It’s “absolutely critical” that banks get their balance sheets in order, FDIC Chairman Sheila Bair warned bankers in a recent speech. “You simply must accept that the credit downturn is far from over. It’s a tough slog but there’s no easy way out.”

Bair ticked off a list of industry problems:

• Troubled loans keep rising across all types. Residential mortgage loans account for the largest share of the increase in the second quarter, but construction loans are the fastest-growing category.
• Although disruptions in financial markets had previously affected mainly the earnings of only the largest banks, the abrupt turn in the credit cycle is now hurting many more institutions.
• The number of “problem” institutions continues to rise. At the end of June, there were 117 institutions on the problem list, the largest number since the middle of 2003, and more will come on the list as credit problems worsen.

Liquidity Risk Management

Bair emphasized the need for smart liquidity risk management. Asset quality problems are putting more pressure on the funding side of the balance sheet, she said. She also noted that liquidity problems, in varying degrees, have contributed to this year’s bank failures.

“Given the trajectory (and a weak economy), strong liquidity management is more important than ever,” Bair said.

She acknowledged that liquidity can be an elusive thing, and warned that “liquidity problems can often hit an institution fast and hard.” The FDIC, she added, is revisiting its off-site monitoring to better detect early signs that can alert on-the-ground examiners identify and resolve liquidity problems promptly.

These early signs include:

• Rapid asset growth funded by potentially volatile liabilities;
• Reliance on large depositors/concentrated funding sources;
• Offering rates significantly above the local deposit market and seeking deposits through internet sites;
• Negative publicity;
• A decline in asset quality or earnings performance;
• Counterparties who increase collateral requirements; and
• Shrinking, or outright loss of credit lines.

FIL Clarifies FDIC Concerns

Bair’s speech followed close on the heels of the FDIC’s issuance of a financial institution letter (FIL-84-2008) that clarified the agency’s concerns about liquidity risk management.

Bair highlighted several issues from the letter, including:

• Contingency planning: Banks should have comprehensive contingency funding plans, which will include pro forma cash flow statements that address multiple stress scenarios and factor in the various “what-ifs” that might influence funding options. A good contingency funding plan will identify areas of stress; clearly spell out management responsibilities and lines of decision-making; detail monitoring tools, such as pro forma cash flows; and consider all possible constraints on funding sources and back-up credit lines.
• Restrictions on brokered & high-rate deposits: Because the rules for brokered deposits and high-cost funds use the capital categories regulators use for “prompt and corrective action,” many banks that relied on volatile funding may now be facing new funding challenges if their capital levels drop. When a bank falls below “well-capitalized,” the amount of this funding is restricted. Although regulators have the power to grant a waiver for a bank that falls to “adequately-capitalized,” the current rules place a number of restrictions on waivers.

The FDIC chairman said there are currently several dozen institutions nationwide that are borderline “well-capitalized” whose brokered deposits as a percentage of assets exceeds 25 percent.

“These are the types of trends that concern us,” she added, “and that will be the subject of much closer scrutiny by our examiners.”