Using Advances for Just-in-Time Liquidity

Andrew Paolillo Icon
Andrew Paolillo

With higher on-balance sheet liquidity persisting, earnings for many members may keep contracting if rates remain near current levels. Just-in-time access to liquidity using FHLBank Boston advances can address any funding needs from loan growth and/or deposit outflows.

Elevated On-Balance Sheet Liquidity

For banks and credit unions, liquidity management has historically involved performing analyses and making decisions to guard against the potential of not having enough liquidity. However, in the current environment, liquidity risk management now means an entirely different thing — how to tackle the issue of having too much liquidity that creates a drag on earnings. For perspective, let’s look at the table below which shows median values for key balance sheet metrics of FHLBank Boston depository members for the fourth quarter of 2019 and the third quarter of 2020.


                               Credit Unions

Q4 2019Q3 2020Q4 2019Q3 2020

Both banks and credit unions have experienced similar trends — a lower amount of loans, greater levels of cash on hand, and deposits comprising a greater percentage of the liability mix. Loan growth has been hard to come by in this operating environment while deposits have surged, remained, and in some cases even continued to flood in. 

Typically, an imbalance between loan and deposit flows like this would lead members to deploy that excess liquidity into the securities portfolio. The table above indicates that many are electing to simply hold elevated amounts of cash as opposed to adding bonds. The prospect of lower yields and tighter spreads has created a seemingly less than ideal risk/reward trade-off.

“The member can utilize advances to manage any interim cash flow needs in excess of what is returned from the investment…”

Continued Margin Compression

Eschewing support for income by holding elevated cash is that much more impactful in the current rate environment, where margins continue to be under pressure. The chart below shows the decline in interest income for FHLBank Boston depository members has been more pronounced than the savings in interest expense, leading to tightening margins. Looking forward, the proximity to the zero bound means that the trend is likely to continue as cost of funds savings plateau out and asset yields continue to grind lower.

This is consistent with discussions we have had with members, who have expressed that the best-case scenario for them would be higher intermediate rates and/or a steeper yield curve that coincided with a resumption of loan growth. This holds true from an interest-rate risk perspective to some extent, for those members who have a greater degree of liability sensitivity. Rising rates would lead to some near-term softness in earnings, but then after one to two years, income would begin to recover as asset yields improve while funding costs remain modest. 

Regardless of the interest-rate risk positioning, for many members the scenario where they are most at risk would be a prolonged period of rates at current or lower levels. The graph below shows an example of a two-year income simulation in an unchanged and higher-rate environment. It highlights the typical profile many members are exposed to currently.

Balancing Current and Future Needs

How can a depository institution support current income needs while maintaining the flexibility to meet future lending and funding needs? One way to accomplish this is to rely on the just-in-time liquidity offered by FHLBank Boston advances. 

While on-balance sheet liquidity metrics have strengthened for many members, so has off-balance sheet liquidity levels due to increased borrowing capacity. Off-balance sheet liquidity can instill confidence to deploy excess cash into defensive, cash-flowing investments such as 10- or 15-year agency mortgage-backed securities (MBS). While they may not produce the yields or spreads that many are used to, they add incremental return versus the small or negative spread being earned from excess cash sitting at the Fed. 

If any lending growth or deposit outflow situations arose and necessitated a funding need, a member would be able to borrow against a significant portion of the MBS market value. By normalizing cash levels, income is improved. As the graph above shows, reduced income in the current environment is a balance sheet risk that is present for many members. Access to liquidity is maintained by investing excess cash, just in a different form.

Let’s look at an example in which a member purchases $10 million of a 10-year agency mortgage-backed security and pledges it as collateral. While a yield in the range of 0.50 % to 0.75% may be far from exciting, it’s an improvement compared to holding cash. With a base case average life between 2.5 to 3.5 years, it has a rapid return of cash flow with minimal extension risk.

In the early months, the access to liquidity is weighted towards a reliance on the available borrowing capacity — in this example assumed to be 97% of market value. Earnings are being supplemented now, and the asset quickly begins to see an accelerated return of principal. The member can utilize advances to manage any interim cash flow needs in excess of what is returned from the investment, and there is the potential for margin expansion when loan demand reverts to stronger levels.

Depending on market conditions and balance sheet positioning at the time of the future funding need, the variety of advance solutions and ease of execution can afford members great flexibility to dynamically manage their risk. Funding options exist whether a member is inclined to align with the Fed’s guidance by funding short, but mitigating liquidity risk, extend liability duration ahead of a steepening curve, or opportunistically benefit from elevated market volatility and capture margin relief with structured advances.

If the market value risk of investments in a rising-rate environment is a concern, there are a couple of ways to address that. 

First, in this article and case study, we discussed how members can utilize advance restructures to mitigate interest-rate risk without adding incremental funding.

Secondly, members can align the base case and rate-shocked average life of any asset purchases with their specific risk tolerance.

Lastly, utilizing the Held-to-Maturity (HTM) classification may offer relief from unrealized changes in market value flowing through Other Comprehensive Income (OCI). With the drop in loan-to-asset ratios over the last few quarters, one might have expected to have seen greater usage of HTM. Conversely, an analysis of FHLBank Boston depository members shows that the percentage of banks and credit unions who are using the HTM classification has dropped from the fourth quarter of 2019 to the third quarter of 2020 as illustrated in the table below.

Banks33 %31 %
Credit Unions47 %44 %

Flexible Funding

Our Financial Strategies group has developed a suite of analytical tools designed to help you identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644,, or your relationship manager for more details.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.

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