2023 has proven to be a challenging year for financial institutions. Since early 2022, the Federal Reserve contracted the money supply through open market activities, driving rates up, and the value of long-term bonds held in bank portfolios down. Meanwhile, many banks have experienced significant deposit outflows as depositors moved balances to capture higher rates in other low risk investments like government bonds and money market accounts. Cost of wholesale funding has risen. Earnings are also being pinched, with net interest margins declining as the rising cost of funds outpaces rate changes on the loan portfolio. Furthermore, today’s customers are tech-savvy and can move their accounts and balances quickly – no deposit can be taken for granted. Historic assumptions about deposit decay rates and betas are no longer relevant. Finally, long term rates are also beginning to rise as more “buy-in” to the belief that the natural rate of interest is higher than currently acknowledged (is ZIRP dead?). Ballooning deficits may keep inflation above trend, forcing rates higher, longer. Rates could go even higher before settling, and then far longer before declining.
Each of these factors contributed to the liquidation of Silvergate and subsequent rapid failures of Silicon Valley Bank and Signature Bank earlier this year. In recent months, smaller banks have begun to feel the pressure of reduced liquidity, as well as increasing unrealized losses on their investment portfolios and slower equity growth (or outright contraction–some banks now have negative equity). While capital is cushioned since bond marks (AOCI) get added back in, the market knows that those losses are real. This is further evidenced by the Moody’s downgrades today.
The banking regulators, having seen how quickly conditions deteriorated at banks in March, are now pressuring institutions across the country to upgrade, or implement, Liquidity Risk Management practices. Asset and Liability management in the last decade have not been a priority for management and Boards - low rates, and the plentiful deposits that accompanied the Federal Reserve’s easy monetary strategy, made these decisions largely inconsequential. For the past 30 years, banks failed because of poor credit decisions, not interest rate risk. This new rate, liquidity and capital environment has caught most banks unprepared, and will be triggering more failures.
Regional banks have absorbed the biggest impacts, and many are downsizing their balance sheets to weather the storm. These reductions are estimated to be 10-15% on average. Banks nationwide are beginning to face the reality that the deposits that flowed in during 2020-21 due to COVID related policies are likely to vaporize. Consequently, lines of business, products and markets are being evaluated for divestiture, exit or termination. Cost reductions will soon follow, as will bank failures for those behind the curve.
Regulators have ramped up the pressure on banks to implement disciplined liquidity risk management practices. During a recent webinar with the Federal Reserve, five topics were highlighted: 1) liquidity risk management, 2) stress testing and assumptions, 3) contingency funding planning and sources, 4) technological impacts on deposit outflows, and 5) focuses during the upcoming exam cycle. Suffice to say, they buried the lead. Liquidity risk is the focus of the upcoming exam cycle. Technology has made deposit outflows quick and easy, making it possible for a bank with primary liquidity of 62% (SVB) to fall due to a bank run. Is your primary liquidity that high?
The regulators recommended that banks adhere to the Interagency Policy Statement on Funding and Liquidity Risk Management from 2010 and consider conservative qualitative overlays, in addition to traditional quantitative measures. They also stressed the importance of diverse funding options and the readiness and accessibility of contingent funding sources. These programs improve the bank's ability to meet its financial obligations in a timely manner, even during adverse market conditions. Enhanced awareness of the threat of a liquidity problem can enable significant strategy changes that could head off a much larger, and possibly terminal, crisis later.
Overall, effective liquidity risk management involves proactive planning, strong governance, robust policies, and continuous monitoring to ensure the bank's financial stability and ability to navigate challenging market conditions.
A meaningful Liquidity Risk Management program requires the following:
The first step is to develop, and maintain, a comprehensive liquidity risk management policy approved by the board. The policy should assign clear responsibilities for liquidity risk oversight and management at various levels of the organization. It should also establish metrics and thresholds that trigger actions under the Contingency Funding Plan. If the bank does not have a Risk Management Committee, one should be created, along with an Asset and Liability Management Committee. Independent advisors can offer both expertise and a valuable counterweight to internal management to provide the Board balanced feedback on market conditions, strategies, and tactics.
Establish a suitable level of liquid assets (cash, high-quality securities) to cover short-term liquidity needs. Align asset and liability maturity, to the extent reasonably practicable, to manage liquidity gaps and minimize funding risks. BASEL III regulatory liquidity requirements, such as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), may not apply directly to your institution but do the math so you know where your exposure is. Having a liquidity buffer could be critical to surviving market turbulence.
A CFP outlines strategies and tactics for addressing liquidity shortfalls during stressed conditions. These must be actionable and consider a range of possible stress scenarios. This includes the potential use of the Federal Reserve’s discount window. Digital banking might be able to help but it is only one component of funding. Banks should use this opportunity to establish access to contingent funding sources, like FHLB advances, backup lines of credit, repo facilities, or emergency borrowing, and engage in planning that recognizes the operational challenges involved in moving and posting collateral to access critical funding in a timely fashion. And, obviously, don’t double count securities available for sale and pledged.
I have seen these tactics fail first-hand in many institutions in times of crisis, ranging from First Republic Bank in 1989 to Merrill Lynch in 2008. During times of stress, contingency lines frequently become unavailable. For example, repo lines may become unavailable to a bank either due to concerns of the repo lender about the creditworthiness of the bank, due to regulatory actions, or due to the repo lender needing to conserve liquidity. Therefore, contingency funding plans should take this dynamic into account, and to the extent possible, include a range of backup funding sources. Consideration should also be given to activities on the other side of the balance sheet, such as unfunded commitments.
Management should conduct a thorough assessment of the bank's liquidity risk profile, considering factors such as cash flows, funding sources, and market conditions. Develop a Risk Appetite Statement which documents the bank's strategies and limits, including liquidity risk. Attempt to quantify liquidity risk through stress testing, scenario analysis, and cash flow projections.
Setup the funding lines and relationships now and test them regularly to ensure their availability in a crisis. Regularly assess the bank's ability to withstand severe liquidity shocks through scenario analysis. Use simulations to model different scenarios and test the impact of varying market conditions on liquidity position, cash flows and funding sources.
Implement robust monitoring mechanisms to track liquidity positions, cash flows, and funding sources in real-time. Generate regular liquidity reports for management and regulatory purposes. Ideally, establish a liquidity dashboard that is monitored daily.
Develop a clear communication plan to inform stakeholders, including depositors, investors, and regulators, during liquidity crises. Establish procedures for swift decision-making and coordination in response to liquidity emergencies.
Implementing liquidity risk management practices at a bank requires a comprehensive and structured approach to ensure the bank's ability to manage and mitigate liquidity risks effectively. Senior management buy-in and commitment is critical; they must support establishing a strong liquidity risk management framework and foster a culture of awareness and responsibility for liquidity risk management across the organization. It is also important to designate a dedicated liquidity risk management team or individual responsible for overseeing and managing liquidity risks. Roles, responsibilities, and reporting lines within the organization should be established to ensure effective coordination. Data and analytics infrastructure is critical. Data must be accurate and timely enough to enable action. To be clear, this means daily data to support daily analytics. Banks should establish a robust data collection and reporting infrastructure to track key liquidity metrics, cash flows, and funding sources, including analytical tools and models for stress testing, scenario analysis, and dynamic monitoring. Third party consulting firms like ours can be particularly helpful to accelerate this process. Finally, communication and effective crisis management can make the difference in surviving or failing. Develop a comprehensive communication plan to ensure effective communication with stakeholders during liquidity crises. Establish protocols for swift decision-making and coordination in response to liquidity emergencies.
To be clear, in many ways the Dodd-Frank Act, the Basel Framework, and the SEC’s money market reform have substantially altered the bank funding framework. Banks are largely on their own to ensure their business and shareholders are protected, while the regulatory system provides protection for the depositors and mandates compliance. Management and Boards should evaluate their risk in this context, as the elements for the next wave of liquidity and credit crises are already in place. Commercial and consumer clients will also be rethinking their relationship with banks that don’t have the capacity to meet their borrowing needs, so both sides of the balance sheet need to be considered in planning.
Looking forward, banks can expect increased discussion and scrutiny from examiners regarding their asset liability management program and the monitoring of deposit behavior, model assumptions, cash flow and contingent funding sources. This has been a topic that has generated extensive regulatory criticisms in many recent bank examinations, a trend which is likely to accelerate in 2023. Expect to see more aggressive regulatory actions this year. An experienced advisory firm like ours can help your bank tackle these challenges.
By following these steps and considering these key aspects, management and the Board can implement effective liquidity risk management practices to safeguard its financial stability and navigate potential liquidity, and insolvency, challenges.
Founded in 2009, Endurance Advisory Partners has an extensive track record of providing strategic solutions and execution resources to regional and community financial institutions and investors nationwide. Endurance achieves results by leveraging deep understanding of financial services, regulatory, technology, risk management, corporate finance and financial markets to help clients develop and execute strategies. Our firm has successfully guided over 70 banks, boards, and investor groups through the execution of complex or operationally challenging strategies and successfully addressing regulatory actions. Our team is led not by consultants, but by former financial services executives with deep execution experience. Our services are highly competitive with the top consulting firms, as we focus on establishing long term relationships based on successful execution, instead of task-oriented projects.
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