Liquidity Risk Management: “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.”  – Bank for International Settlements (BIS)

Liquidity Risk Management (LRM) is currently garnering more attention from examiners as rates begin to rise. 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

As is often the case, the 2008 financial crisis was the spark requiring institutions to dive deeper into LRM. At the time, regulators judged LRM practices to be deficient in general, noting a wide-ranging lack of useful cash-flow projections and contingency planning. As a result, regulators 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 complex balance sheets needed to model the liquidity dynamics of their balance sheet/business model so that it was commensurate with each institution’s complexity. That said, LRM is also key for less complex institutions.

A number of practices central to sound LRM include the following:

  • Board Oversight – Board members must be able to comprehend modelling, approve strategies, and supervise implementation. Bottom line: The buck stops with the Board.
  • Comprehensive Measurement – Institutions must be able to identify risk tolerances, use reasonable assumptions, develop robust stress scenarios, and document strategies.
  • Active Intraday Management & Diversification of Funding Sources – Institutions must regularly test collateral/funding sources, allow for regulatory and operational limits, avoid funding mismatches, and avoid funding concentrations.
  • Maintain Adequate Levels of Highly Liquid/Marketable Securities – Institutions must measure and test for the appropriate/necessary level of liquid securities.
  • Comprehensive Contingency Funding Plan (CFP) – They must be able to identify stress events, assess severity/timing given current/potential funding sources, establish event management/response process, and establish monitoring framework for contingent events.

Approaches to Liquidity Modeling

A common model is a “Sources/Uses” approach, where management identifies all sources of incoming cash and offsets it by all cash outflows. Another approach, “Structure of Funds,” often augments or supports the Sources/Uses method; this measures the change in the liquidity profile of marketable assets currently held on the balance sheet relative to assets likely to become illiquid under adverse conditions. Examples of sources of liquidity include new deposits, maturing investments, interest/principal payments, fee income, asset sales, borrowing lines, repurchase agreements, or even asset sales. It is important for risk managers to comprehensively measure all sources and uses of funding when measuring risk, regardless of their size or perceived significance.

Contingency Funding Plan

Contingency Funding Plan (CFP) should determine the conditions used for stress testing an institution’s liquidity position. CFPs often define the conditions and relative severity of market downturns, as well as the impact on sources and uses of liquidity. Comprehensive CFPs typically establish a hierarchy of severity levels corresponding to stress events (e.g., Level 1 through Level 5), where each level often contains a description of market conditions that might occur. The CFP also should inform an institution’s LRM framework, so managers’ responsibilities and escalation procedures are appropriately defined, along with potential remedies they might use in each severity category.

Basic Stress-Testing Principles

Modeling stress events is another key in recognizing the institution’s liquidity profile, although management must properly understand the underlying assumptions. This includes the inability to fund asset growth, renew or replace maturing liabilities, or unexpected exercise options embedded within liabilities. Several key principles can help guide the modelling process.

  • Develop realistic assumptions about depositor behavior – This is a vital principle that should require risk managers to maintain and leverage data on their core depositors to determine their sensitivities to market rate changes.
  • Model for a variety of periods, including daily, monthly and annual forecasts – It is often the case for shorter measurement periods to be associated with maintaining operations, while longer periods can often be used in combination with strategic planning or stress testing. By measuring the effects of stress events, an institution can better determine the length of time that would be required to breach policy limits or exhaust secondary liquidity sources.
  • Ensure that stress scenarios are comprehensive – Measuring the liquidity behavior of an individual instrument or account is helpful but inadequate on its own. For instance, a stress scenario assuming a shock in rates (e.g., 100 bps) would impact the cash-flow behavior of both liabilities (a change in depositor behavior) and assets (borrowers’ prepayment behaviors, especially mortgage loans).

In addition to measuring the consequences of tighter liquidity conditions, stress testing can also provide feedback to determine whether an institution is carrying too much liquidity, a circumstance that can result in lower returns and long-term capital growth.

Benefits of sound LRM

Ultimately, institutions with a high-quality, well-planned CFP – combined with rigorous stress testing – should use these in a continuous feedback loop. Management who understand the regulatory guidance and use it to structure policies and procedures are more likely to be prepared for an unexpected market shock. By seeking continuous liquidity-model improvement through stress testing, institutions’ results can be used to gather insights into the best ways to optimize balance-sheet strategies and increase safety.

Tyler Dunn

Director, Advisory Services at ALM First