Preparing for a New Era in Liquidity-Risk and Funds Management
by Mike Guglielmo, Managing Director
Darling Consulting Group
2009 is clearly emerging as a year of tumultuous change in the financial services
industry. It seems like new problems, issues, challenges, and concerns emerge every
day—many from unintended consequences driven by the bevy of political, accounting,
regulatory, and auditing activities, rules, pronouncements, laws, and commentary.
More than ever, financial institution executives need to be engaged in the daily
events and activities taking place throughout the industry and must proactively
participate and react to the many debates and discussions taking place. Choosing
to sit by idly on the sidelines and wait out the storm could prove disastrous. But
with all the changes occurring, even the most resourceful are finding it hard to
keep pace with the many twists and turns happening each and every day.
One of the areas in which significant change is afoot is in liquidity risk and funds
management. The recent liquidity/credit crisis has led to a profound change in the
wholesale funding landscape and an institution’s ability to manage liquidity from
both an operational and contingency standpoint.
As Wall Street works to overcome its problems and Washington continues to enact
and implement changes meant to stabilize the industry and the economy as a whole,
liquidity-risk managers are faced with an ever-changing landscape that requires
constant attention and adjustment.
The bottom line: traditional operating philosophies, measurements, and management
practices will no longer suffice, and the industry and regulators are actively developing
and adopting more robust liquidity-risk management standards. Now is the time to
become engaged in the process or become subject to potential unintended consequences.
New interagency guidance is here.
On June 30, 2009, the OCC, FRB, FDIC, OTS, and NCUA, in conjunction with the Conference
of State Bank Examiners, issued a request for comments on a joint statement titled,
Interagency Guidance on Funding and Liquidity Risk Management. This guidance
represents a comprehensive expansion of the liquidity-risk measurement and management
process, and institutions of all sizes and levels of complexity are going to be
doing more than they ever have in the past.
So what does this new regulatory guidance call for? Here are the highlights:
- Projection of your future funding capacity and liquidity needs through detailed
sources/uses forecasting
- Implementation of a stress-testing process that will allow your organization to
quantify how your funding needs and availability might change under various states
of duress
- Changes to traditional investment portfolio strategy, collateral management, and
wholesale funding practices
- Adoption of an early-warning monitoring system that will allow you to identify issues
before they become problems
- Expansion of policies, procedures, and risk guidelines along with documentation
of liquidity-risk management strategies
- Development and more frequent review of a contingency funding plan
- Internal controls and independent validation of the liquidity-risk management process
While few institutions are experiencing a liquidity crisis at the moment, adoption
of these new guidelines is going to take some considerable effort. And of course,
the best time to fix the barn door is before the horses run out.
Fundamental changes in liquidity-risk management practices are expected.
As you reflect on your own process and the changes that are likely required, there
are eight fundamental questions you and your ALCO should be able to answer:
- How much liquidity do we have for both operational and contingency purposes?
If you are relying on traditional (regulatory) ratios and measures, you are unable
to really know. An effective measurement process will quantify your available liquidity
and the various sources.
- How accessible is it and what are the relative costs? It is important to
maintain an up-to-date summary of funding availability, the level of accessibility,
and the relative costs. Accessibility and pricing, especially in volatile times
can vary dramatically, and it is crucial that you and your ALCO stay well informed
of these issues or, consequently, find yourself without funding when you need it
most.
- How much operational liquidity do we need short term and longer term? An
area where most institutions fall short is in forward-looking liquidity forecasting.
It is also evident that the tools and information needed to forecast accurately
need some work as well. ALM models are in need of refinement. Forecasting your future
source and uses will soon become a mainstream liquidity management activity.
- If market conditions change, how could our liquidity needs and cash availability
change? Given the volatile marketplace within which we now operate, it is important
to perform alternative simulations and “what if” exercises. Understanding your ability
to withstand adverse conditions (financial, economic, reputational, etc.) needs
to be an integral part of the ALCO process.
- What crisis or events could markedly affect our operational needs and impede
our access to reserves and/or contingency sources? Given the strong linkage
liquidity now has with credit and capital, ALCOs or liquidity-risk management teams
need to be cognizant of the growing list of potential events or conditions that
could impede access to funding (temporarily or permanently) and discuss them regularly,
as they can and will change.
- Do we have a sufficient early warning system that could prompt actions prior
to a problem? Adopting the use of a liquidity “scorecard” will allow you, your
ALCO, and your board to keep an eye on conditions and trends that could foretell
a growing liquidity problem or crisis before it occurs. This would serve as the
monitoring mechanism of your contingency funding plan.
- What actions would we take in the event of a liquidity crisis, and how long
could we sustain operations? Once you have an appreciation for the potential
financial impact of moderate, significant, and severe liquidity events, it’s time
to develop a set of detailed action plans highlighting varying levels of response,
expected results, and potential risks. This should be a quantitative and qualitative
exercise that involves the personnel key to the execution of these action plans.
- Do we have adequate processes and controls in place that will ensure action
plans will be executed successfully? If your plans are not well documented,
you will not only run the risk of regulatory scrutiny, but more importantly, risk
poor or failed execution. Specific actions, contacts, individual roles and responsibilities,
timelines, and communication protocols are some of the things that need to be documented.
You cannot be over prepared.
We have clearly entered a new era in liquidity-risk management, and now is the time
to prepare yourself and your institution. In fact, it is not possible for you to
be over-prepared. Liquidity forecasting, stress testing, collateral management,
funding diversification, contingency planning, back-testing, documentation of processes
and controls, accessibility testing: all are at the foundation of an effective liquidity-risk
management process in today’s environment.
The efforts and activities surrounding liquidity-risk management are destined to
rival that of interest-rate risk management. Those institutions that properly invest
the time and resources required will be best prepared for a future liquidity event,
while those that don’t may not be around for a second chance.
Looking forward.
While liquidity risk, credit risk, capital preservation, and earnings are at the
top of financial institutions’ and examiners’ lists of concerns, a growing unease
over potential increased exposure to rising interest rates is also brewing. It is
important that the industry does not take its eye off the ball and one day wake-up
to an interest-rate risk problem. Your internal or external resources should already
be preparing you and your institution for this next potential event. If they are
not, they need to be directed to do so.
The world of financial services is changing rapidly, and the consequences of mistakes
can be catastrophic. The role of your ALCO has never been more important. Its members
must stay focused and become fully engaged in the growing labyrinth of challenges
and changes taking place in the industry. To borrow a quote from Charles Darwin,
“In the struggle for survival, the fittest win out at the expense of their rivals
because they succeed in adapting themselves best to their environment.”
Mike Guglielmo is managing director at Darling Consulting Group, a Massachusetts-based
ALM consulting firm. Mike has over 20 years in asset/liability management and provides
both technical and strategic consulting to a diverse group of financial institutions
in the U.S. and abroad.
For additional information about the proposed guidelines, please see the
Interagency Guidance on Funding and Liquidity Risk Management.
Join Mike for the upcoming Web seminar, Managing and Tracking Liquidity Risk.
This Web seminar is being offered as part of the Seattle Bank’s fall educational
series, A Chance to Get It Right: Key Elements of the Strategic Planning Process.
Register
online now for this and other educational events coming soon!