Page 42 - February 20, 2025 Bulletin

BUSINESS PARTNERfeature article

Liquidity Risk Management:

A Continued Regulatory Focus

Dale Sheller
Managing Director & Director of Financial Strategies Group
The Baker Group

It has been almost two years since the failures of Silicon Valley at a moment’s notice. Identification of potential funding sources
Bank and Signature Bank have shown that liquidity risk can for shortfalls that result from stress scenarios is a key component
produce a bank failure instantly versus a slower, asset quality- of an adequate CFP. A best practice is to test those lines at least
related failure. These liquidity-related failures put a level of annually, if not more frequently in today’s environment, and to
fear and panic into the banking industry during a time when document the testing of those lines.
the Federal Reserve increased interest rates at an unpreceded
pace and magnitude. Over the last few years, the actions of the Liquidity Cash Flow Modeling and Stress Testing
Federal Reserve quickly reversed liquidity out of the banking Historically, many financial institutions used single point-
system and tightened liquidity levels across many institutions. in-time measurements (such as a liquid asset ratio) to assess
Liquidity risk management and contingency funding planning their liquidity position. Static liquidity measures can provide
remain front and center for many risk management examiners. valuable information, but cash flow forecasting (sources or
uses of funds reporting) can enhance a financial institution’s
Deposit Competition Has Eased
ability to manage and monitor liquidity risk. The complexity of
During the height of the pandemic, institutions were drowning liquidity cash flow forecasting models can range from the use
in deposits and excess liquidity. But after 525 basis points of of a simple spreadsheet to more comprehensive liquidity risk
tightening from the Federal Reserve in under two years, a battle models. Liquidity stress testing is typically done by utilizing your
for deposits ensued. Alongside the 100 basis points of Fed easing liquidity cash flow model and changing various assumptions in
in late 2024, deposit pricing and pressures have eased for many the base case scenario. Institutions should conduct stress tests
institutions. As a result, most institutions reached their peak regularly for a variety of institution-specific and market-wide
funding costs in Q4 2024. events across multiple time horizons. The results of liquidity
stress testing should play a role in shaping the institution’s
Contingency Funding Planning
contingency funding planning. When in doubt, think about
As a direct result of the 2023 bank failures and tighter liquidity high impact and low probability type of scenarios. It isn’t what
environment, the regulators released an “Addendum to the you expect to happen, but what could possibly happen, even if
Interagency Policy Statement on Funding and Liquidity Risk the chance is remote.
Management: Importance of Contingency Funding Plan” in
July 2023. The guidance reiterates the need for an actionable Whether you recently finished a recent regulatory examination
CFP that considers a range of possible stress scenarios. or are gearing up for one, you will likely agree that liquidity
Additionally, the guidance called for depository institutions to risk management remains one of the hottest regulatory focus
test the operational readiness of their CFP by regularly testing items. Ensuring you have an iron clad liquidity risk management
their borrowing lines to ensure their staffs are well versed in program well before your next examination is critical.
how to access the lines. The guidance encourages depository
institutions to incorporate the discount window as part of their
contingency funding planning. As a rule of thumb, it is never
bad to have more avenues to add liquidity to the balance sheet

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