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Liquidity Stress Testing: Strengthen Your Framework Today

Understanding how a strong liquidity risk management framework can help your organization prepare for a potential liquidity crisis is critical. Read more.
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Liquidity risk is the risk that a bank’s financial condition, or overall safety and soundness, is adversely affected by an inability, or perceived inability, of the bank to meet its obligations when they come due, without incurring unacceptable losses. Since the start of 2023, liquidity risk has been a topic of increasing importance.

The unprecedented pace of interest rate hikes by the Federal Reserve resulted in large, unrealized losses in bank fixed-income investments and an increase in deposit funding costs. These unrealized losses stunted liquidity, played a significant role in the recent failure of several large banks, and triggered a reduction in confidence in the banking industry. The loss of confidence resulted in significant deposit run-offs in many mid-to-large-sized financial institutions, creating a liquidity squeeze. Looking to the future, the implementation of stricter regulatory oversight of funding and balance sheet management appears likely, requiring banks to devote greater attention to liquidity risk management. Understanding how a strong liquidity risk management framework can help prepare for a potential liquidity crisis is critical.

Managing Liquidity Risk Through Quantitative Methods

Banks can manage liquidity risk by establishing a strong risk management framework consistent with the Interagency Statement on Funding and Liquidity Risk Management,1 which provides banks with expectations regarding sound practices for managing funding and liquidity risk. Once liquidity risks are understood by management, the framework should include methods for identifying, quantifying, and managing liquidity risk. A variety of components and ratios are used to measure an institution’s current liquidity position, such as liquidity coverage ratio (LCR), loan to deposit ratio (LDR), on-hand liquidity ratio, and unencumbered liquid assets to total assets.

A robust liquidity risk management framework should also include a comprehensive Contingency Funding Plan (CFP), which details procedures for management to follow in the event of a liquidity crisis. The CFP should identify potential events that may cause stress and the primary and contingent sources of funding that a bank may utilize in the event of stressed liquidity. Costs associated with each funding option and its impact on earnings should also be considered.

Quantitative modeling techniques for evaluating banks’ balance sheets have increased in prevalence and complexity to match the demand for stronger risk management, allowing for more efficient analysis and quantification of liquidity risk. Many institutions have adopted Asset Liability Management (ALM) modeling techniques in order to identify, measure, and manage institutional liquidity risk. Effective ALM models monitor liquidity, liquidity ratios, and their established policy limits. These models can also quantify the necessary cash flows for a variety of sources and uses of funds. ALM models can help simplify complex business activities and guide a robust CFP; however, an overly complex ALM model with an inappropriate scope can introduce extraneous risk. A best practice to manage model risk and augment the use of ALM models includes stress-testing model inputs to incorporate severe economic scenarios and evaluating the outputs at various stress levels.

Liquidity Stress Testing

While liquidity ratios provide a picture of a bank’s existing liquidity position, liquidity stress testing enables institutions to forecast future levels of liquidity in various institution-specific and market-wide stress scenarios. ALM models have a variety of key inputs that should be stressed to evaluate liquidity. Several key assumptions that should be included in all liquidity stress testing are highlighted below:

  • Cash Flows
    • Sources of Funds: deposits, both insured and uninsured, non-core funding sources (FHLB advances, brokered deposits, etc.), and loan and investment maturities, and contractual payments
    • Use of Funds: loan portfolio growth, draws on unfunded lines of credit, and investment portfolio growth
  • Contingent Funding Sources
    • Federal Home Loan Bank (FHLB) Advances
    • Unpledged available-for-sale securities
    • Brokered deposits
    • Correspondent lines of credit
    • Federal Reserve funding (BTLP & Discount Window)

The stress scenarios for the above variables should occur in escalating levels of severity, such as mild, moderate, severe, and/or crisis. Cash flows should be projected for a minimum of twelve months. Stress scenarios should incorporate increasing levels of deposit run-off, segmented between insured versus uninsured. Model results should not only include the impact of the stress scenario on an institution’s ability to maintain funding but also measure the impact to key liquidity and capital ratios. Often, the results of more extreme stress scenarios show the institution becoming illiquid. Management and the Board can use these results to manage liquidity more effectively, with the goal of averting a liquidity crisis.

An additional step that banks should consider as a part of their stress-testing process is to revisit the limits/thresholds under which their key liquidity ratios must remain for both their ALM model and their stress-testing model. Given the current environment, and considering possible future institution-specific and market-wide adverse scenarios, are a bank’s liquidity limits and thresholds still in line with its risk appetite?

To maintain healthy levels of liquidity, institutions should invest in strengthening their stress-testing programs to help appropriately manage liquidity risk. Key questions for stakeholders to consider:

  • How can our stress-testing results be used to make more informed financial decisions?  Hint: Stress-testing results can help identify volatile funding sources and quantify concentration levels. Scenarios in which key liquidity metrics fall outside the defined thresholds can help evaluate risk before it is too late. 
  • How does stress testing help mitigate liquidity risk? Hint: Stress testing should quantify the impact of a plausible set of adverse institution-specific and market-wide systemic shocks across varying time horizons. Knowing the result of a range of liquidity scenarios can aid in building a robust action plan. 
  • With all our competing priorities, is the effort to strengthen our liquidity stress-testing program now worth it? Hint: Yes.

Framing the Outlook on Liquidity Risk

The events of 2023 serve as a reminder of the importance of an effective liquidity risk management framework. A robust liquidity stress-testing process is a vital component of that framework. It is clear that upcoming safety and soundness exams, regardless of agency, will emphasize liquidity risk management. Management and the Board’s response to this evolving environment will go a long way in improving the liquidity risk management process and determining the results of future exams.

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