Published in: CUNA Councils
Liquidity Risk Management (LRM) is garnering more attention from examiners, given the hike in interest rates predicted by the Fed. In fact, regulators have found most institutions’ risk-management practices to be inadequate to meet the demands of tighter liquidity constraints and decreased funding access, especially in the wholesale market. Risk managers must have a strong grasp of regulatory principles, as well as knowledge of the methodology and procedures for stress testing their institution’s liquidity profile to provide an adequate response to regulators’ comments and requirements.
Regulatory History
Early in the 2007-09 financial crisis, the Bank for International Settlements (BIS) issued guidance on liquidity principles deemed by the regulators to be central to ensure an efficiently operating economy and safe lending institutions. The core principles didn’t provide specific prescriptive actions; however, their framework laid a foundation that regulators would later use to build processes that are more descriptive. Using this framework, regulators defined liquidity risk as “the risk that an institution’s financial condition or overall safety and soundness is adversely affected by an inability (or perceived inability) to meet its obligations.”
At the time, regulators judged management practices to be deficient in general, noting a wide-ranging lack of useful cash-flow projections and contingency planning. To correct this tendency, the policy statement highlighted the importance of detailed cash-flow projections, diversification of funding sources and an appropriate cushion of liquid assets, as well as a formal, comprehensive contingency funding. Regulators also were concerned that large organizations with intricate balance sheets needed to model the liquidity dynamics of their balance sheet/business model so that it was commensurate with each institution’s complexity. But this is not to imply that a simple institution shouldn’t develop an extensive stress test.