Sunday, October 22, 2017

Preventing a Dry Season: Focusing on Liquidity Risk Management

Posted by Jim December 31, 1969 7:00pm

Photo Credit: Carlos Porto

Liquidity risk management has increasingly become a “key” area of focus by regulatory agencies. The reasons for this attention are not difficult to understand, as liquidity related issues were a major contributing factor to the failures at Bear Stearns, Lehman Brothers and numerous other institutions. The resulting “turmoil” in the financial markets and overall damage to the economy have prompted federal regulators to issue a new, more detailed Interagency Policy Statement covering “Funding and Liquidity Risk Management.”

What is covered in the Interagency Statement on Funding and Liquidity Risk Management?

The Interagency statement (FIL 10-13) seeks to clarify and expand earlier (2008) guidance regarding sound management of funding and liquidity. This includes processes that financial institutions should follow in order to identify, measure, monitor and control liquidity risk.  The guidance stresses the importance of the role of the Board of Directors in understanding risks, establishing oversight, setting appropriate limits on risk, and assuring that adequate contingency planning is in place.

What basic aspects of funding and liquidity are stressed in the statement?

The guidance suggests that safe and sound liquidity risk management include the following:

  • A policy statement which fixes basic responsibilities of management and the Board, and establishes associated monitoring/control mechanisms which will: Establish overall scope and objectives of the policy; Define and set minimum limits on liquid assets; Require quantification and reporting of liquidity positions and trends; Require detailed projections of cash flows and analysis of maturity gaps; Report on secondary liquidity available and establish key metrics (such as the various ratios in UBPR). The policy  should set  appropriate limits on such metrics to control risks. The policy should also require  periodic reporting to senior management and the Board of these metrics versus policy limits and show recent trends. Reports to management should be at least monthly,  and reports to the Board should be at least quarterly.
  •  The policy should be reviewed and approved by the Board (or appropriate Board committee) on at least an annual basis.
  •  A Contingency Funding Plan to effectively deal with liquidity disruption events, including short      and long term disruptions in normal funding patterns, and more remote disruptions of      greater magnitude, intensity and/or duration.
  • Coordination of Liquidity Policy and CFP with other policies as well as the bank’s normal  planning activities, such as business plans (budgets), strategic plans, Asset/Liability (IRR)  plans, Capital plans, and any other financial plan of the institution.
  • A requirement to conduct periodic testing and/or “walk-throughs” of steps outlined in the  Policy or CFP to verify that the process will work and that required documentation is in place.
  •  Involvement of both Board and management personnel to ensure that all key functional  areas of the bank are involved and will coordinate action steps to resolve any serious disruption  of  liquidity.

What additional items should be addressed in the Liquidity Policy? 

In addition to setting out liquidity metrics and appropriate risk limits, the Liquidity Policy should cover actions and approvals required in the event of an exception (e.g., violations of policy limits). Typically, exceptions should be reviewed and actions approved by the Board of Directors (or a designated Board committee) as soon as possible. The Policy should also address the degree of permissible concentration and/or requirements for the diversification of funding sources (e.g., by counterparty, product, and maturity). Finally, the Policy may consider specific limits on assets or liabilities which may have a detrimental impact on liquidity. This might include the setting of maximum levels of certain types of illiquid assets, or limits on uses of brokered deposits (if these are not already covered by separate policies).  

What other policies and activities related to liquidity should be addressed?

As noted above, the Liquidity Policy should be coordinated with other significant planning and policy processes of the bank. The Liquidity Policy should also be consistent with such policies as Asset Liability Management (IRR), Investments, Brokered Deposits, and Borrowings. In particular, such other policies should also place coordinated limits on activities which would reduce liquidity.

The Asset Liability Management (IRR) and Investment Policy should receive particular attention due to the fact that they authorize transactions involving investment securities and money market asset instruments, and are able to establish limits on credit ratings, maturities and other characteristics which affect the liquidity of the securities portfolio. This is also true for Borrowing and Brokered Deposit policies which deal with transactions involving retail and/or wholesale deposits, money market instruments, and debt/capital market offerings.

Liquidity Policy limits should also be considered when the bank establishes its business planning (budgeting and strategic planning), sets its Capital Plan, and makes its product offering decisions. These other planning processes should incorporate quantification of the Liquidity Policy metrics which would result from implementation of such plans.

What exactly is a Contingency Funding Plan (“CFP”) and why do we need it?

The Contingency Funding Plan (“CFP”) is a comprehensive plan, formally adopted by the Board of Directors, which describes the bank’s realistic plans action steps to identify liquidity disruption events, address funding shortfalls, and guide liquidity crisis management. It also assigns responsibilities to employees, senior management and the Board for monitoring events, reporting information and taking actions during a liquidity event. Finally, it provides guidance on the dissemination of information within the bank, to regulators, and to correspondents and the bank’s various stakeholders in times of stress.

The focus of the CFP is on the various types of liquidity events which may occur. The plan should identify broad categories of liquidity difficulty that may arise, in terms of both severity and duration. The description of such events should include an identification of potential “trigger events” and a list of “indicators” to help determine the emergence of a liquidity event. For example, a trigger may be a downgrade of the bank’s credit rating. This in turn may generate an indicator such as rise in rates offered to attract/retain deposits. The CFP should identify steps which would be implemented to meet each level of the event. It should also identify persons responsible for determining that the event has begun and taking the steps to implement the CFP.

The Plan should also include a quantitative analysis of a number of potential liquidity “stress scenarios” and what actions would be implemented to meet each scenario. Again, this should be quantified and demonstrate that the bank has sufficient contingent liquidity sources for the event, or identify the magnitude of any shortfall. The quantification of impacts from the “stress” scenarios should be reviewed and updated periodically.

Furthermore, there should be a requirement of ongoing monitoring of both indicators (e.g., increasing cost of deposits relative to national or local markets) and trigger events (e.g., a down grade of the bank’s credit rating or adverse publicity). It should be noted that a “trigger” may be of either institution-specific or general market origins.

What are the components of a CFP?

A CFP usually has several key elements:

  • An Introduction which details the Plan’s objectives and what operating entities are covered   or the time period.
  • An Implementation and Governance section which defines the roles of Board, senior      management and other key groups, such as the CEO, CFO, Treasurer, and/or ALCO. This should also cover periodic review, update and reporting requirements to the Board.
  • A set of definitions of the types of liquidity “events” covered in the Plan, usually described in terms of both the severity of disruption and likely time period involved.  For each event there should be a narrative that describes potential causes, assumptions, mitigation strategies and expected results. There should be a specific action plan which provides the Board and management with identified contingent sources to be accessed, operational actions to be taken, and individual assignments relating to reporting and communication to key stakeholders. The Plan (or the related Liquidity Policy) may require ongoing monitoring and reporting on these indicators and triggers.
  • An analysis of various “stress” scenarios identified within the Plan. This should include at least three to four events of increasing severity and at least one very severe scenario.  There should again be a description of the event, its causes and likely duration. The analysis should quantify the amounts / cash outflows involved in the disruption and timeframe, and should show the amounts which could be obtained from all the contingent sources and other action steps which will be implemented. The result should demonstrate that the action steps would mitigate the effects of the event. The quantification is usually addressed by starting from the cash flow projections prepared, as required under the Liquidity Policy. The impacts of the liquidity event can then be added to the basic projection to develop an estimate for the “stress” scenario, if it were to occur now. This is then further adjusted by adding the impacts of the action steps outlined in the CFP.
  • Requirements for periodic testing of the action steps to ensure that: they can be implemented quickly and smoothly, documentation is up-to-date, and both bank personnel and counterparties are familiar with the process and procedure. The objectives are testing, identification of any issues, and training of staff. For those steps which cannot be actually carried out, some form of “dry run” or walk through should be performed periodically.

How can we improve liquidity risk management?

There are a number of things that will improve liquidity risk management. First, review the Liquidity Policy and the joint statement to insure your policy covers all topics. Since the Board must re-approve the Liquidity Policy periodically, this is a good time to perform a thorough review. Second, do the same thing to your CFP versus the statement requirements. This includes making sure you have identified, and quantified, the impacts of stress scenarios, and your action steps to address them. Third, review your periodic reporting, and make sure you have included cash flow projections, maturity gap analysis, and other metrics established in your Policy. Make sure your policy limits for these metrics are appropriate and specified in the policy. Also remember to include metrics required for the CFP, such as the status of “trigger” events and/or measurements of “indicator” variables in your periodic liquidity reporting. You may need to obtain new data or perform new analyses, such as rates paid versus competitors and market averages, deposit rollover rates, and data on concentrations of sources and uses. Fourth, periodically (on at least a quarterly basis) report these liquidity measurements to the Board, compared to policy limits, and make sure any exceptions are highlighted, discussed, and appropriate action taken. This should be clearly documented in the minutes. Finally, review your related policies such as Investments, Lending, Borrowing, Brokered Deposits and Asset Liability Management (IRR) to identify and resolve any inconsistencies with the Liquidity Policy and/or CFP.

In summary, develop and implement an up-to-date policy and CFP. In the event that a liquidity disruption occurs, your CFP can provide a guide to your response. Seek to keep your Board, regulators, and larger funds providers informed about events at the bank. If there is “bad news” make sure you speak with one voice, as defined in the CFP. Work now to find and establish more diverse funding sources, before they are needed. Finally, create procedures and systems to ensure that prudent and realistic policies and limitations are monitored and exceptions addressed.


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James Cole

Financial Senior Audit Manager

Jim Cole, Financial Risk Manager, has a diverse and comprehensive background covering many different aspects of the financial area, such as budgeting and strategic planning, asset liability management, profitability and liquidity analysis, financial systems and processes, public offerings, risk management, accounting and financial reporting, investment performance monitoring and financial hedging.

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