28 Hoosier Banker October 2016 DIRECTORS / SENIOR 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, 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 faculties 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. Every banker knows that liquidity has a tendency to ebb and flow with changing market conditions. As a rule, liquidity rises and falls inversely with the general trend and direction of interest rates. The ability to reasonably project the behavior of balance sheet cash flows, and therefore liquidity, is critical to sound asset/liability management processes. Some banks have relatively simple balance sheets that experience very little cash flow volatility. Other institutions are much more active and dynamic, including off-balance sheet transactions and financial instruments with high degrees of optionality or cash flow uncertainty. In general it is the magnitude of this cash flow volatility that can result in undesirable levels of liquidity risk and financial performance. Among other effects, extreme variation in balance sheet cash flows can result in volatile measures of economic value of equity (EVE). Identifying the Need Three points of focus help to determine the degree to which institutions should have access to cash flow-level interest-rate risk reports and simulation analysis: wholesale funding, off-balance sheet commitments and options risk. Banks that make heavy use of wholesale funding sources including brokered deposits or advances, for example, and those that have a high percentage of “non-core” funding generally are certainly candidates for robust cash flow analysis and reporting. Also, off-balance sheet funding commitments would trigger a need for such tools. Perhaps the most notable characteristic that would call forth a need for such cash flow analysis is a high degree of options risk, particularly in assets. Options risk entails uncertainty with respect to cash flow. Cash flow projections and therefore liquidity forecasts become more difficult, since it cannot be predicted precisely when principal will return to the balance sheet for reinvestment or redeployment. In short, bank balance sheets that contain a high level of options risk should make a greater effort to analyze and monitor those cash flows. Measuring and Reporting A critical aspect of dynamic cash flow analysis is the development and modeling of assumptions. The analysis must project the response or Asset/Liability Management: Modeling the Dynamics of Liquidity
RkJQdWJsaXNoZXIy MTg3NDExNQ==