I read an article a couple of days ago about a bank on the Gulf Coast that literally handed out cash (which it had dug out of vaults and teller drawers covered with mud) to victims of Hurricane Katrina when people could not access their local financial institutions or ATM machines to buy food or other necessities. Cash was handed out to customers and noncustomers alike with the request to return it when they could. The result of that act of kindness was a phenomenal growth in deposits the following year, but more importantly, the experience left an indelible mark in the minds of the communities the bank served. The character of any person or business is defined by their actions in times of stress. In our current crisis, we have heard references and analogies to the generations before us who went off to war. Today, across the globe, instead of a call to duty, there is a call to action. While for a majority of us that means doing nothing, financial institutions in particular have been asked to help their communities “weather the storm.” Extensions of credit to hard-hit borrowers, modifications of loan terms, inevitable disruptions in normal cash flows will generate internal stresses in your financial institution as you seek to alleviate the personal stress of the individuals you serve. The key is to be prepared, understand your weaknesses and vigilantly monitor one of the most critical risks in banking — liquidity risk. Then when your “Katrina moment” arises, you will be prepared to leave your indelible mark.
Contingency funding plans (CFP) are required of all financial institutions, regardless of size or complexity, and should clearly establish a strategy for addressing liquidity shortfalls in emergency situations. A CFP is a comprehensive plan that delineates policies to manage a range of stress events, establishes responsibility and articulates clear implementation and escalation procedures. It is likely most financial institutions failed to identify our current emergency situation in their contingency funding plans. Nevertheless, here we are and whether you specifically identified it or not, this is clearly one of those “low probability/high impact” scenarios. If you have not evaluated, or reevaluated, your contingency funding plan, now is the time to do so. To recap the fundamentals, contingency funding plans should address the following:
- Identify stress events
- Assess levels of severity and timing
- Assess funding sources and needs
- Identify potential funding sources
- Establish liquidity event management processes
- Develop risk mitigation action plans
- Establish a monitoring framework for contingency events
- Require stress testing
As you look at this list, it should become clear that with definition around this current stress event, the responses and mitigation strategies currently defined in your CFP may need some modification. In addition, given the changes that are occurring on a daily basis, your strategies may need to be modified nearly as frequently. The crisis management team should be actively reviewing the liquidity position of your financial institution. Included in that is an evaluation of your funding sources and confidence that access to all liquidity sources has been properly tested and documented.
Equally important is stress testing liquidity risk exposure. Liquidity stress tests are based on cash flow projections that are modified to reflect a stress event and are meant to identify early warning signs to potential funding risks. Emerging market conditions make liquidity stress testing and monitoring of the thresholds established by your institution in its stress testing scenarios more relevant now than ever. Thresholds may require modification as once arbitrarily set parameters become more realistic probabilities. If your CFP is not currently activated, perhaps a refreshed view of your stress scenarios will provide needed clarity.
Stress scenarios used in your stress testing should be financial-institution specific but equally important now are systemic and market-wide scenarios. Consider layering scenarios as further definition evolves around this event. Examples of some institution-specific scenarios include deterioration of asset quality, reputational issues, or concentrations in a particular industry. Remember the uniqueness of your balance sheet should be the focus. System or market-wide scenarios include changing interest rates, deteriorating economic conditions on a macro level and capital markets disruptions, to name a few. We have been programmed to look at liquidity stress testing on a quarterly basis in normal times. These times are far from normal. Continuous stress testing around this ever-evolving stress event is necessary, as is the stress testing for longer-term recession-type scenarios. The ultimate goal of this exercise is to establish the correct operational framework to deal with the risk posed now and in the future.
In short, having a clear eye on the size and impact of any liquidity shortfall will help you weather the storm and will help those you serve weather the storm. At Wipfli we are committed to your success and are willing to assist you in any manner possible during this troubling time.