Devoted to Advancing the Practice of Bank SupervisionVol. 14, Issue 1 InsideCommunity Bank Liquidity Risk: Trends andObservations from Recent ExaminationsThe Bank Secrecy Act: A Supervisory UpdateRegulatory and Supervisory RoundupSummer 2017
Supervisory InsightsSupervisory Insights is publishedby the Division of Risk ManagementSupervision of the Federal DepositInsurance Corporation to promotesound principles and practices forbank supervision.Martin J. GruenbergChairman, FDICDoreen R. EberleyDirector, Division of Risk ManagementSupervisionJournal Executive BoardDivision of Risk ManagementSupervisionGeorge E. French, Deputy Director andExecutive EditorJames C. Watkins, Senior DeputyDirectorMartin D. Henning, Deputy DirectorMaureen E. Sweeney, Deputy DirectorDivision of Depositor and ConsumerProtectionSylvia H. Plunkett, Senior DeputyDirectorJonathan N. Miller, Deputy DirectorRegional DirectorsMichael J. Dean, Atlanta RegionKristie K. Elmquist, Dallas RegionJohn R. Jilovec, Acting RegionalDirector, Kansas City RegionJames D. LaPierre, Acting RegionalDirector, Chicago RegionKathy L. Moe, San Francisco RegionJohn F. Vogel, New York RegionJournal StaffKim E. LowryManaging EditorAmanda M. LeeFinancial WriterMichael T. RegisterFinancial WriterSupervisory Insights is available on-lineby visiting the FDIC’s Web site atwww.fdic.gov. To provide comments orsuggestions for future articles, requestpermission to reprint individual articles,or request print copies, send an e-mailto SupervisoryJournal@fdic.gov.The views expressed in Supervisory Insights arethose of the authors and do not necessarily reflectofficial positions of the Federal Deposit InsuranceCorporation. In particular, articles should not beconstrued as definitive regulatory or supervisoryguidance. Some of the information used in thepreparation of this publication was obtained frompublicly available sources that are consideredreliable. However, the use of this information doesnot constitute an endorsement of its accuracy bythe Federal Deposit Insurance Corporation.
Issue at a GlanceVolume 14, Issue 1 Summer 2017Letter from the Director 2ArticlesCommunity Bank Liquidity Risk: Trends and Observations from Recent Examinations3FDIC examiners recently have observed liquidity stress at a small number of banks. Although these have beenisolated instances, they illustrate the importance of liquidity risk management as many institutions continue toreduce holdings of liquid assets. Bank management should be cognizant of potential funding issues that can arisein stress situations as they develop or revise contingency funding plans. The article reiterates principles outlined inexisting supervisory guidance and is intended as a resource for bankers who wish to heighten awareness of prudentliquidity and funds management.The Bank Secrecy Act: A Supervisory Update 21The information collected through Bank Secrecy Act/Anti-Money Laundering (BSA/AML) programs is critical to theUnited States government’s counter terrorist financing initiatives and other longstanding efforts to protect the financialsystem from illicit finance. The FDIC carefully evaluates a depository institution’s compliance with the recordkeepingand reporting requirements of the BSA and implementing AML regulations. The focus of the BSA/AML examinationis to assess whether the depository institution has established appropriate policies, procedures, and processesconsistent with the institution’s BSA/AML risk. The article reports that the vast majority of BSA/AML compliancedeficiencies identified by the FDIC are resolved through the supervisory process without the need for an enforcementaction. The article also provides examples of rare, but significant, failures in BSA/AML compliance programs.Regular FeaturesRegulatory and Supervisory Roundup 30This feature provides an overview of recently released regulations and supervisory guidance.Supervisory Insights Summer 20171
Letter from the DirectorThe FDIC strives to makeinformation available to ourreaders to help them navigatechanges in laws, regulations, andthe economic climate. This issueof Supervisory Insights focuseson recent trends in liquidity riskmanagement and compliance with theBank Secrecy Act (BSA).The FDIC has observed an increasein the use of non-core and wholesalefunding sources and a decrease inholdings of liquid assets at a numberof the institutions we supervise.At a few institutions, asset qualityproblems have resulted in significantliquidity stress. Although suchsituations have been infrequent,they illustrate the importance ofeffective management of liquidityrisk. “Community Bank LiquidityRisk: Trends and Observations fromRecent Examinations” discusses theprocess for developing liquidity riskmanagement policies and proceduresthat are tailored to the risk profileof the bank, and emphasizes theimportance of planning for highimpact, unexpected liquidity events.The article features a guide fordeveloping and reviewing a bank’scontingency funding plan.The article notes that the majorityof FDIC-supervised institutionshave in place adequate systems ofBSA-related internal controls, andthat when compliance deficienciesare identified, they are resolvedin the vast majority of instancesthrough the supervisory process inthe normal course, without the needfor a formal enforcement action. Thearticle also provides examples of rare,but significant, failures in BSA/AMLcompliance programs.This issue of Supervisory Insightsalso includes our regular summaryof recently released regulations andsupervisory guidance.We hope you read both articles inthis issue and find the informationuseful. We encourage our readersto provide feedback and suggesttopics for future issues. Please emailyour comments and suggestions toSupervisoryJournal@fdic.govDoreen R. EberleyDirectorDivision of Risk ManagementSupervisionFDIC examiners are receivingquestions from bankers aboutcompliance with the BSA. “The BankSecrecy Act: A Supervisory Update”describes the purpose, development,and changes to the BSA over theyears. The article provides anoverview of the examination processand includes information on recenttrends in BSA examination findings.2Supervisory Insights Summer 2017
Community Bank Liquidity Risk: Trendsand Observations from Recent ExaminationsIntroductionThe FDIC recently has observedinstances of liquidity stress at a smallnumber of insured banks.1 Althoughthese have been isolated instances,they illustrate the importance ofliquidity risk management as manybanks continue to increase lending andreduce their holdings of liquid assets. Itis important for bankers to be aware offunding issues that can arise in stresssituations, especially as they developor review their contingency fundingplans (CFPs). This article is intendedas a resource for bankers who wish toheighten awareness of such issues andshould not be viewed as supervisoryguidance or required reading.The article begins with a broadoverview of trends in smaller banks’(those with less than 10 billion inassets) balance sheets, which suggestthat as the current business cycleprogresses, liquidity risk is generallyincreasing for these institutions asa group. This is followed by a moredetailed discussion of a number ofspecific funding issues that can giverise to liquidity stress, especially forinstitutions experiencing credit qualityissues or more watchful counterpartiesseeking higher collateral and termsto protect their exposure. The articleconcludes with a discussion of the useof contingency funding plans and cashflow projections by bankers to helpdetermine the size of their liquiditycushions and to otherwise plan forfuture success.1Trends in Liquidity Risk OverviewBank loan growth has pickedup considerably in recent years.Chart 1 illustrates that following thesteady loan run-off and slowdown inoriginations since the financial crisis,the ratio of total loans to total assetshas rebounded sharply since 2012 forinstitutions with less than 10 billionin assets.Chart 1:1 Total Loans and Leases on the Rise after Retreating Post-CrisisTotal Loans andLeases to Total AssetsAssets Less than 250MMAssets 250MM-1BAssets 812/31/201212/31/2016Source: Call Report DataThroughout this article, the word “bank” is used synonymously and interchangeably with the words “insureddepository institution,” unless the context requires or suggests otherwise.Supervisory Insights Summer 20173
Community Bank Liquidity Riskcontinued from pg. 3Chart 2: Liquid Assets Rebound then Retreat Post-CrisisLiquid Assets toTotal AssetsAssets Less than 250MMAssets 250MM-1BAssets 200812/31/201212/31/2016Source: Call Report DataLiquid Asset Proxy: Cash, Federal funds sold, Reverse Repos, and Unpledged Held-to-Maturity (HTM) andAvailable-for-Sale (AFS) SecuritiesChart 3: Wholesale Funding to Total AssetsAssets Less than 250MMAssets 250MM-1BAssets 1B-10BWholesale Funding toTotal 812/31/2012Loan growth has been accompaniedby a decrease in liquid asset holdings.Further, a number of communitybanks have increased reliance onnon-core and wholesale sources2 tofund loan growth. Charts 2 and 3illustrate trends in liquid assets andwholesale funding since 2001.While many well-managedinstitutions have successfullyintegrated non-core or wholesalesources and borrowings as acomponent of their liquidity andfunding strategy, some have usedthese funding sources in concentratedamounts as part of aggressive loangrowth or other leverage strategies.Although these sources can be partof a well-managed funding strategy,they may also be problematic wheninstitutions overly rely upon them.For example, during periods offinancial stress, many of these fundingsources are subject to counterpartyrequirements and certain legal andregulatory restrictions, especiallyif capital levels deteriorate. Thedeclining liquid asset cushions andincreased use of potentially non-stableliquidity sources depicted respectivelyin Charts 2 and 3 suggest that smallbanks as a group are increasing theirliquidity risk profiles as the currentbusiness cycle progresses.12/31/2016Source: Call Report DataWholesale Funding: Brokered, Listing Service, Foreign, and Public Deposits; FFP; Repos; and Borrowings24Supervisory Insights Non-core funding may include, but is not limited to, borrowed money such as Federal Home Loan Bank(FHLB) advances, short-term correspondent loans, and other credit facilities, as well as brokered certificatesof deposit (CDs) and CDs larger than 250,000. Wholesale funding includes, but is not limited to, brokereddeposits, Internet deposits, deposits obtained through listing services, foreign deposits, public funds, Federalfunds purchased (FFP), FHLB advances, correspondent credit lines, and other borrowings. High-rate anduninsured deposit accounts are also potentially volatile in certain cases and may have characteristics similarto non-core or wholesale funding. These potentially volatile funding sources are addressed in the FDIC Manualof Examination Policies, Section 6.1 - Liquidity and Funds Management, Pages 8-17. See pdf.Summer 2017
Unencumbered Liquid Assets A Pillar of Strength in CrisisBased on the FDIC’s experience, thefirst line of defense for respondingto a liquidity event is a cushion ofunencumbered liquid assets (i.e.,assets free from legal, regulatory, oroperational impediments). A numberof recent cases indicate that aninsufficient level of unencumberedliquid assets can compound liquiditytroubles. As illustrated in Chart 2,overall trends indicate that somecommunity banks are experiencing adrop in liquid asset levels.In a stress scenario, accessibility ofliquid assets is important. It is typicallyeasier for an institution to sell a readilymarketable security or withdraw aFederal Reserve district bank depositthan to request an advance from afunds provider that may be aware ofan institution’s financial problems andworrying about the volume of pledgedcollateral. The most marketable andliquid assets typically consist of U.S.Treasury and agency securities, shortterm, investment-quality, moneymarket instruments, and FederalReserve or correspondent deposits.These highly liquid, on-balancesheet resources can generally be soldor pledged at little or no discountand serve as a banking institution’slifeblood in a crisis situation. Theliquid asset pool is most useful whenthe assets are free of encumbrance,meaning no party has collateral orother claim at present or on a standby/contingent basis.Supervisory Insights Chart 4: Unrealized Securities Gains (Losses) to Tier 1 CapitalUnrealizedGain(Loss) to Tier 1Capital35%Assets Less than 250MM (Left)Assets 250MM-1B (Left)Assets 1B-10B (Left)10 Year U.S. Treasury Yield urce: Call Report Data, HTM and AFS securitiesAdditionally, when consideringavailability of the liquid asset pool,it is important to recognize potentialmarket risk in the fixed-incomeportfolio. As interest rates increase,the price of fixed-income instrumentstends to decline. In the currentrising rate environment, unrealizeddepreciation in the liquid asset poolcould result in a loss of principal if thesecurities are sold, further constrainingon-balance sheet resources. Chart4 illustrates the long-term decliningtrend in unrealized gain and losspositions of held-to-maturity andavailable-for-sale securities. Even if abank’s investment portfolio consists ofvery liquid, unencumbered securities,factors such as the interest rateenvironment could result in realizedlosses if securities are liquidated.Unrealized losses in such portfolioswould lead to lower collateral amountsavailable to secure future borrowings.Summer 20175
Community Bank Liquidity Riskcontinued from pg. 5Financial Institutions have Increased Municipal Bond Holdings Post-CrisisWhile community bank liquid assets have gradually contracted, holdings of municipalbonds have increased. As of December 31, 2016, nearly a quarter of all insured financialinstitutions (1,455) had municipal bond holdings that exceeded 100 percent of tier 1 capital.Prior to the crisis, at December 31, 2007, only 10 percent of insured financial institutionshad this level of municipal bond holdings relative to capital. Banks have increasinglyinvested capital in municipals for several reasons, including that they generally havecomparatively low historical default rates, carry attractive tax-free yields, and provide adesirable means to support local, county, and state authorities.Although municipal bonds are included in the investment portfolio and can beliquidated or used for collateral, they are generally less liquid than U.S. governmentand agency-guaranteed securities. Some factors that influence the liquidity profile ofmunicipal bonds include: The long duration of many municipal bonds, which exposes banks to potentialdepreciation in a rising rate environment; The large number (thousands) of municipal bond issuers, all with different creditcharacteristics, purposes, and repayment sources; The long-term “buy and hold” view of retail and institutional investors (likebanks), with relatively few bonds trading daily; The difficulty of conducting credit analysis with respect to certain issuers, andthe sometimes stale and hard-to-find nature of financial information; and The uncommon use of municipal bonds as collateral for repurchase agreements,resulting in generally higher collateral haircuts than those for federallyguaranteed securities.Some of these characteristics are addressed in an FDIC informational video onmunicipal bond credit analysis that can be found at r/technical/municipal.html.6Supervisory Insights Summer 2017
Liability and FundingConsiderationsA “core” customer deposit baseserves as the primary funding sourcefor most community financialinstitutions. These deposits aregenerally stable, lower-cost, andtend to re-price in a more favorablemanner than other instruments whenbank-specific conditions or marketconditions change. However, whencore deposits are unavailable or arenot preferred in a funds managementstrategy, some financial institutionsturn to funding from non-core orwholesale sources.For purposes of this discussion ofliquidity risk, the terms non-core andwholesale funding sources refer tofunding sources other than insuredcore deposits. Such funding sourcesare typically more expensive and lessstable than insured core deposits.Further, these funding sources maybe difficult or more costly to replace,especially if the institution becomesless than well capitalized and subjectto certain legal restrictions detailedlater. Non-core and wholesale fundingsources may include borrowings,as well as brokered, listing service,3Internet, and uninsured deposits.These deposit categories are not3mutually exclusive, and this articlewill not address the regulations andlegal interpretations addressing whena deposit is or is not brokered.In some recent instances,institutions that had concentratedpositions in less stable fundingsources have experienced liquiditystress. Weak contingency fundingplanning and cash flow forecastingalso contributed to liquidity strain,leaving some institutions unable toeffectively respond to the fundingcrisis at hand. Some of thesepotentially volatile funding sourcesand their risks are described laterto illustrate recent developments.The information is not intended torepresent any negative views towardthese funding sources. Many banksuse these sources successfully aspart of a prudent asset-liabilitymanagement program marked bystrong risk management, monitoring,and controls. Thus, the informationlater is based on recent observationsand should be viewed as “lessonslearned” from recent experiences.Further, the descriptions containfootnotes to applicable rules andguidelines, and readers shouldnot construe the discussion assupervisory guidance.Note that Section 29 of the Federal Deposit Insurance Act does not exclude “listing services” from thedefinition of “deposit broker.” 12 U.S.C. §1831f. Staff has previously opined that deposits gathered from“passive” listing services may not be considered brokered deposits. See FDIC Advisory Op. 04-04 (July 28,2004). However, if the listing service places deposits or facilitates the placement of deposits (in addition tocompiling and publishing information on interest rates and other features of deposit accounts), the listingservice is a deposit broker, and the deposits should be reported as brokered deposits.Supervisory Insights Summer 20177
Community Bank Liquidity Riskcontinued from pg. 7Brokered DepositsChart 5: Brokered Deposits Greater than 10% of Total AssetsAssets Less than 250MMAssets 250MM-1BAssets 1B-10BPercentage of 31/2008Source: Call Report Data8Supervisory Insights 12/31/201212/31/2016A brokered deposit is generallya deposit obtained, directly orindirectly, from or through a depositbroker.4 Brokered deposits cancomplement core deposits and othersources as part of a comprehensivefunding program. However, theFDIC has observed that rapid assetgrowth funded by brokered depositshas been directly associated with ahigher incidence of problem banksand failures.5 The proportion of banksmaterially utilizing the brokereddeposit market as a funding sourcehas been trending slightly higher forthe past several years, as indicatedby Chart 5. Brokered deposits can bemore rate sensitive than other fundingsources and have substantial run-offrisk after maturity if competitiveinterest rates are not offered. Further,if the bank falls below well capitalized,brokered deposit restrictions, as wellas
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