,884,333 Total Outflows 55,254,540 92,655,515 52,084,214 52,433,319 66,973,100 81,661,017 66,878,280 58,385,809 74,010,504 78,784,258 71,386,828 54,483,192 Cumulative Outflows 55,254,540 147,910,055 199,994,268 252,427,587 319,400,688 401,061,705 467,939,985 526,325,794 600,336,298 679,120,556 750,507,384 804,990,577 Cash Flow Surplus (Deficit) 4,762,702 (6,463,894) 4,766,014 2,194,498 (4,363,357) 783,185 3,719,287 998,632 (4,111,725) 245,137 1,407,241 1,956,035 Cum Cash Flow Surplus (Deficit) 4,762,702 (1,701,193) 3,064,822 5,259,320 895,964 1,679,149 5,398,436 6,397,068 2,285,344 2,530,481 3,937,722 5,893,757

Total Inflows 60,017,242 86,191,620 56,850,228 54,627,817 62,609,744 82,444,203 70,597,567 59,384,441 69,898,780 79,029,396 72,794,069 56,439,227 Change in Overnight Position (4,762,702) 6,463,894 (4,766,014) (2,194,498) 4,363,357 (783,185) (3,719,287) (998,632) 4,111,725 (245,137) (1,407,241) (1,956,035) Avail HLUM Sec, Cash, Overnite 15,872,820 13,408,925 18,174,940 20,369,438 21,006,081 21,789,266 25,508,554 26,507,185 26,395,460 26,640,598 28,047,839 30,003,874 Unused Borrowing Capacity 13,717,820 20,143,612 22,342,316 25,815,670 29,682,234 33,422,104 35,578,346 39,383,940 42,468,326 44,599,502 47,377,476 49,511,436 Total Available for Liquidity 84,845,180 126,208,052 92,601,469 98,618,427 117,661,415 136,872,388 127,965,179 124,276,934 142,874,291 150,024,358 146,812,143 133,998,502 Total Outflows 55,254,540 92,655,515 52,084,214 52,433,319 66,973,100 81,661,017 66,878,280 58,385,809 74,010,504 78,784,258 71,386,828 54,483,192 Total Liquidity Gap 29,590,640 33,552,537 40,517,256 46,185,108 50,688,315 55,211,370 61,086,900 65,891,125 68,863,786 71,240,100 75,425,315 79,515,310 Total Liquidity Sources/Uses 153.55% 136.21% 177.79% 188.08% 175.68% 167.61% 191.34% 212.85% 193.05% 190.42% 205.66% 245.94% Total Liquidity Gap/Assets 9.94% 11.68% 14.29% 16.63% 18.43% 20.25% 22.36% 24.31% 25.22% 25.91% 27.21% 28.39%

Cumulative Inflows 60,017,242 146,208,862 203,059,090 257,686,908 320,296,651 402,740,854 473,338,421 532,722,862 602,621,642 681,651,037 754,445,106 810,884,333 Cum Change In Overnight Pos (4,762,702) 1,701,193 (3,064,822) (5,259,320) (895,964) (1,679,149) (5,398,436) (6,397,068) (2,285,344) (2,530,481) (3,937,722) (5,893,757) Avail HLUM Sec, Cash, Overnite 15,872,820 13,408,925 18,174,940 20,369,438 21,006,081 21,789,266 25,508,554 26,507,185 26,395,460 26,640,598 28,047,839 30,003,874 Unused Borrowing Capacity 13,717,820 20,143,612 22,342,316 25,815,670 29,682,234 33,422,104 35,578,346 39,383,940 42,468,326 44,599,502 47,377,476 49,511,436 Cumulative Available for Liquidity 84,845,180 181,462,592 240,511,524 298,612,695 370,089,003 456,273,076 529,026,885 592,216,919 669,200,085 750,360,656 825,932,699 884,505,886 Cumulative Outflows 55,254,540 147,910,055 199,994,268 252,427,587 319,400,688 401,061,705 467,939,985 526,325,794 600,336,298 679,120,556 750,507,384 804,990,577 Cumulative Liquidity Gap 29,590,640 33,552,537 40,517,256 46,185,108 50,688,315 55,211,370 61,086,900 65,891,125 68,863,786 71,240,100 75,425,315 79,515,310 Cum Liquidity Sources/Uses 153.55% 122.68% 120.26% 118.30% 115.87% 113.77% 113.05% 112.52% 111.47% 110.49% 110.05% 109.88% Cumulative Liquidity Gap/Assets 9.94% 11.68% 14.29% 16.63% 18.43% 20.25% 22.36% 24.31% 25.22% 25.91% 27.21% 28.39%


XYZ BankForecast Cash Flow Liquidity Report - Liquidity Gaps and Ratios


XYZ BANK CASE STUDy

Setting Liquidity Gap Policy Limits at XYZ BankFigure 5-13 is an illustration of proposed threat level ranges for XyZ. Will the specific ranges stated in the policy be sufficient to allow XyZ to effectively deal with stress scenarios? The answer will not be known until stress tests are run. Once the stress tests are run, XyZ may need to revisit the numerical guidelines being used to assess stress levels.

In Tool 1, XyZ management acknowledged the liquidity issue in developing its capital plan, and these changes are already addressing the liquidity issue.

The XyZ cumulative liquidity gap/asset ratio begins at the end of the first quarter at 9.9%. That ratio is consistent with the fact that XyZ has little asset-based liquidity to deal with short-term stresses like the one-month stress test delivered by the LCR discussed in Tool 4. As you may recall, XyZ was $3 million short of passing that test with an LCR of 78.7%. XyZ also has very little Near-Core and Non-Core borrowing capacity available, as we saw in Tool 3. As it begins the business plan, it has a Near-Core and Non-Core utilization equal to 35.9% of assets against a 40% overall policy limit. Given XyZ’s relatively weak current contingent liquidity position, it would be reasonable to expect it to fail their cumulative liquidity gap/asset guideline in the short-term.

However, by the end of March 2010, XyZ’s cumulative liquidity gap/assets has reached the yellow range at 11.7%. (See Figure 5-12, pages 20-21.) By the end of the fourth quarter, the one-year cumulative liquidity gap/asset ratio is in the green range at 16.6%. From there, the liquidity gap/asset ratio continues to build, hitting 28.4% by the end of the three-year forecast. While the LCR is not displayed by quarter, it is likely to be headed into the green range at roughly the same speed as the one-year cumulative liquidity gap/asset ratio. The LCR would improve because XyZ’s capitalplan proactively addressed liquidity risk by increasing HLUM securities and reducing reliance on Non-Core Funding.

Is the transformation sufficient for regulators to sign off on the plan? Before addressing that question, XyZ management first needs to determine whether its red/yellow/green light ranges provide sufficient liquidity to deal with liquidity stress events: management needs to stress-test the plan.








< 10% Red Light





< 0% Red Light


Figure 5-13 Liquidity Gap Policy Limit







STEP 2 Stress Test the Base Liquidity PlanThe purpose of a stress test is to determine whether an institution has sufficient liquidity to survive a severe liquidity stress. As part of the stress test, modifications are made to the cash flow assumptions in the business plan to implement the test.

XYZ: Four Stress ScenariosIn Tool 1, XYZ management defined four stress events that are likely to place XYZ under liquidity stress. Here is a brief description of each stress event.

• Economic Recovery Scenario is a high probability/high impact cascading event scenario that begins with an economic recovery that increases loan demand, causing an unanticipated growth in loans.

• Payment Disruption Scenario is a low probability/high impact scenario where a local disaster or system outage causes a disruption in incoming deposit account and loan payment transactions, causing a short-term liquidity problem.

• Market Dislocation Scenario is a low probability/high impact event brought on by a market dislocation or widening credit default spreads in the securities markets, causing XYZ to be forced to hold mortgages originated for sale in the markets.

• Capital Scenario is a low probability/high impact cascading event scenario that begins with a combination of an economic downturn and poor credit underwriting that cause operating losses, leading to a cascading series of events.

XYZ has already run the LCR test for a severe 30-day scenario, which would approximate both the Payment Disruption Scenario and the Market Dislocation Scenario. The Economic Recovery Scenario is already addressed in its business plan. Therefore, XYZ has elected to run a stress test on the fourth stress event, the Capital Scenario. The Capital Scenario is often referred to as a “going out of business scenario,” a scenario regulators want to see tested. The objective is to develop a business strategy that will save the institution from going out of business for lack of liquidity.


XYZ BANK CASE STUDy

Running Stress TestsA review of the phase-in section (Figure 5-14) of the Capital Scenario developed in Tool 1 reveals the timeline for the Capital Scenario.

XyZ is already through the first three-month period in the Capital Scenario, and is facing an asset quality problem. An economic downturn, preceded by a period of lax underwriting, has already occurred, resulting in net operating losses. The press has not yet noticed XyZ’s asset quality problems. It is likely to see significant PCA and CAMELS downgrades in its upcoming examination, scheduled in the next quarter.

For purposes of stress testing, XyZ management assumes that the scenario’s first three-month phase has already happened. The second three-month phase will play out in the first quarter of the XyZ business plan, as the exam causing CAMELS downgrades has not yet occurred. XyZ management also assumes that the failure of PCA well-capitalized status occurs in the second quarter. The full effect of the Capital Scenario will hit XyZ in the third and subsequent quarters of the plan.

Figure 5-15 shows the adjustments XyZ management made to the base sources and uses from the Business Plan to reflect the asset side of the Capital Scenario stress event. This asset cash flow report is a stressed version of Figure 5-9 on pages 12-13. The adjustment to the Figure 5-9 cash flows assumes the following:

• After the first quarter, purchases that increase the size of the investment portfolio are deferred. Instead, the funds will end up in the more liquid Fed Funds Sold account, net of the results of other actions. Existing investments are replaced as cash flows mature to maintain the size of the investment portfolio at current levels.

• Loan inflows are cut to 85% of current levels, reflecting a slowdown of prepayment speeds and a slowdown of cash flows from collections of scheduled payments.

• Loan outflows are trimmed to 80% of current levels in the first two years of the plan and 70% in year 3. XyZ management had already curtailed lending in the base business plan in order to shrink the balance sheet in years 1 and 2. These assumptions for the purpose of the stress test reflect a further reduction in loan originations. The business plan had anticipated loan growth in year 3 of the base plan. Under the stress scenario, further loan portfolio shrinkage is anticipated in year 3. These reductions in loan originations take into consideration the potential for customers to draw down available credit lines to ensure access to funds.

The asset side modifications result in a cumulative total of $31.4 million of net funds inflows in year 1 (loan cash flows less originations), $16.8 million in year 2, and $14.0 million in year 3, compared with net inflows in the base business plan (Figure 5-9) of $27.6 million in year 1 and $7.8 million in year 2. A net outflow of $5.5 million was anticipated in year 3 of the base strategy.

Figure 5-15 Liquidity Gap Report – Capital Scenario – Assets


Total Investments Inflow 611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 1,565,805 1,741,536 1,782,416 1,754,762 Outflow - Hold Investments 2,611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 1,565,805 1,741,536 1,782,416 1,754,762 Net (2,000,000) - (0) 0 - (0) (0) 0 - 0 (0) (0)

Total Loans Inflow (85%) 28,829,770 28,605,746 15,819,065 24,439,480 23,951,660 29,956,937 16,690,906 27,123,622 27,526,641 28,966,912 17,058,695 23,006,284 Outflow (80%, 80%, 70%) 20,451,994 21,097,086 9,235,596 17,516,823 20,756,803 26,426,628 13,958,576 23,795,051 24,616,527 25,562,216 15,097,037 20,098,827 Net 8,377,775 7,508,659 6,583,469 6,922,657 3,194,857 3,530,309 2,732,330 3,328,571 2,910,114 3,404,696 1,961,658 2,907,457

Non-Earning Assets Inflow 610,318 857,362 1,374,288 1,426,105 1,450,984 1,461,973 1,515,049 1,573,471 699,924 784,964 812,529 804,093 Outflow - - - 271,115 432,221 455,510 520,526 590,538 - 63,436 108,407 104,266 Net 610,318 857,362 1,374,288 1,154,990 1,018,763 1,006,463 994,523 982,934 699,924 721,528 704,122 699,827

TOTAL ASSETS Inflow 30,052,030 32,159,072 18,086,324 26,877,264 26,629,651 32,714,278 19,618,656 30,150,891 29,792,370 31,493,412 19,653,640 25,565,139 Outflow 23,063,937 23,793,051 10,128,567 18,799,617 22,416,031 28,177,506 15,891,803 25,839,386 26,182,332 27,367,189 16,987,860 21,957,856 Net 6,988,093 8,366,021 7,957,757 8,077,647 4,213,620 4,536,771 3,726,853 4,311,505 3,610,038 4,126,224 2,665,780 3,607,284 Cumulative 31,389,517 16,788,749 14,009,326

Forecast Cash Flow Liquidity Report - AssetsCapital Scenario Stress Test

XYZ Bank


Figure 5-14 Capital Scenario Timeline


Total Investments Inflow 611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 1,565,805 1,741,536 1,782,416 1,754,762 Outflow - Hold Investments 2,611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 1,565,805 1,741,536 1,782,416 1,754,762 Net (2,000,000) - (0) 0 - (0) (0) 0 - 0 (0) (0)

Total Loans Inflow (85%) 28,829,770 28,605,746 15,819,065 24,439,480 23,951,660 29,956,937 16,690,906 27,123,622 27,526,641 28,966,912 17,058,695 23,006,284 Outflow (80%, 80%, 70%) 20,451,994 21,097,086 9,235,596 17,516,823 20,756,803 26,426,628 13,958,576 23,795,051 24,616,527 25,562,216 15,097,037 20,098,827 Net 8,377,775 7,508,659 6,583,469 6,922,657 3,194,857 3,530,309 2,732,330 3,328,571 2,910,114 3,404,696 1,961,658 2,907,457

Non-Earning Assets Inflow 610,318 857,362 1,374,288 1,426,105 1,450,984 1,461,973 1,515,049 1,573,471 699,924 784,964 812,529 804,093 Outflow - - - 271,115 432,221 455,510 520,526 590,538 - 63,436 108,407 104,266 Net 610,318 857,362 1,374,288 1,154,990 1,018,763 1,006,463 994,523 982,934 699,924 721,528 704,122 699,827

TOTAL ASSETS Inflow 30,052,030 32,159,072 18,086,324 26,877,264 26,629,651 32,714,278 19,618,656 30,150,891 29,792,370 31,493,412 19,653,640 25,565,139 Outflow 23,063,937 23,793,051 10,128,567 18,799,617 22,416,031 28,177,506 15,891,803 25,839,386 26,182,332 27,367,189 16,987,860 21,957,856 Net 6,988,093 8,366,021 7,957,757 8,077,647 4,213,620 4,536,771 3,726,853 4,311,505 3,610,038 4,126,224 2,665,780 3,607,284 Cumulative 31,389,517 16,788,749 14,009,326

Forecast Cash Flow Liquidity Report - AssetsCapital Scenario Stress Test

XYZ Bank

27

Cause Effect Horizon

Economic Downturn and Lax Underwriting

• Asset Quality Problem • Increased Line Utilization • Market Dislocations

3 Months

Asset Quality Problem • Net Operating Losses • Adverse Press • PCA and CAMELS Downgrades

3 Months

Failure of Well-Capitalized Status

• Increased FHLB Haircuts • Loss of Access to Brokered CDs • Loss of Brokered Deposits • Adverse Press • PCA and CAMELS Downgrades • Rating Agency Downgrades • Limits on Deposit Offering Rates

3 Months

Adverse Press

• Loss of Large Depositors • Loss of Core Funding • Increased Line Utilization • Inability to Raise New Deposit

Funding

3 Months


XYZ BANK CASE STUDy

Figure 5-16 shows the result of stress testing on the liability and capital side of the balance sheet. The numbers for this portion of the balance sheet prior to stress testing appear in Figure 5-11 on pages 16-17. Key modifications to cash flow assumptions on the liability and capital portion of the balance sheet include the following:

• Rather than Core deposit growth, the stress test assumes shrinkage of Core deposits by $17.6 million, a little over 10% over the 36 months of the plan. Funding the deposit outflow results in a $17.6 million use of funds over the three-year forecast. This outflow of Core Funding occurs as a result of negative publicity, but

helps accomplish the goal of shrinking assets to maintain higher capital/asset ratios.

• XyZ was already planning to reduce Near-Core Funding as part of its business plan. The stress test assumes a reduction to only 85% of Near-Core deposit openings and renewals as compared to the levels projected in the business plan. Projected uses of funds for outflows total $11.8 million over three years.

• In the Non-Core section of Figure 5-16, all wholesale brokered CDs are allowed to run off, as a result of regulatory actions barring the use of brokered deposits once risk-based capital

Figure 5-16 Capital Scenario – Liabilities & Capital


Core Funding Inflow (90%) 16,597,475 25,385,843 20,671,120 13,208,753 17,054,534 27,585,462 28,843,728 14,870,905 17,610,641 23,532,685 27,188,373 17,103,367 Outflow 15,771,201 28,348,719 22,925,338 14,700,959 17,526,869 29,877,947 31,319,433 14,841,405 18,415,611 25,745,732 30,241,449 17,559,811 Net 826,274 (2,962,875) (2,254,217) (1,492,206) (472,335) (2,292,484) (2,475,705) 29,499 (804,970) (2,213,047) (3,053,076) (456,444) Cumulative (5,883,025) (5,211,025) (6,527,537) Near-Core Funding Inflow - 85% 1,116,610 4,607,441 1,745,480 1,926,105 1,193,315 2,593,803 4,660,340 1,653,037 747,434 1,209,027 3,310,278 1,529,724 Outflow 1,699,948 6,583,405 2,749,961 2,809,915 1,754,597 5,172,609 5,862,276 2,225,447 1,159,084 1,570,289 4,599,058 1,981,692 Net (583,338) (1,975,965) (1,004,480) (883,810) (561,282) (2,578,805) (1,201,936) (572,409) (411,650) (361,262) (1,288,781) (451,967) Cumulative (4,447,593) (4,914,432) (2,513,660) Non-Core Funding Inflow 1,253,000 4,148,000 - 1,259,000 2,410,313 1,452,252 1,061,784 837,402 2,079,995 1,918,874 1,232,650 - Outflow 8,907,026 23,889,231 13,130,896 10,888,153 4,289,118 3,331,057 2,940,589 2,716,207 3,958,800 3,797,679 3,781,065 1,209,722 Net (7,654,026) (19,741,231) (13,130,896) (9,629,153) (1,878,805) (1,878,805) (1,878,805) (1,878,805) (1,878,805) (1,878,805) (2,548,415) (1,209,722) Cumulative (50,155,307) (7,515,220) (7,515,747) Other Liab Inflow - - - - - - - - 3,000 3,000 3,000 3,000 Outflow 9,776 13,909 13,909 13,909 4,000 4,000 4,000 4,000 - - - - Net (9,776) (13,909) (13,909) (13,909) (4,000) (4,000) (4,000) (4,000) 3,000 3,000 3,000 3,000

Capital Inflow - - - - - - - - 156,008 135,470 351,707 235,680 Outflow 689,653 752,928 826,644 841,560 235,456 291,715 132,162 124,553 - - - 182,552 Net (689,653) (752,928) (826,644) (841,560) (235,456) (291,715) (132,162) (124,553) 156,008 135,470 351,707 53,128

Total Liab & Capital Inflow 18,967,085 34,141,284 22,416,601 16,393,858 20,658,162 31,631,518 34,565,852 17,361,344 20,597,077 26,799,057 32,086,008 18,871,772 Outflow 27,077,605 59,588,192 39,646,748 29,254,496 23,810,040 38,677,328 40,258,460 19,911,612 23,533,495 31,113,700 38,621,573 20,933,777 Net (8,110,520) (25,446,908) (17,230,147) (12,860,639) (3,151,878) (7,045,810) (5,692,607) (2,550,268) (2,936,418) (4,314,644) (6,535,565) (2,062,005) Cumulative (63,648,213) (18,440,564) (15,848,631)


Capital Scenario Stress Test



Core Funding Inflow (90%) 16,597,475 25,385,843 20,671,120 13,208,753 17,054,534 27,585,462 28,843,728 14,870,905 17,610,641 23,532,685 27,188,373 17,103,367 Outflow 15,771,201 28,348,719 22,925,338 14,700,959 17,526,869 29,877,947 31,319,433 14,841,405 18,415,611 25,745,732 30,241,449 17,559,811 Net 826,274 (2,962,875) (2,254,217) (1,492,206) (472,335) (2,292,484) (2,475,705) 29,499 (804,970) (2,213,047) (3,053,076) (456,444) Cumulative (5,883,025) (5,211,025) (6,527,537) Near-Core Funding Inflow - 85% 1,116,610 4,607,441 1,745,480 1,926,105 1,193,315 2,593,803 4,660,340 1,653,037 747,434 1,209,027 3,310,278 1,529,724 Outflow 1,699,948 6,583,405 2,749,961 2,809,915 1,754,597 5,172,609 5,862,276 2,225,447 1,159,084 1,570,289 4,599,058 1,981,692 Net (583,338) (1,975,965) (1,004,480) (883,810) (561,282) (2,578,805) (1,201,936) (572,409) (411,650) (361,262) (1,288,781) (451,967) Cumulative (4,447,593) (4,914,432) (2,513,660) Non-Core Funding Inflow 1,253,000 4,148,000 - 1,259,000 2,410,313 1,452,252 1,061,784 837,402 2,079,995 1,918,874 1,232,650 - Outflow 8,907,026 23,889,231 13,130,896 10,888,153 4,289,118 3,331,057 2,940,589 2,716,207 3,958,800 3,797,679 3,781,065 1,209,722 Net (7,654,026) (19,741,231) (13,130,896) (9,629,153) (1,878,805) (1,878,805) (1,878,805) (1,878,805) (1,878,805) (1,878,805) (2,548,415) (1,209,722) Cumulative (50,155,307) (7,515,220) (7,515,747) Other Liab Inflow - - - - - - - - 3,000 3,000 3,000 3,000 Outflow 9,776 13,909 13,909 13,909 4,000 4,000 4,000 4,000 - - - - Net (9,776) (13,909) (13,909) (13,909) (4,000) (4,000) (4,000) (4,000) 3,000 3,000 3,000 3,000

Capital Inflow - - - - - - - - 156,008 135,470 351,707 235,680 Outflow 689,653 752,928 826,644 841,560 235,456 291,715 132,162 124,553 - - - 182,552 Net (689,653) (752,928) (826,644) (841,560) (235,456) (291,715) (132,162) (124,553) 156,008 135,470 351,707 53,128

Total Liab & Capital Inflow 18,967,085 34,141,284 22,416,601 16,393,858 20,658,162 31,631,518 34,565,852 17,361,344 20,597,077 26,799,057 32,086,008 18,871,772 Outflow 27,077,605 59,588,192 39,646,748 29,254,496 23,810,040 38,677,328 40,258,460 19,911,612 23,533,495 31,113,700 38,621,573 20,933,777 Net (8,110,520) (25,446,908) (17,230,147) (12,860,639) (3,151,878) (7,045,810) (5,692,607) (2,550,268) (2,936,418) (4,314,644) (6,535,565) (2,062,005) Cumulative (63,648,213) (18,440,564) (15,848,631)



failure has occurred. Collateral haircuts will only allow 50% of FHLB advances to be renewed, so, the Non-Core portion of the balance sheet shows a $50.2 million net outflow of funds in year 1 and an additional $7.5 million runoff in years 2 and 3. By the end of the three years there are no remaining brokered CDs from a $47.0 million portfolio on 9/31/09. The FHLB advances are reduced to $24.8 million from a $43.3 million portfolio.

Cumulative liability and capital outflows (uses of funds) total $63.6 million in year 1, another $18.4 million in year 2 and $15.8 million in year 3.


XYZ BANK CASE STUDy

Figure 5-17 Liquidity Gap Report – Capital Scenario – Summary


Total Inflows 49,019,115 66,300,356 40,502,925 43,271,121 47,287,812 64,345,796 54,184,508 47,512,235 50,389,447 58,292,469 51,739,648 44,436,911 Cumulative Inflows 49,019,115 115,319,471 155,822,395 199,093,517 246,381,329 310,727,125 364,911,633 412,423,868 462,813,314 521,105,784 572,845,432 617,282,343 Total Outflows 50,141,542 83,381,243 49,775,315 48,054,113 46,226,071 66,854,834 56,150,263 45,750,998 49,715,826 58,480,889 55,609,432 42,891,632 Cumulative Outflows 50,141,542 133,522,785 183,298,100 231,352,213 277,578,284 344,433,118 400,583,381 446,334,379 496,050,205 554,531,094 610,140,526 653,032,159 Cash Flow Surplus (Deficit) (1,122,427) (17,080,887) (9,272,390) (4,782,992) 1,061,742 (2,509,039) (1,965,754) 1,761,237 673,620 (188,420) (3,869,784) 1,545,279 Cum Cash Flow Surplus (Deficit) (1,122,427) (18,203,314) (27,475,704) (32,258,696) (31,196,955) (33,705,993) (35,671,748) (33,910,511) (33,236,891) (33,425,310) (37,295,095) (35,749,816)

Total Inflows 49,019,115 66,300,356 40,502,925 43,271,121 47,287,812 64,345,796 54,184,508 47,512,235 50,389,447 58,292,469 51,739,648 44,436,911 Change in Overnight Position 1,122,427 17,080,887 9,272,390 4,782,992 (1,061,742) 2,509,039 1,965,754 (1,761,237) (673,620) 188,420 3,869,784 (1,545,279) Unused Borr Cap 17,264,192 21,026,538 22,706,422 25,205,335 27,021,716 27,155,579 26,779,824 29,267,673 30,787,734 31,188,891 30,089,990 31,854,045 Available HLUM Securities 19,993,563 11,408,925 14,174,940 16,369,438 12,006,081 12,789,266 16,508,554 17,507,185 13,395,460 13,640,598 15,047,839 17,003,874 Total Available for Liquidity 87,399,297 115,816,707 86,656,677 89,628,886 85,253,868 106,799,680 99,438,640 92,525,857 93,899,020 103,310,378 100,747,262 91,749,551 Total Outflows 50,141,542 83,381,243 49,775,315 48,054,113 46,226,071 66,854,834 56,150,263 45,750,998 49,715,826 58,480,889 55,609,432 42,891,632 Total Liquidity Gap 37,257,755 32,435,463 36,881,362 41,574,773 39,027,797 39,944,846 43,288,378 46,774,859 44,183,194 44,829,489 45,137,829 48,857,919 Total Liquidity Sources/Uses 174.31% 138.90% 174.10% 186.52% 184.43% 159.75% 177.09% 202.24% 188.87% 176.66% 181.17% 213.91% Total Liquidity Gap/Assets 12.51% 11.29% 13.01% 14.97% 14.19% 14.65% 15.85% 17.26% 16.18% 16.30% 16.28% 17.44%

Cumulative Inflows 49,019,115 115,319,471 155,822,395 199,093,517 246,381,329 310,727,125 364,911,633 412,423,868 462,813,314 521,105,784 572,845,432 617,282,343 Cum Change in Overnight Pos 1,122,427 18,203,314 27,475,704 32,258,696 31,196,955 33,705,993 35,671,748 33,910,511 33,236,891 33,425,310 37,295,095 35,749,816 Unused Borr Cap 17,264,192 21,026,538 22,706,422 25,205,335 27,021,716 27,155,579 26,779,824 29,267,673 30,787,734 31,188,891 30,089,990 31,854,045 Avail HLUM Sec, Cash & Ov Inv 19,993,563 11,408,925 14,174,940 16,369,438 12,006,081 12,789,266 16,508,554 17,507,185 13,395,460 13,640,598 15,047,839 17,003,874 Cumulative Available for Liquidity 87,399,297 165,958,249 220,179,462 272,926,986 316,606,081 384,377,964 443,871,758 493,109,237 540,233,399 599,360,583 655,278,356 701,890,077 Cumulative Outflows 50,141,542 133,522,785 183,298,100 231,352,213 277,578,284 344,433,118 400,583,381 446,334,379 496,050,205 554,531,094 610,140,526 653,032,159 Cumulative Liquidity Gap 37,257,755 32,435,463 36,881,362 41,574,773 39,027,797 39,944,846 43,288,378 46,774,859 44,183,194 44,829,489 45,137,829 48,857,919 Cum Liquidity Sources/Uses 174.31% 124.29% 120.12% 117.97% 114.06% 111.60% 110.81% 110.48% 108.91% 108.08% 107.40% 107.48% Cumulative Liquidity Gap/Assets 12.51% 11.29% 13.01% 14.97% 14.19% 14.65% 15.85% 17.26% 16.18% 16.30% 16.28% 17.44%


XYZ BankForecast Cash Flow Liquidity Report - Liquidity Gap & Ratios

Figure 5-17 summarizes the results of the stress test, concentrating on the same gaps and ratios shown pre-stress in Figure 5-12 on pages 20-21. The first section of Figure 5-17 indicates that a very significant cash flow deficit opens up in the stressed scenario, reaching $35.7 million cumulatively, by seven quarters into the stressed version of the business plan. From that point it fluctuates mildly, staying in the same general range through the 12th quarter of the forecast. The cash flow deficit builds rapidly at first, as wholesale brokered CDs run off the books in the first 18 months of the forecast, then stabilizes after the wholesale brokered CDs have all matured.

Line 2 of the Section 2 shows changes in the overnight position needed to balance the cash flow mismatches.

As Section 3, Line 2 of Figure 5-17 indicates, cumulative changes to the overnight position match the cumulative cash flow deficit numbers in the previous paragraph. However, because Non-Core term funding is rolling off the books even faster than the overnight position is changing, unused borrowing capacity (Section 2, Line 3) grows from $17.26 million to $31.854 million by the end of the forecast.

Note that unused borrowing capacity should take into account two factors:

• Policy limits on use of Non-Core Funding both at the individual source level and overall

• Actual unused borrowing capacity with the various funding providers

Running Stress Tests, continued



Total Inflows 49,019,115 66,300,356 40,502,925 43,271,121 47,287,812 64,345,796 54,184,508 47,512,235 50,389,447 58,292,469 51,739,648 44,436,911 Cumulative Inflows 49,019,115 115,319,471 155,822,395 199,093,517 246,381,329 310,727,125 364,911,633 412,423,868 462,813,314 521,105,784 572,845,432 617,282,343 Total Outflows 50,141,542 83,381,243 49,775,315 48,054,113 46,226,071 66,854,834 56,150,263 45,750,998 49,715,826 58,480,889 55,609,432 42,891,632 Cumulative Outflows 50,141,542 133,522,785 183,298,100 231,352,213 277,578,284 344,433,118 400,583,381 446,334,379 496,050,205 554,531,094 610,140,526 653,032,159 Cash Flow Surplus (Deficit) (1,122,427) (17,080,887) (9,272,390) (4,782,992) 1,061,742 (2,509,039) (1,965,754) 1,761,237 673,620 (188,420) (3,869,784) 1,545,279 Cum Cash Flow Surplus (Deficit) (1,122,427) (18,203,314) (27,475,704) (32,258,696) (31,196,955) (33,705,993) (35,671,748) (33,910,511) (33,236,891) (33,425,310) (37,295,095) (35,749,816)

Total Inflows 49,019,115 66,300,356 40,502,925 43,271,121 47,287,812 64,345,796 54,184,508 47,512,235 50,389,447 58,292,469 51,739,648 44,436,911 Change in Overnight Position 1,122,427 17,080,887 9,272,390 4,782,992 (1,061,742) 2,509,039 1,965,754 (1,761,237) (673,620) 188,420 3,869,784 (1,545,279) Unused Borr Cap 17,264,192 21,026,538 22,706,422 25,205,335 27,021,716 27,155,579 26,779,824 29,267,673 30,787,734 31,188,891 30,089,990 31,854,045 Available HLUM Securities 19,993,563 11,408,925 14,174,940 16,369,438 12,006,081 12,789,266 16,508,554 17,507,185 13,395,460 13,640,598 15,047,839 17,003,874 Total Available for Liquidity 87,399,297 115,816,707 86,656,677 89,628,886 85,253,868 106,799,680 99,438,640 92,525,857 93,899,020 103,310,378 100,747,262 91,749,551 Total Outflows 50,141,542 83,381,243 49,775,315 48,054,113 46,226,071 66,854,834 56,150,263 45,750,998 49,715,826 58,480,889 55,609,432 42,891,632 Total Liquidity Gap 37,257,755 32,435,463 36,881,362 41,574,773 39,027,797 39,944,846 43,288,378 46,774,859 44,183,194 44,829,489 45,137,829 48,857,919 Total Liquidity Sources/Uses 174.31% 138.90% 174.10% 186.52% 184.43% 159.75% 177.09% 202.24% 188.87% 176.66% 181.17% 213.91% Total Liquidity Gap/Assets 12.51% 11.29% 13.01% 14.97% 14.19% 14.65% 15.85% 17.26% 16.18% 16.30% 16.28% 17.44%

Cumulative Inflows 49,019,115 115,319,471 155,822,395 199,093,517 246,381,329 310,727,125 364,911,633 412,423,868 462,813,314 521,105,784 572,845,432 617,282,343 Cum Change in Overnight Pos 1,122,427 18,203,314 27,475,704 32,258,696 31,196,955 33,705,993 35,671,748 33,910,511 33,236,891 33,425,310 37,295,095 35,749,816 Unused Borr Cap 17,264,192 21,026,538 22,706,422 25,205,335 27,021,716 27,155,579 26,779,824 29,267,673 30,787,734 31,188,891 30,089,990 31,854,045 Avail HLUM Sec, Cash & Ov Inv 19,993,563 11,408,925 14,174,940 16,369,438 12,006,081 12,789,266 16,508,554 17,507,185 13,395,460 13,640,598 15,047,839 17,003,874 Cumulative Available for Liquidity 87,399,297 165,958,249 220,179,462 272,926,986 316,606,081 384,377,964 443,871,758 493,109,237 540,233,399 599,360,583 655,278,356 701,890,077 Cumulative Outflows 50,141,542 133,522,785 183,298,100 231,352,213 277,578,284 344,433,118 400,583,381 446,334,379 496,050,205 554,531,094 610,140,526 653,032,159 Cumulative Liquidity Gap 37,257,755 32,435,463 36,881,362 41,574,773 39,027,797 39,944,846 43,288,378 46,774,859 44,183,194 44,829,489 45,137,829 48,857,919 Cum Liquidity Sources/Uses 174.31% 124.29% 120.12% 117.97% 114.06% 111.60% 110.81% 110.48% 108.91% 108.08% 107.40% 107.48% Cumulative Liquidity Gap/Assets 12.51% 11.29% 13.01% 14.97% 14.19% 14.65% 15.85% 17.26% 16.18% 16.30% 16.28% 17.44%


XYZ BankForecast Cash Flow Liquidity Report - Liquidity Gap & Ratios

For the purpose of these projections, sufficient unused capacity is assumed at the various sources to allow XyZ to reach its overall policy limit of 40% of funding all through the stress scenario. Should that not be the case, Figure 5-17 may overstate XyZ’s unused borrowing capacity.

Available HLUM securities fail to grow, due to the elimination of Fed Funds Sold and due to the fact no additional investments are being purchased after the first quarter in the stress scenario. The total liquidity gap, including unused borrowing capacity, grows from $37.25 million to $48.9 million by the end of the three-year forecast. Because assets shrink throughout the forecast, the cumulative liquidity gap/asset ratio grows from 12.51% at the end of the first quarter to 17.44% by the end of the three-year forecast.


XYZ BANK CASE STUDy

Establishing Stress Test Policy Limits and Assessing ComplianceXyZ’s Stressed Threat Level guidelines, found in Figure 5-18, assume that during a stress event, liquidity resources may be drawn down. The liquidity gap/asset ratios may drop into the yellow and possibly the red range as a result of a stress test. After all, the base business plan policy limit cushion was put in place to deal with stress events. A review of the stressed one-year cumulative liquidity gap/asset ratio in Figure 5-17 shows the ratio to be 14.97%. By the seventh quarter of the forecast it has moved above 15%.

So has XyZ management successfully made it through the stress event? Not yet. The Capital Failure Scenario modeled in Figures 5-15 through 5-17 on pages 24-29 causes XyZ to end up with an overnight borrowing position

in the range of $33 million. The Capital Failure Scenario assumes all of XyZ’s available FHLB borrowing capacity has been allocated to its term advance portfolio, due to increased collateral haircuts. Since the FHLB is XyZ’s only source of collateralized overnight funding, it is likely XyZ’s unsecured overnight borrowing source will dry up early in the Capital Failure Scenario, so it will be without a source for $33 million in overnight borrowings.

Where will XyZ secure the $33 million in Non-Core or Near-Core Funding needed to balance its balance sheet? That will need to be addressed in the CFP for the Capital Failure Scenario and will be dealt with in the next step.

Figure 5-18 XyZ Threat Level Guidelines for the Stressed 12-Month Cumulative Liquidity Gap Ratio








< 10% Red Light





< 0% Red Light








STEP 3 Develop and Test the Contingency Funding PlanHistorically, many banks have relied on the availability of fed funds and Federal Home Loan Bank (FHLB) advances as their primary vehicle for meeting needs in times of stress. The recent financial crisis shows that these sources can be volatile at times when the bank may need them the most. The CFP addresses issues like these by outlining a process to assess the liquidity sources available under times of stress and discussing how they will be used and who will manage the process.

Regulatory pressure is weighing heavily on institutions to build and maintain effective CFPs, which contain a review of the base liquidity plan in addition to the consideration of unexpected events that impact liquidity levels.

For most community banks, a CFP does not need to be complex to be practical. The primary focus of the CFP should be what sources the bank would use to obtain its funding and in what order the sources would be tapped.

To build your CFP, you need to compile many of the items we have discussed until now. A good contingency plan should outline limits on various funding sources. These limits were set in Tool 3. In addition, the role of each funding source (base/contingent) and its collateral requirements are outlined. In Tool 3, you also completed a Non-Core Funding Worksheet for each funding source describing its collateral requirements, its role, its policy limit and its facility status. Information from these worksheets can be incorporated in your CFP.

A good CFP should outline limits on various funding sources, the role of each funding source, and its collateral requirements, in addition to its facility status.


The team of individuals responsible for various actions in a liquidity event are outlined and assigned. Key concerns include:

❏ Communication with regulators, shareholders and customers

❏ Board communications

❏ Primary contact with funding sources

❏ Media and shareholder relations

❏ Primary contact for credit issues

By assigning these critical roles, all parties involved know how to respond in the event of a crisis.

The CFP should:

❏ Outline management’s stress event scenarios,

❏ Establish clear lines of responsibility for various activities in case of the event occurring, and

❏ Identify the implementation process including reporting frequencies and expectation.


The CFP should apply a minimum of two to three different stress scenarios to the base liquidity projections.

These should include:

❏ A short-term event that might include natural disaster. For XYZ, we identified two in Tool 1: a Short-term Payment System Disruption and a Market Dislocation involving freeze up of the securitization markets.

❏ An event that projects a potential going-out-of-business situation. The XYZ Capital Failure Scenario is this event.

❏ Any other event that may be reasonably expected to occur such as an economic recovery after slowdown. The fourth stress scenario we identified for XYZ is the Economic Recovery Scenario.

At a minimum, these scenarios should be reviewed and updated every year to reflect the changing market and institutional conditions. Regular updating ensures the CFP reflects a meaningful assessment of the potential threats within each institution and the types of conditions the institution may confront that could impair its liquidity. These scenarios define a timeline for various events that might occur in a cascading fashion. These cascading time events are described in the Scenario Worksheets completed in Tool 1.

Stress scenarios should be reviewed at least every year to reflect the changing market and institutional conditions.


Capital Scenario Stress Event at XYZ Bank

XYZ BANK CASE STUDy

When XyZ management conducted the Capital Failure Scenario (pp. 24-27), they found that, while the liquidity gap/asset ratios remain in the green range all through the 12-quarter forecast, the projection uses $33 million of overnight borrowings to make up for daily funding shortfalls. These overnight funds are unlikely to be available from either the FHLB (collateralized source) or from XyZ uncollateralized sources once they have fallen below PCA well capitalized minimums. Management will need a CFP to address this shortfall and any others they have encountered in their stress testing.

Figure 5-19 describes the series of actions XyZ would take in dealing with the Capital Failure stress event.

Fortunately, XyZ management have already incorporated key portions of the CFP for the Capital Failure Scenario: reductions in investment purchases, some use of asset-based liquidity (Fed Funds Sold), reductions in loan originations, and balance sheet shrinkage. Therefore, XyZ should be able to survive the Capital Failure Scenario for 2-3 years, by closing the $33 million funding gap with some combination of CDARS, Core Funding growth, rate board CDs, and collateralized fed borrowings.

XyZ management was able to begin closing the funding gap early, because it had early warning indicators in the form of trigger ratios in place. Management actively monitored those ratios and began executing as soon as the triggers indicated the potential development of a problem.


2

Event Action

Triggers indicate development of asset quality problem, declines in performance, and potential for a capital failure event.

1. Replace maturing brokered CDs with FHLB advances or similar instruments that have maturities of at least 2-3 years.

2. Begin moving jumbo CDs into CDARS network to provide access to deposit insurance to those depositors to reduce potential runoff and reduce collateral pledging requirements, freeing up asset-based liquidity.

3. Use Core Funding strategies to grow deposits, replacing Non- Core Funding as it matures.

4. All maturing investments held in fed funds or short-term investments.

5. Loan originations cut back.

6. Begin shrinking the balance sheet to build capital and liquidity using net loan cash flows to pay off maturing funding.

PCA well-capitalized failures or regulatory actions remove access to brokered CD network. FHLB increases collateral haircuts.

1. Replace renewing brokered CDs and FHLB advances with Rate Board CDs to the extent needed to fund the balance sheet. Extend terms to 2-3 years.

2. Make further cutbacks in loan originations and potentially liquidate asset-based liquidity to shrink the balance sheet.

3. Package and sell conforming consumer mortgages in the secondary market.

4. Explore the sale of business lines or branches to further shrink the balance sheet.

Adverse publicity causes loss of Core Funding.

1. Consider further cutbacks in lending to level needed to sustain key customer relationships. Objective is to allow deposit runoff through shrinkage.

2. Begin using the fed window as a collateralized borrowing source to plug any remaining funding gaps.

Figure 5-19 Stress Event Sequence and Responses – Capital Failure Stress


Economic Recovery Scenario at XYZ Bank

XYZ BANK CASE STUDy

The Economic Recovery Scenario is a high probability/high impact event. Because it is high probability, it is best dealt with in the base liquidity strategy rather than with stress testing. The scenario and its potential effects are described in the XyZ Base Liquidity Plan. The business plan anticipates that growth will turn positive in year 3, but it only looks out three years and never reaches the equilibrium forecast in the fifth year of the capital plan. A stress test is unnecessary; should loan growth exceed deposit growth, the effect will immediately begin to show up in XyZ’s trigger ratios. Some examples follow:

• To the extent loan growth is funded from reductions in investments, the LCR would begin declining, eventually breaking through barriers between green and yellow, alerting management to the threat. The threat level guidelines prescribe changes to the business strategy to counter these threats.

• A similar movement would occur to the NSFR, with the ratio breaking the green/yellow barrier, and ultimately the yellow/red barrier. Again, the threat level guidelines prescribe changes to the business strategy to counter these threats.

• The cumulative one-year liquidity gap/asset ratio would begin moving downward, showing the use of liquidity to fund loan growth, eventually breaking through the green/yellow barrier and alerting management.

• Individual funding sources would begin moving in the direction of limits, and overall use of Near-Core and Non-Core Funding would begin moving up away from its goal and in the direction of the policy limit, alerting management to liquidity issues.

• Depending on the relationship between the loan growth rate and the capital growth rate, capital ratios could begin to decline, falling below capital goals which would also alert management of an issue.

Should loan growth exceed Core Funding growth to the extent that it is felt a liquidity or capital threat is developing, the contingency actions in figure 5-20 would be considered.


Figure 5-20 Stress Event Sequence and Responses – Economic Recovery Stress Scenario

38

Event Action

Declines in LCR with the potential of falling to a higher threat level barrier Declines in NSFR with the potential of falling to a higher threat level barrier Declines in the unstressed cumulative liquidity gap/asset ratio with the potential of falling to a higher threat level barrier Increases in individual borrowing category ratios/assets or overall Near-core and Non-Core Funding/assets with the potential of violating policy limits or using funds needed for contingencies Declines in the capital/asset ratio to management threat level points or with the potential to fall below PCA well capitalized minimums

A portion of loan production formerly retained is sold in the secondary markets Pricing and/or increased underwriting standards are used to reduce loan demand In severe situations, loan originations are limited to those necessary to maintain key customer relationships A portion of the loan portfolio is packaged and sold or participated Funding growth, but only to the extent that faster overall asset growth does not represent a threat to the overall capital ratio


Market Dislocation Scenario at XYZ Bank

XYZ BANK CASE STUDy

Figure 5-21 Stress Event Sequence and Responses – Market Dislocation Stress

The Market Dislocation Scenario considers an inability to sell loans originated for sale in the secondary markets, because the securitization markets freeze up, forcing XyZ to hold the loans in its portfolio. The Market Dislocation Scenario is a low probability/high impact event and should normally be dealt with as a stress scenario. In the XyZ case, normal levels of loans in the pipeline in any given month pending sale are $3-5 million. Assuming XyZ chooses to honor verbal commitments to customers where there is not a firm commitment, honor those written commitments to originate that have not yet closed, and deal with loans in the pipeline that are already closed, XyZ’s maximum exposure would be in the range of $15 million or 5% of its balance sheet.

But in calculating its LCR, XyZ management has already run a much more severe 30-day stress test, so a stress test is superfluous. The impact of the Market Dislocation

Scenario is much less severe than the LCR test for the following reasons:

• XyZ is likely to have full access to its Non-Core Funding sources. Under the LCR, it is cut off from all Non-Core sources.

• XyZ is unlikely to see the deposit runoff, since lack of access to securitization markets is unlikely to trigger a deposit run.

• Even though XyZ does not currently pass the LCR test, XyZ has more than enough asset-based liquidity to handle its maximum exposure.

Even so, XyZ’s CFP should describe how management would bring the funding on-line to handle the Market Dislocation Scenario. The series of actions are contained in Figure 5-21.

4

Event Action

Securitization Markets freeze up making it impossible for XYZ to sell loans originated for sale in the secondary markets.

1. Immediately suspend committing to originate loans for sale in the secondary market

2. Determine whether sufficient asset and liability-based liquidity exists to honor verbal non-binding commitments

3. In a manner consistent with maintaining key customer relationships, reduce origination of other loans until this short-term event is resolved

4. To the extent asset growth might cause an undesirable decline in the capital ratio, fund the retained loans using asset-based liquidity

5. To the extent asset growth does not cause a decline in the capital/asset ratio, fund the loans from XYZ Near-Core and Non-Core Funding sources


Payment System Disruption Scenario at XYZ Bank

Figure 5-22 Stress Event Sequence and Responses – Payment Disruption Stress

The Payment System Disruption Scenario is a low probability/high impact scenario brought on by the failure of a processing partner or a local disaster. The duration is limited to a few days. It should normally be dealt with in a stress test; however, the LCR test is much more severe and occurs over a longer duration (30 days). The XyZ Payment System Scenario is less severe for the following reasons:

• While the event could cause a minor deposit outflow as individuals tap into liquidity, the outflow is likely to be much less than in the LCR test.

• XyZ would likely have all of its Near-Core and Non-Core Funding available.

• The level of asset-based liquidity called for in the LCR test is likely to be well above that needed to deal with the Payment System Disruption Scenario without tapping into liability-based liquidity.

Nevertheless, the CFP should describe how XyZ would bring the funding on-line to handle the Payment System Disruption Scenario. The actions to be taken are described in Figure 5-22.

XYZ BANK CASE STUDy

42

Event Action

Short-term payment system disruption occurs causing XYZ to be unable to clear incoming deposit transactions and payments on loans

1. To the extent short-term asset growth creates capital concerns, tap into asset-based liquidity to meet liquidity needs during this stress event

2. To the extent short-term asset growth does not create a capital concern, use a combination of unused borrowing capacity and asset-based liquidity to meet liquidity needs during this stress event







STEP 4 Build Monitoring and Reporting SystemsAs has been discussed all through Tool 5, emphasis has shifted away from static measures in the direction of measures based on a combination of a starting balance sheet and a business plan. The most efficient method for monitoring liquidity risk is to develop a business plan and then test that plan under multiple rate environments and with multiple liquidity stress tests. In an ideal world, you will update your business plan once a quarter – or more often – and use that business plan for liquidity and interest rate testing.

Using a competent ALM model, you can modify the following process to suit your business situation:

❏ Obtain an updated interest rate forecast and load it into the ALM model. A forecasting firm will provide you with three rate forecasts and update on a monthly basis. The highest probability forecast is used as the base forecast.

❏ Download updated Core system and G/L data into the model, defining the starting point as the most recent month-end for which you have data.

❏ Tune the business plan assumptions to reflect what has happened within your institution and in the economy since the last time you updated the business plan. Extend the assumptions by the amount of time that has elapsed since the last time you did a business plan update. The business plan should contain assumptions that will allow you to forecast your balance sheet and income statement at least 2-3 years.

❏ Update key assumptions, such as decay rates on non-maturity deposits and prepayments on loans, to reflect a combination of the current market experience and your base rate forecast.


❏ Once data and assumptions are loaded, run Economic Value of Equity (EVE) tests on your current balance sheet to test value-at-risk in your current balance sheet structure.

❏ Tune the business plan for the highest probability rate environment. Once you feel comfortable with the plan for the base rate environment, run the business plan through the other two rate environments to test how much your income is at risk to changes in interest rates. The horizon you run for income-at-risk testing should be at least two years.

❏ Run the same EVE tests you ran on the current balance sheet in Step 6 on the balance sheet under your base strategy to see what kind of effect the strategy will have on value-at-risk at the end of your horizon.

❏ Review the liquidity gap report and projected key liquidity ratios for the base strategy to determine compliance with liquidity policy limits.

❏ Run the stress tests you have defined for liquidity risk stress testing on the business plan for the base rate environment, reviewing results for compliance with stressed limits.

Outputs – which should include ratio reports – will reveal the following:

• Return (ROE/ROA) in the most likely rate environment

• How much of that income will be at risk under the other rate environments being modeled

The fluctuations in earnings should be compared to your income-at-risk policy limits to determine whether you are inside or outside those limits.

• The value at risk in the current balance sheet

The fluctuations in EVE should be compared to your EVE limits to determine whether you are outside those limits.


• What the business plan will do to your EVE fluctuations

Those fluctuations should be compared to your EVE limits to determine whether your business plan will keep you inside or take you outside your policy limits.

• The trends in trigger ratios and policy ratios like the LCR and other ratios you monitor

Trends in these ratios may call for modifications to the business plan or indicate whether liquidity measures are moving in a favorable or unfavorable direction. Those ratios with policy limits should be compared to limits.

Trends in capital ratios will give you a sense for the effect of the strategy on capital risk. These capital ratio trends will allow you to compare strategy results to capital goals and institution limits as well as to regulatory minimums.

• Trends in the cumulative liquidity gap/asset ratio

Trends in the cumulative liquidity gap/asset ratio should indicate whether you are within or outside your limits and whether the business plan improves or worsens liquidity.

• The cumulative liquidity gap/asset ratios for stress scenarios

The cumulative liquidity gap/asset ratios for stress scenarios should be compared to stressed limits to determine whether the plan is inside or outside limits and whether the ratios improve or worsen as the stress tests unwind. You may also want to track trends in other key liquidity ratios in to uncover any other issues in the set of stressed results.

When you optimize the relationship between multiple kinds of risk and return, you get the most use from the holistic approach. After you run the above reports for a single business plan, you can also produce it for multiple potential business plans you wish to consider. For each you will have the effect of the strategy on multiple measures of risk as well as return.


ALM MODEL: Validation and Liquidity Analysis

Much has been written and discussed within the industry regarding the validation of ALM models for interest rate risk calculations. Incorporating the discipline of cash flow projections and review of maturing funds from the modeling software will help to spot problems with data and inaccurate projections. A regular review of these basic values will help to ensure that the management and board can build reliable strategies and have confidence in the risk levels projected. Too often the results of models are focused on the outputs being measured, and little attention is paid to how those measures are arrived at. An interesting byproduct of using an ALM model for liquidity analysis is that it forces users to look at cash flows. Many times the review leads to discovery of and corrections applied to data being provided to the model. The critical items to measure a result like net income include: volume of assets and liabilities, rates offered, and speed of cash flow repayment. By building our liquidity management system on the backbone of the interest rate risk and planning model, we are achieving several very important goals at once: validity in model data, single source for assumptions and outputs, internal controls on values, to name a few.

Managing Trade-Offs Between Risk and ReturnStrategy decisions have a direct effect on earnings, capital, interest sensitivity, liquidity and other key ALCO objectives, and they cannot be made in a vacuum. Finding the right path toward performance and risk goals is not a one-time process, but rather a series of decisions, made over time, with consideration of market realities, that moves an institution in the direction of strategic goals and objectives. The rolling planning environment enhances an institution’s ability to deal with economic and financial events as they unfold while maintaining consideration of long-range financial goals.


Managing Trade-Offs Between Risk and Return

XYZ BANK CASE STUDy

In the base plan for XyZ, management’s goal is to shrink the bank by using cash flows from the loan portfolio to fund a reduction in Non-Core Funding. Lowering overall dependence on these Non-Core sources should help to lower interest expenses quickly. However, in reviewing the cash flow analysis, XyZ’s business plan is building up significant amounts of cash beyond the amounts needed to pay off maturing brokered CDs and borrowings. That cash flow surplus is invested in HLUM securities. yield on these assets is below the cost of funding, which would lead the ALCO to examine a variety of potential strategies that might be considered before the plan is finalized. The committee is considering three primary choices:

• Continue with the base business plan strategy and reinvest excess cash into securities in an effort to shore up the level of asset-based liquidity.

• Put more effort into lending to quality borrowers, investing the excess cash flow in loans, and trading liquidity risk for return.

• Use the excess cash to replace other funding sources, thereby continuing the effort to shrink liabilities and reduce assets, which would improve ROA and increase the capital/asset ratio through a smaller denominator.

These three options clearly illustrate XyZ’s liquidity management silo.

Figure 5-23 introduces a visual decision matrix as an example of a matrix that can be used to assess risk and return trade-offs between alternative strategies. The numbers on the matrix do not tie directly back to the XyZ case. Rather, they are designed to show how to use a decision matrix as a tool for decision making.

The matrix assumes the institution has developed threat level guidelines for a variety of measures of capitalization, earnings, sensitivity (interest rate risk), and liquidity using the red/yellow/green light system discussed earlier in Tool 5.

Results compare the institution’s Base Business plan strategy with two alternatives, Strategy 1 and Strategy 2. Individual blocks show the numeric values for key metrics and are color coded to show where they fall within the institution’s threat level guidelines.

The Base Business Plan strategy is the least risky strategy from the standpoint of liquidity and interest rate risk, gathering green lights in all measures used in monitoring those two forms of risk. However, earnings are well below investor expectation, gathering a red light for ROA for all three years. Note that red lights for years 1 and 2 would be anticipated as XyZ is working its way through an asset quality problem. The lack of earnings slows capital accumulation, causing all three capital ratios to fall into the yellow light range.


Figure 5-23 Decision Matrix Three-year Forecast

Strategy 1 trades some increase in risk and some additional shrinkage for a higher return and additional capital accumulation. Two of three capital ratios are still yellow, but earnings moves from red to yellow in year 3. One interest rate risk measure falls into the yellow range while the other two are still green. Three of the four liquidity measures drop from green to yellow.

Strategy 2 moves earnings high into the green range in year 3 and all three measures of capital into the green range. But the plan significantly increases both liquidity and interest rate risk, moving two liquidity measures and one interest rate risk measure into the red range.

While such large swings between three strategies in a three-year horizon would be unusual, the changes in Figure 5-23 illustrate a point. It is possible by using threat level guidelines for the measures of risk and return to provide a graphic illustration of trade-offs between strategies.

Once the graphics are in place, the matrix can be used as a decision tool. Most management teams would eliminate the Base Strategy (Return/Capital) and Strategy 2 (Sensitivity and Liquidity) and focus on further tuning Strategy 1 to attempt to move more of the measures into the green range. In doing so they would evaluate a variety of alternative strategies, ultimately settling on the strategy representing the best trade-offs between risk and return.

CAMELS Component Ratio Base Plan Strategy 1Core Capital 8.39% 8.75%

Capital Risk Tier 1 Leverage 8.39% 8.75%Risk Based capital 11.35% 12.07%ROA - Year 1 -1.07% -0.80%

Earnings ROA - Year 2 -0.20% 0.10%ROA - Year 3 0.25% 0.55%Income at Risk -10.55% -18.50%

Interest Rate Risk Current EVE Minimal MinimalForecast EVE Minimal Minimal1 Year Liquidity Gap - Base 16.63% 14.75%

Liquidity Risk 1 Year Liquidity Gap - Stressed 14.97% 9.77%1 Year Liquidity Coverage Ratio 107.50% 102.60%Nr- Non-Core/Assets 28.40% 26.50%







STEP 5 Create an Effective Policy StatementPolicy statements clarify acceptable and unacceptable activities, risk levels and other actions. These statements are made by the Board of Directors as guidelines for management to follow in the day-to-day operation of the institution. Policy statements outline the specific limits and actions allowed/disallowed, and discuss how the limits will be tracked, reviewed, validated and updated. As such, they hold all employees accountable. The liquidity risk management policy may live on its own or be incorporated into other comprehensive risk management policies such as a funds management or ALM policy. In any case, it is crucial that the other policy areas with similar concerns be aligned with the statements and limits.

Corporate GovernanceAs with all policy statements, the primary goal is to establish operating parameters and hold people accountable for performance. Ultimately that oversight is a board role as they must adopt and approve all policies. However, the roles for management versus board must be delineated as the day-to-day operational and market forces require institution management to be in charge of the measures and actions. The following guidelines are provided as a suggested checklist for governance requirements by function.

Board of Directors ❏ Understand the nature of the liquidity risk and develop a sound

process for identifying, measuring, monitoring, and controlling liquidity risk.

❏ Oversee the establishment and approval of liquidity management strategies, policies and procedures, and review them at least annually.

❏ Establish executive-level lines of authority and responsibility for liquidity risk management.

The sample liquidity policy statement for XYZ Bank is located at www.aba.com/ LiquidityToolbox. Note that the focus of the statement is solely on liquidity. It is not intended to represent a complete ALCO policy statement.


❏ Ensure that liquidity risk tolerance limits are established and communicated in a manner that allows all levels of management to clearly understand the institution’s approach to managing the trade-off between liquidity risk and short-term profits.

❏ Understand and periodically review the CFP.

Senior ManagementThe liquidity plan has identified potential liquidity risks events and CFPs and has established a general framework for measuring all risks across the institution. The policy statement should outline expected responses from senior management to events based on the severity of the risk.

❏ Ensure that board-approved strategies, policies, and procedures are appropriately executed.

❏ Oversee the development and implementation of appropriate risk measurement and reporting systems, liquidity buffers, and CFPs.

❏ Create an effective internal control infrastructure.

❏ Stress test the liquidity plan and implement changes to the plan based on the results of the testing.

❏ Report to the board regularly on the liquidity risk profile.

❏ Determine the structure, responsibilities, and controls for managing liquidity risk.

❏ Integrate liquidity costs, benefits, and risk into internal pricing, performance measurement, and new product approval processes for significant business activities.

❏ Monitor liquidity risk for each entity across the institution on an ongoing basis.


StrategiesIn the liquidity management statement, acceptable strategies should be laid out. Strategies should be aligned with approaches towards managing other risks. In addition, it is critical that the policy statement directly discuss the expectations for strategy formation and execution at various levels of risk. Slight policy variances should call for different actions than severe deficiencies. The severity of the risk should be outlined in the establishment of the risk limits section with a corresponding discussion on expectations for measurement and reporting in each case.

❏ Strategies should be well documented.

❏ Strategies should identify primary sources of funding daily operating cash outflows, as well as cyclical cash flow fluctuations.

❏ Strategies should address alternative responses to various adverse business scenarios.

Policies and ProceduresThe main section of the liquidity policy should deal with how plans and actions are to be formulated and carried out. The risk zones identified in the liquidity plan define the majority of these issues. If an institution is involved in multiple currencies, or is a part of a multi-company organization, specific language on how these issues relate to risk measures and actions should be outlined.

Any modeling that is done within an organization requires that the model be validated. The liquidity policy should outline a process for periodically reviewing assumptions that will be followed to ensure that the board is aware of how to measure management’s use of assumptions within the analysis.


Define Periodic Facility TestingThe goal of all of these efforts is to have a plan that can be executed in times of need. Poor documentation ensures poor execution when needed. Well documented but untested plans provide a false sense of security. It is important that as part of the overall documentation process you include a description of your liquidity measurement and monitoring process for the primary and trigger measures and why these measures were selected. As these measures move from green to yellow or red zones, specific actions, including the use of alternative sources of funding, should be outlined.

If an institution’s plan includes the use of external funding sources, such as FHLB advances, loan sales, use of the Federal Reserve Bank discount window, etc., these sources should be periodically tested to understand the process and delivery timing for these sources. Institutions that wait to contact these sources until there is need may find that the counterparty may be slower to execute or reluctant to participate given the lack of relationship with or knowledge of the institution. Potentially higher costs for faster execution may result.

Of course, institutions must strike a balance between testing the facility for access and timing. The overuse of a facility may bring into question accounting treatment for some assets or send a mixed message to shareholders or the market.

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