The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and National Credit Union Administration issued an addendum to the "Interagency Policy Statement on Funding and Liquidity Risk Management" dated March 22, 2010.
The addendum issued on July 28, 2023, reminds banks of the importance of maintaining, assessing and testing their contingency funding plans as part of their liquidity risk management program and activities.
The events of the first half of 2023 have further underscored the importance of liquidity risk management and contingency funding planning. The addendum highlights the importance of contingency funding plans to promote the availability of adequate sources of funding in times of stress, including that banks take the following actions:
- Assess the stability of their funding and maintain a broad range of funding sources that can be accessed in adverse circumstances.
- Confirm they have access to a range of contingent funding sources, especially when some contingency lines may be unavailable in times of idiosyncratic or market stress.
- Test contingency borrowing lines and provide adequate training to ensure the staff is well versed with the functioning of the process.
- Review and revise contingency funding plans periodically, and more frequently as market conditions or strategic initiatives change.
- Understand requirements and maintain operational readiness to borrow from federal funding facilities, such as the Federal Reserve discount window, if these facilities are part of their contingency funding plans.
- Maintain actionable contingency funding plans that consider a range of possible stress events.
- Establish and maintain operational readiness to borrow from the discount window.
- Federal and state-chartered credit unions can access the Central Liquidity Facility as a contingent federal liquidity source. The Central Liquidity Facility exists to provide federally sourced backup liquidity when a credit union’s liquidity and market funding sources prove inadequate.
Because a high potential exists for liquidity pressures to spread from one source to another during a significant event, a financial institution should conduct advanced planning to ensure alternative sources of liquidity and access to emergency standby funding sources will be readily available.
If asset securitization is planned to meet standby liquidity needs, this planning and analysis should include an assessment of the market’s depth and the implications for those markets if the liquidity crisis is the result of a broader market stress event rather than a name-specific event.
Effective contingency funding planning and testing can help financial institutions understand whether they have sufficient infrastructure to access these funding sources (e.g., established lines, processes and availability). For institutions lacking the required infrastructure, planning can help management understand resource requirements, including time needed to establish access to these funding sources and whether establishing access would be feasible and timely in a stressed liquidity scenario.
To ensure the effective and timely implementation of the contingency funding plan (CFP), financial institutions should develop a process for identifying a potential liquidity event before it becomes a crisis. This can be accomplished through the use of early warning indicators and event triggers that are readily observable during the financial institution’s normal reporting process. These should be tailored to the institution’s specific liquidity risk profile.
For example, a financial institution should have early warning indicators that signal whether embedded triggers in certain products (i.e., callable public debt, over-the-counter derivatives transactions) are about to be breached, or whether contingent risks are likely to materialize, such as backup lines to off-balance-sheet conduits (i.e., asset-backed commercial paper), which would force a financial institution to provide additional liquidity support for the product or bring assets back onto the balance sheet. Early recognition of a potential event allows institution management to enhance an institution’s readiness as the event actually evolves.
The CFP should identify a reliable crisis management team and administrative structure, including realistic action plans for given levels of stress. It should also be integrated with other contingent planning activities such as the continuity of business planning. It should provide for frequent communication among the crisis team, the board of directors, management and other interested parties.
This communication optimizes the contingency plan’s effectiveness by ensuring that business decisions are coordinated to reduce the impact on a financial institution’s liquidity position. Effective crisis management may also include increased preparation of regular liquidity reports as well as additional reports that aren’t normally prepared.
Appropriate internal controls address all aspects of liquidity risk management, including policy adherence; the adequacy of risk identification; the accuracy and appropriateness of risk measurement and reporting; fraud prevention and internal manipulation of reports; and compliance with applicable laws and regulations.
Controls over assumptions and changes to assumptions are critical. Therefore, internal controls should ensure that assumptions aren’t changed without clear justification consistent with approved strategies. Documentation for cash flow assumptions should be readily accessible, understandable and in an auditable format. This should be followed through a challenge and approval process.
We recommend that financial institutions review their asset-liability management practices, including liquidity and interest rate risk modeling, stress testing and sensitivity analysis. A focus on ensuring operational readiness to access contingency liquidity sources is warranted in light of the degree and speed of deposit flight observed in early 2023.
Internal audit reviews will need to be enhanced to review liquidity risk management processes and should be conducted to test and document the current measurement processes, evaluate the system’s accuracy, compliance with policies and procedures, and recommend solutions for identified weaknesses.
Contact us for an internal controls assessment.
The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.