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SRC Insights: Third Quarter 2010

Elements of a Sound Funding and Liquidity Risk Management Program, Part II

Many banks experienced strained liquidity provisions during the recent financial crisis, and some banks are still working through liquidity issues. While liquidity conditions have improved at many banks during the past year, a focus on sound liquidity risk management (LRM) practices remains vitally important. On March 17, 2010, the federal banking regulators issued SR Letter 10-6, Interagency Policy Statement on Funding and Liquidity Risk Management,1 to provide financial institutions with consistent interagency guidance on the principles of sound LRM. This is the second of two articles focusing on sound LRM. In the second quarter 2010 issue of SRC Insights, corporate governance and liquidity strategies, policies, and limits were discussed. This article will focus on the two remaining areas of an effective LRM program: liquidity risk measurement, monitoring, and reporting and contingency funding plans (CFPs).

If the recent crisis taught us anything, it is that liquidity events happen quickly, and proactive measures on management's part are critical to avoiding a severe liquidity crisis. Liquidity managers need to understand the funding vulnerabilities of their institutions and the impact that problems in other areas of the bank may have on liquidity. LRM practices that incorporate forward-looking cash flow projections, as well as stresses to these projections, will enable a liquidity manager to implement strategies early to mitigate a liquidity crisis.

Liquidity Risk Measurement

While cash flow projections are part of the LRM practices at many institutions, some banks are still relying on static balance sheet ratios to measure their liquidity risk profile. While static ratios are very useful in presenting historical information in a clear and easily understood format, they do not incorporate forward-looking projections and therefore fall short in predicting future funding vulnerabilities.

To be effective, the liquidity risk measurement process must include robust cash flow projections arising from assets, liabilities, and off-balance sheet items. Examiners review ALCO packages, including ALCO meeting minutes, to ensure that cash flow projections are an integral part of the liquidity measurement process. Pro forma cash flow statements for various time buckets, such as daily, weekly, monthly, quarterly, and annually, should be part of a liquidity risk measurement process. Because some of the cash flow projections are based on assumptions, such as those related to nonmaturity deposits, it is imperative that the assumptions are reasonable, adequately documented, and periodically reviewed and approved. The base case, or "business-as-usual," cash flow projections can be used as the base case scenario in a bank's CFP.

Collateral position management. Liquidity managers must be aware of their bank's collateral positions, including the value of pledged assets and the amount of unencumbered assets that can be pledged if necessary. Management needs to be aware that the pledging of collateral may take time, especially if physical delivery of the collateral is required. Therefore, it is best to have collateral in place well before the need to borrow against it arises.

Management reporting. Liquidity risk reports should be provided to management and the board of directors on a regular, timely basis. The scope of these reports is dependent on the complexity of the bank's operations and risk profile. Liquidity reports should be clear and include pertinent information, including, but not limited to, the following:

  • Cash flow gaps
  • Cash flow projections
  • Asset and funding concentrations
  • Critical assumptions used in cash flow projections
  • Key early warning or risk indicators
  • Funding availability
  • Status of contingent funding sources
  • Collateral usage

If the liquidity risk position of the bank should increase, the frequency of management reporting should increase. Examiners review liquidity reports and committee meeting minutes to determine whether management is adequately informed of the liquidity risk profile of the bank on a regular, timely basis.

Contingency Funding Plans

Contingent liquidity events are unexpected situations that may be institution-specific or may arise from external factors. Over the past few years, some banks experienced liquidity shortfalls when problems in other areas of the bank had a direct impact on their ability to maintain and/or procure funding. Asset quality deterioration can affect a bank's ability to attain credit-sensitive funding, such as FHLB advances and fed funds. Banks that fall below well-capitalized, or that are subject to a formal enforcement action that contains a capital provision, typically are prohibited from renewing or obtaining brokered deposits. These are examples of institution-specific events that should be incorporated into CFPs, if appropriate. Examples of external events that may impact liquidity are disturbances in the payments systems and dislocations in the financial markets.

It is imperative for all banks to have a CFP that is commensurate with its size and complexity. CFPs provide a framework for managing unexpected liquidity events and ensuring that the bank's sources of liquidity, including contingent liquidity resources, are sufficient to fund the bank's commitments under stressed scenarios. CFPs have been recommended by regulators for many years. However, there are banks that still do not have appropriate and/or effective CFPs. A recurring examination finding is improving the CFP. The interagency policy statement outlines the required elements of effective CFPs. The following table contains these elements, as well as typical weaknesses noted by examiners.

CFPs Should:Common Weaknesses Noted by Examiners
Identify stress events
  • Institution-specific and systemic
Stress events do not adequately address the risk profile and/or funding vulnerabilities of the bank.
Assess levels of severity and timing
  • Various levels of stress severity
  • Early-warning indicators
  • Red flags
  • Comprehensive actions plans
The plan does not contain enough levels of stress scenarios.

Action plans may not be realistic.

Assess funding sources and needs
  • Quantitative stressed cash flow analyses
  • Erosion of funding under alternative stress scenarios
  • Alternative contingency funding sources
Stressed cash flow analysis does not contain realistic and/or documented assumptions.
Identify potential funding sources
  • Alternative sources of readily-assessable contingency funding
  • Advance planning and periodic testing of these sources
Management is not testing its backup funding sources.
Establish liquidity event management processes
  • Crisis management teams
  • Communication and reporting
  • Communication with counterparties, credit-rating agencies, the media, and other liquidity stakeholders
The CFP does not specify the individuals responsible for communicating with various stakeholders.
Establish a monitoring framework for contingent events
  • Establish an early recognition system (event triggers)
Event triggers have been encountered, but management has not taken proactive measures.

The CFP should be a living document and should be frequently reviewed and updated as necessary. When early warning triggers are encountered, action plans must be set into motion. It is imperative to take measures early to avoid a critical liquidity situation. Liquidity managers who are slow in recognizing impending liquidity strains often have a difficult time getting through them.

If you have any questions on liquidity management or liquidity risk management, please contact Andrea Anastasio at (215) 574-6524 or Mark Kemmerer at (215) 574-6156.

  • 1   SR Letter 10-6, Interagency Policy Statement on Funding and Liquidity Risk Management, is available on the Board of Governors' website External Link.

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.