With liquidity remaining a regulatory hot button, many examiners are taking a harder look at the areas of contingency funding plans (CFPs) and the stress testing of those plans. This article discusses the key elements that go into developing an effective CFP along with some of the more common exam findings in this area.
The increased regulatory focus on CFPs highlights the importance of taking a comprehensive approach to liquidity management. Asset liability committees often find themselves focused on how to address current liquidity needs. While it is essential to know the bank’s current position, discussions should also center on planning for future scenarios so the bank is prepared to respond to contingent liquidity events. As such, all financial institutions, regardless of size, should have a CFP in place.
A CFP is designed to ensure a bank has adequate sources of liquidity in place to fund normal operations under various contingent liquidity event scenarios. Contingent events can result from circumstances unique to a specific bank or external occurrences that are indicative of systemic financial conditions. Common events specific to an individual bank include operational or strategic risks, difficulties in funding asset growth, or the inability to replace maturing liabilities. External events generally tend to center around economic conditions, interest rate changes, or volatility of financial markets. Contingent liquidity events may be unexpected and short-term in nature or result from mounting pressures that have a long-term impact on liquidity. The expected duration of events is an important consideration when developing a CFP.
There are several factors to consider when designing a CFP. A comprehensive plan should achieve the following:
- Identify contingent liquidity events. Possible events may include, but are not limited to, deterioration of asset or credit quality, downgrade of CAMELS composite rating, operating losses, rapid asset growth funded with volatile liabilities, disruption of markets, a noticeable decline in customer relations, and negative press coverage.
- Assess severity of events. Events will have varying levels of severity and duration. Funding needs may be immediate or may require a prolonged period of funding. In the latter case, it is critical to evaluate the level of funding required at each stage throughout the event.
- Assess funding needs. A key element to any CFP is a quantitative assessment based on projections developed for each event. Assumptions used in the projections should be realistic and timely. Results are only as reliable as the input data, so it is important to continuously update assumptions as anticipated conditions change. Stress testing is a typical method employed by banks to evaluate the potential impact of various scenarios on liquidity needs. Cash flow shortfalls and potential erosion of funding will vary depending on the scenario and at each stage of the event. Additionally, both on-balance-sheet and off-balance-sheet cash flows should be considered in the assessment.
- Identify potential funding sources. Once funding needs have been identified for each event, a plan must be put in place to access funds. Because potential exists for liquidity pressures to spread from one funding source to another during a serious event, banks should identify alternative sources of liquidity. Having options available in the event of a liquidity crisis is critical. Advance planning and knowing the actions to be taken should a specified event occur is vital to ensure that contingent funding sources will be available when needed.
- Establish processes for monitoring and event management. Management should designate a crisis-management team to execute a plan of action in the event one of the potential scenarios occurs. In a stress event, communication among all parties involved is key, including the crisis team, bank management, and the board of directors. Additional reporting may be required during an event to monitor liquidity levels. Staying alert to early warning signs may prevent a potential liquidity event from becoming a full-blown crisis and possibly minimize the financial impact to the bank.
Recent trends in exams indicate deficiencies in CFPs due to reliance on less stable funding sources to pursue growth. According to a recent supervisory insights publication issued by the FDIC, the first and best line of defense in response to a liquidity event is a cushion of unencumbered liquid assets, meaning that no party has a collateral claim to the assets. It is typically easier to sell unencumbered liquid assets such as U.S. agency securities, money market funds, or correspondent deposits than to obtain outside funding in the midst of an adverse financial situation. However, trends indicate a recent drop in liquid asset levels for community banks.
An area that the FDIC cautions against is turning to brokered deposits as a liquidity funding source, as these types of deposits are more rate sensitive and have a higher run-off risk after maturity than other funding options. Brokered deposits are also subject to rollover restrictions should a bank fall below well capitalized. A heavy reliance on brokered deposits has also been linked with a higher prevalence of problem banks.
Recommendations from examiners in response to CFP deficiencies include:
- Enhanced scenario testing
- Better aligning the CFP with the bank’s risk profile
- Understanding asset encumbrances and back-up line availability
- Monitoring trigger events that are early indicators of potential liquidity problems
Examiners expect to see that banks not only have a CFP in place, but are also stress testing the plan for various scenarios, typically on a quarterly basis. A planned response should be developed for each vulnerability identified. The expectation is that management not only went through the process, but has considered the results and prepared a plan of action.
Contingency planning is an ongoing process that is constantly changing. While the considerations outlined above are important steps in developing an effective CFP, no two plans will be alike. In order to get the most value out of a CFP, the plan should be tailored to the size, complexity, and specific risks faced by each bank. Although no one intends for their bank to experience a liquidity crisis, you don’t want to be caught unprepared should the worst happen. Having a plan in place and the key players identified ahead of time will set your bank up to successfully navigate through a difficult situation. Contact our offices today to for more information.