Publications & Resources
July/August 2010
Regulatory Changes & Restructuring
Time to Update Your Contingency Funding Plan
By Neal V. Brauner
The final version of the regulators’ Interagency Policy Statement on Funding and Liquidity Risk Management was issued in March of this year. While this document does not break a lot of new ground conceptually, it does serve to highlight the importance of prudent liquidity risk management in these volatile times. Among other things, the guidance stresses the need for having diversified funding sources; routinely preparing cash flow projections along with periodic stress testing; maintaining a cushion of liquid assets; and having a “formal, well-developed contingency funding plan”.
Banks tend to view liquidity much like people regard water: we fail to realize how critically important it is until we suddenly find ourselves without any. The events of the past few years have produced varying levels of instability in the funding sources of many banks, and have served to highlight the importance of having sound liquidity policies and procedures.
Where we often see the greatest weakness in bank liquidity management is in the preparation of a contingency funding plan (“CFP”). The focus here needs to be on the word plan: institutions need to think through and articulate a comprehensive plan for meeting liquidity shortfalls under a variety of stress scenarios. It is not enough to just prepare a list of “things you’ll think about” if the bank should start to encounter liquidity issues. It also doesn’t add much value to fill your CFP with paraphrased sections of the regulatory guidance. Liquidity planning is important, and the regulators expect banks to put some effort into developing realistic and actionable responses to both high- and low-probability stress scenarios.
As with the development of any type of plan, the first step is to identify situations under which a bank’s liquidity position may be compromised. The objective is to brain-storm different events which could either increase the demand for liquidity and/or limit the sources of supply. These could be internal stresses that would primarily impact just your bank, or they could be system-wide shocks that would affect the entire industry.
Having identified a series of stress scenarios, the next step is to think through how each scenario may affect the availability of liquidity from both primary and secondary sources. Don’t fall into the trap of thinking the funding availability that you have right now will stay the same in an actual stress scenario. It is useful here to quantify the impacts on various liquidity sources and uses by running cash flow projections for each scenario – this is where liquidity gap analysis and stress testing comes into play.
After gaining an understanding of the liquidity challenges of potential stress scenarios, strategies for mitigating the impact of those scenarios need to be developed. It can be helpful to classify stress scenarios by the severity of the impact on the bank. We tend to define three stages of liquidity events, with Stage I being fairly short-term in nature and requiring fairly minor changes to operations and strategies. On the other end of the spectrum, a Stage III event would severely affect the bank’s liquidity position over a much longer timeframe, and would require much more drastic action to correct.
As your management team works through both the quantitative and qualitative aspects of the stress scenarios, try to identify ‘early warning’ indicators: specific ratios or trends that would help identify a deteriorating liquidity position. These indicators should be tracked and reported to ALCO and the board of directors on a monthly basis. The indicators can alert management of the need to take early action to reverse adverse trends.
As the plan begins to take shape, specific responsibilities for executing each strategy should be assigned to members of the liquidity management team. Effective internal and external communications policies are going to be an important part of the plan, in addition to clearly defined escalation procedures should a liquidity event continue to worsen. Finally, include provisions to regularly review and update the CFP to ensure that it remains relevant and workable as the bank and the economic climate continues to change.
Your bank’s contingency funding plan should be something more than a stale document that gets a rubber-stamp review once a year. Rather, it should be a continuously evolving blueprint that addresses how management will indentify and proactively manage the bank’s liquidity position in the light of uncertain future events.
Neal V. Brauner is director of Financial Services Advisory Partners, LLC. He can be reached at 626-921-6074 or nbrauner@fsapartners.com.
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