SRC Insights: Second Quarter 2010

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

by Andrea Anastasio, Senior Specialist, and Mark Kemmerer, Senior Examination Analyst/Asset Liability Specialist

On March 17, 2010, the federal banking regulators issued SR Letter 10-6, Interagency Policy Statement on Funding and Liquidity Risk Management, to provide financial institutions with consistent interagency guidance on the principles of sound liquidity risk management.¹ Given the turbulence in the financial markets over the past two years and the continued deterioration in asset quality, earnings, and capital at many institutions, strong liquidity risk management practices are more important than ever. However, examiners have found that liquidity risk management programs at many financial institutions continue to be less than adequate. This is the first of two articles highlighting pertinent items included in the guidance and discussing some of the approaches that examiners may enlist when evaluating an institution's liquidity risk management program.

Liquidity risk management programs should include processes to address both current and future funding needs and to provide a system to identify and manage unexpected liquidity events. Failure to maintain an adequate liquidity risk management process is considered an unsafe and unsound practice. Several elements need to be included in a sound liquidity risk program. These include the following:

Effective corporate governance consisting of oversight by the board of directors and active involvement by management in an institution's control of liquidity risk
Appropriate strategies, policies, procedures, and limits to manage and mitigate liquidity risk
Comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the institution
Active management of intraday liquidity and collateral
An appropriately diverse mix of existing and potential future funding sources
Adequate levels of highly liquid marketable securities-free of legal, regulatory, or operational impediments-that can be used to meet liquidity needs in stressful situations
Comprehensive contingency funding plans (CFPs) that sufficiently address potential adverse liquidity events and emergency cash flow requirements
Internal controls and internal audit processes sufficient to determine the adequacy of the institution's liquidity risk management process

Corporate Governance

Similar to all effective risk management, it is important to remember that effective liquidity risk management starts at the top of the organization. The board of directors is ultimately responsible for the liquidity risk assumed by an institution. It is the board's responsibility to ensure that the institution maintains effective oversight of the liquidity risk management process, and that a proper framework is in place to identify, measure, monitor, and control liquidity risk.

Board members need to be aware of all liquidity risks facing the institution and assign responsibility to management to manage these risks. Board minutes should reflect a review and discussion of pertinent liquidity information, such as a review of the organization's compliance with board-approved liquidity measurement policy thresholds.

Board minutes must be thorough enough to ensure that the institution's liquidity position has been effectively communicated to the board. Board packages should include reports prepared by management that clearly and concisely portray the liquidity profile of the organization. Supplemental liquidity reporting should be provided when necessary to enhance communication to the board. In addition, the board needs to review and approve liquidity policies and procedures, including the bank's contingency funding plan, at a minimum on an annual basis.

Senior management needs to ensure that board-approved liquidity management processes are implemented effectively. Management needs to establish liquidity measurement and monitoring systems that adequately portray the liquidity profile of the institution. Management must ensure that the bank has sufficient liquidity to support daily operations and contingent sources of liquidity, such as highly liquid assets or available lines of credit, that can be utilized for unforeseen liquidity events. Management also needs to ensure that liquidity reports communicate relevant information in an accurate and timely manner.

Committee oversight. Most institutions delegate the oversight of liquidity to the Asset-Liability Committee, or ALCO. To be effective, the ALCO should be composed of individuals from various units of the institution, including, but not limited to, lending, funding, and investments. Examiners thoroughly review ALCO minutes and packages to ensure that pertinent liquidity information is being captured adequately and communicated effectively. In many institutions, a separate Liquidity Committee or Funding Committee has been established to address an institution's funding and/or liquidity needs. These committees likely report to the ALCO, but meet more frequently.

Strategies, Policies, Procedures, and Limits

Examiners expect institutions to have well-documented liquidity strategies and policies and procedures that are commensurate with the size and complexity of the organization. These documents should be reviewed and approved at least annually. Liquidity strategies should set the overall framework for managing liquidity and clearly articulate the risk tolerances of the organization. Policies should translate these strategies into operating standards and should include the following information:

Authorization to an individual(s) or committee, delineating responsibilities for planning, executing, and reporting
Primary sources of funding utilized for daily operating activities, as well as sources of back-up liquidity
Risk tolerance threshold/targets, both quantitative and qualitative
- Examples include: targeted amount of unencumbered liquid assets, ratios of wholesale funding to total liabilities, funding concentration limits, unfunded loan commitments level, and cash flow mismatches or gaps
The frequency of the review of the assumptions used in liquidity projections
The nature and frequency of management reporting

Diverse funding mix. While institutions may employ various strategies to mitigate their exposure to liquidity risk, two strategies that are often used are: 1) establishing a diversified funding base and 2) creating a cushion of liquid assets. Management should strive to achieve a diversified funding base in terms of funds providers and the tenure of the funding. Over-reliance on one funding source heightens a bank's liquidity risk profile and is considered an unsafe and unsound banking practice.

Management should be keenly aware of its wholesale funding capacity from each source and should strive to maintain positive relationships with funds providers. Management must also be aware of the sensitivity of funds providers to changes in the bank's real or perceived financial condition. ALCO and board packages should include a report summarizing the amount of outstanding funds from each wholesale funding source and the remaining capacity with each of these sources.

Adequate levels of highly liquid marketable securities. In addition to having a diversified funding base, institutions should maintain an adequate cushion of unencumbered liquid assets that can be sold or pledged to respond to an unexpected liquidity event. These assets include those that can be readily pledged or converted to cash without undue loss, such as interest-bearing bank balances, fed funds sold, and unencumbered investment securities. Management needs to determine the appropriate level of these assets to hold based on stress-testing analyses. Examiners consider asset liquidity a critical component of proper liquidity risk management.

Internal Controls and Internal Audit Processes

Management should oversee the development and implementation of effective internal controls and review processes for the management of liquidity risk. Liquidity processes should be reviewed by an independent third party on a regular basis to ensure that policies and procedures are being followed. The third party should also assess the adequacy of the bank's risk identification and measurement systems, as well as the reporting process.

Summary

The second article in this two-part series will appear in the third quarter issue of SRC Insights and will deal with the essentials and importance of a solid contingency funding plan and effective liquidity risk measurement, monitoring, and reporting.

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.

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.