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Wednesday, July 30, 2014

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SRC Insights: First Quarter 2009

Liquidity Risk Management: Are You Prepared?

Liquidity is a financial institution's ability to meet its cash and collateral obligations without incurring unacceptable losses. Liquidity risk is the risk to financial condition or safety and soundness that is created when a financial institution cannot meet its contractual obligations, both real and perceived. Under the current market situation, the importance of proper liquidity risk management practices is evident more than ever before. This is the first of a two-part series on liquidity risk management. This article will provide an overview of the elements of financial institution liquidity and sound liquidity risk management. Part two of the series, to be published in the second quarter issue of SRC Insights, will focus on liquidity risk measurement and contingency funding plans (CFPs).

Liquidity Management Basics

Liquidity need and liquidity supply are situation-specific—different circumstances will cause a bank's needs to differ. Likewise, the supply of liquidity by creditors or depositors will change given differing situations. Too much liquidity can impact a financial institution's profitability; too little liquidity can result in various negative repercussions resulting from the inability to meet contractual obligations.

The basic elements of liquidity management are as follows:

  • Assessing current and expected future needs for funds on an ongoing basis and providing that sufficient funds or access to funds exists in order to meet those needs at the appropriate time
  • Providing for an adequate cushion of liquidity to meet unanticipated cash flow needs that may arise from potential adverse circumstances ranging from high-probability/low-severity events that occur in daily operations to low-probability/high-severity events that occur less frequently, but that could significantly affect a financial institution's safety and soundness
  • Striking an appropriate balance between the benefits of providing for adequate liquidity to mitigate potential adverse events and the cost of that liquidity from various types of liabilities, transactions, and service fees

Liquidity is dynamic and changes according to events both at a bank and in the market. Some events may be planned or can be expected, while others occur unexpectedly. Changes in interest rates; economic conditions; and operational, reputational, legal, and credit risk exposure can all impact a financial institution's liquidity profile and heighten risk.

Types of liquidity risk include the following:

  • Mismatch Risk—The risk that there will be insufficient cash to meet obligations in the normal course of business due to ineffective matching of cash inflows and outflows
  • Market Liquidity Risk—The risk that market constraints will affect the conversion of assets into cash or hinder access to sources of funds
  • Contingent Liquidity Risk—The risk resulting from unexpected events

A financial institution must understand that its liquidity position is constantly changing and that it must employ sound liquidity risk management in order to respond to all events to remain safe and sound and manage profitability effectively.

Elements of Sound Liquidity Risk Management

Liquidity risk management serves to prospectively assess the need for funds to meet contractual obligations and ensures the availability of cash or collateral to fulfill those needs at the appropriate time by coordinating all sources of funds available to the financial institution. In general, sound liquidity risk management calls for financial institutions to have: 1) effective corporate governance over the management of liquidity risk, including active involvement by the board of directors and senior management, and 2) a liquidity risk management process that is adequate for the size, complexity, and business activities of the financial institution.

Board and senior management oversight. Senior management should establish and the board of directors should approve limits and guidelines on the nature and amount of liquidity risk the financial institution is willing to assume. Such limits and guidelines and the level of supporting detail should be appropriate to the size, complexity, and financial condition of the organization and be consistent with the financial institution's overall approach and strategies for measuring and managing liquidity.

Role of the board of directors—The board should understand and guide the strategic direction of liquidity risk management. These responsibilities include the following:

  • Understanding the nature of the financial institution's liquidity risks
  • Maintaining a general strategy for managing liquidity risk
  • Understanding and approving liquidity risk management policies
  • Establishing acceptable risk tolerances
  • Establishing executive-level lines of authority and responsibility for managing liquidity risk
  • Understanding and periodically reviewing the financial institution's CFP
  • Understanding the liquidity risk profile of important subsidiaries and affiliates and their potential impact on the overall liquidity of the financial institution

Role of senior management—Senior management should ensure that liquidity risk management strategies, policies, and procedures are adequate for the size and complexity of the financial institution. Management should ensure that policies and procedures are appropriately executed on both a long-term and day-to-day basis. Management should also oversee the design and implementation of an appropriate risk measurement system and standards, a comprehensive liquidity risk reporting and monitoring process, an appropriate CFP, and effective internal controls and review processes.

Senior management should periodically review the organization's liquidity risk management strategies, policies, and procedures and its CFP to ensure that they all remain appropriate and sound. Management should also coordinate the financial institution's liquidity risk management with its efforts for disaster, contingency, and strategic planning, as well as with its business and risk management objectives, strategies, and tactics.

The risk management process. The elements of a sound liquidity risk management process include the following:

  • Comprehensive management strategies, policies, procedures, and limits that are appropriately designed, implemented, and monitored
  • Adequate liquidity and liquidity risk measurement systems
  • Appropriate management information systems that provide for reports throughout the corporate governance structure
  • Comprehensive CFPs for addressing potential adverse liquidity circumstances and emergency cash flow needs
  • Adequate internal controls that include the involvement of internal audit in the periodic review of compliance with established policies, procedures, and limits

A financial institution's strategies for managing its liquidity and liquidity risk exposure are largely reflected in the policies, procedures, and limits imposed upon the liquidity management process. This includes the plans and courses of actions identified for dealing with the potential for temporary, intermediate-term, and long-term liquidity disruptions. Policies and procedures for managing liquidity and liquidity risk should:

  • Identify the objectives of the financial institution's liquidity management and its expected and preferred reliance on various sources of funds to meet liquidity needs under alternative scenarios
  • Delineate clear lines of responsibility and accountability over liquidity risk management and management decisionmaking
  • Specify quantitative limits and guidelines that define the acceptable level of risk for the financial institution
  • Identify the frequency and methods used to measure and monitor liquidity risk
  • Define the specific procedures and approvals necessary for exceptions to policies, limits, and authorizations

All liquidity risk policies, procedures, and limits should be reviewed periodically and revised as needed.

Sound liquidity risk management begins with appropriate policies, procedures, guidelines, and limits and effective board and senior management oversight. An institution's liquidity risk management is a critical piece for its ongoing safety and soundness. Part II in this series will discuss liquidity risk measurement, CFPs, and adequate internal controls. If you have any questions on liquidity management and liquidity risk management, please contact Avi Peled at (215) 574-6268 or Andrea Anastasio at (215) 574-6524.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.