23 Hoosier Banker July 2015 DIRECTORS / SENIOR MANAGEMENT A bank is a system of interrelated functions. No single part of the balance sheet should be analyzed in complete isolation, as the output of one decision serves as the input for another. This idea is particularly applicable to questions of liquidity and marketability of securities. You can always buy bonds with higher yield, but only if you are willing to accept greater credit risk, more cash flow volatility, or less liquidity. This fundamental tradeoff is not negotiable. Investments and liquidity. Bank portfolio managers should think of the investment portfolio as a storehouse of liquidity and safety, and as a tool for managing interest rate risk in the balance sheet. The portfolio should contain highly marketable bonds, such as those backed by the U.S. Treasury, government-sponsored enterprises or high-grade municipals. These bonds are widely traded in liquid secondary markets. Bonds with private-label names, exotic collateral, or complex structure, and those that “trade by appointment,” should be avoided. At some point these may cause the frustration of illiquidity and the unpleasantness of major price deterioration. In addition to marketability, selection of bonds and bond types that provide reasonably consistent and predictable cash flow is critical. When purchasing a bond or considering alternatives, portfolio managers should take a hard look at the cash flow uncertainty or optionality, as well as the underlying price sensitivity. Some bonds have well-defined cash flow, because they return principal in one lump sum on the maturity date; however, they yield less, due to predictable cash flow. Other bonds have uncertain and dynamic cash flow that ebb and flow with different conditions. These bonds will yield more to compensate for that cash-flow uncertainty. What’s essential, however, is that banks have solid interest rate risk modeling or asset/liability reporting tools for monitoring the dynamics of investment cash flow across a variety of scenarios. A good system will allow for modeling of multiple rate scenarios and curve shift environments, and for the reporting of impact on liquidity. It is also important to understand that the degree of price sensitivity tends to vary directly with the degree of cash flow uncertainty, assuming bonds of comparable credit. In other words, as cash flow volatility increases, the market value of the portfolio will become increasingly volatile, as well. A portfolio consisting entirely of bullet bonds will have a level of price sensitivity or duration that is more or less constant and predictable. It may be high or low, but it will not experience much variation. Bonds with a high degree of cash flow uncertainty, on the other hand, will also carry a good deal of variable price sensitivity, and this price sensitivity is a liquidity consideration. Conclusion. Liquidity comes in several forms. It is a stream of stable and predictable cash flow. It is the ability to quickly convert marketable assets to cash. It is the ability to monetize or borrow against assets, which in turn requires the underlying value of those assets to be known and measurable. These aspects of liquidity should be well measured, monitored and reported, particularly the dynamics of balance sheet or portfolio cash flow. At the end of the day, all aspects of liquidity risk management should be governed by asset/liability policies and prudent investment strategies designed to keep the individual system that is the bank profitable and sound. t Liquidity and Investment Management About the Author Jeffrey F. Caughron is chief operating officer/ managing director of The Baker Group. He has been working in banking, investments and interest rate risk management since 1985, and currently serves as a market analyst and portfolio strategist. His trading experience includes several years on the Treasury desk for an international bank on Wall Street, with subsequent positions trading mortgage-backed securities and other taxable fixed-income products for regional broker/dealers. Caughron has published numerous articles on risk management topics and is quoted frequently in the financial press. A graduate of the University of Oklahoma, Caughron has served on the faculty of several banking schools and has done consulting work for foreign banks. The author can be reached at 800-937-2257, email: jcaughron@GoBaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider.
RkJQdWJsaXNoZXIy MTg3NDExNQ==