Looking at funding concentrations and the net non-core funding dependence ratio makes sense conceptually but can easily break down in practice.
This was excerpted with permission from Plansmith’s whitepaper, “Risk Measurements: The Good, The Bad and The Ugly.”
The four most commonly used liquidity measurements are the liquidity ratio, cash flow modeling, the net non-core funding dependency ratio and funding concentrations. Can you guess which among these is “the good,” which is “the bad,” and which is “the ugly?”
If you said, the good ones are the liquidity ratio and cash flow modeling, you are correct! For more details on these good measures, please see our full whitepaper. Another good resource for credit unions looking at liquidity is the liquidity section of the National Credit Union Administration’s examiner’s guide.
The “bad” measure listed here is funding concentrations. Why I think it is bad may not be immediately apparent. Monitoring funding concentrations is extremely valuable and should be part of any sound funds-management program. All credit unions should monitor their sources of funds, understand the risks of each source and set targets for their funding composition. Furthermore, institutions using non-core funding sources should also set individual and aggregate limits for their use. Where “the bad” comes into play is with the liberties regulators sometimes take with what should be considered as non-core funding sources.
For the most part, both credit union managers and examiners agree that non-core funding sources include brokered deposits, internet deposits, correspondent and Federal Home Loan Bank borrowings, and in some cases, large or uninsured deposits. However, examiners have recently expanded the traditional view of non-core liabilities and coined a new term, “potentially volatile funding sources.”
Not only has the guidance for this calculation been limited, but its application has been extremely inconsistent, and there is no clear formal guidance as to what should be included as a PVFS. Perhaps even worse, examiners are often including what they consider to be “high-rate deposits” in the calculation. Again, in concept, monitoring the level of deposits that may be purely “rate driven” (and thus, volatile) is extremely relevant when assessing funding risk. However, the big question is “What is a high rate deposit?” That is, what is the rate threshold that makes it high rate? There is no clear guidance for this, which allows for a lot interpretation by examiners.
So, what should you do about it? If you’re not already doing it, I’d suggest that you start closely and regularly (at least quarterly) monitoring your funding composition and set limits for individual and aggregate funding source concentrations. Regulators expect that, and it’s part of a sound liquidity management program.
Second, you should find a reliable source to track deposit rates in your market. That might be as simple as anonymously calling those banks and credit unions or finding a good market or internet source. Be sure that your source includes deposit promotions and not just standard rates (many national rate services do a poor job of getting promotional deposit rates). I’ve found that depositaccounts.com is a very good source, depending on what geographic market you’re in.
Lastly, you should use the results of the rate survey to either specifically track deposits categories where you pay above market rates, or at least use that information to estimate what portion of your deposits could be considered PVFSs and the resulting impact they have on your liquidity risk profile.
And that brings us to “the ugly”—the net non-core funding dependence ratio, which is included in the National Credit Union Administration’s AIRES program, but not its Financial Performance Reports. (Some credit unions don’t use this ratio since they don’t typically take non-member deposits or borrow.)
To understand why this ratio is so awful (and why you should care), we’ll dive a bit deeper into how it’s calculated and what impact it has when examiners assess your level of funding risk.
The definition for the ratio is “non-core liabilities less short-term investments divided by long term assets.” Here are definitions of the key terms:
- Non-core liabilities equal the sum of total time deposits of more than $250,000, other borrowed money, foreign office deposits, securities sold under agreements to repurchase, federal funds purchased and insured brokered deposits less than $250,000.
- Short-term investments equal the sum of interest-bearing bank balances, federal funds sold, securities purchased under agreements to resell and debt securities with a remaining maturity of a year or less.
- Long-term assets equal the sum of net loans and leases, loans and leases held for sale, held-to-maturity securities and available-for-sale securities, less debt securities.
The ratio is meant to determine if your credit union is using non-core (volatile) liabilities to fund long-term assets—that is, if you have more non-core liabilities than short-term investments and, if so, how much of your long-term assets that imbalance represents. Obviously, if you are using volatile funding sources (i.e., funding sources that could go away) to fund long-term assets, and you lose access to those funding sources, you could have a real liquidity problem.
So, at its basis, the purpose of the ratio makes complete sense. However, the calculation methodology is so flawed that its results are often completely meaningless. Worse yet, all too frequently examiners use the ratio as one of the few key measurements they consider when assigning the liquidity rating.
What’s wrong with the way this ratio is calculated?
First, it considers all CDs over $250,000 as noncore. As any CFO knows, some of the most stable deposits are often CDs with balances over $250,000. Those frequently include CDs of directors and/or CDs held as collateral for loans. In those cases, it would seem clear that those deposits are, in fact, core deposits, and do not increase funding risk, regardless of their balance.
Second, it ignores term structure/maturities of the “noncore” sources. As noted above, this ratio includes all non-core liabilities, regardless of their maturity. As such, you could have a five-year brokered CD, or even a 10-year non-callable FHLB borrowing, and the ratio would consider both to be “non-core” funding sources. You should certainly be aware of when such liabilities mature, and consider that in your assessment of funding risk. However, automatically considering them to be non-core funding sources, and then by default, liabilities that increase funding risk, is short-sighted and inappropriate.
Third, it only includes investments with maturities of less than a year. This is perhaps the most egregious weakness of the ratio. As we just pointed out, the ratio definition considers the noted liability categories, regardless of their maturities, to be non-core. However, it only measures the extent to which investments maturing in less than one year cover all non-core funding sources (regardless of their maturities, as just discussed in the second point). As such, the ratio would not give you credit for a Treasury note maturing in 366 days, but one maturing in 364 days would be included. It would seem far more appropriate to include any unencumbered marketable security at its market value. That is, why should maturity have any relevance if it could be sold or pledged to get cash to pay off a maturing non-core liability?
Fourth, it ignores pledging, or securities that are pledged to secure deposits/shares. This typically occurs for members/depositors with funds in excess of the insured amount and is something credit unions are allowed to do, but not all actually do.
All short-term investments are included, regardless of if they are pledged. So, going back to our example in the third point, you could have a security maturing in 364 days that is fully pledged, and the ratio would consider it as an offset to the non-core liabilities. However, a completely unencumbered bond (not pledged) maturing in 366 days would be excluded from the calculation (because it matures in more than one year).
Fifth, it fails to include many liabilities that are, in fact, volatile in nature (which actually understates risk in many cases). Examples of liabilities not included as “non-core” by definition are internet/listing service CDs under $250,000 and high-rate deposits under $250,000. In many cases, these CDs are “rate-driven” and likely to leave the institution if competitive rates are not paid. As such, it would appear that these deposits are non-core by nature and, in turn, increase funding risk.
It’s almost certain that competition for deposits will further intensify, which will require comprehensive deposit monitoring and funding concentration management strategies. It’s critical that all credit unions have a sound grasp on their liquidity levels and funding composition. Managing on- and off-balance sheet liquidity has a material impact on both profitability and funding risk. Striking the proper balance (an effectively managing that position) is more important now than ever.
Dave Wicklund is director of educational & advisory services at CUES Supplier member Plansmith, Schaumburg, Illinois.