Financial Institutions and Banking

Stay On Top of Liquidity Risk

In an uncertain economy, with rampant inflation and other significant economic headwinds, it’s a good idea for community banks to ensure their loans are based on sound funding sources and that the degree of liquidity risk they’re carrying is reasonable and manageable for the foreseeable future. This means your bank needs to have adequate procedures in place to mitigate risk and stay solvent through tough times.

What are the problems?

The recent economic downturn is just one reason for the increase in liquidity risk. It’s also tied to loan growth accompanied by shrinking liquid asset holdings and increasing reliance on noncore and wholesale sources — such as borrowings, brokered deposits, internet deposits, deposits obtained through listing services and uninsured deposits — to fund loan growth.

Typically, these alternative funding sources are more expensive and volatile than insured core deposits. And they’re subject to legal, regulatory, and counterparty requirements that can create liquidity stress, particularly if a bank has credit quality issues or deteriorating capital levels.

The Federal Deposit Insurance Corporation (FDIC) recognizes that alternative funding sources can be an important component of a well-managed bank’s liquidity and funding strategy. But these sources can be problematic if a bank relies on them too heavily. Incorporating a balanced funding strategy into a comprehensive liquidity risk management plan is key to success.

How can you manage liquidity risk?

The FDIC urges banks to consult the federal banking regulators’ Interagency Policy Statement on Funding and Liquidity Risk Management, which outlines the essential elements of sound liquidity risk management. The statement notes that banks should balance the use of alternative funding sources “with prudent capital, earnings, and liquidity considerations through the prism of the institution’s approved risk tolerance.” Specifically, they should:

  • Ensure effective board and management oversight,
  • Adopt appropriate strategies, policies, procedures, and limits to manage and mitigate liquidity risk,
  • Implement appropriate liquidity risk measurement and monitoring systems,
  • Actively manage intraday liquidity and collateral,
  • Have a diverse mix of existing and potential future funding sources, and
  • Hold adequate levels of highly liquid marketable securities that are free of legal, regulatory, or operational impediments.

What’s the backup plan?

Banks also should design a comprehensive contingency funding plan (CFP) that sufficiently addresses potential adverse liquidity events and emergency cash flow requirements. Finally, they need to set up appropriate internal controls and internal audit processes.

For banks that rely heavily on volatile funding sources, it’s important to ensure that the banks’ risk tolerances and recovery strategies are reflected in their asset-liability management programs and CFPs. A well-developed CFP should help a bank manage a range of liquidity stress scenarios by establishing clear lines of responsibility and articulating implementation, escalation, and communication procedures. It also needs to address triggering mechanisms, early warning indicators, and remediation steps that cover the use of contingent funding sources.

CFPs should identify alternative liquidity sources and ensure ready access to contingent funding because liquidity pressures can spread during a period of significant stress. Examples of backup funds providers include federal home loan banks, correspondent institutions, and others that facilitate repurchase agreements or money market transactions.

An independent party should regularly review and evaluate the various components of a bank’s liquidity management process. The review should match the process against regulatory guidance and industry best practices as adjusted for the bank’s liquidity risk profile. The reviewer then should report the results to management and the board of directors.

How do you stay afloat?

Clearly, for community banks, managing liquidity risk is key to staying solvent and profitable. Without appropriate strategies in place for dealing with potential funding source issues, your bank could be left to flounder in an ocean of problems. Help your bank stay afloat by ensuring you have robust practices in place.

Contact one of our experts if you need help staying on top of liquidity risk.

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