As we close out 2023 and look forward to the new year we’ve been discussing risks. Last week we discussed the basics of asset and liability management (ALM). ALM can be thought of as a coin. Heads is managing interest rate risks. This week we flipped the coin and we got tails: liquidity risk. At the most basic level, liquidity risk is the risk that a bank will not have sufficient cash to meet its financial commitments in a timely manner. The past couple years have increased liquidity pressures with the competition for deposits heating up and tougher economic conditions, so how should you be thinking about reducing these pressures? It’s a matter of planning for the unexpected.
The first line of defense is a cushion of unencumbered liquid assets, also referred to as a liquidity buffer. The bread and butter of a liquidity buffer are marketable and liquid assets such as U.S. securities and short- term, investment-quality, and Federal Reserve deposits. These highly liquid resources can generally be sold or pledged at little or no discount and serve as a banking institution’s life vest, keeping the bank above water in a crisis. If you’re ever feeling a liquidity crunch, having a pool of these assets is the best way to avoid a shortfall and while that’s all well and good, you may be wondering how you should be setting this buffer in the first place. Assessing historical cash flow needs during normal business conditions is a good starting point. From there, the cushion could be set by forecasting expected or unexpected needs. The liquid asset buffer can provide liquidity a time of stress, complemented by secondary funding sources.
Part of forecasting future needs is evaluating your concentration of “non-core” deposits. “Core” deposits are the primary funding source for most community banks. These deposits are generally stable and lower-cost. “Non-core” refers to funding sources other than insured core deposits. Such funding sources are typically more expensive and less stable than insured core deposits. They may be difficult or more costly to replace. In the recent past, banks with concentrated positions in less stable funding sources have experienced more liquidity stresses.
Contingency funding plans (CFP) are vital. A CFP is a strategy to address unexpected liquidity shortfalls. Liquidity strains are often linked to multiple risks and a comprehensive and up-to-to date CFP navigate funding at a time when resources and attention are split between multiple fronts. To address the CFP deficiencies, regulators have suggested enhancing scenario testing, understanding asset encumbrance, and aligning the CFP with the risk profile and activities of the institution.
While you cannot expect the unexpected, you can plan for it. We have a liquidity risk management audit worksheetthat you may find useful in and a variety of useful tools in our Asset and Liability Management Toolkit.