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Liquidity Risk Management 8


Liquidity Risk Management

8000 8100 8200 8201 8202 8203 8204 820$ 8300 8400 8$00 8$01

Executive Summary... Legislative Summary.. Policy Liquidity a!ageme!t P"iloso#"y...

8-2 8-3 8-4 8-$ 8-( 8-) 8-8 8-8-10 8-11 8-13 8-14

%dequate &a!ge o' Liquidity. Sources o' Liquidity Limits o! *orro+i!g Large ,e#osits Pla!!i!g &is. &is. easureme!t a!d *oard &e#orti!g a!ageme!t...

/#eratio!al Procedures

Reference Manual Spring 2005

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Liquidity Risk Management Executive ummary

ecti!n 8"""

Executive Summary
The ability of a financial institution to meet demand for deposit withdrawals and other cash outflows is a visible indicator of its viability. If a credit union cannot meet depositor withdrawal requirements, general creditor expenses, or if it is forced to significantly limit new lending, a lack of member confidence can develop. The level of liquidity which is maintained must at a minimum meet regulatory requirements. Liquidity must also be sufficient to satisfy demand for cash withdrawals, financing commitments for approved loans, and routine operating cash outflows. Too much liquidity (excess liquidity , on the other hand, can be an inefficient use of funds, and can restrict the profitability of the credit union. Liquid assets should be managed with due regard to principal safety, yield volatility, and, where liquid assets bear risk, investment diversification. !redit unions should have access to supplemental lines of credit or segregated liquidity pools to satisfy liquidity requirements. " credit union which has not met legislated liquidity requirements is restricted from regular lending and investment activities (see section #$(% of &egulation '()*+ . Insufficient liquidity may also lead to intervention by ,I!-. " credit union can meet standards of sound business and financial practices by ensuring it has developed and implemented liquidity policies, risk and performance measurement techniques, and risk management procedures comparable to those contained in this chapter. .olicies, measurement techniques and procedures should be appropriate for the si/e and complexity of the credit union0s operation.

Reference Manual Spring 2005

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Liquidity Risk Management Legislative ummary

ecti!n 8#""

Legislative Summary
1ections %( to #% of .art 2 of &egulation '()*+ contain minimum liquidity requirements for credit unions. These sections prescribe three different liquidity requirements. The first, under section %(, requires the maintenance of a one per cent reserve of cash or near cash items. The second liquidity measure requires the maintenance of a %$ per cent reserve of liquid assets prescribed under sections %' and %3 (or eight per cent if the credit union is a member in a liquidity pool . The third liquidity requirement is partially set out in section #% of &egulation '()*+. This last requirement examines liquidity less short term borrowings. "ll three liquidity requirements are examined below, as well as 41!-0s reporting requirements which are set out in sections #$ and #%. 1chedule 3.% provides a summary of the important regulatory restrictions pertaining to liquidity management. "s only a summary is provided, readers should refer to the "ct, &egulation '()*+ and 5inistry Interpretative 6ulletins for a complete description of a credit union0s regulatory rights and obligations.
chedule 8$# RELE%&'( L)*+),)(- REL&(E, LE.) L&()/' The Act %dequacy o' liquidity Su#eri!te!de!t0s orders - additio!al liquidity requireme!ts &e#ort to Su#eri!te!de!t o! liquidity %dequate liquidity Liquidity #ool 1o!-com#lia!ce *orro+i!g #o+ers Pledgi!g o' assets Su2ordi!ated i!de2ted!ess Limits o! credit u!io! 2orro+i!g *orro+i!g 'rom ot"er credit u!io!s o!itori!g 2y 2oard 183 184-18$ 18( 18) 188 1884 8$-88 81(-18 120-21 Regulation 76/95

Reference Manual Spring 2005

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Liquidity Risk Management P!licy 80""


It is recommended that the credit union adopt a liquidity policy that addresses7 sources and acceptable ranges of operational liquidity8 quality of assets used for liquidity purposes8 maximum limits on liquidity borrowings8 maturity matching and)or hedging of large deposits8 frequency, form and content of board reporting. These recommended ob9ectives of liquidity policy are discussed in greater depth in 1ections 3#$% to 3#$+. "dopting a liquidity policy will assist the credit union to manage risk and to comply with the 1tandards in ,I!- 6y:law ;o. +. 4or recommended operational procedures, refer to 1ection 3+$$. <xamples of liquidity policy are available in the ,I!- publication 1ample .olicies, and are available to the industry for customi/ation as appropriate. "s well, the information provided in 1ections 3#$% to 3#$+ will also assist in establishing policies of liquidity management. Liquidity policy must not conflict with the requirements prescribed by the "ct, &egulation '()*+, and any interpretative bulletins or guidelines issued by 41!-. It is optimal for key regulatory liquidity requirements to be repeated in liquidity policy for greater clarity and ease of reference.

Reference Manual Spring 2005

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Liquidity Risk Management Liquidity Management Phil!s!phy

ecti!n 80"#

Liqui ity !anagement Philoso"hy

"dopting a liquidity management philosophy is an important first step in drafting liquidity policy. The philosophy sets out the broad goals and ob9ectives of the credit union with regards to liquidity, as established by the board of directors. This philosophy governs all liquidity policy constraints and helps address new situations where policy does not yet exist. =hile goals and ob9ectives will differ depending upon the circumstances and environment of the credit union, important principles of liquidity management should always address the following principles7 ensuring enough liquidity to guarantee the orderly funding of members needs8 providing a prudent cushion for unforeseen liquidity needs8 investing liquid funds in a manner which emphasi/es the need for security and liquidity.

Reference Manual Spring 2005

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Liquidity Risk Management &dequate Range !f Liquidity 80"0


A equate Range o# Liqui ity

4rom a business perspective, the gross liquidity requirement stipulated in legislation represents only an arbitrary minimum for most credit unions. " minimum operating liquidity level should be established to maintain a comfortable cushion beyond the minimum statutory requirement, in order to meet cash needs. " desired target maximum for operating liquidity also needs to be established to reflect the fact that too much liquidity has a negative effect on earnings. "ccordingly, a target range for operating liquidity, stated as a percentage of assets, needs to be established. In order for a financial institution to decide the optimum level of liquidity for its operations, it should look at the following factors7 cash flow needs for the immediate future (one year 8 previous years liquidity fluctuations (at least two years 8 expected increases)decreases in loan demand8 income requirements for the year8 volume of deposit withdrawals8 volume of institutional deposits and large deposits8 any other known factors which may have an effect on available liquidity. .art of this process includes having a comprehensive understanding of the nature of the credit union0s assets and liabilities, and the cash flows these represent. This type of information can be obtained from the cash flow analysis statement.

Reference Manual Spring 2005

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Liquidity Risk Management !urces !f Liquidity 80"1


Sources o# Liqui ity

1ections %( to %3 of &egulation '()*+ list the assets that may be used by a credit union for liquidity purposes. These include, among others, the following deposit instruments7 deposits in a league8 deposits in a chartered bank8 treasury bills issued by !anadian governments8 bonds and debentures unconditionally guaranteed by !anadian governments8 !anadian dollar deposits with or acceptances issued by 1chedule I banks or 1chedule II banks with a ,6&1 rating of &:% low or better. =hen purchasing liquid assets, the credit union should rely either on its league, or on brokers that have been authori/ed by the credit union. (" list of authori/ed brokers should form part of the credit union0s investment policy8 this list can be the same for both investment and liquidity purposes . The credit union may also wish to establish policy limits on the maximum terms (length of time that securities can be purchased for. "ssets purchased for the liquidity portfolio should generally have a contractual maturity of less than one year.
!inimum $uality o# Liqui Assets

.urchases of liquid assets should also adhere to minimum investment quality limits. >enerally, the credit union should ensure that the quality of their liquidity investments comply with the limits prescribed in &egulation '()*+. ?owever, a credit union which is dealing with chronically low levels of liquidity may choose to elect more restrictive limits on quality. " credit union which has a sophisticated or complex liquidity portfolio may also want to set more restrictive quality limits on all or a percentage of its portfolio.

Reference Manual Spring 2005

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Liquidity Risk Management Limits !n 2!rr!3ing

ecti!n 80"4

Limits on %orro&ing
In situations of liquidity shortages, credit unions may need to borrow funds to meet liquidity needs and minimum statutory requirements. =hen doing so, the credit union should be aware of regulatory limits on borrowing. 1ection %3@ of the "ct prescribes regulatory limits on external borrowings7 #+ per cent of a credit unionAs regulatory capital and deposits in ordinary circumstances8 and +$ per cent of regulatory capital and deposits in circumstances where a specific by:law of the credit union permits higher borrowings. "s well, section #% of &egulation '()*+ prescribes a liquidity adequacy test which deducts certain forms of short term borrowing. 4unds borrowed to meet statutory liquidity requirements or general liquidity needs can prove costly to a credit union due to its negative impact on profit. !onsequently, borrowings should be used on an exception basis, when non:anticipated withdrawals of a significant amount or unexpected loan growth threaten to bring liquidity below statutory levels. !redit unions should consider using borrowings as a short term solution for liquidity shortages only. It should consider more permanent options to reduce liquidity shortages in the long term, such as appropriate financial and marketing strategies (see 1ection 3+$% for examples of these . To discourage use of borrowings over the long term, policy could require board approval for use of borrowings over periods of six months. 4inally, the credit union may want to establish limits on liquidity borrowings that are more restrictive than those set out in the "ct.
Lines o# 're it

=henever a credit union establishes a supplemental line of credit with a league or a chartered bank, the relationship should be in writing and should be specific to the amount and conditions of possible use. " credit union should keep the arrangement under constant review, and provide full disclosure to the lender of fluctuating liquidity requirements. " credit union0s lender will be keenly interested in the client0s credit worthiness8 in particular, the level of capital in the credit union and the quality of the loan portfolio. The higher the level of capital, the lower the risk to the lender and the more likely the availability of supplemental lines of credit.

Reference Manual Spring 2005

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Liquidity Risk Management Large ,ep!sits

ecti!n 80"5

Large (e"osits
It is generally acknowledged that a credit union which relies on a significant number of large deposits is in a less favourable liquidity position than one whose deposit base consists of many average si/ed accounts. The withdrawal of large deposits due to interest rate competition or members0 investment discretion can significantly impair liquidity and should be avoided. In this regard, the credit union should adopt a policy which requires the identification of deposits held by one member that are over a certain si/e. The following elements of a large deposits policy are recommended7 .olicy should define what it considers a large deposit for these purposes. >enerally, a large deposit is one that if withdrawn, would have a significant impact on operational liquidity. The si/e can best be expressed as a percentage of assets or deposits. =hen defining large deposits, the policy may want to distinguish between large institutional deposits and large member deposits. =hen determining what qualifies as a large deposit, management should consider the total amount of deposits that belong to an individual and group of connected persons. .olicy should require the appropriate maturity matching of any large deposits. This involves ensuring funds equal to the amount of the deposits are invested in liquid assets, in addition to normal operating liquidity. "lternately, policy may require a ($ day notice period before withdrawal of large deposits.

Reference Manual Spring 2005

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Liquidity Risk Management Planning

ecti!n 81""

"nnually, management and the board of directors must develop an business plan for the credit union, summari/ing the credit union0s goals and ob9ectives for the coming year. This annual business plan includes a strategic financial plan that addresses each area of risk management, including liquidity. "s part of the strategic financial plan, management and the board must set financial targets and plans for liquidity management. The elements of a liquidity plan are set out in !hapter % on .lanning, and should be referred to for planning purposes.

Reference Manual Spring 2005

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Liquidity Risk Management Risk Measurement and 2!ard Rep!rting 84""


Ris) !easurement an %oar Re"orting

It is recommended that the credit union measure the performance and risk level of the liquidity portfolio and report these findings to the board.
Ris) !easurement

The following are minimum risk and performance measures of liquidity management, required by sound business and financial practices7 the volume of liquid assets, relative to the plan and to historic levels, and compared against regulatory requirements8 the average liquidity yield8 the amount of short term borrowings (i.e. less than %$$ days 8 identification of large deposits (as defined in 1ection 3#$+ . The credit union must comply with any liquidity related measurement requirements set out in the "ct and &egulations. The credit union may track any other measures of the liquidity portfolio as it sees fit. These measurements should be compared to financial targets in the annual business plan and the budget, so that management can determine whether the credit union is meeting its goals. 5anagement can also assess whether there are material variances from the plan which need to be addressed. !omparison of these measurements against historical performance, where possible, can also identify significant trends which may need to be addressed by management.
Ris) !easurement Techniques

,ue to the similarities between the investment portfolio and liquidity portfolio, the techniques used to measure liquidity risk are the same as the techniques used to measure investment risk. Therefore, the discussion on risk measurement techniques in 1ection (B$% should be referred to when developing risk measurement techniques for liquidity management.
%oar Re"orts

The measurements of liquidity risk discussed earlier should be reported to the board of directors, so that the board can also monitor the liquidity portfolio and ensure adherence to regulatory requirements and to the annual business plan. 5aterial variances from plan and their causes, as well as management0s plan to correct the variance, should also be included in the report. 5anagement should also provide the board with a summary on compliance with liquidity policy and relevant regulatory requirements.

5anagement should provide the board with a report on the liquidity portfolio for each board meeting.

Reference Manual Spring 2005

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Liquidity Risk Management Risk Measurement and 2!ard Rep!rting 84""



1chedule 3.# on the following page illustrates a 1ample 6oard &eport on Liquidity 5anagement which can be used by management to monitor liquid asset portfolio, ensure regulatory compliance and report findings to the board. The report compiles and compares all the volumes, targets and policy limits required to properly manage the risk of the credit union0s liquid asset portfolio. This report can be adopted or amended for use by the credit union. Information contained in the report can be expressed on a periodic basis (monthly, quarterly , or on a year:to:date, or both, depending upon the preferences of the board and the frequency of reporting. The frequency, form and content for board reports on liquidity should be set out in liquidity policy.
chedule 8$0 &MPLE 2/&R, REP/R( /' L)*+),)(- M&'&.EME'( Part *+ Liqui ity, Liqui ity %orro&ings an Liqui ity -iel s Latest #ro3ected liquidity !eeds4 5 Actual Per Plan Per Policy Statutory .ariance Requirement #rom Plan 8 8 8 8

6otal liquid assets7 as a 8 o' de#osits a!d 2orro+i!gs4 6otal s"ort term 2orro+i!gs 9i.e. less t"a! 100 days: as a 8 o' de#osits a!d 2orro+i!gs:4 %verage yield o! liquid assets 98:4

8 8

8 mi!4 max4 8

8 8 8

;aria!ces s"ould 2e calculated as a #erce!tage o' t"e corres#o!di!g 'igure stated i! t"e 2usi!ess #la!.

Part **+ * enti#ication o# Large (e"osits Large de#osits de'i!ed as exceedi!g4 5 Actual Same !onth Last -ear 5 8 8 /o& much+ 1 'orrective Action/Strategy /as su##icient a itional liqui ity 0een set asi e #or large e"osits+ <ES = 1/ 1um2er o' large de#osits4

,ollar volume o' large de#osits4 Large de#osits as a 8 o' de#osits a!d 2orro+i!gs4

Part ***+ 'orrective Action/Strategies .ariance

Reference Manual Spring 2005

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Liquidity Risk Management Risk Measurement and 2!ard Rep!rting 84""


Reference Manual Spring 2005

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Liquidity Risk Management Risk Management 85""


Ris) !anagement
'orrective Action

"n important activity in the effective management of risk is management0s timely response to unathori/ed risk or poor performance developments. "s a follow up to the liquidity risk measurements taken by the credit union (discussed in 1ection 3B$$ , management should investigate all significant performance variances relative to the annual business plan and to historical performance, and respond by taking action to correct these variances. 5anagement must similarly respond to any contravention of board policy or regulatory requirements, or other unauthori/ed risk.
2"erational Proce ures

It is recommended that credit unions have procedures in place which will ensure compliance with7 minimum liquidity requirements, set out both in legislation and in board policy8 minimum investment quality limits, set out both in legislation and in board policy8 and that large deposits are properly hedged or matched, so that operational liquidity will not be greatly affected if these deposits were withdrawn. 1ection 3+$% discusses procedures that can assist management to monitor cash flow needs, monitor compliance with regulatory and policy liquidity needs, and address liquidity shortages or excesses. To assist in implementation, procedures should be both appropriate and cost effective given the si/e of the credit union0s operations. It is a sound business and financial practice for credit unions to document procedures. =ritten procedures result in higher staff productivity and better control over resources.

Reference Manual Spring 2005

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Liquidity Risk Management /perati!nal Pr!cedures 85"#


2"erational Proce ures

The following procedures can assist management to monitor cash flow needs, to monitor compliance with regulatory and policy liquidity needs, and to address liquidity shortages or excesses.
!onitoring Liqui ity 3ee s

The credit union0s liquidity needs should be reviewed on a periodic basis. 4or most credit unions, this will mean at least on a weekly basis. This review should encompass a detailed forecast of imminent liquidity requirements and a broad pro9ection of cash needs for the next three month period. 1ummary measurements of liquidity needs should be prepared for board review at each board meeting, in addition to the risk measurements discussed in 1ection 3B$$. To determine immediate cash flow needs, a cash flow statement can be used to develop pro9ections for the next three months. .eriodic (weekly or monthly cash flow pro9ections can predict whether excess or deficient liquidity levels will be experienced by the credit union in the near future. If deficiencies are below operational levels, management will have to take action to correct these levels.
Liqui ity Shortages

=henever deficient liquidity levels are discovered, management must prepare marketing and financial strategies to align liquidity levels within desired targets, or take defensive actions. ,efense actions to protect the liquidity position of a credit union would normally include7 marketing measures to improve deposit levels8 9udicious use of standby lines of credit8 9udicious use of borrowings for liquidity support8 temporary curtailment of lending8 sale of assets to a third party. It should be recogni/ed that the above noted defense actions are listed in order of most attractive to least attractive option. !urtailment of lending activity is considered least desirable because of the negative effect on member confidence, however, certain restrictions on lending may become a necessary trade:off in a liquidity crisis. <arly reaction, in terms of moderate or temporary curtailment of lending, will often overcome the need for drastic measures at some later stage. "lternative liquidity defense strategies such as an available overdraft facility and an approved line of credit facility with a league or chartered bank are recommended sound business and financial practices. The use of an overdraft facility permits a credit union to maximi/e the value of its float without 9eopardi/ing the clearance of its negotiable instruments. -ne example of an aggressive cash management strategy would be to make the greatest possible use of short term call deposits in the money market while permitting the current account to be in occasional overdraft position, in order to maximi/e earnings.

Reference Manual Spring 2005

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Liquidity Risk Management /perati!nal Pr!cedures 85"#


Excess Liqui ity

=here a credit union has significant liquidity in excess of statutory requirements due to unanticipated net cash inflow, management should examine options to reduce liquidity to an appropriate level. ?igh levels of liquidity generally have an unfavourable effect on profitability, as the rate of return earned on short:term investments is usually not as high as the yield on loans, and cash held in the credit union earns no interest. In order to reduce liquidity which is in excess of operational requirements, management should ensure it has exhausted all credit granting opportunities, without compromising on credit quality. "lternatively, the credit union should undertake membership drives to expand loan demand. =here the promotion of credit does not fully utili/e excess liquidity, interim investment of funds should generally be made in short:term investments, so that conversion to new loans may readily occur. ,uring an economic downturn or in situations where aging member demographics are difficult to reverse, board and management may determine that a portion of excess liquidity is likely to persist for longer than the current fiscal period. In such situations, management should look for safe investments with terms in excess of one year that would generate higher yields. 4or more on investments, refer to !hapter ( on Investment 5anagement.

Reference Manual Spring 2005

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