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 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:
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:
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.
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:
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:
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:
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.