Managing Liquidity Risk and the Importance of Bank Contingency Funding Plans
This post is part of a series titled “Supervising Our Nation’s Financial Institutions.”
U.S. banking supervisors are asking the nation’s bankers to evaluate the liquidity risk inherent in their banks’ current operations and to have contingency funding plans in place and ready to execute in the event of liquidity shortfalls.These supervisors consist of the Federal Reserve System, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the National Credit Union Administration, and state supervisors as represented by the Conference of State Bank Supervisors. That guidance is spelled out in an updated interagency policy statement issued in July.
The original policy statement on funding and liquidity risk management was issued in March 2010, and outlined the process insured depository institutions and bank holding companies should follow to appropriately identify, measure, monitor and control their funding and liquidity risks. The 2010 guidance stressed 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 funding and liquidity risks. Processes and systems used should be commensurate with a bank’s complexity, risk profile and scope of operations, the guidance noted.
The importance of funding and liquidity risk management was vividly demonstrated earlier this year, when three banks—Silicon Valley Bank, Signature Bank and First Republic Bank—failed and another bank, Silvergate Bank, voluntarily liquidated itself. While many factors contributed to these failures, funding and liquidity issues dominated.
To boost liquidity in the banking system, the Fed in mid-March launched the Bank Term Funding Program (BTFP), a short-term lending facility for banks, savings banks and credit unions designed to ease the liquidity impact of underwater securities held on bank balance sheets. Banks were encouraged to use the BTFP as well as the discount window to meet any short-term liquidity shortfalls, such as a decline in deposits.
In July’s updated guidance, the agencies point to the events of the first half of 2023, noting that banks need to be aware that depositor behavior and broader market conditions can change over time, and at unanticipated speed. Banks should have at the ready actionable contingency funding plans for a wide range of possible stress scenarios, such as funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds, and contingent liability events.
Moreover, banks need to know the operational steps required to access funding from contingency sources such as the Federal Reserve System’s discount window and BTFP, and the Federal Home Loan Bank System’s advances. These steps include verifying contact details and understanding the types of collateral accepted for pledging. Once established, these contingency borrowing lines should be regularly tested by bank staff for functioning.
Discount Window Readiness
The Fed’s discount window is singled out in the interagency update as an important tool for banks to use to manage their liquidity risk, and they are encouraged to incorporate the discount window into contingency funding plans. As with other types of contingency funding, banks should be operationally ready to use the discount window rather than waiting until it’s needed. To be ready, banks need to establish borrowing arrangements and understand the pledging process for various collateral types; the agencies also noted that pre-pledging collateral is possible and can speed up the process of obtaining discount window loans. Regular testing of discount window readiness with small value transactions is encouraged.
No Stigma in Establishing Diverse Funding Strategy
Federal and state banking regulatory agencies have actively encouraged bank management to establish discount window or BTFP access and have made clear that institutions will not be criticized for establishing these lines of credit. Yet, I continue to hear concerns from some bankers about the possible stigma associated with using these programs. Consistent with the interagency guidance, our bank examiners will not criticize an institution for establishing a diverse funding strategy to meet liquidity needs in stressful situations that might arise.
- These supervisors consist of the Federal Reserve System, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the National Credit Union Administration, and state supervisors as represented by the Conference of State Bank Supervisors.