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Home > Financial Risk Management Best Practice > Formulating a Contingency Funding Plan to Manage Liquidity Risks

Financial Risk Management Best Practice

Formulating a Contingency Funding Plan to Manage Liquidity Risks

by Gary Deutsch

Executive Summary

  • How financial institutions can use their liquidity risk management program as the launch point for developing a comprehensive contingency funding plan (CFP) to address potential adverse liquidity events and emergency cash flow requirements.

  • Guidance on establishing a CFP, management strategies for implementing a CFP, and steps for developing CFP liquidity needs and availability based on stress-testing.

  • Conclusions and next steps, as well as an extensive list of reference sources for those looking to delve into this topic in more detail.

Introduction

Managing the funding activities of a financial institution has become quite challenging as the global economy continues to develop economic linkages that can lead to unexpected volatility and systemic problems. The European Union, the United States, Asia, and other world economies have become connected through trade and currencies, and changing cultures and demographics such that it is no longer possible to focus solely on local or regional markets when planning for liquidity risk management.

Liquidity risk measurement and monitoring systems must, of necessity, look to worldwide economic linkages to understand how to assess current and prospective cash flows and to establish plans for funding sources and uses. Financial institutions need to establish a forward-looking approach to developing liquidity management strategies, policies, procedures, and limits to ensure that they draw on a diverse mix of existing and potential future funding sources.

Moreover, to protect against unexpected economic volatility and systemic problems, financial institutions need to hold adequate levels of highly liquid financial instruments free of legal, regulatory, or operational impediments to meet liquidity needs in stressful situations.

The Importance of a Contingency Funding Plan

A contingency funding plan (CFP) should describe the procedures that a bank or financial institution will implement to fund cash flow shortfalls that could occur in situations of stress or liquidity crises. To develop effective stressed or crisis-based CFP procedures, institutions must create plausible scenarios that simulate what could happen in various stress or crisis conditions.

CFP procedures must outline in sufficient detail areas such as:

  • specific tasks and responsibilities, including decisions that must be made;

  • timely and detailed liquidity information;

  • alternative contingency funding measures.

CFP procedures cannot be passive. The procedures have to be tested, adjusted, and updated as market conditions, regulations, funding sources, business operations, and the capabilities of internal systems change over time.

Furthermore, because CFP procedures are derived from a financial institution’s liquidity risk management (LRM) program, the procedures must be coordinated with the institution’s overall asset–liability management program as well as with its central bank to avoid possible contagion effects that could disrupt the efficiency and stability of money market channels.

Consider the scenario presented in the case study as an example of how a minor problem can grow into a liquidity crisis if not handled according to a properly developed and executed CFP. This example will then be discussed in the remainder of the section.

Case Study

Bank Without an Effective Contingency Funding Plan

Bank A did not have an effective CFP. Negative news related to the bank’s capital position caused sufficient concern about its viability that some depositors decided to move their accounts to a more stable bank. Although Bank A had plans approved by its regulator to raise additional capital, the limited run on its deposit base left it with a funding shortfall for which it had no prepared response. As a result, the press reported that the bank might not be able to fund a new loan to XYZ Corporation. As a result of the latest new report, the bank pressured its correspondents to assist with temporary credit lines, but since it did not have prior arrangements in place for this funding, it had to turn to its central bank for emergency funding. However, without an emergency funding plan, Bank A did not have sufficient collateral to support its funding shortfall.

More negative news was published and deposit withdrawals began to accelerate. Without an emergency funding source, the bank’s correspondents were not able to support its deposit clearing activities or overnight cash needs. With matters growing worse by the day, and without detailed procedures to handle the growing funding shortfall, negative news prompted still more depositors to move their accounts and a run on the bank ensued. The run escalated and created a public relations problem for other banks in Bank A’s markets. Bank A, unable to find funding sources to deal with its liquidity crisis, resorted to selling assets at fire-sale prices. What started as a minor capital problem for the bank became a liquidity crisis in its wholesale and retail markets and led to increasing uncertainty as to the viability of the bank.

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Further reading

Articles:

Reports:

  • Basel Committee on Banking Supervision. “Principles for sound liquidity risk management and supervision.” Bank for International Settlements, September 2008. Online at: www.bis.org/publ/bcbs144.htm
  • Basel Committee on Banking Supervision. “Principles for sound stress testing practices and supervision.” Bank for International Settlements, May 2009. Online at: www.bis.org/publ/bcbs155.htm
  • Biais, Bruno, Fany Declerck, James Dow, Richard Portes, and Ernst-Ludwig von Thadden. “European corporate bond markets: Transparency, liquidity, efficiency.” Centre for Economic Policy Research report. City of London Corporation, May 2006. Online at: www.cepr.org/PRESS/TT_CorporateFULL.pdf
  • Bühler, Wolfgang, and Monika Trapp. “Time-varying credit risk and liquidity premia in bond and CDS markets.” Working paper no. 09-13. Centre for Financial Research, October 2009. Online at: tinyurl.com/7k629v7 [PDF].
  • Chen, Long, David A. Lesmond, and Jason Wei. “Bond liquidity estimation and the liquidity effect in yield spreads.” December 2002. Online at: tinyurl.com/86bjlxh [PDF].
  • Chen, Yaru. “What explains credit default swaps bid–ask spread?” Master’s thesis. Singapore Management University, 2007. Online at: tinyurl.com/796637c [PDF].
  • Erigero, David, Rick Miller, Bonn Phillips, and Michael Cawthorn. “Sound liquidity risk management in a challenging environment.” Federal Reserve Bank of San Francisco and Federal Deposit Insurance Corporation, October 2008. Online at: tinyurl.com/6tcdzco [PDF].
  • European Central Bank. “EU banks’ liquidity stress testing and contingency funding plans.” November 2008. Online at: tinyurl.com/84q2efd [PDF].
  • Financial Services Authority. “Strengthening liquidity standards, including feedback on CP08/22, CP09/13, CP09/14.” Policy statement 09/16. October 2009. Online at: www.fsa.gov.uk/pubs/policy/ps09_16.pdf
  • Fragnière, Emmanuel, Nils S. Tuchschmid, and Qun Zhang. “Liquidity adjusted VaR model: An extension.” Haute Ecole de Gestion de Genève, 2008. Online at: campus.hesge.ch/tuchschmidn/pdfs/LiquidityVaR.pdf
  • Friewald, Nils, Rainer Jankowitsch, and Marti Subrahmanyam. “Illiquidity or credit deterioration: A study of liquidity in the US corporate bond market during financial crises.” July 2009. Online at: archive.nyu.edu/bitstream/2451/28293/2/wp9.pdf
  • Han, Song, and Hao Zhou. “Nondefault bond spread and market trading liquidity.” Federal Reserve Board, April 2007. Online at: www.fdic.gov/bank/analytical/cfr/2007/apr/liq.pdf
  • Kunghehian, Nicolas. “Stress testing for liquidity risk: The impact of the new regulations.” Moody’s Analytics, November 2010. Online at: tinyurl.com/7zdecqo [PDF].
  • Matten, Chris. “Stress testing liquidity and the contingency funding plan.” PricewaterhouseCoopers, PRMIA members’ meeting, February 2009. Online at: tinyurl.com/cyq73p [PDF].
  • Molitor, Philippe. “The development of robust and internationally consistent approaches for liquidity supervision: The current state of international initiatives.” Money Market Contact Group, European Central Bank, September 2009. Online at: tinyurl.com/7eovddc [PDF].
  • Muranaga, Jun, and Makoto Ohsawa. “Measurement of liquidity risk in the context of market risk calculation.” In “The measurement of aggregate market risk.” CGFS publication no. 7. Bank for International Settlements, November 1997; pp. 193–214. Online at: www.bis.org/publ/ecsc07.htm
  • Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and National Credit Union Administration, with the Conference of State Bank Supervisors. “Interagency policy statement on funding and liquidity risk management.” March 2010. Online at: tinyurl.com/77wq8hh [PDF].
  • Schwarz, Krista. “Mind the gap: Disentangling credit and liquidity in risk spreads.” October 2010. Online at: finance.wharton.upenn.edu/~kschwarz/Spreads.pdf
  • Stragiotti, Franco. “Stress testing and contingency funding plans: An analysis of current practices in the Luxembourg banking sector.” Working paper no. 42. Banque Centrale du Luxembourg, December 2009. Online at: tinyurl.com/85pfpgk [PDF].
  • Zhen Qi, Claudia, K. R. Subramanyam, and Jieying Zhang. “Accrual quality, bond liquidity, and cost of debt.” Marshall School of Business, University of Southern California, August 2010. Online at: tinyurl.com/6ngrje9 [PDF].

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