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1 January 2017 CFA Institute Journal Review

Do Banks Actively Manage Their Liquidity? (Digest Summary)

  1. Vassilis Efthymiou, CFA

In 2010, the Basel III Accord introduced the net stable funding ratio to establish a regulatory monitor of international banks’ liquidity. The authors find that US banks had already been practicing active liquidity management for at least a decade with the objective of profitably converging to a targeted loans-to-core-deposits ratio.

What’s Inside?

The authors examine the management of the loans-to-core-deposits (LTCD) ratio in a large sample of US banks over the period 1992–2012 and conclude that US banks had proactively targeted a minimum LTCD ratio long before the introduction of Basel III’s net stable funding ratio (NSFR). Moreover, in any year with a gap between the actual and targeted LTCD ratio, banks effectively adjust their liquidity to close the gap at an average speed of 26% per year, and it would take 7.6 years to close the gap assuming no liquidity surprises going forward.

How Is This Research Useful to Practitioners?

The authors show that the speed at which banks adjust their LTCD ratios is financially efficient. Larger banks, and especially those with significant liquidity gaps, tend to act a little more quickly to adjust their LTCD ratios closer to their optimal targets.

Larger banks and publicly traded banks can afford to exhibit above-average LTCD ratios because their loan portfolio is more diversified and they are able to swiftly tap sources of short-term funding (e.g., repos and commercial paper) at a low cost. Banks that are rapidly growing their asset base also have relatively high LTCD ratios. Banks that report large equity capital buffers are associated with lower-than-average LTCD ratios—possibly because their strong solvency is deemed to carry “franchise value” worthy of protection.

Commercial banks with unused commitments and credit lines target higher ratios. Banks with an extensive network of branches target lower LTCD ratios as they focus on securing relatively stable retail deposits. LTCD ratios tend to increase during the last stages of an economic expansion. The aforementioned bank characteristics seem to affect the NSFR, which is considered the regulatory analog of the LTCD ratio.

Equity research analysts covering the US banking sector can identify and explain significant differences in liquidity levels and management on the basis of the authors’ findings. Moreover, analysts may reasonably predict that larger banks will operate with fewer liquid assets and, if they become too illiquid, will correct it at a faster pace than small and medium-sized commercial banks.

There is no history available to help predict outcomes when regulatory capital requirements and liquidity standards coexist.

How Did the Authors Conduct This Research?

To calculate the LTCD ratio and the NSFR, the authors use the official reporting history of 10,190 different US commercial banks excluding systemically important banks over the period 1992–2012. This sample provides the researchers with an unbalanced panel of 127,828 bank-year observations of data from financial statements, sourced from relevant Federal Financial Institutions Examination Council reports and Federal Reserve Y-9C reports.

The LTCD/NSFR targets and the speed of annual adjustment toward these targets are estimated with a partial-adjustment model run on the panel data. In the simpler model (generalized method of moments estimation), the average speed of adjustment is set to be constant both cross-sectionally and in terms of time series, whereas in the more dynamic form (ordinary least-squares estimation), the speed of adjustment is assumed to vary with respect to the individual bank’s business and financial characteristics and the macroeconomic climate over time. The authors study systemically important banks separately and test for robustness.

Such variables as total assets, equity capitalization, public listing, growth strategy plan, credit line commitment, significant mortgage exposure, branch network, and positive economic conditions are tested for significance in determining bank liquidity targets. Finally, the speed of adjustment to the targeted levels of the LTCD ratio or the NSFR is estimated in relation to the magnitude of the lagged liquidity gap and its interaction with the bank’s size.

Abstractor’s Viewpoint

Altogether, the authors’ findings suggest that US commercial banks did not seem to wait for minimum liquidity levels to be established in the regulatory landscape in order to actively apply liquidity optimization practices. Yet, compliance with strict NSFR rules introduced with Basel III in 2010 is envisaged to shift banks’ attention to striking a balance between increasing profitability through growth in risky long-term assets and increasing net stable funding by eliciting core deposits to the detriment of interest margins.

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