Alert July 07, 2009

Federal Banking Agencies and the National Credit Union Administration Seek Comments on Proposed Interagency Guidance on Funding and Liquidity Risk Management

The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and the National Credit Union Administration (collectively, “the Agencies”) in conjunction with the Conference of State Bank Supervisors (the “CSBS”), issued proposed Interagency Guidance on Funding and Liquidity Risk Management (“the Guidance”) and have requested comments on all aspects of the Guidance.

The Agencies and the CSBS have proposed the Guidance to provide consistent interagency expectations on sound practices for managing funding and liquidity risk.  When finalized, the Guidance will apply to all domestic banks, savings associations, affiliated holding companies, and credit unions (collectively, “institutions”).  In addition to summarizing principles of sound liquidity management that the Agencies have previously issued, the Guidance, where appropriate, aligns these principles with the Basel Committee on Banking Supervision’s guidance titled Principles for Sound Liquidity Management and Supervision

The Guidance generally emphasizes the importance of cash flow projections, diversified funding sources, stress testing, a cushion of liquid assets, and a formal well-developed contingency funding plan as methods for monitoring and managing liquidity risk.  “Liquidity risk” is defined by the Guidance as the risk that an institution’s financial condition or overall safety and soundness is adversely affected by an inability (or perceived inability) to meet its contractual obligations.  The Guidance sets forth the following as critical elements of a sound liquidity risk management plan, and provides that supervisors will assess these elements when reviewing an institution’s liquidity risk management process, considering also the institution’s size, complexity, and scope of operations:

Corporate Governance.  The board of directors and managers of an institution should take an active role in establishing, overseeing, and approving the institution’s comprehensive liquidity risk management plan.  The Guidance also outlines the responsibilities of the board of directors and management with respect to the execution of the institution’s comprehensive liquidity risk management plan, including that the board of directors is ultimately responsible for the liquidity risk assumed by the institution.  

Strategies, Policies, Procedures, and Risk Tolerances.  Institutions should consider liquidity costs, benefits, and risks when engaging in the strategic planning and budgeting processes, and should also document strategies for managing liquidity risk, including strategies for managing different types of adverse business scenarios.  The Guidance further provides that certain information should be included in an institution’s policies and procedures for managing and mitigating liquidity risk exposure, such as an articulation of the institution’s liquidity risk tolerance, the nature and frequency of management reporting, the potential courses of action for handling liquidity disruptions, and the liquidity issues that are unique to the institution’s individual currencies, legal entities and business lines.  The policies should also contain provisions for documenting and periodically reviewing assumptions used in liquidity projections.

Liquidity Risk Measurement, Monitoring and Reporting.  The Guidance calls for institutions to employ comprehensive methods of measuring and monitoring liquidity risk, which should incorporate: cash flow projections that rely on reasonable, appropriate, and documented assumptions; proper valuation of assets that consider market conditions potentially lowering such valuations; assessments of vulnerabilities to changing liquidity needs and capacities; regular stress testing and the evaluation of stress test results; the calculation of available and pledged collateral; and the monitoring and control of the institution’s liquidity risk exposures and funding needs within and across legal entities and business lines, considering legal, regulatory, and operational limits on the transferability of liquidity.  Additionally, liquidity risk reports should provide the institution’s management with detailed information that enables the management to assess the institution’s sensitivity to changes in market conditions, its own financial performance, and other important risk factors.  Such reports may contain information regarding cash flow gaps and projections, critical assumptions used in projections, asset and funding concentrations and availability, collateral usage, key risk indicators, the status of contingent funding sources, and the availability and utilization of government support.

Intraday Liquidity Position Management.  The Guidance notes that interdependencies that exist among payment systems and the inability to meet certain critical payments may cause systemic disruptions to payment systems and money markets; therefore, senior management of institutions that engage in significant payment, settlement and clearing activities should adopt an intraday liquidity strategy as a component of the institution’s liquidity risk management process.  The Guidance provides that the intraday liquidity strategy should allow the institution to: monitor and measure expected daily gross liquidity inflows and outflows; utilize collateral to obtain intraday credit; identify and prioritize obligations; control credit to customers; and consider collateral and liquidity obligations when assessing the institution’s overall liquidity needs. 

Diversified Funding.  Noting that undue reliance on any one source of funding is considered an unsafe and unsound practice, the Guidance also provides that institutions should diversify available and potential sources of funding.  Among other diversification strategies, institutions should consider secured and unsecured market funding, securitization vehicles, geographic markets, access to capital markets and the identification of funding sources that would strengthen the institution’s capacity to withstand both institution-specific and market-wide liquidity shocks. 

Cushion of Liquid Assets.  Institutions should have ready access to unencumbered, highly liquid assets because liquid assets are critical to an institution’s ability to effectively respond to potential liquidity stress.  Stress testing and the institution’s risk profile and tolerance should support the amount of liquid assets available to the institution. 

Contingency Funding Plan.  Institutions should have a formal and regularly tested contingency funding plan that sets forth the institution’s strategies for addressing liquidity shortfalls in emergency situations and in the event that the institution becomes subject to Prompt Corrective Action.  The contingency funding plan should: identify stress events; delineate between levels of stress severity; equip the institution’s management to accurately assess and quantify the institution’s expected funding needs and capacity during stress events; identify potential funding sources that would be readily available when needed; and establish a monitoring framework for potential liquidity stress events that enables the institution to strategically prepare for depletion of the institution’s liquidity.  The Guidance notes that institutions should not base their liquidity strategies on temporary government programs.

Internal Controls.  The Guidance provides that institutions should maintain internal controls and audit procedures relating to liquidity risk in accordance with board-approved policies and applicable rules and regulations.  The institution’s management should ensure that an independent party regularly reviews and evaluates the various components of the institution’s liquidity risk management process, and that the independent party reports significant issues to the appropriate level of management. 

Liquidity Risk Management at the Holding Company Level.  Underscoring that liquidity difficulties at the holding company level may spread to subsidiary companies, the Guidance also provides that financial holding companies, bank holding companies, and savings and loan holding companies (collectively, “holding companies”) should develop and maintain liquidity management processes and funding programs.  Therefore, holding company liquidity should be maintained at levels sufficient to fund its operations and the operations of affiliates for an extended period of time, subject to legal, regulatory, and practical restraints.  The Guidance notes that the Federal Reserve’s Trading and Capital Markets Activities Manual and Bank Holding Company Supervision Manual and the Office of Thrift Supervision’s Holding Company’s Handbook provides further guidance regarding the principles of safe and sound liquidity risk management of holding companies. 

Comments on the Guidance must be submitted on or before September 4, 2009.  The Guidance is available at