ABAToolb x on Liquidity ABA Members Only. Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan

ABAToolb x on Liquidity ABA Members Only Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan

Dear Reader, Welcome to Tool 5 of the ABA Liquidity Toolbox. All the work in Tools 1-4 comes together here. We explore how liquidity planning fits in with the overall asset/liability committee (ALCO) process. Finally, we emerge from Tool 5 with structure, measurement systems, policy limits, a liquidity policy, and a contingency funding plan (CFP). Many of the figures in Tool 5 are outputs from FARIN & Associates Foresight Asset-Liability model. (To learn more about Farin & Associates asset-liability services visit www.farin.com/alm/.) Many thanks to Dave Koch, Chief Operating Officer for FARIN & Associates for his assistance in preparing Tool 5. Tom Farin, Farin & Associates, Lead Author Mr. Farin is the author of three separate books on financial institution asset-liability management, as well as a popular asset-liability newsletter. Farin & Associates is best known for using technology and education to help community banks develop and implement retail strategies. Banker Reviewers Steven W. Corrie Senior Vice President Security National Bank Sioux City, Iowa Phil Emma CFO Merrimack County Savings Bank Concord, New Hampshire Troy K. Lewis, CPA Vice President Heritage Bank St. George, Utah Dave Koch, Farin & Associates Mr. Koch is the Chief Operating Officer at Farin & Associates. Dave consults regularly with community banks on the ALCO process, board education, strategy development, and safety and soundness compliance issues. ABA Staff Contributors Mary Frances Monroe Deanne Johnson de Mariño Susan Einfalt Mark Tenhundfeld James Chessen Ryan Zagone Mako Parker Keith Leggett Donna Fisher Ellen Collier Rachaell Davis Lisa Gold Scheier Robin Gordon About American Bankers Association The American Bankers Association represents banks of all sizes and charters and is the voice for the nation s $13 trillion banking industry and its two million employees. The majority of ABA s members are banks with less than $165 million in assets. ABA s extensive resources enhance the success of the nation s banks and strengthen America s economy and communities. 2011 American Bankers Association, Washington, D.C. This publication was paid for in part with the dues of ABA member financial institutions and is intended solely for their use. Please call 1-800-BANKERS if you have any questions about this resource, ABA membership or would like to copy or license any part of this publication. This publication is designed to provide accurate information on the subject addressed. It is provided with the understanding that neither the authors, contributors nor the publisher is engaged in rendering legal, accounting, or other expert or professional services. If legal or other expert assistance is required, the services of a competent professional should be sought. This guide in no way intends or effectuates a restraint of trade or other illegal concerted action.

Building a Liquidity Policy Statement and Contingency Funding Plan 5 A Process for Dynamic Liquidity Management 1 Step 1: Define and Build a Base Liquidity Plan 3 Step 2: Stress Test the Base Liquidity Plan 23 Step 3: Develop and Test the Contingency Funding Plan 31 Step 4: Build Monitoring and Reporting Systems 40 Step 5: Create an Effective Policy Statement 46 Intro 1 2 3 4 5 Introduction to the ABA Toolbox on Liquidity Developing an Effective Capital/ Liquidity Plan Developing a Core Funding Strategy Through an Initial Strategic Review Integrating Near-Core and Non-Core Sources Into Bank Funding Measuring Assetbased Liquidity with the Liquidity Coverage Ratio Developing a Liquidity Plan

Glossary Asset-based liquidity buffer The total of highly liquid unencumbered marketable (HLUM) securities plus cash and near-cash held as a reserve against a liquidity stress event Asset-liability management(alm) process The process in which banks manage the relationship between risk and return Contingency funding plan (CFP) The portion of a liquidity policy devoted to outline lines of authority, contingent liquidity sources, and the series of steps management would take in responding to one or more liquidity stress events Cumulative liquidity gap/asset ratio A ratio that measures the cumulative size of the gap between sources and uses of funds, considering both the asset-based and liabilitybased liquidity buffers as a percentage of assets; usually over a one-year horizon Dynamic liquidity management The process of managing liquidity in the context of a business plan as opposed to merely focusing on a current balance sheet Graduated policy limits A set of policy limits that incorporate stepped threat level guidelines and define appropriate response at each step; e.g., red, yellow and green light ranges that represent increasing severity Liability-based liquidity buffer Total unused borrowing capacity constrained by sources and policy limits held as a reserve against liquidity stress events Liquidity stress test A test that measures the effect of a liquidity stress event on the relationship between sources and uses of funds Net Stable Funding Ratio (NSFR) A proposed Basel 3 liquidity ratio that measures the extent to which stable funding is available as a funding source for assets requiring stable funding, calculated over a 1 year stress horizon Triggers and trigger ratios Early warning indicators of a developing problem like a liquidity problem; when using ratios, it is helpful to see historical trends in the ratios as well as the forecast trends in the ratios under a business strategy

A Process for Dynamic Liquidity Management The process of managing liquidity has become more integrated and dynamic than in the past. New ratios help to analyze overall liquidity, and stress tests help to consider unforeseen events. These raise the question of how liquidity risk management is to fit in with the management of other risks, such as interest rate risk and capital risk. The asset/liability management (ALM) process is the place where banks manage the risk/return equation. Adding a new level of sophistication to the analysis, banks have expanded their focus to include liquidity risk. As we discussed in Tool 4, regulators are placing increased emphasis on holding higher levels of asset-based liquidity in the form of highly liquid unencumbered marketable (HLUM) securities. While increasing levels of HLUM securities mitigates liquidity risk, it may place pressure on earnings because of the low yields associated with HLUM securities. In addition, increased levels of liquidity may increase interest rate risk in an institution that is already asset sensitive. These trade-offs mean banks need to adopt a holistic approach to risk management in the ALM process that not only considers the effect of business plan strategies on risk levels of all kinds, but also measures the effect of these strategies on return. Much has been written and discussed within the industry regarding the validation of ALM models for interest rate risk calculations. Incorporating the discipline of cash flow projections and review of maturing funds from the modeling software will help to spot problems with data and inaccurate projections. A regular review of these basic values will help to ensure that the management and board can build reliable strategies and have confidence in the risk levels projected. Too often the results of models are focused on the outputs being measured, and little attention is paid to how those measures are arrived at. An interesting byproduct of using an ALM model for liquidity analysis forces users to look at cash flows. Many times the review leads to discovery of and corrections applied to data being provided to the model. The critical items to measure a result like net income are issues such ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 1

as volumes of assets and liabilities, rates offered, and speed of cash flow repayment, to name a few. By building our liquidity management system on the backbone of the interest rate risk and planning model, we are achieving several very important goals at once: validity in model data, single source for assumptions and outputs, and internal controls on values, to name a few. Tool 5 will help to bring the pieces from the four previous tools together into a consistent and coherent liquidity plan and policy. An effective liquidity plan considers how the changing projections on volumes of loans, investments, Core, Near-Core and Non-Core Funding will impact future availability of liquidity to meet business plan needs as well as to deal with events leading to liquidity stress. When ratio analyses, such as the liquidity coverage ratio (LCR) described in Tool 4, are combined with the analysis of sources and uses of funds, a complete picture develops. Applying a sources and uses of funds analysis to a business plan or strategy and the development of a contingency funding plan (CFP) involves the following series of steps: Step 1 Define and Build a Base Liquidity Plan Step 2 Stress Test the Base Liquidity Plan Step 3 Develop and Test the Contingency Funding Plan Step 4 Build Monitoring and Reporting Systems Step 5 Create an Effective Policy Statement STEP 1 Define and Build a Base Liquidity Plan STEP 2 Stress Test the Base Liquidity Plan STEP 3 Develop and Test Contingency Funding Plan STEP 4 Build Monitoring and Reporting Systems STEP 5 Create an Effective Policy Statement 2 American Bankers Association

STEP 1 Define and Build a Base Liquidity Plan STEP 2 Stress Test the Base Liquidity Plan STEP 3 Develop and Test Contingency Funding Plan STEP 4 Build Monitoring and Reporting Systems STEP 5 Create an Effective Policy Statement STEP 1 Define and Build a Base Liquidity Plan A base liquidity plan is the liquidity component of a business plan or strategy and looks at the relationship between funding sources and funding uses the cash flow. Measurement systems aimed at cash flow-based evaluation of liquidity consider an institution s most recent balance sheet as well as its business plan or strategy. As we move in the direction of cash flow-based measurement systems, you might wonder what happens to the traditional regulatory measures like loans/deposits and Non-Core Funding reliance. They still play a role in the future of liquidity measurement as triggers, early warning indicators that a liquidity problem may be developing and that action by management may be needed. While a sources and uses analysis cannot be derived using Call Report data alone, the traditional ratios and the new Basel III ratios certainly can. Using the LCR to Set Limits In Tool 4 we introduced one of the new Basel III ratios, the Liquidity Coverage Ratio (LCR), which is aimed at identifying the quantity of shortterm HLUM securities needed to meet liquidity needs in a 30-day stress test environment. The LCR is an excellent tool for measuring whether the institution has sufficient levels of HLUM securities and expected cash flow to cover a short-term liquidity crisis event covering 30 days. The LCR can also be included within guidelines that outline the acceptable limits for the LCR and define actions to be taken when the LCR falls outside those limits. Limits such as these are usually established using graduated risk levels, which allow institutions to measure both the level of risk and the trends in risk. A common graduated system is one that reports the risk levels as a green, red, and yellow light zone limits for exposure reporting. ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 3

Green Light Zone The green light zone contains the range of potential exposures that the Board believes to be normal and acceptable operating behavior for liquidity levels. In a green light zone, normal liquidity assessment, and Board and asset-liability committee (ALCO) reporting requirements are in effect. Red Light Zone The red light zone limit defines an institution s absolute liquidity exposure compliance limit. Operation in the red light zone is not acceptable. Should the institution find itself in the red light zone, a comprehensive program of management and ALCO responses to address the excessive risk should be provided to the Board at its next meeting. In addition, special meetings and/ or reporting might be presented to the ALCO and Board for as long as the red light zone situation continues. XYZ BANK Case Study LCR Limits at XYZ Bank XYZ is currently in the midst of an asset quality issue that is impacting loan repayments and loss of funds to other institutions. In Tool 4 we identified the LCR risk parameters we would use for the Basel III LCR 30- day stress test. The resulting LCR (Figure 5-1) shows XYZ to have inadequate HLUM securities to meet its stressed 30-day liquidity needs, falling short of target by approximately $3 million. While the LCR was applied to XYZ s current balance sheet, it could also be calculated for each month or quarter of XYZ s business plan or strategy. Doing so would allow XYZ to monitor the how the business plan or strategy is affecting levels of asset-based liquidity and whether XYZ would pass this asset-based test in future periods, as the business plan evolves. The business plan should incorporate strategies that will allow XYZ to plug its LCR shortfall of $3.0 million within a reasonable period of time. In reviewing its current LCR levels, XYZ has established guidelines that outline the acceptable limits for the LCR and define actions to be taken as severity of the shortfall increases. As figure 5-2 indicates, when the LCR is > 105%, it is in the green light range, meaning no short-term (30-day) liquidity threat exists. No additional reporting or measures are required, other than to monitor the projected LCR levels in the plan. Should the LCR drop to between 100% and 105%, the level of severity is raised to yellow. The yellow limit requires the ALCO to review and make modifications to the business plan with the objective of moving the Figure 5-1 Liquidity Coverage Ratio Liquidity Coverage Ratio 78.7% Target Ratio 100.0% Numerator (Net High Quality Liquid Assets) 11,177,770 Excess(Short) (3,026,629) Denominator (Net Cash Outflows) 14,204,399 4 American Bankers Association

Yellow Light Zone The yellow light zone is the range of liquidity exposures that falls below maximum allowable limits but is more than the normally acceptable liquidity risk levels. The advantages of liquidity exposure zone limits are that they simultaneously define maximum, temporarily allowable, and normal exposure delimiting for liquidity risks. In the yellow light zone, they establish an early warning mechanism and mandate proactive corrective procedures for risk exposure should it move outside normal levels. An institution s exposure zone limit definitions constitute a key and significant step forward in understanding, monitoring and controlling its liquidity-related risks and can be proactively assessed in relation to other risk areas such as capital, earnings, asset quality, and value. LCR back to green light status within the following six months. In cases where the LCR is < 100% (red light status) as is the case in the example in figure 5-1, more immediate modifications to the business plan must be made to return to yellow levels within three months, and green within nine months *. In the XYZ case, the strong possibility of failure of PCA well-capitalized minimums, as a result of asset quality problems and the resulting threat to its Non-Core, Near- Core, and Core Funding base, warrants tighter limits and faster actions, and makes the availability of asset-based liquidity crucial to its survival of a stress event. Note: These timeframes are illustrative. Your regulator may require faster action. Figure 5-2 LCR Policy Limits LCR Level Required Actions > 105% Green Light No change in plans or actions 100-105% Yellow Light < 100% Red Light Demonstrate in the business plan the return to more stable levels in the coming 6 months, monitor and report quarterly on plan to actual Immediate actions taken to return to yellow levels within 3 months and green within 9 months. Reporting to be communicated monthly until yellow level achieved. 12-Month Liquidity Gap/Asset Ratio Threat Level Actions ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement No and actions Contingency required, continue Funding normal Plan 5 => 15% Green Light monitoring and reporting Develop options for asset or liability

Using Other Triggers to Set Limits Management must monitor additional indicators of potential liquidity problems to determine in advance if there are approaching liquidity problems. These early warning indicators, or triggers, do not necessarily require an institution to take drastic corrective measures. Rather, they are used as a warning system to motivate management to take action in advance of a liquidity stress event actually appearing. Examples of trends that may point to the development of a liquidity stress event include: A decline in recent or projected earnings performance Credit rating agency downgrades or announcements of potential downgrades Rapid asset growth, especially when involving loan growth well in access of Core Funding growth Management must monitor additional indicators of potential liquidity problems to determine in advance if there are approaching liquidity problems. Rapid growth in potentially volatile liabilities Negative publicity, real or perceived Overall decline in asset quality Maturing/renewing or committed loan offers cancelling and/ or not renewing Higher collateral requirements on credit facilities Loss or restricted credit lines access from correspondent banks Inability to secure longer-term debt from counterparties and brokers Loss of brokered CD buyers, forcing the institution to deal directly with fewer willing counterparties A loss of rate sensitive buyers, such as money managers and public entities An increase in early withdrawal requests from depositors Decreasing transaction sizes, due to large deposits not renewing Having to pay a higher spread on deposits relative to local competitors or relative to national or regional composites to acquire or retain funds Many of these events can be tracked using ratios the institution may already be producing to monitor earnings performance, asset quality, capital adequacy, etc. 6 American Bankers Association

The triggers selected will depend on the types of assets and liabilities on the balance sheet, market opportunities, and overall risk levels. All of the ratios you select can be calculated from an existing balance sheet and from balance sheets at the end of projected reporting periods in a business plan or strategy. That means you can not only look at the historical evolution of these ratios using progressively older balance sheets, they can also be calculated from projected balance sheets as part of your business plan or strategy. Below are the trigger ratios that are considered to be most useful. Each represents a candidate for inclusion into your liquidity policy and reporting system. Each ratio s calculation is defined and its role in the overall measurement and management process outlined for the following trigger ratios: Net Stable Funding Ratio (NSFR) Non-Core Funding Dependence Loans/Deposits Ratio Wholesale Brokered Deposits/Total Assets and Total Brokered Deposits/Total Assets Borrowings/Assets Noncurrent Loans/Gross Loans and Noncurrent Assets plus Other Real Estate Owned/ Total Assets Return on Assets As with the LCR, these can also be used in conjunction with graduated risk levels. However, management should consider the potential implications of the overuse of threat level guidelines. It is possible make it difficult to reach the green zone in all your threat level guidelines. We recommend you pick the four or five triggers most important to your management team as early warning indicators of emerging liquidity problems and set threat level guidelines for those ratios. Net Stable Funding Ratio The Net Stable Funding ratio (NSFR) is the second measurement introduced by the Basel III standards in December 2010 and helps to determine whether there is sufficient medium- and long-term funding to support an institution s assets, should an extended, bank specific stress scenario occur. The ratio itself is a stress test run over a one-year horizon. [The NSFR] is designed to act as a minimum enforcement mechanism to reinforce other supervisory efforts by promoting structural changes in the liquidity risk profiles of institutions toward more stable, longer-term funding of assets and business activities. ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 7

The philosophy behind the NSFR calculation is that an institution needs to have sufficient stable funding in an extended stress scenario to fund the portion of its asset base requiring stable funding. To perform the NSFR calculation, take an inventory of all available sources of stable funding (after stressed runoffs) as the numerator, and divide that by the amount of stable funding needs, both on- and off-balance sheet. Non-Core Funding Dependence Non-Core Funding dependence is the difference between Non-Core liabilities and short-term investments, divided by long-term assets, and postulates that Non-Core liabilities are better suited to fund short-term investments than long-term assets. A lower ratio implies that an institution is better able to meet its liquidity needs. Concerns with Non-Core Funding dependence as a measure of liquidity include the following: Highly stable funding items, such as long-term borrowings and long-standing large deposits, are considered Non-Core Highly volatile Internet deposits are considered Core deposits All loans regardless of time to expected repayment are considered long-term The NSFR was designed to provide a more meaningful way to examine the relationship between stable funding and assets requiring stable funding. If you elect to use the NSFR in your policy, there is no need to develop threat level guidelines for the Non-Core Funding dependence ratio although you may want to track it in your measurement system, as regulators are likely to continue to monitor it. However, before beginning to use Non-Core Funding dependence, you may want to wait for U.S. regulators to address a number of issues in U.S. implementation. Loans/Deposits Ratio The loans/deposits ratio was originally designed to measure how much of the institution s stable funding (deposits) was committed to assets (loans) that could not easily be converted into cash. Shortcomings of the loans/ deposits ratio are similar to those of the Non-Core dependency ratio. Once again, the NSFR was designed to provide a more meaningful way to examine the relationship between stable funding and assets requiring stable funding. If you elect to use the NSFR in your policy, there is no need to develop threat level guidelines for the loans/deposits ratio although you may want to track loans/deposits in your measurement system, as regulators are likely to continue to monitor it. 8 American Bankers Association

Wholesale Brokered Deposits/Total Assets and Total Brokered Deposits/Total Assets Establishing limits around the total funding sources allowed by brokered deposits is a prudent trigger for management to employ. The difference between the two ratios above reflects what portion of the bank s deposits come from reciprocal sources, which are usually relationship monies, meriting a higher threshold. Institutions that rely on brokered deposits as part of their base liquidity strategy should set red/yellow/green levels along with discussion on the ALCO actions in each case. Establishing threat levels is especially important, because banks are usually prohibited from using wholesale brokered deposits if they become less than well-capitalized. Also, regulators tend to frown on the use of brokered deposits to grow a balance sheet of an institution with deteriorating asset quality. Borrowings/Assets Trends in borrowings/assets can be used as an indicator of unbridled asset growth without corresponding growth in Core deposits. In Tool 3 we set limits on both individual sources and on an overall basis. However, our overall policy limit included all sources of Near-Core and Non-Core Funding rather than just borrowings. A set of red/yellow/green levels should be set for whatever measure you used in defining your policy limit, with discussion of the ALCO actions in each case. Institutions heavily involved in portfolio mortgage lending will often accept a higher level of borrowings than commercial lending firms. Noncurrent Loans/Gross Loans and Noncurrent Assets plus Other Real Estate Owned/Total Assets Measuring the level of noncurrent loans/gross loans is an indicator of potential cash flow concerns on existing loans and the development of potential asset quality problems that could lead to ratings downgrades and capital concerns. A very similar measure to noncurrent loans/gross loans is noncurrent assets plus other real estate owned/total assets. By establishing either of these ratios as an early warning trigger for credit concerns affecting liquidity, the institution will be positioned to make changes in liquidity levels or assess contingency plans surrounding degrading credit and act proactively. A set of red/yellow/green levels should be set for noncurrent loans/gross loans, as well, with discussion of the ALCO actions in each case. ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 9

Return on Assets Poor earnings may be an indicator of asset quality deterioration, leading to capital erosion, all of which can impact liquidity sources. Using the Liquidity Gap Report to Set Limits The above ratios provide a good evaluation of the structure of the balance sheet, but to get a picture of current and prospective cash flows, you need to have a sources/uses approach. Sources and uses reports that measure liquidity gaps become the most important measurement tool for triggering action by the institution s ALCO or Board. To effectively measure liquidity risk and evaluate trade-offs between risk and return, it is critical to use ALM models, since they contain the data and assumptions needed to project cash flows from the existing balance sheet as well as the assets and liabilities added as part of a business plan. Sources and uses reports that identify liquidity gaps provide a common framework for measuring liquidity risk in both the base business plan and in scenarios that stress an institution s liquidity resources. Sources and uses reports measuring liquidity gaps are the most important measurement tool for triggering action by the institution s ALCO or Board. A sources and uses forecast measures the cash flows occurring within the institution s plan in order to see the impact on the overall liquidity position. A sources and uses report generally looks at the cash flows month by month for at least three months and then quarterly over a specified time frame, usually 24-36 months. By reviewing the impacts resulting from strategy changes, an institution is better able to see how these strategies will impact future liquidity levels. Additionally, if a strategy is creating new liquidity as a result of the acquisition of new HLUM securities or by paying down existing borrowings, these sources of liquidity can be examined and incorporated into the projected liquidity levels. We recommend a rolling approach to liquidity analysis, where the analysis is updated periodically. In a rolling environment the most intense focus should be on the next 12 months. However, it is worthwhile to look at liquidity gaps for periods longer than a year as trends in liquidity gaps become more apparent. Sources and uses reports can be laid out in a variety of ways. A common approach is to group all the sources of funds in the top half of the report, with a total summing the sources. The uses are grouped in the bottom of the report with a sum of the total uses, so investments appear as a source of 10 American Bankers Association

funds (maturities and cash flows from the investment portfolio) at the top of the report and as a use of funds (new investment purchases) at the bottom of the report. Because investment sources and uses are separated into the two halves of the report, it is somewhat difficult to determine whether, on a net basis, investments are a source or a use of funds. In the analysis for Tool 5, we organize the report in a different way, by balance sheet category, displaying both sources and uses for each category, as well as the net impact on cash flow. Either approach will work as they will both lead to the same summary results. Asset Sources and Uses In considering asset sources, all anticipated payments whether contractual or not are considered a source of funds. Since a sources and uses report is generally run using the institution s ALM model, monthly payments amounts, maturities, prepayments, and sales of assets prior to maturity all represent asset sources of funds. ALM models often incorporate assumptions on the level of anticipated prepayments under differing rate forecasts, which can then be used to produce cash flow projections for liquidity analysis. Back-testing the prepayment assumptions in a plan and adjusting speeds based on the backtesting will lead to more accurate planning, liquidity, and interest rate risk projections. In addition to prepayment assumptions, assets may cause an inflow from call and put options. The trigger point for these options should also be assessed in the planned interest rate scenario. Any funds expected to be available should be included in the sources of funds. In projecting asset uses, the liquidity gap ratio report lists the anticipated purchases, renewals, and originations of investments and loans. In addition, planned purchases of fixed or other assets or an increase in non-accrual loans represent a use of funds as they are removing cash from an available status. So, when an institution decides to plan for a new branch or computer system, the impact of higher non-earning assets will affect the amount of available funds for other uses. The relationship between levels of asset sources and uses should move the institution in the direction of the asset balance sheet mix and loan growth goals laid out in the capital plan. It is unlikely that a business plan will be developed that hits the capital plan goals exactly. However, there should be a strong correlation between the general direction set forth in the capital plan goals and the progression in numbers in the business plan. ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 11

XYZ BANK Case Study Figure 5-8 Asset Goals from Capital Plan 14% 12% 10% 8% 6% 4% 2% 0% 12% 10% 8% 6% 4% 2% 0% 25% 20% 15% 10% 5% 0% -5% -10% -15% 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 Investments/ Ending Year Assets Investments Dec-09 6.50% 19,513 Dec-10 9.00% 24,218 Dec-11 11.00% 28,734 Dec-12 12.00% 32,052 Dec-13 12.00% 33,724 Dec-14 12.00% 36,422 SFG 12.00% NE Assets/ Ending Year Assets NE Assets Dec-09 10.42% 31,266 Dec-10 9.50% 25,564 Dec-11 8.40% 21,942 Dec-12 7.60% 20,300 Dec-13 7.00% 19,672 Dec-14 7.00% 21,246 SFG 7.00% Loan Growth Ending Ending Asset Year Rate Loans Assets Growth Dec-09 0.00% 249,218 300,000 0.00% Dec-10-12.00% 219,312 269,094-10.30% Dec-11-4.00% 210,539 261,215-2.93% Dec-12 2.00% 214,750 267,102 2.25% Dec-13 6.00% 227,635 281,031 5.21% Dec-14 8.00% 245,846 303,514 8.00% SFG 8.00% Figure 5-9 Liquidity Gap Report Base Forecast Assets XYZ Bank Forecast Cash Flow Liquidity Report - Assets Base Forecast - Capital Plan [Flat rates] Liquidity Report Mar-2010 (Q) Jun-2010 (Q) Sep-2010 (Q) Dec-2010 (Q) Mar-2011 (Q) Jun-2011 (Q) Sep-2011 (Q) Dec-2011 (Q) Ma (Dollars in Thousands) Total Investments Inflow 611,942 2,695,965 892,971 1,011,679 1,227,006 1,295,368 1,412,701 1,453,797 OutFlow 2,611,942 6,695,965 892,971 1,011,679 6,227,006 1,295,368 1,412,701 1,453,797 Net (2,000,000) (4,000,000) (0) 0 (5,000,000) (0) (0) 0 Cumulative by Year (6,000,000) (5,000,000) Total Loans Inflow 33,917,376 33,653,818 18,610,665 28,752,329 28,178,424 35,243,455 19,636,360 31,910,144 OutFlow 25,564,993 26,371,358 11,544,495 21,896,029 25,946,004 33,033,285 17,448,220 29,743,814 Net 8,352,383 7,282,460 7,066,170 6,856,300 2,232,420 2,210,170 2,188,140 2,166,330 Cumulative by Year 29,557,314 8,797,060 Non-Earning Assets Inflow 610,318 857,362 1,374,288 1,426,105 1,450,984 1,461,973 1,515,049 1,573,471 OutFlow - - - 271,115 432,221 455,510 520,526 590,538 Net 610,318 857,362 1,374,288 1,154,990 1,018,763 1,006,463 994,523 982,934 Cumulative by Year 3,996,957 4,002,682 TOTAL ASSETS Inflow 35,139,636 37,207,145 20,877,923 31,190,113 30,856,414 38,000,796 22,564,110 34,937,412 OutFlow 28,176,935 33,067,323 12,437,466 23,178,822 32,605,231 34,784,163 19,381,447 31,788,148 Net 6,962,701 4,139,822 8,440,458 8,011,290 (1,748,817) 3,216,633 3,182,663 3,149,264 Cumulative by Year 27,554,271 7,799,742 12 American Bankers Association

Asset Sources and Uses Figure 5-8 reviews the capital plan goals for XYZ from Tool 1, which include annual targets as a percent of assets for investments and non-earning assets. It also includes annual goals for loan growth for each year of the five-year plan. XYZ set goals to move investments from 6.5% to 9.0% of assets in Year 1 of the plan. That means the business plan will need to incorporate levels of investment purchases sufficient to cover cash flows from the investment portfolio in Year 1, plus those investment purchases needed to reach the investment portfolio mix goals set forth in the business plan. As a result, uses of funds for investments (purchases) would exceed sources (maturities and cash flows) by an amount sufficient to reach the investment goals at the end of Year 1. Figure 5-9 shows that XYZ plans to grow HLUM securities in its investment portfolio by $2 million in the first quarter of its business plan, another $4 million in the second quarter, an additional $5 million in the 5th quarter and a final $4 million in the 9th quarter of the plan. XYZ s capital plan calls for it to reduce the size of the loan portfolio by 12% in 2010. That means that in 2010, cash flows from the loan portfolio (liability sources) should exceed loan originations (liability uses) by an amount sufficient to reduce the loan portfolio by 12%. Cumulative loan sources exceed uses by $29.6 million in Year 1 of the plan, and another $8.8 million in Year 2. The major portion of the loan portfolio reduction is used to build HLUM securities in the investment portfolio and to shrink assets, which drop from $300 million to $271 million by the end of the 8th quarter of the plan. On the other hand, in the last four quarters of the plan, loans on a net basis turn into a use of funds, exceeding sources by $4.3 million. It is in Year 3 that loan growth goes from negative to positive as called for in the capital plan. Non-earning assets that accumulate as a result of XYZ s asset quality problem are converted back to earning assets under its plan. In Figure 5-9, non-earning assets as a source of funds start in the range of $4 million per year in the first two years of the plan and decrease to $3 million in Year 3. Overall, asset sources exceed asset uses by $27.6 million in 2010 and $7.8 million in 2011, providing the cash to retire liabilities which will allow XYZ to shrink its balance sheet. r-2012 (Q) Jun-2012 (Q) Sep-2012 (Q) Dec-2012 (Q) 1,565,805 1,741,536 1,782,416 1,754,762 5,565,805 1,741,536 1,782,416 1,754,762 (4,000,000) 0 (0) (0) (4,000,000) 32,384,283 34,078,720 20,069,053 27,066,217 35,166,466 36,517,452 21,567,195 28,712,610 (1,077,740) (1,083,150) (1,088,570) (1,094,020) (4,343,480) 699,924 784,964 812,529 804,093-63,436 108,407 104,266 699,924 721,528 704,122 699,827 2,825,401 34,650,012 36,605,220 22,663,998 29,625,072 40,732,271 38,322,424 23,458,018 30,571,639 (4,377,815) (361,622) (384,448) (394,194) (5,518,078) In 2012, asset sources fall short of asset uses of funds by $5.5 million, the difference driving the growth of the asset side of the balance sheet. The analysis of the asset side of the balance sheet fails to consider changes in overnight investments and cash and due. They will be taken into consideration a bit later. ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 13

Liability Sources and Uses Non-maturity deposits are handled in a variety of different ways in a sources and uses reports. The method that uses the change in balances from period to period as either a source or use of funds does not inflate the total cumulative sources and uses, since the assumed cash flows are not counted each period as both a source of funds and a use of funds. Liability sources include the expected renewal of existing funds and the planned acquisition of new funds. Non-maturity deposits are handled in a variety of different ways in a sources and uses report. Some models will assume the projected decay or runoff of existing non-maturity deposits as a monthly outflow offset by new nonmaturity deposits being booked. Other models assume that in each period being analyzed, all funds are immediately available for outflow and inflow. A third method is to use the change in balances from period to period as either a source or use of funds. All three methods arrive at the same difference between sources and uses of funds in a period. However, the first or second analysis inflate the total cumulative sources and uses relative to the third method, since the assumed cash flows are counted each period as both a source of funds and a use of funds. Term liability uses consist of outflows due to maturities including planned or unplanned runoff of funds. Embedded options on liabilities must be considered the same way we consider options on assets. Early CD withdrawals may be a concern for institutions with ineffective CD penalties, especially during stress events. The existence of wholesale contracts with call options held by an issuer like an FHLB might cause funding to leave prior to maturity, a possibility that should also be factored into the uses of funds. In the capital account, retained earnings (income net of dividends) and any capital raised represent a source of funds. Capital retirement (stock repurchases, payoff of subordinated debt, preferred stock or TARP funds) as well as operating losses represent a use of funds to the extent they cause a reduction in retained earnings. 14 American Bankers Association

XYZ BANK Case Study Liability Sources and Uses On the funding side of its balance sheet, as part of its capital plan, XYZ set a number of goals. One of the goals was to grow Core Funding by 2% in 2010 (Figure 5-10), followed with a 5% growth in 2011 and a 7% growth in 2012. At the same time, XYZ planned to reduce its reliance on Near-Core and Non-Core Funding from its current 35.9% level to 28.4% in 2010, 23.3% in 2011, and 20.1% in 2012. That reduction is consistent with its Near-Core and Non-Core Funding plan which sets the goal to reach a position where approximately half of its Near-Core and Non-Core Funding limit is utilized as part of its base business strategy with the other half available as a source of funding to deal with liquidity stress events. The methods XYZ will use to grow Core Funding were laid out in its Core Funding plan (Tool 2). The 2010 $3.3 million projected Core Funding growth (Figure 5-11) is more than offset in Year 1 by a reduction of $2.8 million in Near-Core Funding and $19.7 million on Non-Core Funding, allowing XYZ to shrink its balance sheet. In Year 2 (2011), Core Funding is projected to grow by $10.4 million, offset by a reduction in Near-Core of $3.1 million and Non-Core of $13.1 million, allowing for additional balance sheet shrinkage. In 2012, projected Core Funding growth of $14.8 million is partially offset by a reduction in Near-Core Funding of $1.3 million and Non-Core Funding of $5.2 million, allowing overall funding growth to support a growing balance sheet. at $784 thousand as opposed to $663 thousand in the capital plan. Projected net income of $696 thousand from the business plan in 2012 came up short of the $925 thousand projected in the capital plan. Once again, it would be unreasonable to expect that the business plan will hit capital plan goals right on the head. But the results from the business plan should be in the same general range as the goals in the capital plan. So far, they are in roughly the same range of each other. On an overall basis, Figure 5-11 shows that the business plan reduces XYZ s liability and capital funding by $22.3 million in 2010 (a net use of funds), and $6.7 million in 2011. Once the growth rate turns around in 2012, the liability and capital side of the XYZ balance sheet becomes a net source of funds of $9.0 million, providing the funding to grow the XYZ balance sheet. Note that any overnight borrowings on the balance sheet are ignored in Figure 5-11. In the capital plan, XYZ anticipated capital shrinkage of $2.845 million in 2010 (Figure 5-10) as a result of operating losses caused by its current asset quality problem. When XYZ actually built its business plan for 2010, the sum of the net equity outflows on the Liability Sources and Uses Report (Figure 5-11) shows a net equity outflow of $3.1 million due to projected operating losses, fairly close to the capital plan goals. Projected operating losses for 2011 in the business plan came in ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 15

XYZ BANK Case Study Figure 5-11 Liquidity Gap Report Base Forecast Liabilities Figure 5-10 Liability and Capital Goals from Capital Plan Liquidity Report Mar-2010 (Q) 10% 8% 6% 4% 2% 0% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 Core Growth Ending Year Rate Core Dec-09 2.00% 164,980 Dec-10 2.00% 168,280 Dec-11 5.00% 176,694 Dec-12 7.00% 189,062 Dec-13 8.00% 204,187 Dec-14 8.00% 220,522 Strat Goal 8.00% Oth Liab/ Ending Year Assets Oth Liab Dec-09 0.20% 589 Dec-10 0.20% 538 Dec-11 0.20% 522 Dec-12 0.20% 534 Dec-13 0.20% 562 Dec-14 0.20% 607 Strat Goal 0.20% Return on Net Year Assets Income Dec-09-1.00% (2,993) Dec-10-1.00% (2,845) Dec-11-0.25% (663) Dec-12 0.35% 925 Dec-13 0.80% 2,193 Dec-14 1.08% 3,157 Strat Goal 1.08% Core Funding Inflow 16,597,475 Outflow 15,771,201 Net 826,274 Cumulative by Year Near-Core Funding Inflow 1,313,659 Outflow 1,699,948 Net (386,289) Cumulative by Year Non-Core Funding Inflow 6,966,473 Outflow 8,907,026 Net (1,940,554) Cumulative by Year Other Liab Inflow - Outflow 9,776 Net (9,776) Cumulative by Year Capital Inflow - Outflow 689,653 Net (689,653) Total Liab & Capital Inflow 24,877,606 Outflow 27,077,605 Net (2,199,999) 60% 40% 20% 0% -20% -40% -60% -80% -100% 40% 35% 30% 25% 20% 15% 10% 5% 0% 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 Dividends/ Dividends New Captl Ending Year Income Paid (Buyback) Lev Capital Dec-09-13.33% 399 26,702 Dec-10 0.00% - 0 23,857 Dec-11 0.00% - 0 23,194 Dec-12 33.00% 305 0 23,813 Dec-13 33.00% 724 0 25,282 Dec-14 33.00% 1,042 0 27,397 Strat Goal 33.33% NonNr Core Ending Year Assets NonNr Fnd Dec-09 35.91% 107,728 Dec-10 28.40% 76,420 Dec-11 23.28% 60,805 Dec-12 20.10% 53,693 Dec-13 18.15% 51,000 Dec-14 18.12% 54,987 Strat Goal 20.00% 16 American Bankers Association

XYZ Bank Forecast Cash Flow Liquidity Report - Liabilities & Capital Base Forecast - Capital Plan [Flat rates] Jun-2010 (Q) Sep-2010 (Q) Dec-2010 (Q) Mar-2011 (Q) Jun-2011 (Q) Sep-2011 (Q) Dec-2011 (Q) Mar-2012 (Q) Jun-2012 (Q) Sep-2012 (Q) Dec-2012 (Q) (Dollars in Thousands) 29,179,130 23,759,908 15,539,710 20,064,158 32,453,485 33,933,798 17,495,182 22,013,301 29,415,857 33,985,467 21,379,209 28,348,719 22,925,338 14,700,959 17,526,869 29,877,947 31,319,433 14,841,405 18,415,611 25,745,732 30,241,449 17,559,811 830,412 834,571 838,751 2,537,288 2,575,538 2,614,365 2,653,777 3,597,690 3,670,124 3,744,017 3,819,398 3,330,007 10,380,968 14,831,230 5,420,518 2,053,506 2,266,005 1,403,900 3,051,534 5,482,753 1,944,750 879,334 1,422,385 3,894,445 1,799,676 6,583,405 2,749,961 2,809,915 1,754,597 5,172,609 5,862,276 2,225,447 1,159,084 1,570,289 4,599,058 1,981,692 (1,162,887) (696,454) (543,909) (350,697) (2,121,075) (379,523) (280,697) (279,750) (147,904) (704,614) (182,016) (2,789,540) (3,131,992) (1,314,284) 14,384,826 10,158,890 5,631,989 10,285,272 8,938,388 8,616,906 5,007,097 12,197,125 11,447,464 11,895,453 3,396,590 23,889,231 13,130,896 10,888,153 14,846,947 11,530,583 10,178,962 9,402,255 13,703,538 13,145,813 13,088,302 4,187,499 (9,504,405) (2,972,007) (5,256,164) (4,561,675) (2,592,195) (1,562,056) (4,395,158) (1,506,413) (1,698,349) (1,192,849) (790,909) (19,673,130) (13,111,084) (5,188,520) - - - - - - - 3,000 3,000 3,000 3,000 13,909 13,909 13,909 4,000 4,000 4,000 4,000 - - - - (13,909) (13,909) (13,909) (4,000) (4,000) (4,000) (4,000) 3,000 3,000 3,000 3,000 (51,503) (16,000) 12,000 - - - - - - - 156,008 135,470 351,707 235,680 752,928 826,644 841,560 235,456 291,715 132,162 124,553 - - - 182,552 (752,928) (826,644) (841,560) (235,456) (291,715) (132,162) (124,553) 156,008 135,470 351,707 53,128 (3,110,785) (783,887) 696,313 48,984,475 35,972,305 23,437,704 31,753,329 44,443,407 48,033,457 24,447,029 35,248,767 42,424,175 50,130,071 26,814,155 59,588,192 39,646,748 29,254,496 34,367,869 46,876,854 47,496,833 26,597,660 33,278,233 40,461,834 47,928,810 23,911,554 (10,603,717) (3,674,443) (5,816,792) (2,614,540) (2,433,448) 536,624 (2,150,632) 1,970,534 1,962,341 2,201,262 2,902,602 (22,294,951) (6,661,995) 9,036,738 ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 17

Identifying Liquidity Gaps The Liquidity Gap section of a Sources and Uses report often begins by reviewing whether the net cash flows between assets and liabilities is adding to or reducing institution liquidity. To calculate cash flows coming from the balance sheet, sources are summed (asset and liability sources) and uses are summed (asset and liability uses). Sources are subtracted from uses to demonstrate the cash flow surplus or deficit. (On a financial institution balance sheet, total assets must equal the sum of total liabilities and capital. For that reason, total sources and uses of funds in any accounting period must be equal.) The purpose of a sources and uses cash flow report, however, is more than merely explaining the changes to investments and borrowings from period to period. The primary reason for performing sources and uses analysis is to determine whether an institution has adequate liquidity to fund its business plan and to survive the effect of stress events. The cumulative ratios are the most important measures of liquidity gap. Common measures of liquidity gap include dollar mismatches and ratios. Both can be calculated on a cumulative and non-cumulative basis. Of the ratios, the cumulative ratios are more important. Fluctuations in liquidity gaps between individual months and quarters may result from timing mismatches between incoming and outgoing cash flows. These timing issues are addressed with overnight investment and overnight borrowing transactions. These individual period mismatches are often neutralized by offsetting mismatches in prior or subsequent periods. On the other hand, a longer-term cumulative mismatch, especially when outflows exceed inflows, may cause erosion in an institution s liquidity position by using up available borrowing capacity or eating into the institution s stock of HLUM securities. Setting Liquidity Gap Policy Limits Graduated risk levels are also appropriate to use with liquidity gap analysis. Policy limits that focus on sources and uses analysis should reflect cash flows needed to allow an institution to survive liquidity stress events. The cumulative liquidity gap/assets ratio is the best measure for liquidity risk, within the sources and uses analysis. See page 22 for the case study on liquidity gap policy limits. 18 American Bankers Association

Which Ratio is a Better Measure of Liquidity? The issue of whether sources/uses is better than liquidity gap/assets as a measure of liquidity is similar to what played out in the early days of interest rate risk analysis and reporting built around repricing gaps. In those days institutions calculated the rate sensitive assets/rate sensitive liabilities (RSA/RSL) ratio in a nearly identical manner to the calculation of the sources/uses ratio. The RSA/RSL ratio was calculated on both a non-cumulative and cumulative basis. But users quickly identified that RSA/RSL really didn t relate the size of the repricing mismatch to the size of the institution. So the industry changed its focus to the cumulative gap/asset ratio as the primary measure of interest rate risk in the gap analysis framework. In much the same way, we are focusing on the liquidity gap/asset ratio, as it relates the size of the liquidity buffer to the size of the institution. XYZ BANK Case Study Identifying Liquidity Gaps at XYZ Bank The top portion of Figure 5-12 looks at the net cash flows coming from the balance sheet, ignoring cash and due from, overnight investments, and overnight borrowings. Totals appear on the top line of Figure 5-12. Line 2 shows the sources on a cumulative basis. Uses of funds (asset and liability sources) are summed and appear on Line 3 of the analysis. Cumulative uses of funds appear on Line 4. Sources are subtracted from uses on Line 5, which shows the cash flow surplus or deficit for the quarter. Cash flow surpluses or deficits are shown on a cumulative basis on Line 6. XYZ shows a cumulative cash flow surplus (sources less uses) of $5.89 million over the three years of its business plan. XYZ s 12/31/09 balance sheet contains $3.159 million in cash and due from and $2.083 million in overnight investments, a total of $5.243 million. Cash and due from are projected to remain at $3.159 million through the 12 quarters of the business plan. For that reason, changes in the total combined balance of $5.243 million that occur under the plan represent additions to or subtractions from overnight investments and overnight borrowings. Figure 5-12 shows a cash flow surplus of $4.763 million for the first quarter of 2010. The surplus increases Cash & Due From and Overnight Investments by $4.763 million (Figure 5-11 Section 2, Line 2). The $4.763 million increase in Cash, Due From, and Overnight investments is the offsetting use of funds that keeps the balance sheet in balance. The second quarter shows a cash flow deficit of $6.464 million (Section 1, Line 5). Cash, Due From, and Overnight Investments decreases by $6.464 million providing the funds needed to cover the cash flow deficit. However a portion of the cash flow deficit is due to the purchase of $4 million of HLUM securities in the second quarter (Figure 5-9) so only a portion of the deficit is a true reduction in asset-based liquidity. That net reduction in asset-based liquidity of $2.464 million can be seen can in Figure 5-12, Section 2, Line 3 as a reduction in available HLUM securities, cash and overnight funding from $15.873 million at the end of the first quarter to $13.409 million at the end of the second. From the end of the second quarter through the end of the 12-quarter forecast, available HLUM securities, cash and overnight funding continue to build to a total of $30.003 million due to a combination of cash flow surpluses adding to the Fed Funds Sold position and additional purchases of HLUM securities, adding to XYZ s asset-based liquidity. ABA Toolbox on Liquidity Tool 5: Building a Liquidity Policy Statement and Contingency Funding Plan 19