Funds Management: Have Your Cake and Eat It Too

Financial institutions are constantly faced with balancing the risk and reward of different business decisions. Should a business loan be funded or is it too risky? Should a new product line be adopted, or will it result in more expenses than revenue?

When it comes to funds management, the balance also comes with the need for liquidity and the need for earnings. What should the institution do with the funds on hand? Invest in consumer loans? Invest in business loans? Invest in securities? Do nothing and hold cash? I think it is important to understand that doing nothing and holding cash is a decision that also has serious consequences, because it will have an effect on the long-term cash flow of the institution.

The goal of funds management is unique. The institution must manage its need for liquidity to pay obligations, while also balancing the need for earning assets to fund operations. An institution needs to develop a funds management policy, which determines where they will place the fulcrum to balance these needs. Ultimately, it will boil down to how much liquidity is necessary, and how the institution will go about accessing it.

A strong funds management policy will allow for efficient use of available funds without the need to wonder how much liquidity is too little or too much. When excess liquidity is identified, it can be put to use. Excess liquidity should be put to use, because the rate of return on holding cash is 0%. In an odd turn of the phrase, having too much cash is literally leaving money on the table! Those funds could even be deployed into CDs with correspondent accounts or low-yield securities that at least pay something above 0%.

Many institutions currently possess too much liquidity. I believe this is the result of three major factors. The first factor is the concern over low interest rates. Institutions don’t want to risk investing in long-term assets only to have their cost of funds increase. This can be overcome by smart asset-liability management.

The second issue has to do with a fear of running out of liquidity in the event of an economic downturn. This is a legitimate concern to a point, but smart funds management can easily preserve liquidity. In modern times, institutions have great access to multiple lines of credit through the FHLB, Fed Funds, etc. Also, if liquidity is invested in available-for-sale (AFS) securities, those investments can easily be converted back to cash.

The third reason I think institutions hold on to too much liquidity is they simply are not sure where and how to invest it. They don’t want to invest in securities only to realize losses if interest rates rise, and they don’t want to invest in complicated loans only to have them default. They may be constrained by their market area and simply have no other way to build consumer loan volume.

The only way to overcome the last concern is by strong management and foresight. An institution needs to find innovative ways to overcome barriers, and those who are willing to innovate will win. There may be costs associated with employing expertise to help with funds management, analyzing securities or buying into participation loans; but ultimately, the cost will be more than recovered in the long run.

Those who will not effectively use a funds management policy or innovate will retain their liquidity, at an opportunity cost. While holding onto cash may seem prudent in the short-term, it is not a profitable decision, and an institution needs profits to keep the lights on and continue to grow its capital. An institution that fails to grow to meet increased customers’ and members’ needs risk losing their competitive edge and may need to merge with a larger institution in the long run.