Liquidity Risk Management In Banking - Be Prepared

I never made it past the Cub Scouts, though the importance of that brief yet formative experience never left me: the notion of always being prepared. That has never been truer in the context of the liquidity issues that surfaced in the banking industry in March 2023. A conversation on the scarcity of liquidity within banking echoes these lessons we learn on preparation early on.

Before I continue, I must give the standard disclaimer that the views I express here are my own and do not necessarily reflect the views of EagleBank (or any of its affiliates), its directors, or any of my colleagues at the Bank.

1. Prevent crises with granular deposits from various customer profiles, including laddered term funding.

An organization with various customers and product offerings is in a better position to withstand any potential disruption or concern over liquidity. As we saw in the Silicon Valley Bank failure, the dependency on venture capital deposits caused a specific and immediate run on the bank due to a contagion concern within that tight-knit industry. Avoiding those kinds of concentrations and having a wide variety of industries represented within a deposit portfolio can protect against discreet industry turmoil or concern.

In terms of product offerings, consumer behaviors vary between checking, money market, and savings accounts simply because these products serve different purposes, and the way in which funds might move or react to a stressor could vary greatly. Additionally, utilizing term deposits that are spread over time, laddered for even turnover, and in smaller, more granular dollar amounts can serve as excellent protection in a liquidity crisis.

Similar to an investment portfolio, diversification and limiting concentrations are key to mitigating risk.

2. There is no such thing as too many sources of contingent liquidity.

Most banks have a few conventional contingent liquidity sources. These might include a local Federal Home Loan Bank (FHLB), correspondent federal funds overnight lines of credit, brokered deposit networks, and, of course, the Federal Reserve Discount Window (Discount Window). Maximizing the availability at these institutions is a key risk mitigant to liquidity issues.

Today, many banks will first turn to the FHLB for day-today liquidity management. While I expect the FHLB system to continue to serve as a source, the complexion of that liquidity may change with recent plans from their regulator. To maximize the availability, a Corporate Treasury function should make sure that all the appropriate collateral (i.e., loans or securities) is being pledged.

Brokered deposit networks offer a safety valve for contingent funding even if they can’t guarantee availability

Most of the federal funds lines of credit offered by correspondent banks are relatively easy to secure, provided your institution is well-capitalized and in overall good standing. It’s important to recognize that these lines of credit generally come with the condition that availability can be canceled at any time and are considered emergency liquidity scenarios.

Brokered deposit networks offer a safety valve for contingent funding even if they can’t guarantee availability. Think of these as networks or aggregators that will allow banks to sell money to said networks overnight or at a term for other banks to then purchase those funds for liquidity needs. Money markets are fluid. As such, when liquidity tightens, these networks can dry up.

The last option, often referred to as the lender of last resort, is the Discount Window. Historically, the Discount Window offered borrowing capacity for brief periods (i.e., 90 days at a time). This primary Discount Window borrowing facility remains in place and should only be considered in extreme liquidity crises.

3. Be operationally prepared to move that money – then model your risk and have a plan.

Having the mechanisms in place to move money when needed requires ensuring the appropriate authorized parties are set up to interact with borrowing institutions. The procedure for moving collateral from one place to another to ensure sufficient capacity should be ready and understood by staff.

The scenarios considered should be varied and fit into a well-conceived Contingency Funding Plan (CFP). The CFP is the artifact that bank management can have available and ready to serve as an action plan for liquidity and funding emergency.

4. Get out there and communicate with your customers; build those relationships.

Customers should know their money is available at their institution should they need access to it, and there are no roadblocks to having those funds presented as requested. That should be the message. This avoids unnecessary panic by insinuating that access to funds is constrained by liquidity limitations.

In navigating the unpredictable terrain of liquidity risk management, drawing parallels to the scout’s motto of “always be prepared” becomes paramount for banks. Just as a scout diversifies skills and equips themselves for any challenge, financial institutions must take adequate steps to ensure readiness in various scenarios.