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Monday, February 13, 2012

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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2009 > Second Quarter

SRC Insights: Second Quarter 2009

Liquidity Risk Management: Are You Prepared? Part II

by Joanne Branigan, Manager

Sound liquidity risk management is an essential function for all financial institutions. Under stressful conditions, the need for sound risk management practices becomes even more critical for operating in a safe and sound manner. Financial institutions need to consistently identify, measure, monitor, and control their liquidity risk. This is the second of a two-part series on liquidity risk management. Last quarter, the elements of financial institution liquidity and sound liquidity risk management practices were discussed. This article will focus on liquidity risk measurement and monitoring and contingency funding plans (CFPs).

Liquidity Risk Measurement and Monitoring

The analysis of liquidity risk should be forward-looking, with the objective of identifying potential future funding mismatches and current imbalances. Effective liquidity risk measures enhance management's understanding of exposures to mismatch, market, and contingent liquidity risks. All financial institutions are expected to manage liquidity risk in an appropriate manner that reflects the institution's risk profile, complexity, and scope of operations-this applies to all aspects of liquidity risk management.

A sound practice for measuring liquidity risk includes establishing a comprehensive method for cash flow forecasting. Cash flow from assets, liabilities, and off-balance-sheet items should be forecasted considering vulnerability to events, activities, and strategies that can significantly strain an institution's ability to generate internal cash flow using an appropriate set of time horizons. Forecasts can range from a simple spreadsheet to very intricate, detailed reports.

Time horizons. Selected time horizons should be meaningful and relate to the current and potential vulnerability to changing liquidity needs under both normal and stressed conditions. All forecasting processes should involve both short-term and long-term time horizons. Common horizons include: intraday, day-to-day, short-term weekly, monthly, and longer-term of up to one year and beyond.

Assumptions. Cash flow forecasting includes the use of assumptions. Institutions should carefully select and regularly review their assumptions to ensure that they are reasonable and appropriate. The board of directors should effectively document and approve assumptions, and management should additionally scrutinize assumptions that are used to assess the liquidity risk of complex assets, liabilities, and off-balance-sheet positions. Assumptions about the stability or volatility of retail deposits, brokered deposits, wholesale borrowings, and other funding sources are especially important, particularly if the related assumptions are used to evaluate contingent liquidity sources.

MIS reporting. As with other elements of sound liquidity risk management, the complexity and sophistication of management reporting and MIS should be consistent with the size and liquidity profile of the institution. For example, larger institutions that use wholesale funds as a funding source may incorporate daily reports of funding source usage, maturities of various instruments, and rollover rates. A smaller institution may need only a simple maturity gap or cash flow report that depicts rollovers and mismatch risks, combined with pertinent liquidity ratios, to adequately manage its risk.

Reports should be customized to the intended audience and level of responsibility. This includes those associated with day-to-day management, regular senior management and ALCO review and decisionmaking, as well as periodic reporting to the board of directors. Liquidity risk reports to senior management should provide aggregate information in sufficient supporting detail to enable management to assess the institution's sensitivity to changes in market conditions or its own financial performance and other important risk factors.

Stress testing. Regular stress testing should be conducted and include a variety of both institution-specific and marketwide events across short- and long-term time horizons. Stress test results assist financial institutions with identifying, quantifying, and analyzing sources of liquidity strain and the potential impact to cash flow. Management should review stress test results and develop and implement risk mitigants, when needed. Management also needs to ensure that any potential exposures are in line with its approved liquidity risk tolerance and to make any necessary adjustments to its liquidity profile. Stress tests also help institutions to develop CFPs.

Ongoing monitoring. Monitoring of liquidity risk should be done on a flow basis and should assess cost trends for both existing and contingent funds providers, funding source concentrations, the adequacy of liquidity reserves, and the sensitivity of funds providers to market events and institution-specific trends and events.

Contingency Funding Plans

A CFP is a combination of policies, procedures, and action plans for responding to contingent liquidity events. Events are unexpected situations or business conditions that may increase liquidity risk, given an institution's balance sheet structure, organizational structure, business activities, and other institution-specific characteristics.

Events can result from:

• The inability to fund asset growth
• The inability to renew or replace maturing funding liabilities
• Unexpected deposit withdrawals or off-balance-sheet commitment activity
• Change in economic conditions, market perception, or dislocations in the financial markets
• Disturbances in payment and settlement systems due to operational or local disasters

A CFP's primary purpose is to assist management with considering potential events and scenarios that may result in a liquidity shortfall, in order to ensure that liquidity sources are sufficient to fund normal operating requirements without incurring undue expense or causing business disruptions. The CFP provides the institution with a plan for responding to a liquidity crisis.

Events can affect any institution, regardless of size or complexity, and can be institution-specific or result from external factors. Institution-specific events are typically related to internal operational and strategic risks, whereas external events may be related to systemic financial market conditions, like securities price volatility resulting from market events, economic conditions, or financial market disruption.

Events can be high-probability/low-impact or low-probability/high-impact, and institutions need to plan for both. The risk from the former can be addressed in an institution's daily management of its sources and uses of funds using variations in expected cash-flow projections and provisions for adequate liquidity reserves. The risk from the latter should be addressed in the CFP.

Key elements of a CFP include:

• Identifying reasonably plausible events-An institution should conduct regular monitoring for potential events and establish early-warning indicators and event triggers that are specific to its liquidity risk profile.
• Evaluating those events under different levels of severity-The various severity levels of each event should be defined and an associated response plan established. This includes temporary liquidity disruptions, as well as intermediate- or longer-term disruptions.
• Conducting quantitative projections and assessments of funding needs and funding capacity-This is a crucial element of a CFP. Analysis should be realistic, include all material on- and off-balance-sheet cash flows, and assess potential funding erosion at the various severity levels of the event and potential cash flow mismatches that may occur. Institutions also need to determine and document the sequence of steps for responding to an event and sources of funds. Two common quantitative reports that are developed are pro forma cash flow reports that estimate funding surpluses or shortfalls over selected future timeframes and under various liquidity event scenarios.
• Identifying potential funding sources-Alternative sources should be identified, and administrative procedures and agreements should be created and established well in advance of any potential liquidity event. These sources are rarely utilized in the normal course of business, yet any steps necessary to ensure that an institution is ready to activate alternative funding sources should be defined and detailed in the CFP.
• Providing for commensurate management processes, reporting, and external communication-A crisis management team should be identified, and appropriate action plans for each event severity level should be established. Communication and reporting among crisis team members and between the team and the board of directors and other business line management are essential. In addition, communication and reporting should be ramped up with each increasing level of event severity.

In the process of establishing a CFP, management may become aware of certain funding positions that are outside its current risk tolerance, providing an opportunity to reduce risk in a normal operating environment. Another benefit of implementing a CFP is that it allows management to develop strategies for managing specific scenarios, thereby reducing response time and financial impact to the institution if the event actually occurs. Also, separate CFPs may be necessary for the parent company and the consolidated banks in a multibank holding company or for separate nonbank subsidiaries.

Conclusion

All financial institutions are expected to appropriately manage liquidity risk, given their risk profile, complexity, and scope of operations. Any liquidity risk analysis should expose current funding mismatches and evaluate contingent liquidity risks. Management and the board of directors should evaluate and understand the institution's liquidity risk profile. If you have any questions on liquidity or liquidity risk management, please contact Avi Peled at (215) 574-6268 or Andrea Anastasio at (215) 574-6524.