Liquidity Risk Management

By: Martina Dowidchuk, Senior Consultant

Does your liquidity management meet the standards of increased regulatory scrutiny?

What was once deemed acceptable is gradually coming under a more rigid review, and financial institutions need to be prepared to show that their liquidity risk management is keeping pace with the latest changes in funding dynamics and is adequate considering the overall level of risk at the bank.

The liquidity risk may not be among the areas of community banks’ immediate concern given the abundance of liquidity in the banking industry today. However, the history shows that liquidity reserves can change quickly and the changes may occur outside of management’s control. A bank’s liquidity position may be adequate under certain operating environments, yet be insufficient under adverse environments. Adequate liquidity frameworks and governance are considered as important as the bank’s liquidity position. While the sophistication of the liquidity measurement tools varies with the bank’s complexity and risk profiles, all institutions are expected to have a formal liquidity policy and contingency funding plan that are supported by liquidity cash flow forecast, projected liquidity position analysis, stress testing, and dynamic liquidity metrics customized to match the bank’s balance sheets.

Some of the common liquidity risk management pitfalls found during annual independent reviews include:

Cash Flow Plan

  • Lack of projected cash flow analysis
  • Inconsistencies between liquidity cash flow assumptions and strategic plan/budget
  • Lack of documentation supporting liquidity plan assumptions
  • Overdependence on outdated static liquidity ratios and lack of forward-looking metrics
  • Lack of back-testing of the model

Stress Scenarios

  • Stress-testing of projected cash flows not performed
  • Stress tests focusing on a single stress event rather than a combination of stress factors
  • Stress tests lacking the assessment of a liquidity crisis impact on contingent funding sources
  • Insufficient severity of stress tests

Contingency Funding Plan Document

  • Contingency funding plan failing to address certain key components, such as the identification of early warning indicators, alternative funding sources, crisis management team, and action plan details
  • Lack of metrics defined to assess the adequacy of primary and contingent funding sources in the baseline and stressed scenarios

Liquidity Policy

  • Inadequate risk limits or lack of acceptable levels of funding concentrations defined in the liquidity policy
  • Liquidity policy failing to address responsibilities for maintenance of the cash flow model, model documentation, periodic assumption review, and model validation

Management Oversight

  • ALCO discussions related to liquidity management not containing sufficient detail and not reflected appropriately in the ALCO meeting minutes
  • Lack of periodic testing of the stand-by funding lines
  • Lack of liquidity model assumption review or documentation of such review

If you are interested in an independent review of your existing liquidity program and a model validation or are looking for an assistance with developing a contingency funding plan, liquidity cash flow plan, and liquidity stress testing, please contact me at 1.800.525.9775 or click here to send an email. Young & Associates, Inc. offers an array of liquidity products and services that can help you to ensure compliance with the latest regulatory expectations.