Liquidity continues to be one of the most integral parts of a prudent risk-management process. Nearly every decision made by financial institution Risk Managers impacts an institution’s liquidity position. A proper liquidity management process can enable more agile and strategic decision-making, ultimately leading to better financial performance.
The following three steps begin building the framework for a best-in-class liquidity management approach that may not only satisfy regulatory requirements but also enable an institution to execute strategies with clarity and confidence.
Step 1: Inventory
This step should be familiar to most – whether you currently subscribe to a basic surplus approach or a different form of measuring accessible liquidity, scheduling out available funding avenues is the foundation of any liquidity strategy.
While each institution will have different liquidity considerations (e.g., public funds requiring collateralization, unique bond portfolios, etc.), the fundamentals are consistent.
Start with an inventory of your most liquid assets, such as cash and pledgeable securities. Keep in mind that liquidity also includes “off-balance sheet” collateral-based avenues. Include access to the Federal Home Loan Bank and other secured borrowing facilities, as well as access to brokered/non-member funding.
Once this inventory is complete, the process of identifying potential focus areas can begin in earnest. Each institution may feel most comfortable managing different metrics, but all should be mindful of potential blind spots in the form of early-warning triggers. Together with business leaders, consider identifying a handful of key liquidity metrics and associated thresholds for various levels of action needed. A red, yellow, and green light approach may be effective in helping isolate liquidity metrics that may need special attention and/or remediation.
Key takeaways: Optimize your borrowing availability and flexibility. It is always a good idea to revisit and potentially diversify funding sources – especially in the wake of uncertainty. Review your policy to borrow from the FHLBank System (see DCG’s article: The FHLBank System at 100: Key Points and Take-Aways) and collateral pledged to different avenues, and strongly consider establishing a borrowing line with the Fed.
Create an early warning system. Whether you subscribe to the stoplight approach or a different methodology, consider instituting a process that alerts key stakeholders to specific weaknesses or opportunities. Once established, leverage those insights to establish formalized documentation or the necessary action steps should these alert levels be triggered. |
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Step 2: Stress Test
The goal of stress testing is to identify criteria and/or scenarios that result in liquidity metrics reaching levels that either create discomfort or negatively impact the balance sheet.
For many, liquidity stress testing scenarios either have not been updated in years or are viewed as a perfunctory step in an otherwise laborious ALCO exercise. The time has come not only to believe your stress tests but also to layer in a healthy dose of humility or skepticism to examine what if you are wrong?
Continuously reviewing the validity of stress testing scenarios can provide valuable context while examining customer/member behavior and the impact to the liquidity position and, ultimately, the organization. (See DCG’s article The Basics of Liquidity Modeling and Documentation for an outline of the design of these stress scenarios.)
Key takeaways: Sometimes bad news can be good news. Knowing with relative precision what it would take for an institution to become illiquid is not only valuable from a regulatory standpoint, but also from a strategic lens. Stress testing can provide a level of “crystal ball” to planning and reveal insights to help manage a balance sheet with conviction. |
Step 3: Document
Now, it’s time to tell your liquidity story. For most institutions, the hardest part of the process is pulling together all the pieces in a comprehensive but succinct way.
Inventorying liquidity access and building out stress tests are well-worn steps in any strong ALM process. Intimately understanding a Contingency Funding Plan (CFP), however, is not always as front-of-mind. The importance of reviewing and updating this document to ensure current applicability along with knowing what, specifically, the institution would do in a liquidity event cannot be understated.
The events of March 2023 highlighted weak liquidity processes throughout the industry. Many institutions discovered outdated policies, philosophies, priorities, and even phone numbers included in their CFPs. A continuous and thoughtful review of this document should allow for a deeper understanding of the overall liquidity position, which leads to a stronger and more compelling liquidity story.
Key takeaways: The evolution of proper and prudent liquidity management will continue to be nuanced, but the foundational pillars remain the same: How much liquidity do you have? What could cause this to change? What would you do about it? Familiarize yourself with the ever-changing answers to these questions and be prepared to narratively explain what they mean to your ability to prudently manage the institution. |
No one can predict the future, but everyone can prepare for the unexpected. When faced with a challenging scenario, the importance of a robust liquidity management process increases substantially – certainly from a regulatory perspective, but also from the perspective of business leaders aiming to confidently execute strategic initiatives.
A key differentiator of institutions that navigate through challenging environments with clarity and confidence will continue to be their capacity for real-time decision making and rapid response when challenges emerge. Don’t wait to build a stronger and more resilient liquidity management structure.
For more information about liquidity management, stress testing, and contingency funding plans, contact DCG.
ABOUT THE AUTHOR
Eric Poulin is a Director at Darling Consulting Group, where he assists community financial institutions with the delicate balance of optimizing earnings while managing risk. Eric strives to distill complex concepts into actionable intelligence and delights in bringing education to the industry – speaking at numerous industry associations annually, reaching thousands of bankers nationwide.
Contact Eric Poulin at epoulin@darlingconsulting.com or 978-499-8010 to work collectively on optimizing earnings while managing liquidity risk
© 2024 Darling Consulting Group, Inc.
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