In the banking industry liquidity has become the topic of the moment. What is liquidity in banking? Ask any banker and they will give you a different definition. It can be anything from providing day-to-day funding for the operations of the bank to the ability to pay off the depositors if the bank is liquidated. These two ends of the spectrum view the assets and liabilities of the bank in a very different light. As an example, cash in a bank appears to be very liquid. Cash is indeed liquid if the bank is to be liquidated, but if the bank is an ongoing concern, cash may the one of the least liquid of its assets because part of cash is being held to meet the regulatory reserve requirements behind the transactions accounts of the bank.
On the liability side of the balance sheet liquidity may be defined as the stability of the funding to the bank for on-going operations. Although many believe that this stability can be defined in customary terms like “core” deposits, the definition of core is up for debate. It is out-dated thinking to believe that the traditional definitions of core are still applicable. Take for instance under $100,000 certificates of deposit. Although the maturity of these deposits may be very short (usually under 1 year), they are still often considered by many to be a core, stable source of funding. Nothing could be further from the truth. With the ability of bank customers to move their money easily from one institution to another anywhere in the United States and even the world, these under $100,000 certificates of deposit will oftentimes at maturity go to the “highest bidder” rather than to the customer’s current bank. At the same time, a brokered certificate of deposit (often referred to as a non-core deposit) with a longer term maturity may have an even greater stability than the typical short-term under $100,000 certificate of deposit.
Most regulators are still slow to pick up on this last nuance of brokered deposits. All brokered deposits are placed in a bucket of being a very volatile source of funding. Rather than looking at maturity structure of these deposits, the fact that they are “brokered” makes them non-core. An argument can be made that in today’s market, all certificates of deposit within a certain length of maturity are volatile. It is up to the bank to set its comfort level for maturity to determine which of the deposits are volatile and those that are stable and that is the key factor in determining the volatility of funding in the bank.
All of this discussion of liquidity ties into the bank’s loan pricing. To the extent the bank is pricing its loans on a “duration matched” basis, the length of funding is extremely important. If this concept of monitoring the amount of duration matched assets to that of the liabilities, the level of interest rate and liquidity risk can be monitored and controlled. This is one more reason why a good loan pricing model, using duration matching is important to the banker of today.
Phill Rowley