The current interest rate and economic environment have brought challenges to financial institutions in managing their liquidity risk. Effective contingency liquidity planning is essential, and financial institutions may need to relook at their risk management strategies and practices.
Specifically, institutions should consider the following:
Revisit forecasts. As unrealized losses on investments have grown and many institutions have seen a reduction in deposit balances, institutions may need to increase the frequency of forecasting. For instance, quarterly forecasting may not enable management to identify funding gaps timely enough. Projections of deposit balances and ability to utilize investments for funding purposes may have changed since the beginning of the year, so management should critically evaluate projections to determine whether any potential funding shortfalls exist.
Enhance stress testing. If institutions are unwilling or unable to sell investments at a loss, then stress testing needs to consider scenarios in which investments are not used to meet liquidity needs. This may highlight the need for alternate funding sources. Additionally, stress testing should consider a scenario around severe and sudden deposit withdrawals. Multiple banks in 2023 have faced “bank run” scenarios, and it’s important for institutions to consider how they would deal with a similar scenario with their own customer base.
Evaluate funding sources. With investment securities having unrealized losses, many institutions are unwilling to sell. Additionally, sudden or gradual reductions in deposit balances may require institutions to find funding outside of the core customer base. Alternate funding sources can include wholesale deposits; while typically more expensive than customer deposits, prudent use of these sources can help fill funding gaps. Alternate funding sources can also include lines of credit through other financial institutions. Institutions may need to evaluate whether their existing lines are sufficient to manage potential funding gaps and, if so, to consider establishing additional lines. The Federal Reserve announced on March 12 that it has established a Bank Term Funding Program (BTFP) that will “make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.” The BTFP may need to be added to contingency funding plans as an approved funding source. Finally, institutions may need to more critically evaluate loan sales and participations as a funding strategies. As overall loan demand has decreased with the current interest rate environment, institutions may find willing buyers for their loans that could help meet immediate funding needs.
Finally, guidance was issued in 2010 by federal bank regulators and the National Credit Union Administration “to provide sound practices for managing funding and liquidity risk and strengthening liquidity risk management practices. The policy statement emphasizes the importance of cash flow projections, diversified funding sources, stress testing, a cushion of liquid assets and a formal, well-developed contingency funding plan as primary tools for measuring and managing liquidity risk.”
Financial institutions should ensure that their risk management practices are in alignment with this guidance and are appropriate based on the risk profile of their institution.
Through our banking services practice, Weaver can help financial institutions assess risks, evaluate and meet independent review requirements associated with liquidity and funding practices, and develop processes and controls necessary for a strong risk management environment. Contact us for information.
