Sound Practices for Liquidity Risk Management


With additional rate hikes on the way from the Fed, examiners’ focus on Liquidity Risk Management (LRM) has increased meaningfully in recent quarters. The Financial Crisis laid bare risk management practices that many regulators deemed insufficient to withstand the strain imposed by tighter credit conditions and reduced access to funding, particularly in the wholesale market. Adequately responding to regulators’ comments and requirements will require risk managers to maintain a firm understanding of not only the regulatory principles related to policies and procedures, but also of the methodology and procedures for stress testing their institution’s liquidity profile.


During the early stages of the recent financial crisis, the Bank for International Settlements (BIS) published guidance on liquidity principles that regulators deemed fundamental to an efficiently functioning economy and safe lending institutions.[1] While the core principles did not provide specific prescriptive actions, the framework of the principles laid the foundation from which regulators would later build processes that are more descriptive.[2] Within this context, regulators defined liquidity risk as “the risk that an institution’s financial condition or overall safety and soundness is adversely affected by an inability (or perceived inability) to meet its obligations.”

Regulators broadly assessed management practices at the time as lacking, citing a general absence of meaningful cash flow projections and contingency planning. To counter this trend, the policy statement re-emphasized the importance of thorough cash flow projections, diversification of funding sources, maintaining an appropriate cushion of liquid assets, and developing a contingency funding plan that was both formal and robust. Intricacy was also a key concern for regulators, in that very large and complex organizations needed to model the liquidity dynamics of their balance sheet/business model in a manner commensurate with the institution’s complexity. However, this should not imply that a simple institution should not develop an extensive stress test.

Because of the findings and subsequent guidance, regulators have recommended a variety of essential components of sound LRM practices that include:

  • Board Oversight
    • Comprehend modelling, approve strategies, and supervise implementation – the buck stops with the Board
  • Comprehensive Measurement
    • Identify risk tolerances, use reasonable assumptions, develop robust stress scenarios, and document strategies
  • Active Intraday Management & Diversification of Funding Sources
    • Regularly test collateral/funding sources, allow for regulatory & operational limits, avoid funding mismatches, and avoid funding concentrations
  • Maintain Adequate Levels of Highly Liquid/Marketable Securities
    • Measure and test for the appropriate/necessary level of liquid securities
  • A Comprehensive Contingency Funding Plan (CFP)
    • Identify stress events, assess severity/timing given current/potential funding sources, establish event management/response process, and establish monitoring framework for contingent events


Risk managers often model the LRM framework with a “Sources/Uses” approach, wherein management identifies all sources of incoming cash and offsets that amount by all outflows of cash. The “Structure of Funds” approach, which measures the change in the liquidity profile of marketable assets currently held on the balance sheet relative to assets that are likely to become illiquid under adverse conditions, often augments or supports the sources/uses method. Sources of liquidity might include new deposits, maturing investments, interest/principal payments, fee income, asset sales, borrowing lines, repurchase agreements, or even asset sales (Structure of Funds). Risk managers should comprehensively measure all sources and uses of funding when measuring risk, no matter how small or seemingly insignificant.


The conditions or circumstances used for stress testing are closely related to the role the CFP plays with regard to contingency planning. In many ways, the CFP should help guide the scenarios used for stress testing an institution’s liquidity position. CFPs often define the conditions and relative severity of market downturns and the impact on sources and uses of liquidity. Thorough CFPs often establish a hierarchy of severity levels that correspond to stress events: for instance, Level 1 through Level 5, where the severity increases at each level. Additionally, each level often contains a description of the market conditions that might occur at each level. Level 1 might assume a 5% decline of core funding (checking, savings, etc.), whereas, Level 5 might assume a 15% decline of the same category of funding sources. An institution’s LRM framework should also rely on the CFP to delineate the responsibilities and escalation procedures required of managers and potential remedies they might use in each of the severity categories.


Modelling an institution’s liquidity profile for stress events can provide a great deal of insight for risk managers and board members. Stress scenarios can vary widely in their assumptions, including an inability to fund asset growth, the inability to renew or replace maturing liabilities, or the unexpected exercise options embedded within liabilities. Considering this variance, several key principles can help guide the modelling process.

Most importantly, stress scenarios should contain realistic assumptions of depositor behavior. Risk managers should maintain and leverage data on their core depositors to determine their sensitivities to changes in market rates. This sensitivity can be used to quantitatively assess the likelihood and amount of an outflow of funds under different rate environments. For example, depositors with very high sensitivities are statistically more likely to withdraw funds when the level of market rates increases, and these accounts should result in more outflows than those with lower sensitivities – a very important consideration for institutions that use wholesale funding.

Second, risk managers should model for a variety of periods, including daily, monthly and annual forecasts. Shorter measurement periods are often associated with maintaining operations, while longer periods can often be used in conjunction with strategic planning or stress testing. Measuring the effects of stress events can help determine the length of time that would be required to breach policy limits or exhaust secondary liquidity sources.

In addition, while it can be helpful to measure the liquidity behavior of an isolated instrument or account, stress scenarios should be comprehensive with regard to effect on the total balance sheet. For instance, if a stress scenario assumes a shock in rates (say 100bps), then the impact on cash flow behavior shouldn’t be limited to one side of the balance sheet. An increase in the level of rates is likely to affect liabilities via depositor behavior (e.g., high yield checking accounts withdrawing to obtain a higher rate with a competitor) resulting in an outflow of funds. However, this rate increase would also affect the asset side of the balance sheet, particularly with regard to borrowers’ prepayment behaviors. An institution with high exposure to fixed rate mortgages would expect to see prepayments decrease as rates increase (cash flow extension), which would also place a strain on cash inflows.

The LRM framework an institution uses can provide a variety of insights with regard to safety. However, risk managers can also use modelling assumptions to provide feedback related to the unexpected results of their balance sheet strategy. In addition to measuring the consequences of tighter liquidity conditions, stress testing can also provide feedback to determine whether an institution is carrying too much liquidity, a circumstance that can result in lower returns and long-term capital growth.


The quality of an institution’s LRM framework can meaningfully influence strategy in the long run and increase short-term safety. A robust CFP and rigorous stress testing should be used in a constant feedback loop with each other, wherein the scenarios used for stress testing inform the limits and responses to market downturns. Management and board members that understand the regulatory guidance and use it to structure policies and procedures will likely be more prepared in the event of an unforeseen market shock. Organizations that seek continuous improvement of liquidity modelling through stress testing can use the results to gather insights into optimizing balance sheet strategies in addition to increasing safety.

[1] Principles for Sound Liquidity Risk Management & Supervision, BIS, September 2018

[2] Interagency Policy Statement on Funding & Liquidity Risk Management, FRB/OCC/FDIC/NCUA/OTS, March 2018

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