It’s Financial Literacy Month and it is not just for your members. All month I will be breaking down some commonly seen and not always understood financial and economic concepts as we learn a little more about how our industry ticks.
To kick the festivities off this year, let’s take a look at liquidity, a concept that recently made headlines due to the failures of Silicon Valley Bank (SVB) and Signature Bank in March.
A basic explanation of liquidity
Liquidity is the measure of an organization’s or individual’s ability to meet its financial obligations. In other words, how quickly you can convert your assets into cash. By definition, cash is the most liquid of assets. Other assets that are considered “liquid” might be stocks where there’s a ready pool of buyers and means of converting those stocks back into cash. An illiquid asset is one that is difficult or time-consuming to turn back into cash. Think real estate.
However, there are degrees of liquidity within these asset groups. Take real estate for example. If you own a nice home in a desirable neighborhood, you will probably have an easier time finding a buyer than with a run-down home in an undesirable neighborhood, thus making the first more liquid.
In a stable rate environment, something like a U.S. Treasury bond is fairly liquid. It’s a large market with plenty of buyers willing to pick up your bond if you need to sell it quickly. But what about in a rising rate environment?
A quick recap of SVB
The collapse of Silicon Valley Bank hinged on two things: a large amount of uninsured deposits from flighty depositors and losses from massive investments made into securities purchased just prior to a raising rate environment.
As a popular banking choice of Silicon Valley startups, SVB experienced a boom in deposits during the pandemic. Deposits increased from just over $50 billion in 2019 to $189 billion by 2022. And as much as 85% of deposits were uninsured; i.e. above the $250,000 per account insured by the FDIC.
Flush with cash, SVB had to do something with all those deposits, so they purchased Treasury bonds and government-backed mortgage securities, which are generally considered safe investments. SVB’s held-to-maturity securities portfolio increased by nearly $100 billion in 2021.
Unfortunately for SVB, in 2022 the Federal Reserve increased interest rates, meaning those long-term bonds’ value was dropping. Inversely, as rates rose, new deposits dipped, shrinking by $30 billion in 2022.
To cover the loss of those deposits, SVB had to sell a chunk of its now devalued securities at a loss of $1.8 billion, which was disclosed in a March 8, 2023 regulatory filing. This loss triggered fear among depositors as they rushed to pull tens of billions of dollars out of the bank on March 9. The run on the bank forced the FDIC to intercede and take control.
As Chip Filson said in his blog, “Confidence is king. Runs start from lack of confidence, and no amount of capital is enough.”
Maintaining reserves and managing cash flows
We now have a basic understanding of liquidity, and what can go wrong when confidence is shaken and financial institutions do not have enough liquid assets to cover a run on deposits. Next we will take a look at a few ways credit unions manage their liquidity.
Obviously, credit unions do not just stuff their vaults full of cash from deposits. How else would they be able to offer loans if all the deposits they have received have been tied up in cash? However, they are required to hold onto some deposits. This is called the reserve, and it serves as a cushion, providing a source of liquidity.
In fact, credit unions are only required to hold 10% of deposits in reserve. And the 10% reserve requirement only applies to deposits in transaction accounts (e.g. checking accounts).
Deposits in savings and money market accounts (considered non-transaction accounts) are not held to these reserve requirements. And what’s more, additional regulations (specifically Reg. D) govern how often members can make withdrawals from their non-transaction accounts before action is needed.
All of this means credit unions need to monitor and manage cash flows to ensure enough reserves are available and no cash shortages happen. They keep an eye on deposits/withdrawals and loan disbursements to keep those reserves within acceptable limits.
So if only a small portion of deposits are held in cash, that means the bulk of deposits are being used elsewhere…
A measurement of credit union liquidity, the loan-to-share ratio divides the total value of outstanding loans by the total of share deposits. The higher the ratio, the less liquid the credit union is, and the more likely it will need to look to outside sources to fund new loans. A higher ratio also means a greater risk as the credit union would likely have to seek outside sources of liquidity in a crisis.
In 2018, the average loan-to-share ratio in the US reached over 85% as rates were low and borrowing was high. In the wake of COVID, this average ratio had dropped down to 76.3%. This marked the lowest it had been since the years following the Great Recession when loan-to-share plummeted to the mid-60s. This was brought on by slowed loan growth and increased savings from consumers who were boosted by government stimulus packages. This trend bottomed out in Q1 2021, when the NCUA reported loan-to-shares had reached 68.8%, a just over 12% drop from the previous year.
Since then, this ratio has been steadily climbing back to pre-pandemic levels, including reaching back over 80% by the end of 2022. As loan volume increases, credit unions will seek to lure in more deposits to help fund additional loans. This might come from offering tantalizing rates on certificates of deposit or high-yield money market accounts.
With the Fed raising interest rates though, lending has slowed considerably and credit unions may find that ratio dipping yet again.
Suppose a credit union finds itself extremely loaned out and in need of an influx of liquidity. Where can they turn?
Accessing borrowing facilities
As it turns out, credit unions have a handful of places to turn when in need of liquidity, essentially borrowing necessary funds with interest. I will touch on some of these briefly (with more to come at a later date on one of them).
Corporate Credit Unions
The credit unions for credit unions. These institutions provide much-needed services to credit unions including cash and investment management. By being a source of liquidity and other financial support to member credit unions, pooling resources of those members, credit unions can more effectively manage risk.
Though they are regulated by the NCUA for safety and soundness, they are not without their own issues. During the financial crisis in late 2008 and 2009, corporate credit unions were hit hard with “losses amounting to perhaps $30 billion, about a third of the approximately $90 billion in total credit union capital,” as reported by NBC News. By the end, five corporate credit unions had failed: U.S. Central, Members United, Southwest, WesCorp, and Constitution.
Central Liquidity Facility
The Central Liquidity Facility (CLF) was established in 1978 by the NCUA to improve the general financial stability of the credit union industry. Credit unions join as members to gain access to liquidity needs “in the same way that the Federal Reserve discount window provides access to loans for its eligible depository institutions” per NCUA.
Sounds like a good situation, right? Well, it might have outlasted its use according to some critics. According to Chip Filson, the CLF, which in 2022 had over $1.3 billion in total equity, had not made a loan since the 2009 financial crisis.
“The CLF does not interact with credit unions,” says Filson. “It has created no programs or options. Until the leadership of the CLF engages with its member-owners and the system to develop solutions relevant for them, it will remain unused, untried and without purpose. A vestigial regulatory organ frozen in bureaucratic time.”
A product of the CUSO Primary Financial, which is itself jointly owned by ten corporate credit unions, SimpliCD provides its member credit unions with a marketplace for issuing and purchasing jumbo certificates of deposit to other member institutions.
Where the CLF has been inactive in providing liquidity, SimpliCD has been wheeling and dealing, with hundreds of credit unions reporting funding.
Federal Home Loan Bank System
In response to the Great Depression, the Federal Home Loan Bank Act of 1932 was established to provide direct loans to homeowners. Over time it has evolved, with eleven regional FHLBs providing services to financial institutions around the country. Their goal? To provide member institutions with “a source of funding for mortgages and asset-liability management; liquidity for a member’s short-term needs; and additional funds for housing finance and community development.”
Recently, in the wake of SVB’s collapse, the FHLB system raised $88.73 billion by selling short-term notes in order to be able to provide liquidity to financial institutions, banks especially, in need.
Bank Term Funding Program
The newest kid on the block, the Bank Term Funding Program (BTFP) is an emergency lending program created by the Federal Reserve established as recently as March 2023 to respond to the aforementioned bank failures. As another provider of emergency liquidity, it becomes an option not just for banks, but credit unions as well.
In the case of the BTFP, loans are offered to depository institutions up to one year in length. To secure funds, credit unions need to pledge collateral that can come in the form of U.S. Treasuries, agency debt, mortgage-backed securities, and other qualifying assets. As of now, this is only meant to be a temporary stopgap for the financial industry and will end March 2024, though it could be renewed by the Fed.
A simple concept with many intricacies
There you have it–liquidity in a nutshell. Did I get something wrong? Did I leave out a key aspect? Let me know about it in the comments! Financial literacy applies to all of us, myself included, as we seek to better understand this incredible industry we work in and for.
very clear, straight forward summary. With very rare exceptions, liquidity has not been a critical factor in credit union crisis because their diverse, member share balances are very stable.