ALM Notes #2: Liquidity Premiums Revisited

Role of FTP

FTP serves two primary purposes—it guides business line decisions by setting parameters on what is profitable, and it is used to make sense of line of business reporting. FTP is used to help originators of loans and deposits know whether they are creating value for the institution and, if so, how much. In this context, FTP guides responsible business managers to take actions that add value while avoiding value destroying actions. FTP also is the basis of a meaningful record of contribution for business lines, more so than traditional accounting results. Simply, as evident in the most extreme cases, businesses that focus largely on loan generation or, alternatively, deposit generation will have meaningless financials without FTP.

The Need for Liquidity Premiums

Liquidity premiums, in theory, represent the cost of funding the institution for a specific term through the wholesale (non-customer) markets. If retail banking, for example, can generate funding for the same term at a lower all-in cost than wholesale funding, then this activity is valuable for the institution. Conversely, if lending lines of business want to make medium and long-term loans, these businesses should expect to pay for the liquidity they are using. Without liquidity premiums, deposit generating businesses would be under-compensated and lending businesses that tie up liquidity would be under-charged.

Liquidity Premiums Today

Since the global financial crisis in 2008-09, the consensus practice is a direct pass-through of the market cost of liquidity. Generally, this is calculated with some combination of bank term debt, brokered CDs, FHLB funding, and/or market benchmarks for bank debt. What liquidity curve to use matters and can create competitive advantages and disadvantages for an institution’s business lines. The primary principle for choosing relevant market rates is to identify the rate or rates which reflect the marginal cost of funds generated through treasury from non-customer sources.

Choosing the FHLB Advances curve or brokered deposit rates tend to advantage lending businesses over deposit taking businesses, as these curves track closely to U.S. Treasury rates due to their implicit or explicit government guarantees. Conversely, unsecured bank debt (e.g., bank notes) will tend to advantage deposit taking over lending businesses as these rates are generally higher than FHLB Advance and brokered deposit rates. However, there is no right answer, but the implications on business line actions should be understood.

Suggested Liquidity Premium Refinements

Adjusting the liquidity premium may be valuable.Themarket cost of liquidity is not always what a bank should pay. Unlike capital issuance which occurs infrequently, transactions that source and use liquidity occur daily, so an institution is subject to the market cost of liquidity daily. However, like capital, the institution should have a point of view on whether it is a good time to “purchase” or “sell” liquidity. This timing decision is a function of two primary factors—the market cost of liquidity and the institution’s liquidity profile. We have discussed the market cost of liquidity which is the same for all institutions of equivalent credit risk status. However, the liquidity profile of an institution is separate from its credit risk profile. Two institutions with the same credit rating could have very different needs for liquidity.

For example, if two institutions had equal access to liquidity sources at the same price, but one institution had excess liquidity as evidenced by a loan-to-deposit ratio of, say, 0.60, and another institution needed liquidity with a loan-to-deposit ratio of 1.20, they should have very different views on what they would be willing to pay to add liquidity. In fact, the first institution should be a seller of liquidity to the second institution.

One way of handling this difference is to add a gearing factor to the market cost of liquidity instead of a direct pass-through of the market cost of liquidity into the FTP calculation. Banks with excess liquidity like the one above at 0.60 loan-to-deposits may want to use a factor of 0.60 times the market cost of liquidity for its liquidity premium. As the loan-to-deposit ratio increases, the factor should increase as well. To carry this example through, when the loan-to-deposit ratio equals 1.00, then the factor for the liquidity premium could be 1.00, and as it increases to a1.20 loan-to-deposit ratio, the factor could increase in lockstep to 1.20. This will result in a liquidity premium which translates the market cost of liquidity into the value of liquidity specific to each bank.

In the case of liquidity premium spikes, this gearing approach will mute the spike if the bank already is liquid. For banks that need liquidity, which was the case for most institutions in 2008-09, the liquidity premium gearing will accentuate the spike and likely result in a severe slowing of lending and an increase in deposit taking. Separately, the spikes which occurred during this downturn were weeded out of calculations where their influence was felt over time (e.g., in liquidity tractors on non-maturity deposits.)

For each of these situations, this approach will result in aligning the bank’s stated value of liquidity with its actual liquidity situation. This communicates to the lines of business when the institution wants to “sell” liquidity by making more loans and, conversely, when it wants to “buy” liquidity by paying more for deposits with the higher liquidity premium.

Concluding Remarks

Calculation and use of liquidity premiums in FTP have gone through significant evolution. The one-size-fits-all tool of direct pass-through of the market cost of liquidity should be refined to achieve outcomes more in line with a financial institution’s balance sheet position. With this recognition in place, business lines in coordination with treasury will be guided to achieve better overall results.