Community Banking Advisor: Recognizing the Warning Signs for Liquidity Risk

Risk management is a critical function at community banks. And while interest rate risk gets the lion’s share of attention, banks shouldn’t overlook liquidity risk. According to regulatory reports, liquidity risk increased in recent years for “smaller” banks (assets under $10 billion).

Why the Increase?

Reasons for this trend include loan growth accompanied by shrinking liquid asset holdings and increasing reliance on noncore and wholesale sources — such as borrowings, brokered deposits, Internet deposits, deposits obtained through listing services and uninsured deposits — to fund loan growth. An article in the Summer 2017 issue of the FDIC’s Supervisory Insights mentions that “rapid asset growth funded by brokered deposits has been directly associated with a higher incidence of problem banks and failures.”

Typically, these alternative funding sources are more expensive and volatile than insured core deposits. And they’re subject to legal, regulatory and counterparty requirements that can create liquidity stress, particularly if a bank has credit quality issues or deteriorating capital levels.

What’s the Plan?

The FDIC recognizes that alternative funding sources are an important component of a well-managed bank’s liquidity and funding strategy. However, these sources can be problematic if a bank relies on them too heavily. Incorporating a balanced funding strategy into a comprehensive liquidity risk management plan is key to success.

The FDIC urges banks to consult the federal banking regulators’ 2010 Interagency Policy Statement on Funding and Liquidity Risk Management which outlines the essential elements of sound liquidity risk management. Banks should balance the use of alternative funding sources “with prudent capital, earnings and liquidity considerations through the prism of the institution’s approved risk tolerance.” They should:

  • Ensure effective board and management oversight,
  • Adopt appropriate strategies, policies, procedures and limits to manage and mitigate liquidity risk,
  • Implement appropriate liquidity risk measurement and monitoring systems,
  • Actively manage intraday liquidity and collateral,
  • Have a diverse mix of existing and potential future funding sources, and
  • Hold adequate levels of highly liquid marketable securities that are free of legal, regulatory or operational impediments.

In addition, banks should design a comprehensive contingency funding plan (CFP) that sufficiently addresses potential adverse liquidity events and emergency cash flow requirements. Finally, they need to set up appropriate internal controls and internal audit processes.

For banks that rely heavily on volatile funding sources, the FDIC emphasizes the need to ensure that the banks’ risk tolerances and recovery strategies are reflected in their asset-liability management programs and CFPs. A well-developed CFP should help a bank manage a range of liquidity stress scenarios by establishing clear lines of responsibility and articulating implementation, escalation and communication procedures. It also needs to address triggering mechanisms, early warning indicators and remediation steps that cover the use of contingent funding sources.

CFPs should identify alternative liquidity sources and ensure ready access to contingent funding because, the FDIC explains, “liquidity pressures may spread from one source to another during a significant stress event.” Examples of backup funds providers include federal home loan banks, correspondent institutions and others that facilitate repurchase agreements or money market transactions.

An independent party should regularly review and evaluate the various components of a bank’s liquidity management process. The review should match the process against regulatory guidance and industry best practices as adjusted for the bank’s liquidity risk profile. The reviewer then should report the results to management and the board of directors.

Which Plan is the Best Fit?

The FDIC emphasizes that community bank CFPs should be customized to fit a bank’s business lines and risk profile. More complex institutions should use cash flow forecasting and stress testing to ensure they maintain a sufficient liquid asset cushion to absorb potential risks. Contact your Elliott Davis advisor if you have any questions or need assistance.