Alert December 30, 2008

FDIC Issues Research Report Concerning Liquidity Risk Management

The FDIC issued a research report (the “Report”) entitled “The Changing Liquidity Landscape” in the FDIC’s Winter 2008 issue of Supervisory Insights.  The Report states that recent disruptions in the credit and capital markets have increased the liquidity management challenges for banking institutions and demonstrated the need for a banking institution to have in place an effective liquidity management plan.  The Report stresses that in the current financial environment, liquidity shortfalls can develop far more rapidly than has historically been the case.

The Report notes that over time, in an effort to increase earnings, banks have moved to an asset structure more heavily weighted to profitable, but less liquid asset classes (such as acquisition, development and construction loans).  At the same time, banks have increased their use of off-balance sheet and liability-based liquidity strategies.  This combination of a less liquid asset mix and liability-based liquidity strategies has led to increased liquidity risks for banks.  Accordingly, it has become critical that a bank have in place an effective Contingency Funding Plan (“CFP”) that addresses, among other things: (1) cash flow mismatches; (2) target amounts of unpledged liquid reserves; (3) asset class concentrations; (4) funding concentrations, e.g., concentrations of deposits with a few large depositors, a family group or deposit brokers; and (5) contingent liability metrics, including amounts of unfunded loan commitments and lines of credit.

The Report states that CFPs should identify and assess possible liquidity-challenging events and should describe the tools that management intends to use to monitor these issues, including stress testing.  Among other things, the Report states that a CFP should assess the adequacy of contingent funding sources, e.g., back-up lines of credit, Federal Home Loan Bank funding and brokered deposit arrangements.  The Report stresses that management should understand the various legal, financial and logistical constraints, such as notice periods, collateral requirements or net worth requirements that could prevent a bank from using a source of contingent funding.  The Report notes that current liquidity runs are not usually characterized by lines of depositors assembled around a branch waiting to withdraw deposits.  Rather, current potential signals of a liquidity run, states the Report, can be: (a) an upward spike in electronic transfers such as ATM withdrawals or wire transfers; (b) public depositors that start requiring increased collateral pledges; (c) movements of deposits to banks that are perceived as “safer”; (d) a significant number of large certificate of deposit holders who are willing to absorb early withdrawal fees to access their funds; and (e) a large number of uninsured depositors rapidly withdrawing funds.