While we await the stringent new liquidity and capital rules expected from U.S. regulatory agencies in the wake of recent bank failures, small and midsize banks can get a head start. They should anticipate what is coming by looking at the more rigorous standards that larger financial institutions must already satisfy.
The impending regulatory changes will raise the bar for liquidity management and contingency funding plans. New rules will likely take effect over the next 12 months, so senior management should begin developing plans and taking action now to be ready in time. Additionally, management should be aware that other stakeholders such as customers, counterparties, investors, and their boards of directors want to be assured that their liquidity risk program can not only meet the new regulatory standards but also be sufficient to protect them from even the most challenging market conditions.
There are several well-accepted principles for liquidity risk management already embedded in the governance of larger banks. In a recent webinar, speakers from the Federal Reserve Board of Governors, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., and state bank regulators collectively emphasized eight of these principles as the foundation for sound liquidity risk management at banks of any size. The eight principles are:
- Effective corporate governance by boards of directors and senior management;
- Appropriate liquidity strategies, policies, procedures, and limits;
- Comprehensive liquidity risk measurement and monitoring systems;
- Active management of intraday liquidity and collateral;
- A diverse mix of existing and future potential funding sources;
- Adequate levels of highly liquid marketable securities;
- Comprehensive contingency funding plans (CFP); and
- Internal controls and internal audit processes.
The spring 2023 banking crisis demonstrated that senior management neglected several of these fundamental principles of liquidity risk management, and the result was the catastrophic collapse of the funding structure for three major financial institutions. Now, all eight of these principles will be part of your next regulatory examination, as described below.
- Effective Corporate Governance by Boards of Directors and Management
Regulators will look for evidence of effective liquidity risk governance. That evidence is documentation in the form of liquidity strategy plans, policies, and procedures focusing on liquidity management and a detailed contingency funding plan—all of which should incorporate board and management input as well as formal approval. Other evidence will be the construction of monitoring systems that comprehensively measure liquidity risk and deliver information promptly to decision-makers.
Regulators also expect the board of directors and senior management to be actively involved. They want management to oversee the development and implementation of the various components of a liquidity risk management program, ensuring that it reflects the unique characteristics and complexity of their institution. The board should review this liquidity program on at least an annual basis, and more often if circumstances warrant, as well as reviewing and approving all the governance material when first developed and whenever there are significant modifications.
- Appropriate Liquidity Strategies, Policies, Procedures, and Limits
The financial institution should articulate a board-approved liquidity risk tolerance by describing it in the strategic plan and liquidity policies. The risk tolerance should include quantitative targets such as limits and qualitative guidelines that clearly express the board’s appetite for liquidity risk. An often overlooked element of this principle is the regular review, independent challenge, and documentation of the assumptions analysis that supports the liquidity risk tolerance.
Rigorous analysis and documentation are especially important for the stress scenario assumptions. There are recent media reports that an executive at a failed institution instructed the analytical staff to change some stress assumptions, saying they were too severe and would cause a limit breach. Subsequent events showed that the original stress assumptions, on the contrary, were not sufficiently adverse. Perhaps if there had been a limit breach, then that failed institution would have been forced to take actions that could have enabled it to survive—or would at least have reduced the costs borne by taxpayers after its failure.
- Comprehensive Liquidity Risk Measurement and Monitoring Systems
Liquidity risk reports should have sufficient detail so senior management can understand their institution’s sensitivity to market conditions and changes in their financial condition such as the loss of some funding sources or an increase in unrealized losses, among other risk factors. Reports should be timely so management can assess and, if necessary, act to mitigate the institution’s risk.
It is especially important for liquidity risk to have the proper granularity and time horizon for management and board reporting. These attributes will vary among institutions, but the huge deposit outflows we saw this past spring indicate that reports should be more granular, particularly in the near-term time frame. For example, it might be prudent to measure projected cash flows daily for at least the first two weeks, switch to weekly time buckets for the remainder of the first three months, and lengthen to monthly buckets out to 12 months. A more granular approach to reporting projected cash flow could satisfy regulators’ renewed focus on intraday liquidity and collateral management.
- Active Management of Intraday Liquidity and Collateral
Regulators will closely monitor and review liquidity and collateral. First, examiners will look for the real-time monitoring of actual daily gross liquidity inflows and outflows relative to expected inflows and outflows. If the mismatch between actual inflows and outflows exceeds institution-specifically defined tolerances or if actual outflows substantially exceed expected outflows, regulators will look for procedures and a reporting mechanism to elevate these potential issues as needed.
Second, collateral management will be a focus of their examination. There were recent instances when an institution sought intraday liquidity from the Federal Reserve’s Discount Window, the Fed’s Bank Term Funding Program, or a Federal Home Loan Bank (FHLB), but was denied because collateral was not properly secured.
Active collateral management starts with gathering a list of all unencumbered assets and then determining if those specific assets can be re-hypothecated, or reused for an additional loan. After identifying this subset of assets, the institution should determine whether some might be better suited for the local Federal Reserve Bank and others for an FHLB. There are differences in the eligibility of assets for certain programs, in the haircut processes for specific assets, or in preferences for certain types of assets such as single-family mortgages. This is a key operational decision because transferring collateral between a Federal Reserve Bank and an FHLB is non-trivial and could affect institutions’ ability to quickly access funds.
An institution must be operationally ready to access these contingent funding sources. It must assign and grant a security interest in the pledged collateral to a Federal Reserve Bank or FHLB, and, as with any collateralized funding, this is not a quick process. One of the recently failed institutions tried to access contingent funding but, because they were not operationally prepared, the request was denied. Either documents were incomplete or the collateral had not been properly secured or both, but the result was that the institution could not offset the deposit outflows, and the subsequent illiquidity led to its failure.
This renewed focus on operational readiness should lead management to devote some of its attention to this topic. This is especially true when pledging loans since that process is quite different from the one used for securities, and it can require more time to access funding even if special arrangements are in place. This is why having marketable securities is critical to liquidity risk management, as discussed below.
- A Diverse Mix of Existing and Future Potential Funding Sources
Financial institutions should create a funding strategy that provides effective diversification in terms of both sources and tenors. In addition to developing a diverse mix of existing and potential funding sources across a variety of time frames, institutions should maintain their presence in their chosen funding markets and work to strengthen those relationships. Some of Treliant’s clients responded to this spring’s bank failures by having their executive teams personally contact all of their important funding providers, which proved to be very effective in stabilizing their liquidity positions even in volatile markets.
Management should also regularly confirm and test its ability to quickly raise funds from each source. Testing is a crucial part of a contingency funding plan, but regular funding sources, such as lines of credit with commercial banks, should also be tested. This testing will also enable management to identify and monitor the main factors, such as reputational risk or quality of the collateral, that affect its ability to raise funds.
- Adequate Levels of Highly Liquid Marketable Securities
An institution should determine whether its securities portfolio is adequate and measure it against the estimated liquidity requirements in a stressed environment. This estimation must include contractual and noncontractual cash flows, including a sudden withdrawal of funds. It is necessary to maintain a sufficient buffer of highly liquid assets to ensure the institution remains liquid in each period across its time horizon. This buffer should consist of unencumbered and high-quality assets that are readily available to generate cash. The obvious choices for this type of asset are Treasuries and other government-guaranteed securities, but other securities can be part of this buffer if their liquidity value is adjusted by taking conservative haircuts and longer-than-normal liquidation timeframes. It would be useful to implement a Liquidity Coverage Ratio (LCR), which measures an institution’s stock of unencumbered high-quality assets relative to its net cash outflows over a 30-calendar-day stress scenario.
However, a liquidity crisis can emerge in a matter of days, which is why it is also important to have day-by-day cash flow projections in at least the first two weeks of a forecasted stress scenario. Technology has enabled depositors to launch a run that would wipe out an institution’s cash reserves in days or even hours. Financial institutions must be operationally prepared to monetize their buffer of liquid assets to meet this threat, reinforcing the need for strong intraday liquidity and collateral management.
- Comprehensive Contingency Funding Plans (CFPs)
A robust CFP is built on several process-oriented elements, which regulators will assess during their next exam. Policies and procedures, which drive the governance process, will be the first documents examiners request. They will also want to understand how liquidity issues are monitored, including data flows and management/board reporting, and what are the escalation steps that would lead to the declaration that the CFP is in effect. The regulators will then look at the communication plan that would inform all stakeholders, especially the board and regulators, that the CFP has been initiated.
For the above processes to be effective, strong scenario analysis and stress-testing programs must be in place. These programs require subjecting the key underlying assumptions to analytical rigor, frequent reviews, and strong controls. The results generated by these programs are very sensitive to assumptions, and there have been recent instances when the review and control mechanisms were circumvented because the stress test results were considered too adverse. Subsequently, when market conditions worsened dramatically, management and the board were surprised and unprepared to take actions that might have prevented the failure of their institution.
It is incumbent on senior management and the board to understand these fundamental components of liquidity analysis. It is necessary to understand the assumption development process, then ask how sensitive analytical results are to changes in assumptions, and finally ensure that stress assumptions are sufficiently severe to warn that the institution might be in trouble if certain market conditions emerge.
Therefore, these assumptions must be reasonable, documented, and regularly reviewed by management and the board. However, the definition of what is “reasonable” is evolving, and it may be best for an institution to develop multiple scenarios. Some scenarios may capture the institution’s historical experience, such as the 2008 financial crisis and subsequent recession. Others should be more hypothetical and extreme but plausible. For example, management should consider interest rate scenarios such as a sharp move up or down, or dramatic changes in the shape of the yield curve. These scenarios should address the already elevated unrealized losses and how potential future losses would impact the liquidity value of an institution’s investment securities.
Other stress scenarios should include a dramatic runoff of insured and uninsured deposits, which both regulators and boards of directors will be seeking due to the recent bank losses of tens of billions of dollars in a day. Regulators are already criticizing institutions if they do not have detailed deposit stability analysis and runoff assumptions that reflect these recent experiences. They are making it clear they will not accept assertions that those events cannot happen again—nor, without convincing analytical support, that they cannot happen to your institution.
The final piece of an effective CFP is its action plans and playbook. Each institution is going to have specific actions that are appropriate for its unique situation and business model. However, there have been recent developments regarding using Federal Reserve Banks as contingent funding sources. Regulators recently came out and encouraged financial institutions to establish access to the Discount Window or the Bank Term Funding Program. They also have said they will not criticize an institution for establishing and testing access to these contingent funding sources. Removal of this old stigma is especially advantageous to institutions that do not have a relationship with an FHLB.
A CFP should also show that an institution is operationally capable of tapping all of these contingent funding sources. Demonstrating this capability should also include evidence that the institution is prepared to place collateral with these sources to access funding.
- Internal Controls and Internal Audit Processes Senior management at any financial institution understands the importance of internal controls in the first (business units) and second (compliance and risk management) lines of defense as well as an independent, robust third line of defense (internal audit function). However, liquidity-related internal controls should be reevaluated given the criticality of all liquidity-related processes. Moreover, given recent events, regulators will scrutinize internal audit functions to understand if those functions are providing adequate oversight of liquidity-related controls and processes. Now would be the time to review internal audit’s risk universe and testing program for liquidity and to strengthen them in anticipation of a more rigorous exam.
Key Takeaway: Prepare for What Is Coming
Financial institutions can expect more scrutiny of their liquidity risk management practices. Regulators will be more rigorous in their upcoming exams than in the past, but management should not be surprised if a regulator contacts an institution outside of the usual examination process. Boards and investors will also be asking more questions of management about liquidity risk. Stakeholders have raised the bar on topics like operational readiness, stress testing and scenarios, CFPs, and the quality of supporting analysis. The market continues to be unsettled so management must take action to demonstrate it can successfully navigate future challenges.