What You Need to Know about Liquidity Risk Management Today
The COVID-19 pandemic (and government stimulus programs) have caused unexpected changes to the U.S. banking industry, offering a uniquely timely demonstration of the significance of liquidity risk management.
Liquidity Risk Management in 2022
With national lockdowns halting travel and social gatherings since 2020, more Americans are depositing unemployment benefits and federal relief payments into their bank accounts. While this alone might not seem like cause for concern, surge deposits have the potential to do serious damage to banks’ balance sheets. Demand for loans is reduced, leaving banks with sudden, unprecedented excess liquidity.
Though in the short term, excess liquidity can provide relief for banks, the long-term effects spell high risk. With loan growth slowing, banks have nowhere to put these surge deposits, which could affect capital and liquidity ratios.
Unplanned global scenarios exacerbate financial uncertainty, such as supply chain issues, potential inflation, and fears of conflicts brewing with powers such as China and Russia. These signs of stress can cause volatility in markets (like currencies and stocks) destabilizing the greater financial ecosystem. Frances Donald, Global Chief Economist at Manulife Investment Management, told Reuters, “It isn’t always clear where the contagion risks lie. This is why liquidity needs to be monitored, not just daily, but hourly at this point, for signs of challenges.”
Today’s uncertainty heightens regulatory pressures for financial institutions to be prepared, which is where liquidity risk management comes into play.
What is Liquidity Risk Management?
Liquidity risk uses real or perceived events to determine how a bank or credit union can meet its cash and collateral obligations… without threatening its financial position or existence. How banks assess and mitigate these risks is liquidity risk management.
Two types of liquidity risk can aggravate an institutions’ assets. Funding risks are when banks cannot meet their obligations, resulting in low cash flows and liabilities. On the other hand, Marketing risks are when assets will not sell, limiting cash flow and causing changes to pricing, collateral, and profitability.
Banks are vulnerable to market conditions. Understanding potential risks helps us to develop action plans that not only predict the worst-case scenario, but offer an aversion strategy through them,
The Fundamentals of Liquidity Risk Management
At MountainView Risk and Analytics, as a company that specializes in helping banks and credit unions manage their liquidity risks, we ask banks to consider:
Can you survive a 30-day stress event with assets only?
This question captures the fundamentals of liquidity risk management; how well a financial institution can endure low amounts of liquidity during unforeseen circumstances or emergencies. It’s critical to ask, because liquidity event fallout can be minimized with early preparation.
But, to effectively manage those risks, banks must know and manage not only their deposit types – insured, uninsured, commercial and retail – but also have a detailed understanding of contingent liquidity risk exposure and event triggers that could come from funding venues.
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Liquidity risk management requires banks to assess assets, liabilities, and regulatory limitations regularly; on an intraday, daily, quarterly, and annual basis. Regular reporting and management of liquidity risk is best practice for identifying potential or escalating threats – regulations require banks to carry out various stress tests and report how they will manage both capital and risk.
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Banks can use historical, hypothetical or simulated scenarios to stress test liquidity and determine how much liquidity is needed to cover any volatilities and liabilities. Stress testing allows us to test operational elements of liquidity sources not typically used in a bank’s day-to-day processes, offering alternative strategies to funding operations in stress events.
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The insights gained from this process inform the contingency management process, an action plan for managing liquidity events. Part of managing liquidity risks is ensuring a Contingency Funding Plan (CFP) is in place for bank managers to execute a controlled response to unforeseen stress events. This plan outlines reactive strategies to be implemented in times of liquidity stress.
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Banks also use liquidity policy plans to outline how to manage liquidity during normal business hours to mitigate risks. They deal with daily management, fluctuations, and strategic initiatives.
Liquidity Risk Management Strategies
Planning, careful calculation and forward-thinking should all be universally practiced by those considering liquidity risk management. However, no single tool can comprehensively measure liquidity and its potential risks.
A combination of the following strategies are routinely used to manage liquidity:
Holding adequate levels of highly liquid, marketable securities free of legal, regulatory, or operational impediments to meet liquidity needs in stressful situations
Strategies for deposit/share generation (promos, pricing review, etc.)
Deposit Insurance Spreading system (i.e. CDARs)
Brokered Deposit sources
Utilization of contingent sources
Guidelines for limiting supply concentration
Managing collateral for pledging
Limiting asset growth (loan originations)
Loan sales, etc.
Careful cash flow management
Cash flow is integral to a bank’s daily operations. Using these liquidity risk management tools effectively can help organizations become more profitable and access appropriate financing facilities.
Managing your Liquidity Risks with MountainView
The importance of liquidity risk management cannot be understated for financial institutions, so it’s important to choose a risk management company that is fluent in navigating risk and delivering results.
MountainView Risk and Analytics (MVRA) consistently help banks and credit unions weather uncertain times with unrivaled market knowledge and a commitment to quality solutions. Guaranteeing peace of mind, the services provided by MVRA are compliant with Federal Reserve regulations (including SR 11-7, FIL 22-2017, and OCC 2011-12) and include risk management services such as program development, gap analysis, program reviews and ALCO or board training.
Rather than only overseeing every liquidity risk, MountainView Risk and Analytics help banks integrate risk management strategies into their daily processes. For those wanting to learn market knowledge and get advice from leading experts, informative guides are available for consumers on the MVRA website.
While this article touches the surface of liquidity risk management, MountainView’s Definitive Guide to Managing Liquidity Risk comprehensively explores the topic, providing insight into advanced industry practices to develop a platform of fine-tuned, holistic management strategies that balance the need for liquidity with profitability.
With MountainView, access the tools needed to guard against unforeseen circumstances so your business is well-equipped to overcome what is on the horizon.
Contact MountainView and talk to one of our liquidity risk management experts to determine how to tighten your processes today, for a better tomorrow.
