Advanced Liquidity Management & Funding Strategies for Credit Unions
Meet withdrawal demands, fund loan requests and manage unexpected financial stresses without compromising financial health.
Effective liquidity management is crucial for credit unions to ensure they can meet their financial obligations and support member needs, especially during periods of economic uncertainty. As consumer-focused institutions, cooperatives must balance the dual goals of maintaining liquidity and providing competitive products and services. The evolving landscape, characterized by regulatory changes, technological advancements and shifting market dynamics demands that depositories adopt advanced liquidity management strategies to remain resilient and competitive.
In recent years, the financial services industry has faced several challenges, including changing and volatile interest rates, COVID induced stimulus and increased competition from fintech companies. These factors have heightened the importance of robust liquidity management practices. Effective liquidity management ensures that institutions can continue to meet withdrawal demands, fund loan requests and manage unexpected financial stresses without compromising their financial health.
Starting With ALM
Advanced liquidity management begins with developing accurate and comprehensive Asset-Liability Management (ALM) models. These models are essential for projecting cash flows and ensuring that a credit union can meet its short-term and long-term obligations. To produce meaningful cash flow projections, financial models must incorporate complete data and sensible assumptions. Calculating meaningful cash flow projections through a robust financial model is where best practice ALM and best practice liquidity management collide. Incomplete data (not complete enough to describe the complexity of the asset) and weak financial models (non-option adjusted, no prepayment model, etc.) put balance sheet managers at a disadvantage when it comes to ALM and producing meaningful cashflow analysis.
Regularly Stress Testing
Along with accurate financial modeling, the last few years have highlighted the need for and importance of stress testing. Stress testing or scenario analysis is vital to understand how different scenarios can impact an institution’s liquidity position. Financial managers should regularly conduct stress tests that evaluate the effects of changes in interest rates, yield curve shifts, spread widening and narrowing, as well as deposit disintermediation. The risks to earnings and economic firm value usually measured in a “what if” framework also impact liquidity management. A market liquidity event like the one we witnessed at the beginning of COVID widened securitized yield spreads, temporarily straining the ABS market and making it very difficult to execute a transaction. Many institutions using their balance sheets to warehouse loans were temporarily stuck with those loans until that market normalized.
Understanding Funding Sources
Scenario analysis will emphasize that relying on a single funding source can expose institutions to significant liquidity risk. To enhance stability, depository institutions should identify and utilize a range of funding sources. Potential options include:
Utilizing the Investment Portfolio
In addition to the various funding sources above, a credit union’s investment portfolio (a store of liquid assets) can provide liquidity to the institution through regular cash flows, maturities, sales, or by pledging securities as collateral for borrowings, repurchase agreements or other transactions such as dollar rolls. Maintaining a high quality, diversified securities portfolio of liquid and easily financeable assets is a best practice for advanced liquidity management. In the high credit quality space liquidity profiles can vary quite a bit so rank ordering assets by this measure is always a good idea. For example, 15- and 30-year Mortgage Backed Securities (MBS) will generally finance better than 10- and 20-year pools simply because they are To Be Announced (TBA) screen priced and more directly eligible for dollar roll financing. The same can be said for Agency Collateralized Mortgage Obligations (CMOs), express your position in the Agency MBS space using 15- and 30-year collateral, all else equal, before using Agency CMOs. Obviously, non-agency MBS and investment grade credit will finance in the reverse repo market but at spreads to SOFR wider than Agency securities and with larger haircuts.
Planning for Unplanned Events
Credit unions will make funding decisions based on unplanned events; a Contingency Funding Plan (CFP) is a critical tool for managing liquidity risks during unplanned events. Funding and investment strategies that are concentrated are at a greater risk of being disrupted by adverse events. A CFP outlines the steps an institution will take to secure funding during these periods of stress to ensure concentration does not occur. A well-developed CFP will include a list of available funding sources, triggers for activation, establish clear lines of responsibility, and articulate clear implementation and escalation procedures. Financial institutions should customize their CFP based on the liquidity risk profile of the institution and identify the types of stressors that their institution might face. Managers should be regularly reviewing and testing their CFP to ensure it is effective and relevant to the institution and can withstand a stressed environment. Testing the plan can include drawing on a contingent borrowing line and operational testing to ensure the funds are available when needed.
Continually Enhancing, Effectively Navigating
Advanced liquidity management and funding strategies should ensure that a credit union is able to maintain a level of liquidity sufficient to meet its obligations in a timely manner and support members effectively. A depository’s best practices should reflect their ability to manage unexpected changes in funding, as well as changes in market conditions that impact their ability to liquidate assets. By leveraging meaningful cashflow projections from financial models, conducting comprehensive stress tests, ensuring access to diversified funding sources, managing a high-quality investment portfolio and developing a detailed CFP, credit unions can continue to enhance their liquidity management practices and effectively navigate unplanned market events.
Robert Perry is Principal for ALM First Financial Advisors in Dallas, Texas.
Savanah Hall is Director, Balance Sheet Strategy at ALM First in Dallas, Texas.