CDFI: Best Practices in Liquidity Management During the COVID-19 Pandemic

By XiXi Dong  |  May 27, 2020

A community development financial institution (CDFI) is a financial institution certified by the Community Development Financial Institutions Fund at the U.S. Department of the Treasury. To date, there are over 1,100 CDFIs in the country including banks, credit unions, loan funds and venture capital funds. Half of them are nonprofit loan funds.

Nonprofit CDFI lenders are established to provide capital access to underserved communities, those that are disadvantaged and the small businesses that have traditionally been overlooked by mainstream financial institutions, by offering flexible qualifications and educational services to borrowers. In March 2020, the World Health Organization declared the outbreak of a novel coronavirus (COVID-19) as a pandemic, which continues to spread throughout the United States. CDFIs are playing a crucial part in this pandemic by providing emergency lending for community organizations.

Despite the great things that CDFI lenders are doing for the communities, they are also facing greater than ever liquidity risk due to the pandemic.

First, CDFIs have limited access to COVID-19 relief funds. The Paycheck Protection Program (PPP) from the Coronavirus Aid, Relief, and Economic Stability Act (“CARES Act”),  signed on March 27, 2020, left out most CDFIs as ineligible lenders because the program requires lenders to have $50 million in small business loans annually, while the average size of a CDFI’s small business loan is significantly less. On April 30, 2020, the regulations were modified to set aside $30 billion of new PPP funding for community financial institutions, which include CDFIs and minority depository institutions with assets under $10 billion. In addition, the threshold of required business loans was lowered to $10 million. However, this funding also includes banks with assets under $10 billion and is being rapidly depleted. According to the latest data released by the U.S. Small Business Administration, approximately $2.8 billion of this second round of PPP funding went to CDFIs as of May 8, 2020.

Second, nonprofit CDFIs are not depository institutions. While banks have greater access to capital through the Federal Reserve, CDFIs rely heavily on cash on hand as they generate capital from government funding, social investments and philanthropies, as well as third-party borrowings.

Third, CDFIs are likely to see significant increases in non-performing loans. Like banks, nonprofit CDFIs are required to establish a loan loss reserve based on anticipated risk such as historical loss, environmental factors, impairment, etc. Beginning in March 2020, COVID-19 poses a new risk to the CDFI’s lenders as they serve the most vulnerable population in the pandemic crisis.  Delayed payment or loan defaults will put CDFIs in greater need of cash flow and liquidity than ever; therefore, it is important that CDFIs manage their liquidity to avoid straining their balance sheets.

Liquidity Ratios

While nonprofit organizations typically manage and monitor their operating liquidity to measure the amount of liquid assets available to fund operating expenses, nonprofit CDFIs should also focus on capital liquidity, which is the availability of liquid assets to fund loans and investments and to repay investors. This ratio measures the CDFI’s ability to meet its short-term investor obligations with available liquid capital and is calculated as follows:

Liquid Assets + Specific % of Current Loans Receivable

             Current Investor Notes Payable

 

In addition to the liquidity ratios, CDFIs should also monitor their current ratio, working capital ratio, cash flow projections, and days cash on hand on a regular basis, especially under the environment of COVID-19 due to the uncertainty.

Risk Rating System and Policies

Having the appropriate internal risk rating system is essential to effectively monitor loan losses, hence managing liquidity. Such a system should include a risk rating matrix that segments the loan portfolio by level of risk. For example, the risk could range from Low, Moderate, High, Watchlist and Doubtful. Each loan risk category can be assigned to a pre-determined loan loss reserve percentage that provides a systematic method to determine loan loss reserves. This system standardizes the risk measurement process and can be used to determine borrower credit risk based on the evaluation of factors such as financial strength and performance of the borrower, credit quality indicators, loan repayment and status. Using a risk rating system promotes the CDFI credit culture by establishing the standards of risk within a CDFI. Once developed, procedures and practices for the risk rating system should be documented in the risk rating policy.

Reporting and Oversight

Based on the risk assigned to each loan portfolio, CDFIs should develop a sensitive assets report on a regular basis for close monitoring of non-performing loans that escalated to a higher level of risk. Information such as borrower profile including outstanding balance, loan status, risk rating, etc., rationale for sensitive asset classification and management action plan should be included in this report and be presented to a designated committee or board of directors. Such a report provides a great tool for oversight of overall risks associated with CDFI liquidity at the governance level.

The suggested practices above are examples of how CDFIs can manage their liquidity during the COVID-19 crisis. However, CDFIs should evaluate their own practices to ensure there is proper and timely internal oversight to manage loan risk, cash flows and liquidity during this time of uncertainty.

About XiXi Dong