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By Trust for Credit Unions Mutual Funds
IBM recently released a white paper on Liquidity Risk Management that explores both the root causes of the 2008 global liquidity crunch and best practices for financial institutions and other types of businesses moving forward.
With more than 35% of total credit union assets held in investments and cash or cash equivalents as of September 30, 2013, it seems like liquidity should not be a pressing issue for many credit unions. However, new NCUA regulations, bond price fluctuations, and loan demand increases make now a good time to review your liquidity management practices and assess risks.
Effective March 31, 2014, credit unions of all sizes must, at minimum, maintain a written policy of liquidity management and a list of liquidity sources it can employ under adverse circumstances. Credit unions of $50 million or more in assets must additionally establish a contingency funding plan (CFP) that sets out strategies for addressing liquidity shortfalls in emergency situations. The CFP should be more robust than the simple written policy, and, at a minimum, include considerations such as identifying lines of responsibility within the institution to respond to liquidity events, the frequency the institution will test and update the plan, and the identification of possible stress events and liquidity responses.
Finally, federally insured credit unions (FICUs) with $250 million or more in assets are also required to establish and document access to either the Federal Reserve Discount Window or the Central Liquidity Facility. FICUs may demonstrate access to the CLF either by maintaining regular membership in the CLF or maintaining membership through an agent such as a corporate credit union.
One of the root causes of liquidity risk is a lack of diversification. IBM’s Liquidity Risk Management white paper separates diversification into two parts (excerpted here in italics):
Diversification of business — Firms specializing in a particular industry or segment are more exposed to extreme risks than diversified ones, as they are unable to compensate for adverse events in their core industry with profits in other sectors of activity. This is the main reason why conglomerates tend to expand into different, uncorrelated, or inversely correlated industries.
Diversification of funding sources — The distinction here is between more and less volatile sources of finance. Retail deposits tend to be more stable and to remain with a bank even in crisis circumstances. Wholesale funding tends to be more volatile and to dry up more quickly. A dangerously slim retail deposit base can prove a crucial cause of liquidity shortage. In fact, this type of liquidity risk has been cited in best practice documents issued by the Basel Committee, local regulators and analysts. Regulators also insist that diversification of funding sources must be taken into account in stress analysis and contingency plans.
Most credit unions do not fall into the category of having a “slim retail deposit base,” but keeping diversification in mind is always a good idea. Providing the credit union movement with a wider array of investment choices is one of the main reasons TRUST, mutual funds for and by credit unions, was created.
The IBM white paper offers a number of best practices, including two with relevance for credit unions (excerpted here in italics):
Integrated stress scenarios — Liquidity risk has some special characteristics that differentiate it from market and credit risk. For example, liquidity risk has a low probability of occurrence, and at the same time can potentially have extreme consequences for a firm’s stability. Firms should always maintain a comprehensive awareness of their risk profile and of the risk factors that could result in the worst potential impact. Contingency plans should be established and reviewed periodically in keeping with an evolving global risk picture.
The need to perform periodical stress tests on liquidity exposures is supported by statements from both the Basel Committee and local supervisors, emphasizing that:
Assumptions underlying stress testing should be subject to periodical revision.
Results of stress tests should be incorporated in the structure of internal limits.
Stress tests must be the basis for elaborating contingency plans, in so far as they provide evidence of the extent of interventions that could become necessary to ensure stability in case of unexpected liquidity emergencies.
Emphasis on quantitative analysis — Whereas the use of sophisticated quantitative approaches — for both normal and stress conditions — are widely accepted for market and credit risk, the same is not true for liquidity risk management, despite the fact that liquidity risk can have more severe consequences. In fact, neither the Basel Committee nor local regulators in general explicitly require banks to use sophisticated quantitative methods to manage their liquidity positions. However, they specify that in managing liquidity risk banks should not rely only on simple static maturity ladders and provide a wide range of indications on additional instruments that should be ordinarily available. For example, regulators have made statements such as:
Banks should define assumptions on the future behavior of assets and liabilities in building up their maturity ladders.
Liquidity should be analyzed utilizing a variety of what-if scenarios.
Liquidity exposures should be subject to periodical stress testing to assess the impact of unlikely adverse events on bank’s stability.
Banks must have in place contingency plans that allow them to promptly cope with unforeseen liquidity shortages.
The lack of standardized quantitative approaches to liquidity risk relates in part to its fundamental nature. Liquidity risk is difficult to quantify in a single number representing an accurate, comprehensive view of it. Some attempt has been made through ratios, but so far this has not become a standard approach, as can be seen by comparing the differing requirements that have been imposed by local supervisors.
The paper goes on to say financial institutions need to go beyond the static maturity ladder and consider more advanced information systems to assist with quantitative analysis related to liquidity risk management. Access your complete copy of the IBM white paper via the Global Association of Risk Professionals. And for more information on the TRUST for Credit Unions, contact us at email@example.com.
This sponsored content article is provided to the credit union community for shared insights and knowledge from a recognized solutions provider in the industry. Please note that the views and opinions offered here do not reflect those of Callahan & Associates, and Callahan does not endorse vendors or the solutions they offer.
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November 18, 2013
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