Tool 5

Tool 5:
Building a Liquidity Policy Statement

and Contingency Funding Plan
ABAToolb x on Liquidity
ABA 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 fts 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 fgures 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 Offcer for FARIN & Associates
for his assistance in preparing Tool 5.
Tom Farin, FARIN & Associates, Lead Author
Mr. Farin is the author of three separate books on fnancial 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 & Associates
Mr. Koch is the Chief Operating Offcer 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
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employees. The majority of ABAs members are banks with less than $165 million in assets. ABAs extensive resources enhance the success of the nations
banks and strengthen Americas economy and communities.
2011 American Bankers Association, Washington, D.C.
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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 Mario
Susan Einfalt
Mark Tenhundfeld
James Chessen
Ryan Zagone
Mako Parker
Keith Leggett
Donna Fisher
Ellen Collier
Rachaell Davis
Lisa Gold Scheier
Robin Gordon
5
Intro
Introduction to
the ABA Toolbox
on Liquidity
1
Developing an
Effective Capital/
Liquidity Plan
2
Developing a Core
Funding Strategy
Through an Initial
Strategic Review
3
Integrating
Near-Core and
Non-Core Sources
Into Bank Funding
4
Measuring Asset-
based Liquidity
with the Liquidity
Coverage Ratio
5
Developing a
Liquidity Plan
A Process for Dynamic Liquidity Management 1
Step 1: Defne 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 defne 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 Management
The 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 ft 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 fow 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 confdence
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 fows. 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 fow
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 Defne 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 2
Stress Test
the Base Liquidity Plan
STEP 4
Build Monitoring
and Reporting Systems
STEP 5
Create an Effective
Policy Statement
STEP 3
Develop and Test
Contingency Funding Plan
STEP 1
Defne and Build
a Base Liquidity Plan

STEP 1
Defne and Build
A 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 fow. Measurement systems aimed at cash fow-based evaluation of
liquidity consider an institutions most recent balance sheet as well as its
business plan or strategy.
As we move in the direction of cash fow-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 Limits
In 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 suffcient levels of HLUM securities and expected cash fow 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 defne 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.
STEP 2
Stress Test
STEP 4
Build Monitoring
STEP 5
Create an Effective
Policy Statement
STEP 3
Develop and Test
STEP 1
Defne and Build
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 defnes an institutions absolute liquidity exposure
compliance limit. Operation in the red light zone is not acceptable. Should
the institution fnd 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 identifed 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 XYZs current balance sheet,
it could also be calculated for each month or quarter of
XYZs 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 defne actions to be taken as severity of the shortfall
increases.
As fgure 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 modifcations
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
defne 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 institutions exposure zone limit
defnitions constitute a key and signifcant 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 fgure 5-1, more
immediate modifcations 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

12-Month Liquidity
Gap/Asset Ratio
=> 10% Green 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 Limits
Management 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 ratios calculation is defned 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 diffcult to
reach the green zone in all your threat level guidelines. We recommend you
pick the four or fve 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 Ratio
The 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 suffcient medium- and long-term funding to support an institutions
assets, should an extended, bank specifc 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 profles 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 suffcient 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 Dependence
Non-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 Ratio
The loans/deposits ratio was originally designed to measure how much of
the institutions 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 refects what portion of the banks 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/Assets
Trends 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 defning 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 frms.
Noncurrent Loans/Gross Loans and
Noncurrent Assets plus Other Real Estate Owned/Total Assets
Measuring the level of noncurrent loans/gross loans is an indicator of
potential cash fow 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 Assets
Poor 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 Limits
The above ratios provide a good evaluation of the structure of the balance
sheet, but to get a picture of current and prospective cash fows, 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 institutions 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 fows 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 institutions liquidity resources.
A sources and uses forecast measures the cash fows occurring within the
institutions plan in order to see the impact on the overall liquidity position.
A sources and uses report generally looks at the cash fows month by month
for at least three months and then quarterly over a specifed 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 institutions ALCO
or Board.
funds (maturities and cash fows 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 diffcult 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 fow. Either approach will work as they will
both lead to the same summary results.
Asset Sources and Uses
In 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 institutions 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 fow 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
infow 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 fxed 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/ Ending
Year 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/ Ending
Year 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 Asset
Year 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)
XYZ Bank
Forecast 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 fve-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
suffcient to cover cash fows 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
fows) by an amount suffcient 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 frst quarter
of its business plan, another $4 million in the second
quarter, an additional $5 million in the 5th quarter and
a fnal $4 million in the 9th quarter of the plan.
XYZs capital plan calls for it to reduce the size of the
loan portfolio by 12% in 2010. That means that in 2010,
cash fows from the loan portfolio (liability sources)
should exceed loan originations (liability uses) by an
amount suffcient 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 XYZs
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 frst 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.
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)
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)
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
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)
XYZ Bank
Liability Sources and Uses
Liability 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 outfow offset by new non-
maturity deposits being booked. Other models assume that in each period
being analyzed, all funds are immediately available for outfow and infow.
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 frst
or second analysis infate the total cumulative sources and uses relative to the
third method, since the assumed cash fows are counted each period as both
a source of funds and a use of funds.
Term liability uses consist of outfows 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 infate the total
cumulative sources and
uses, since the assumed
cash fows are not
counted each period as
both a source of funds
and a use of funds.
XYZ BANK CASE STUDY
Liability Sources and Uses
On 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 outfows on the Liability
Sources and Uses Report (Figure 5-11) shows a net
equity outfow 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 XYZs 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/ Ending
Year 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 Net
Year 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 Ending
Year 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 Ending
Assets 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 Ending
Rate 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%
2014 2013 2012 2011 2010 2009 2008 2007
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
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)
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)
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 Bank
Forecast Cash Flow Liquidity Report - Liabilities & Capital
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
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)
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)
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
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 Bank
Identifying Liquidity Gaps
The Liquidity Gap section of a Sources and Uses report often begins by
reviewing whether the net cash fows between assets and liabilities is adding
to or reducing institution liquidity. To calculate cash fows 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 fow surplus or defcit. (On a fnancial 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 fow 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 fows. 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 outfows exceed infows,
may cause erosion in an institutions liquidity position by using up available
borrowing capacity or eating into the institutions stock of HLUM securities.
Setting Liquidity Gap Policy Limits
Graduated risk levels are also appropriate to use with liquidity gap analysis.
Policy limits that focus on sources and uses analysis should refect cash
fows 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 Bank
The top portion of Figure 5-12 looks at the net cash fows
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 fow surplus or defcit for the
quarter. Cash fow surpluses or defcits are shown on
a cumulative basis on Line 6. XYZ shows a cumulative
cash fow surplus (sources less uses) of $5.89 million
over the three years of its business plan.
XYZs 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 fow surplus of $4.763 million
for the frst 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 fow defcit
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 fow defcit.
However a portion of the cash fow defcit is due to the
purchase of $4 million of HLUM securities in the second
quarter (Figure 5-9) so only a portion of the defcit 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 frst 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 fow
surpluses adding to the Fed Funds Sold position and
additional purchases of HLUM securities, adding to XYZs
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 identifed that RSA/RSL
really didnt 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 infows
from Section 1, adding changes in the overnight position,
adding HLUM securities (net of cash fows occurring in
the quarter), and adding unused borrowing capacity.
The sum of the frst four lines of Section 2 shows total
available sources of liquidity on Line 5. Total outfows are
then brought down from Section 1. Total liquidity gap for
each period is calculated by subtracting outfows from
total liquidity sources. The total liquidity sources/uses
ratio is calculated by dividing total liquidity sources by
outfows. 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 infows
and outfows are on a cumulative basis. It is important
in calculating cumulative ratios to only accumulate cash
fows 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.
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%
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)
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 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 Bank
Forecast Cash Flow Liquidity Report - Liquidity Gaps and Ratios
In XYZs case, there is a cash fow 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 XYZs 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 fow 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 refects
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
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
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)
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
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)
XYZ Bank
Forecast Cash Flow Liquidity Report - Liquidity Gaps and Ratios
XYZ BANK CASE STUDY
Setting Liquidity Gap Policy Limits at XYZ Bank
Figure 5-13 is an illustration of proposed threat level
ranges for XYZ. Will the specifc ranges stated in the
policy be suffcient 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 frst 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 XYZs 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, XYZs 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 XYZs capitalplan proactively
addressed liquidity risk by increasing HLUM securities
and reducing reliance on Non-Core Funding.
Is the transformation suffcient for regulators to sign
off on the plan? Before addressing that question, XYZ
management frst needs to determine whether its red/
yellow/green light ranges provide suffcient liquidity to
deal with liquidity stress events: management needs to
stress-test the plan.

< 100% Red Light

12-Month Liquidity
Gap/Asset Ratio
=> 15% Green Light
within 6 months
< 10% Red Light
to yellow

12-Month Liquidity
Gap/Asset Ratio
=> 10% Green Light
to quarterly
< 0% Red Light

Figure 5-13 Liquidity Gap Policy Limit
STEP 1
Defne and Build
STEP 2
Stress Test
STEP 4
Build Monitoring
STEP 5
Create an Effective
Policy Statement
STEP 3
Develop and Test

STEP 2
Stress Test
The purpose of a stress test is to determine whether an institution has
suffcient liquidity to survive a severe liquidity stress. As part of the stress test,
modifcations are made to the cash fow assumptions in the business plan to
implement the test.
XYZ: Four Stress Scenarios
In Tool 1, XYZ management defned 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 Tests
A 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 frst 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 XYZs
asset quality problems. It is likely to see signifcant PCA
and CAMELS downgrades in its upcoming examination,
scheduled in the next quarter.
For purposes of stress testing, XYZ management assumes
that the scenarios frst three-month phase has already
happened. The second three-month phase will play out
in the frst 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 refect the asset side of the Capital Scenario stress
event. This asset cash fow report is a stressed version
of Figure 5-9 on pages 12-13. The adjustment to the
Figure 5-9 cash fows assumes the following:
After the frst 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 fows mature to maintain the size of the
investment portfolio at current levels.
Loan infows are cut to 85% of current levels,
refecting a slowdown of prepayment speeds and
a slowdown of cash fows from collections of
scheduled payments.
Loan outfows are trimmed to 80% of current
levels in the frst 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 refect 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 modifcations result in a cumulative total
of $31.4 million of net funds infows in Year 1 (loan cash
fows less originations), $16.8 million in Year 2, and
$14.0 million in Year 3, compared with net infows in
the base business plan (Figure 5-9) of $27.6 million in
Year 1 and $7.8 million in Year 2. A net outfow of $5.5
million was anticipated in Year 3 of the base strategy.
Capital Scenario Assets
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
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
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
Capital Scenario Stress Test
XYZ Bank
Figure 5-14 Capital Scenario Timeline
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
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
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
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 modifcations to
cash fow 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 outfow results
in a $17.6 million use of funds over the three-
year forecast. This outfow 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 outfows 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)
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
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)
XYZ Bank
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)
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
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)
XYZ Bank
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 outfow 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 outfows (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
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
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
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 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
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
XYZ Bank
Forecast 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 frst section
of Figure 5-17 indicates that a very signifcant cash
fow defcit 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 fuctuates mildly, staying in the same general range
through the 12th quarter of the forecast. The cash fow
defcit builds rapidly at frst, as wholesale brokered CDs
run off the books in the frst 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 fow mismatches.
As Section 3, Line 2 of Figure 5-17 indicates, cumulative
changes to the overnight position match the cumulative
cash fow defcit 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
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
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 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
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
XYZ Bank
Forecast Cash Flow Liquidity Report - Liquidity Gap & Ratios
For the purpose of these projections, suffcient 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 XYZs 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
frst 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 frst quarter to 17.44%
by the end of the three-year forecast.
XYZ BANK CASE STUDY
Establishing Stress Test Policy Limits and Assessing Compliance
XYZs 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 XYZs available FHLB borrowing capacity
has been allocated to its term advance portfolio, due to
increased collateral haircuts. Since the FHLB is XYZs
only source of collateralized overnight funding, it is likely
XYZs 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

< 100% Red Light

12-Month Liquidity
Gap/Asset Ratio
=> 15% Green Light
within 6 months
< 10% Red Light
to yellow

12-Month Liquidity
Gap/Asset Ratio
=> 10% Green Light
to quarterly
< 0% Red Light

STEP 1
Defne and Build
STEP 2
Stress Test
STEP 4
Build Monitoring
STEP 5
Create an Effective
Policy Statement
STEP 3
Develop and Test

STEP 3
Develop and Test
the Contingency Funding Plan
Historically, 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 fnancial 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 managements 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
identifed 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
identifed for XYZ is the Economic Recovery Scenario.
At a minimum, these scenarios should be reviewed and updated every year to
refect the changing market and institutional conditions. Regular updating
ensures the CFP refects 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 defne 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 refect 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 ffth 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 XYZs 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 fgure 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 frm commitment, honor those written
commitments to originate that have not yet closed, and
deal with loans in the pipeline that are already closed,
XYZs 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 superfuous. 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, XYZs 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
outfow as individuals tap into liquidity, the
outfow 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 1
Defne and Build
STEP 2
Stress Test
STEP 4
Build Monitoring
STEP 5
Create an Effective
Policy Statement
STEP 3
Develop and Test

STEP 4
Build Monitoring
As 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 effcient 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 frm 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,
defning the starting point as the most recent month-end for which
you have data.
Tune the business plan assumptions to refect 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 refect 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 defned 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 fuctuations 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 fuctuations 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 fuctuations
Those fuctuations 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 modifcations 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 fow
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 confdence 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 fows. 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 fow 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 Return
Strategy 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 institutions ability to deal with economic and fnancial events as they
unfold while maintaining consideration of long-range fnancial goals.
Managing Trade-Offs Between Risk and Return
XYZ BANK CASE STUDY
In the base plan for XYZ, managements goal is to shrink
the bank by using cash fows 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 fow analysis, XYZs business plan is building up
signifcant amounts of cash beyond the amounts needed
to pay off maturing brokered CDs and borrowings. That
cash fow 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 fnalized. 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 fow 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 XYZs 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 institutions 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
institutions 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 signifcantly 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 1
Core 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 Minimal
Forecast EVE Minimal Minimal
1 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 1
Defne and Build
STEP 2
Stress Test
STEP 4
Build Monitoring
STEP 5
Create an Effective
Policy Statement
STEP 3
Develop and Test

STEP 5
Create an Effective
Policy Statement
Policy 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 specifc 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 Governance
As 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 institutions approach to managing the trade-
off between liquidity risk and short-term profts.
Understand and periodically review the CFP.
Senior Management
The liquidity plan has identifed 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 profle.
Determine the structure, responsibilities, and controls for managing
liquidity risk.
Integrate liquidity costs, benefts, and risk into internal pricing,
performance measurement, and new product approval processes for
signifcant business activities.
Monitor liquidity risk for each entity across the institution on an
ongoing basis.
Strategies
In 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
defciencies. 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 outfows, as well as cyclical cash fow fuctuations.
Strategies should address alternative responses to various adverse
business scenarios.
Policies and Procedures
The main section of the liquidity policy should deal with how plans and
actions are to be formulated and carried out. The risk zones identifed in
the liquidity plan defne the majority of these issues. If an institution is
involved in multiple currencies, or is a part of a multi-company organization,
specifc 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 managements use of assumptions within the analysis.
Defne Periodic Facility Testing
The 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, specifc actions,
including the use of alternative sources of funding, should be outlined.
If an institutions 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 fnd 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.
1120 Connecticut Avenue, NW | Washington, DC 20036 l aba.com | 1-800-BANKERS

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