Actions in a Liquidity Crisis

• A contingency funding plan (CFP) serves as a logical connection to the liquidity stress testing framework. A CFP utilizes the stress test results and other related information as inputs to the CFP governance, menu of contingent liquidity actions, and decision framework.
• Contingent liquidity events can be categorized by their level of estimated adverse impact and probability.
  • Institutions manage one end of the spectrum – the low-impact, high-probability events – as part of their business-as-usual (BAU) funding and liquidity risk management activities.
  • Institutions use CFPs to address the other end of the spectrum associated with high-impact low-probability events.
• CFPs provide a structured approach for developing and implementing the institution’s financial and operational strategies for effectively managing such contingent liquidity events during periods of severe market and financial stress.

Evolving Capabilities And Enhancements

• Formalized CFPs have gained greater traction and importance over the past decade as market disruptions have become more common and concerns for the survival of institutions in crisis have drawn sharpened attention. Progress has been made in formalizing and standardizing CFPs; however, there remain notable differences among institutions with respect to the level of coverage and detail. In general, smaller institutions have typically included their CFPs as part of their broader business continuity plans, while larger institutions have established more formalized CFPs. Larger, more complex firms may also have several CFPs to address the specific challenges and options for different subsidiaries and legal entities.
• As part of this guidance, supervisors have indicated that CFPs should have defined policies and procedures that address the governance, roles and responsibilities, liquidity measures and triggers, menu of contingent actions, and communication protocols. Further, an institution’s CFP, or collective set of CFPs, should be tailored to the specific business and risk profiles of the institution, covering the different set of businesses, subsidiaries, legal entities, products/asset classes, and geographic and foreign exchange (FX) coverage in which the institution operates. Finally, institutions should also regularly test their CFPs to ensure operational effectiveness.
• In addition to the specific guidance on CFPs, other supervisory guidance on capital management, liquidity risk management, and recovery and resolution planning have impacted how institutions design their CFPs. In particular, the Federal Reserve’s Comprehensive Liquidity Assessment and Review (CLAR) and the daily liquidity regulatory reporting requirements have linkages to the CFPs’ governance and liquidity measures.
• Additionally, CFPs are often referenced as part of and aligned to an institution’s recovery and resolution planning activities, as liquidity risk is often one of the key drivers of the potential institution’s failure and a critical resource needed to effectively support the execution of the institutions’ resolution strategies’. In this capacity, the CFP serves as an important bridge between the institution’s BAU liquidity risk management practices and the recovery and resolution planning activities, where specific parts of the institution must be resolved.

Design Considerations

• While no universal CFP exists that can cover all types of institutions and situations, there are several CFP key design considerations that firms should be mindful of in designing or refreshing their CFPs. These considerations include the following:
  1. Alignment to business and risk profiles – CFPs should be considered in the context of the institution’s specific business and risk profiles, including the scope of business activities, products/asset classes, geographic and FX coverage, and legal entity structures. Institutions should ensure consistency by aligning their risk appetite statement to the CFP framework, through quantifiable early warning indicators, limits, and escalation levels.
  2. Integration with broader risk management frameworks – The CFP is not a stand-alone tool, but rather, an integrated part of the institution’s liquidity risk management and firm- wide risk management frame-works, including enterprise risk management (ERM), capital management, and business continuity and crisis management. The CFP should be explicitly linked to the liquidity risk measurement framework and the liquidity stress test, in particular through its limit structure and escalation levels. For example, the liquidity risk measures used in the institution’s BAU risk management activities serve as a foundation from which the CFP defines its early warning indicators (EWIs). Additionally, linkages to the business continuity and crisis management frameworks will reinforce key operational and communication protocols during times of crisis.
  3. Operational and actionable, but flexible playbook – As a playbook, the effectiveness of the CFP lies in its operational readiness. In a crisis, the ability to convene management and start to develop contingent strategies and a plan of action would likely prove highly challenging without prior planning. As such, it is important for the CFP to include a menu of possible contingency actions that management can undertake in different stress scenarios and at graduated levels of severity. These graduated stress levels should be aligned to EWIs, triggers, and contingency actions. Since CFP cannot anticipate all possible situations that may lead to a liquidity crisis, effective CFPs strike a balance between specifying recommended contingency actions while enabling management sufficient flexibility and discretion to make informed decisions as the crisis evolves over time.
  4. Inclusive of appropriate stakeholder groups – The involvement of appropriate stakeholder groups, including various management committees (e.g., asset-liability committee (ALCO), risk and capital committee, investment committee), business units, finance, corporate treasury, risk, operations and technology, is needed to capture the appropriate elements of the CFP as part of the design and to ensure successful coordination from an execution standpoint. In practice, involvement of the various stakeholder groups provides a strong forum in which potential issues or challenges can be openly discussed and addressed.
  5. Supported by a communication plan – As in any crisis, the coordinated and timely communication of information to stakeholders is critical – a key lesson that resurfaced in the recent financial crisis. Apart from internal coordination, external communication to clients, analysts, counterparties, and regulators with timely and accurate information is critical as it helps to reinforce confidence in the institution and mitigate potential risk that rumors and fears do not further precipitate and adversely impact the institution.

Framework And Building Blocks

• Key components of a CFP framework include the following:
  1. Governance and oversight
  2. Scenarios and liquidity gap analysis
  3. Contingent actions
  4. Monitoring and escalation
  5. Data and reporting

Governance And Oversight

• An effective CFP requires both well-defined roles and responsibilities and a strong communication strategy that ensures timely coordination and communication among internal and external stakeholders. Both the organizational roles and communications plan need to be supported by well-defined policies and procedures, and reinforced through CFP periodic testing and simulation exercises.
  1. Stakeholder Involvement, Roles, and Responsibilities
     A well-designed CFP requires representation from a variety of stakeholder groups across the institution. Front office and business groups can provide insights into how their businesses perform under different business environments and stress scenarios; corporate finance, treasury and risk management groups can provide perspectives on how funding and liquidity risk profiles are managed, and the tools afforded as the liquidity crisis escalates; and operations can describe the collateral and cash management processes and how they manage the inflows and outflows of liquidity. There are four important roles in a firm with respect to CFP. These roles should be customized according to institution- specific organizational structure, capabilities, and coverage/responsibilities:
     1. Corporatet reasury– As part of its BAU activities, corporate treasury monitors the ongoing business, risk, funding, and liquidity profile of the institution. The treasurer, in consultation with the CFO and others, may invoke the CFP and convene the liquidity crisis team (LCT) based on a review of the markets, industry, institution-specific conditions, and liquidity stress testing results.
     2. Liquidity crisis team – The LCT serves as the central point of contact and is responsible for the continuous monitoring of the institution’s liquidity profile. The LCT will also provide recommendations on CFP actions, working closely with corporate treasury and the management committee. The LCT should be composed of senior members of the institution’s business and supporting functions, including C-level executives, and heads of business segments, geographies, and legal entities. Generally, the LCT is responsible for designing the CFP and submitting it to the senior management group for review and approval.
     3. Management committee – During a crisis, the senior management of an institution provides oversight of the LCT and consults with the board of directors, monitoring the institution’s liquidity risk profile and reviewing specific recommendations for and coordination of CFP actions.
     4. Board of directors – The board of directors should be actively engaged, in coordination with the management committee and LCT teams, during the crisis and serve as an advisor and counsel to them. A strong understanding of the contents of the CFP will enable board members to be actively engaged with the management committee in evaluating CFP actions being considered, particularly if the institution’s liquidity position continues to worsen, and strategic actions, such as large asset and/or subsidiary sales, need to be taken.
  2. Communication and Coordination – CFPs should include a communications strategy and plan to ensure proper notification, coordination, issue reporting and escalation. The different groups across the institution must work in concert, relying on each other to ensure information is available on a timely basis to support management decision-making. In any crisis situation, clear and timely communication helps the institution demonstrate a sense of control and confidence that management understands the challenges ahead and has a plan of action. This is important to both internal and external stakeholders. Communications with respect to messaging and content should be centrally managed. However, the bidirectional communication with the stakeholders should exist with those executive and management teams that have existing working relationships. For example:
     • Business units – clients, counterparties
     • Corporate treasury – regulators and supervisors, rating agencies, clearing banks
     • Investor relations – investors, analyst community, public media
     • Legal and compliance – regulators and supervisors
  3. Policies and Procedures – Institutions should document their CFPs and ensure alignment with other risk management, business continuity, and recovery planning-related policies and procedures. Documentation should include all aspects of the CFP, including the governance structure, processes, data, and reporting activities. An illustrative example of a CFP policy outline is as follows:
     • Introduction
       • Overview and purpose of the CFP
       • Related policies including CFPs across business segments, geographies and legal entities, resolution and recovery planning, and business continuity policies
     • Governance
       • Roles and responsibilities
       • Review and approval
       • Periodic review
     • Stress testing and scenarios overview (likely covered in detail in separate document)
       • Methodology
       • Scenario design Inputs, outputs, and calculations
       • Key assumptions
       • Data control
       • Model validation
     • Monitoring and escalation
       • Regular monitoring and risk management
       • Liquidity gap analysis
       • Contingent actions
     • Reporting
       • Reporting frequency
       • Briefing decks and reports
         The CFP policy should be consistently applied, whether it is a single CFP or multiple CFPs, and should be reviewed and updated periodically.
  4. Testing and Readiness Assessment – On a periodic basis, institutions should evaluate their CFP operational readiness and test targeted elements of their CFPs to ensure relevance and execution effectiveness in times of stress, particularly given changing market dynamics and the institution’s business and risk profiles. Some market activities such as debt issuances, brokered deposits issuances, and limited securities sale of the investment portfolio to generate additional liquidity may be appropriate to test. Some contingent activities, such as business divestitures, large asset sales, and use of Federal Reserve borrowing, may be impractical or unavailable for testing.
     Additionally, institutions should evaluate the CFP’s operational effectiveness: Such activities should include the CFP’s governance, escalation process, communication, coordination, and reporting. Further, the test simulations may also identify potential gaps and/or improvement opportunities that would otherwise be undetected if the CFP were left purely as a theoretical design exercise.

Scenarios And Liquidity Gap Analysis

• Institutions should align their CFP stress scenarios to those in its liquidity stress testing framework, as well as to other frameworks such as the recovery and resolution plans. The liquidity stress testing scenarios will cover both systemic (general market) and idiosyncratic (institution-specific) risks and address both market (asset) liquidity and funding liquidity, over short-term and prolonged stress periods. The liquidity stress testing framework should ensure that effects of these stresses on the institution’s liquidity profile is appropriately measured and monitored. The CFP in turn should provide a tactical mechanism for escalating a developing crisis to management’s attention and ensuring actionable responses are available.
• In addition to incorporating the outcomes of the institution’s liquidity stress testing, the CFP itself may contain additional liquidity-related stress scenarios. These additional scenarios, while outside the institution’s broader liquidity risk monitoring and limit structure (as contained within the liquidity stress test), ensure effective contingency plans are in place in the event of certain events that could potentially impact liquidity. For example, the CFP might include scenarios in which its intraday debit cap with Fedwire is exceeded, specific counterparties fail, or Federal Home Loan Bank funding becomes unavailable.

Contingent Actions

• Based on the liquidity gap analysis, institutions can develop contingent actions/capital recovery actions that will help strengthen the institution’s liquidity position. In general, the applicability and appropriateness of such contingent actions should be considered in the context of the nature and severity (amount) of capital shortfall, associated timing and pattern of the expected capital shortfall, estimated capital relief from the contingent action, and the institution’s ability to execute internal or external/market activities associated with such contingent actions.
• Examples of contingent actions include, but not are limited to the following:
  • Maintaining lines of credit that allow borrowing without major restrictions on use and reasonable rates
  • Increasing underwriting standards and dialing back lending
  • Adjusting pricing strategies to increase premiums paid on deposit products in order to entice investors to place deposits with the institution
  • Changing investment strategy to roll off reinvestment of securities at maturity
  • Shifting allocation from short-term funding to longer-term funding sources
  • Increasing issuance of brokered CDs or direct to consumer Deposits
  • Securitizing retail assets (e.g., mortgages, credit card receivables, loans, auto leases)
  • Pledging of assets through the Federal Reserve discount Window
  • Selling liquid assets/investments
  • Drawing down on securitization conduits
  • Issuing subordinated debt
  • Reducing asset growth through reduced balance transfers
  • Issuing at-call loans (which can be recalled to provide cash when needed)
  • Selling consumer loans and/or credit card receivables
  • Selling business or business units
  • Raising equity funds through asset sales or issuance
  • Reducing capital distributions
  • Curtailing discretionary spending and expenses
• The availability and potential impact of these contingent actions is dependent on the systemic and/or idiosyncratic nature and severity of the stress events. In general, a number of market factors can impact the institution’s ability to take contingent actions including, but not limited to the following:
  • Shutdown of securitization markets
  • Restricted access to repo funding due to solvency issues, credit downgrades, or reputation damage
  • Ratings downgrade and subsequent increase in collateral/ margin requirements
  • Predatory margin and collateral practices by counterparties
  • Increased cash deposit requirements with custodian banks
  • Increased cost-of-funding (i.e., debt yields)
  • Deposit runoff
  • Collapse of interbank market and wholesale funding concentration
  • Counterparties not willing to roll over funding
• Management should try to anticipate these challenges as well as the implications they may have on its liquidity responses. Where possible, the CFP should document mitigating actions that management would consider taking to address such challenges.
• In the early stages when an institution experiences liquidity stress, it may elect to curtail certain businesses activities, tighten its credit and lending standards, and/or limit its exposure to higher risk counterparties to strengthen its liquidity profile and resources. While these responses will provide some measure of improved liquidity, such actions may send inadvertent signals to the market and thereby impact the external perception of the institution’s financial strength and reputation, adversely limiting the availability and/or effectiveness of future contingent actions as the crisis evolves. A change in the market’s perception of an institution’s viability could have rapid and severe impacts on its liquidity. For this reason, certain actions could cause more harm than benefit depending on the severity of the stress and the institution’s financial strength.

Monitoring And Escalation

• The CFP should leverage the institution’s liquidity risk monitoring and measurement framework. This framework should include a portfolio of measures that can be organized as market and business measures (external and internal and liquidity health measures (internal). Collectively, these measures form a set of key risk indicators or Early Warning Indicators (EWIs) that provide advance signaling of potential liquidity problems on the horizon.
  1. Market and business measures reflect the market environment and institution-specific business strategy and activities. Such information can include a combination of macroeconomic measures, industry measures, and institution-specific measures.
     1. Macro-environment measures should focus on risks that are specific to the financial system and its general liquidity. Examples may include repo spreads, asset haircut trends, and movements in credit default swap (CDS) spreads.
     2. Industry factors include trends in the profitability of the financial sector, recent rating agency action, banking industry capital adequacy, S&P financial institution sector movement, and other factors. Competitor analysis can also be applied to evaluate the trends in the industry to detect potential performance problems in an institution’s peer group.
     3. Institution-specific measures help management to assess the market’s perception of the institution’s financial strength and the likelihood of a liquidity crisis through external information. Internal measures provide greater insight into the operations of the institution and their potential impact on its liquidity position.
        Examples of EWIs encompassing market and business factors include:
        • Significant and unexpected drop in stock market indices
        • Downgrade of U.S. Treasury or other sovereign debt rates
        • Spike in market volatility (e.g., VIX)
        • Unexpected catastrophic events (e.g., September 11, 2001, earthquakes)
        • Rapid asset growth funded by potentially volatile liabilitiesReal or perceived negative publicity
        • A decline in asset quality
        • A decline in earnings performance or projections
        • Downgrades or announcements of potential downgrades of the institution’s credit rating by rating agencies
        • Cancellation of loan commitments and/or not renewing maturing loans
        • Wider secondary spreads on the institution’s senior and subordinated debt, rising CDS spreads and increased trading of the bank’s debt
        • Increased collateral requirements or demand collateral for accepting credit exposure to the institution from Counterparties
        • Counterparties and brokers unwilling to deal in unsecured or longer-term transactions
        • Requests from depositors for early withdrawal of their funds, or the bank has to repurchase its paper in the market
        • Calls by debt holders for the institution to buy back its debt or CD issuance
        • Volatility in foreign exchange markets, particularly in the currencies in which the institutions has exposure to and/or requires as part of its liquidity risk management.
          Such EWIs are generally most useful before or at the onset of the liquidity crisis, and during the early stages of the CFP escalation levels; however, their usefulness and applicability are aligned to the specific stress scenario and the institution’s specific business and risk profiles.
  2. Liquidity health measures are mostly ratios that help quantify the impact of the liquidity risks and to support decision making on CFP actions being considered. These metrics will typically be detailed in the institution’s liquidity risk management policy and referenced by the CFP. Key liquidity health measures include, but are not limited to, the following:
     • Projected net funding requirements to current unused funding capacity – It measures the funding and borrowing needed to finance the institution’s increased lending activities and banking activities, and provides an approach to assess the institution’s future lending obligations in proportion to the total funds available at the institution.
     • Non-core funding to long-term assets – It measures the proportion of long-term funding needs that are supported by less stable sources of funding. A higher non-core funding dependency ratio is indicative of a high dependence on volatile funding sources that, during times of financial stress, may have limited availability or may only be available at a much higher cost.
     • Overnight borrowings to total assets – It measures the reliance on overnight funding to fund the institution’s assets as the use of this volatile source of funding can expose the institution to increased liquidity risk.
     • Short-term liabilities to total assets – It measures the funding levels that will need to be rolled over within a predetermined short-term time period (e.g., under 30 days, 60 days, 90 days) to support the institution’s assets.
     • Funding sources concentration – The concentration of funding sources for an institution is an important measure for understanding if the majority of liquidity is provided only by a few firms.. Liquidity providers that comprise a substantial proportion of an institution’s funding needs could cause serious harm to liquidity during times of stress, if they decide that their exposure to the institution is too large and decrease that exposure.
     • Funding maturity profile – In addition to managing the concentration of funding sources, institutions should also evaluate the concentration of maturities for their funding. Large concentrations at given maturities can threaten an institution’s liquidity position, particularly when a concentration in maturity is accompanied by a reliance on short-term funding.
     • Used capacity to total borrowing capacity – It measures the borrowing capacity available to the institution, based on the used capacity relative to the total borrowing capacity, where the used capacity represents the amount of funding currently being utilized across all funding channels (core funding, interbank markets, and funds generated by institutional sales).
     • Liquid assets to volatile liabilities – It measures the basic surplus or cushion that liquid assets provide over required funding needs and can be used to monitor the level of liquid assets available to offset volatile funding.
     • Unpledged eligible collateral to total assets – It measures the institution’s ability to sell assets or use assets as collateral to obtain funding to meet future requirements. This helps the firm to optimize its management of the collateral, particularly during periods of market stress.
     • Loans to commitments – It measures the exposure to credit facilities that may be required at some point in the future. As these commitments are drawn down, utilization increases, prompting further need for funding to meet the obligations.
       For institutions with more advanced liquidity risk management capabilities, these liquidity health measures will also include daily liquidity position reporting, the Basel III Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) measures.
       These liquidity health measures should be monitored continuously over the course of the crisis. Their importance is related to their associated limits. As these liquidity health measures start to reach predefined limits, management should  start to evaluate what contingent actions are appropriate. Just like market and business measures, the usefulness and applicability of liquidity health measures are dependent upon the institution’s scope and complexity of business activities.
• Both market and business measures and liquidity health measures are important for informing management of the potential effects of different liquidity stress scenarios. Internal and external EWIs should be selected in concert so that the institution can identify emerging liquidity risks and the nature of these risks as idiosyncratic, systemic, or some combination of the two. The combination of EWIs and escalation levels enable the institution to anticipate and manage the liquidity crisis as it unfolds over time.
• Escalation Levels – In designing their CFPs, institutions establish a series of escalation levels properly aligned to the scenarios, contingency actions, and liquidity measures, including EWIs and health measures. While there are no specific guidelines in the number of escalation levels required in CFPs, three to five escalation levels are common industry practice. For illustrative purposes, the following is an example of the different escalation levels, using three levels –
  • Level 1 – This is the initial escalation level which could be triggered by stress test results indicating a greater decline in liquidity than the institution’s risk appetite targets and/or a shift in the market’s perception of the institution. The convening of the LCT prompts closer coordination and communications among the various stakeholders internally and a communication plan is executed to keep external stakeholder properly informed and aware of the institution-specific issues and challenges, and actions being contemplated. Monitoring should remain focused on forward-looking measures of the institution’s liquidity health and the general market perception. Business activities that may impact the business and risk profile of the institution will be closely monitored with increased frequency and scrutiny.
  • Level 2– At this escalation level, the institution has experienced noticeable markets and/or idiosyncratic events that are adversely impacting its business and liquidity risk profile. The institution should monitor indicators of its current liquidity position and any causes of deterioration more closely, with a focus on how the institution’s peers and counterparties react to the changing market dynamics. As the crisis continues to worsen, management’s attention is on recovery while sustaining business and financial performance; however, the focus is more attuned to the immediate and short-term horizon. The LCT and management committee activities are taken to actively enhance the institution’s liquidity position, likely curtailing business activities, and limiting the extension of additional and new credit facilities. In addition, the institution may take steps to improve its liquidity through strategic sales of less liquid portfolio investments and assets, in addition to evaluating the feasibility of significant CFP contingent actions, such as larger asset sales, business divestitures, and discontinuing certain business activities, given the evolving market conditions.
  • Level 3 – At the later stages of the crisis, the institution would have taken dramatic steps to stabilize its liquidity position, potentially including significant curtailing of liquidity intensive business activities or disposition/sales of businesses. At this point, the institution’s focus is primarily on survival.
    Events that trigger the status of the escalation level should be analyzed to understand the cause of the trigger event(s) and the association to capital adequacy; findings should be summarized and communicated, along with specific recommendations. The movement from one escalation level to another – whether up or down – should be explicitly considered and approved by the LCT. While the CFP provides a structured outline for the expected levels and trend of EWIs and liquidity risk measures, the importance of management’s expert judgment and ability to put together the mosaic of the different challenges and decide on a proper course of action should not be understated.
    At each escalation level, notification, review and approval requirements should be defined to ensure appropriate communications and reporting, in alignment and concert with the defined CFP governance structure, roles and responsibilities. For example, the Level 1 escalation level, which represents heightened management monitoring, may require only notification and periodic update to senior management, CFO, CRO, etc.; contingent actions taken at this level may require ALCO and/or the Treasurer. At the Level 2 or 3 escalation levels, where contingency actions typically involve more severe actions, notification as well as approvals for certain contingent actions will inevitably involve senior management and/or the Board.

Data And Reporting

• The frequency of generation, assessment and reporting of various measurements utilized to monitor and manage liquidity risk is an important consideration. While daily reporting of the liquidity profile to the treasury function and the funding desks is already prevalent at many institutions, there are a number of institutions that could benefit from increasing the frequency of liquidity management reporting, especially to other areas of the institution (such as senior management group, ALCO and other risk committees, and the board). This broader reporting of liquidity management should have the contextual information and qualitative guidance to support senior management in its approach to understanding the institution’s liquidity profile.
• Reports should convey the methods used to determine liquidity coverage for upcoming liabilities and funding needs and elaborate on the level of coverage predicted by these measures. In addition, institutions should ensure that existing reports capture intraday liquidity positions, track exposure to contingent liabilities, and monitor capacity usage in funding sources. Consideration should be given to the dissemination of liquidity risk reports within the institutions, how these reports are used by management and the board in making decisions, and the appropriateness of the information contained within the reports, given their audience.