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Sound Practices for Liquidity Risk Management

BY TYLER DUNN

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 requirementswill 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.

THE REGULATORY BACKDROP

During the early stagesof 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 mannercommensurate with the institution’s complexity.However, this should not imply that a simple institution should not develop anextensive stress test.

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


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