Liquidity risk management is one of the most critical challenges community banks and credit unions face today. Increased deposit volatility, heightened sensitivity to rate fluctuations, and heavier regulatory scrutiny have raised the stakes significantly.

Traditional methods that used historical data and static reporting are no longer sufficient. Institutions are now required to adopt new strategies that enable faster insights and analyses.

These changes have resulted in liquidity risk management evolving from a policy-driven task to more of a decision-based framework. Institutions must now go beyond just the underlying theories of models by showing that the data, assumptions, and analyses carry through to real-world customer behaviors.

Here, we’ll discuss how to outline a practical framework for liquidity risk management, one that’s based on theoretical models and that utilizes real-world data and behaviors as a foundation.

What Is Liquidity Risk Management in Banking?

For financial institutions (FIs), liquidity risk management is the process by which workflows and controls are established. These ensure cash obligations can be satisfied when they’re due.

Liquidity risk management largely involves ensuring proper inflows and outflows on the bank’s balance sheet. Institutions should also have access to additional funding sources to account for a wide range of possible scenarios.

These sources are especially crucial for smaller credit unions and community banks. Unlike larger financial institutions, they rely on a smaller customer base for deposits.

They are also less likely to have as many funding options as nationwide banks and tend to operate with smaller teams and fewer resources. As such, the margins are much smaller when it comes to being able to deal with unexpected shifts in deposit behavior.

Notably, it’s important to differentiate daily liquidity risk management from stress condition management. Day-to-day activities emphasize things like monitoring balances, funding costs, and more immediate needs for cash.

Liquidity risk management takes it a step further by determining how the institution would handle unexpected and adverse circumstances that could hike funding needs.

Why Liquidity Risk Is More Challenging Today

Liquidity risk is more challenging today as deposit volatility has increased significantly. Customers are much quicker in reacting to rate changes, news of economic outlooks, and other market events.

Among banks and credit unions, competition for customers has also increased. Competition has forced these financial institutions to develop new programs in determining the right balance of policy and product changes to attract and retain clientele.

These changes reflect broader risk management trends that are shaping how institutions approach balance sheet and scenario analysis. At the same time, many banks and credit unions have experienced increased risk with a shift in the concentration of funding mixes.

For example, institutions can increase liquidity pressure if they are dependent on a smaller subset of high-balance deposit relationships. Uncertainty in market conditions also tends to make forecasting more challenging, with historical data being less applicable in predicting future conditions.

With those in mind, regulatory policies are now placing a larger emphasis on liquidity governance. Financial institutions now have greater expectations when it comes to being able to demonstrate oversight, adequate stress testing methods, and contingency plans.

Therefore, banks and credit unions must regularly update and document their liquidity risk management processes to ensure adherence to regulatory expectations.

Core Elements of a Liquidity Risk Management Framework

A strong liquidity risk management framework should help financial institutions understand their liquidity positions, anticipate pressure points, and have plans in place for when adverse conditions occur.

While regulatory guidance is a good starting point, an effective framework must be tailored to each institution based on its risk appetite, size, and customer profile.

Below are the core elements of a fundamentally sound liquidity risk management framework:

• Governance and Oversight: Clear accountability at the ALCO and board levels, with defined roles, responsibilities, and action plans for when metrics deviate from acceptable norms.
• Liquidity Risk Measurement: Ongoing measurement of metrics such as cash flow gaps and financial ratios, as they can act as early warning signs for market risks.
• Stress Testing and Scenario Analysis: Specific scenarios that reflect the reality of the bank’s actual customers, including funding behaviors and potential market disruptions.
• Contingency Funding Planning: Documented, actionable plans with options, decision triggers, and procedures during unexpected liquidity events.
• Monitoring and Reporting: Consistent reporting that allows teams and management to understand the bank’s positions and compare them over time.

How Financial Institutions  Manage Liquidity Risk Day to Day

The ability to manage liquidity risk daily is a key factor in determining how financial institutions will perform when stressed. Banks and credit unions often start by monitoring deposit trends, availability of funding sources, and short-term needs for cash.

Regular monitoring of balances and pricing trends helps identify potential risks early before they create undue stress and pressure. Here, effective deposit risk management also plays a role in effective decision-making and liquidity monitoring.

Assumptions on market conditions and deposit behaviors also require regular oversight and monitoring. Customer behavior can fluctuate in response to rate changes or other market events. Financial institutions will need to evaluate this new set of behaviors, rather than relying on historical patterns.

Here, treasury and finance teams must work in unison to ensure each is operating off the same set of data and assumptions.

Effective liquidity risk management can turn monitoring into actionable plans. Financial institutions should have the ability to turn basic reporting into a sequence of informed decisions, should market conditions change.

Why Stress Testing Is Central to Liquidity Risk Management

Stress testing is the core of a sound liquidity risk management framework. Its insights allow scenario analysis to translate into actionable tasks, options, and informed decisions.

Financial institutions can use stress testing as more than just a regulatory exercise. They can gain better insight into how they would perform and react under adverse market conditions.

Effective stress tests consider multiple scenarios and risk aspects. For instance, scenarios involving rate changes can highlight possible impact on deposit behavior and funding costs.

Market disruptions assess the impacts on funding access. And deposit runoff events can model the potential effects on different customer segments. Having stress testing events unique to a bank’s customer profile is key to ensuring practicality and usefulness.

Notably, the key value in stress testing is the ability to tie results to decisions. Insights from stress testing should provide options on contingency plans and escalation points. Done correctly, stress testing can enhance a bank’s confidence and preparedness for volatile market conditions.

The Role of Technology in Liquidity Risk Management

Technology simplifies consistency in liquidity risk management processes. It can also strengthen accuracy, speed, and confidence in results. Without it, banks and credit unions may have to rely on manual processes, often inadequate to keep pace with complex and rapidly changing market conditions.

Modern liquidity risk management software helps FIs move a step beyond analysis and into processes that allow for automated tasks. These automations help minimize errors and discrepancies that are more likely to occur with manual processes.

It can also help ensure a standardized set of assumptions and that scenarios run more consistently as data inputs and market conditions shift. As a result, teams can evaluate data and scenarios more quickly.

Liquidity risk management software also allows for a more robust compliance program. Banks and credit unions can take advantage of audit trails, version control, and higher transparency when it comes to documented assumptions.

Results are subsequently easier to understand and explain to board directors, regulators, and other stakeholders.

Integrating Liquidity Risk with ALM and Planning

Liquidity risk management cannot be done in its own silo. Instead, institutions should align it with financial planning and balance sheet strategy. This must be done in order to ensure teams operate off a consistent set of assumptions, data, scenarios, and logic.

When it’s anchored in broader asset and liability management (ALM) processes, institutions get a clearer picture of balance sheet risk.

Integrating liquidity risk management with other teams begins with a shared set of assumptions. To be specific, your baseline LST forecast should mirror what you have in planning as closely as possible, so teams share a common starting point, even if planning isn’t directly connected to LST. 

Data on deposit behavior, rates, growth targets, and other relevant strategies should align across teams like ALM, risk management, and planning.

Consistent data here ensures greater levels of confidence in the corresponding outputs and analyses. Management teams can therefore more clearly see how certain decisions can impact liquidity under a wide range of scenarios.

Done correctly, scenario analysis can also improve insight for more effective strategy and risk appetite discussions. Institutions can more easily see the impact on liquidity based on strategic changes in rates, products, and other effects on the balance sheet. With this, more informed discussions can also be had at the board and ALCO levels.

Choosing the Right Liquidity Risk Management Solution

Choosing the right liquidity risk management solution is a critical decision, especially for institutions with limited staffing and resources. Credit unions and community banks fall in this category.

To select the best solution, institutions should consider how compatible it is with how its teams and internal processes function. In other words, do not focus solely on features.

A robust liquidity risk management platform should be able to offer the following:

• Built for Banks and Credit Unions: Designed to take into consideration behaviors specific to financial institutions, as opposed to generic models, features, and functions.
• Scenario-Based Modeling: Contains the functionality to model various scenarios for purposes of stress testing.
• Integration With ALM and Planning: Can share data and assumptions across various teams to ensure consistency and reduce redundancy.
• Scales for Lean Teams: Efficient workflows that save time and do not require manual processes, large teams, or massive resources.
• Supports Regulatory Expectations: Provides strong version control, documentation, and transparency for examiner and audit reviews.

How Empyrean Supports Liquidity Risk Management

By working with Empyrean, institutions can get the guidance and solutions necessary to align technology with the right framework in liquidity risk management.

Empyrean’s platform can help institutions move from fragmented data analysis to a more unified platform that allows for greater consistency in evaluating data and decision-making.

Notably, Empyrean’s liquidity stress testing can be tailored to each specific bank’s reality when it comes to things like funding behaviors, deposit mixes, and market nuances. Banks receive a greater degree of accuracy and confidence in comparison to generic models.

Integrated scenario modeling also allows banks and credit unions to evaluate the impact of rate changes, deposit runoffs, and other balance sheet changes. As a result, financial instituions see fewer manual processes, which can improve the speed and efficiency in decision-making.

Integrating data with other teams helps to ensure better governance, data analysis, escalation decision points, accountability, and transparency.Learn more about Empyrean Risk Management, or request a demo today to see how Empyrean helps institutions manage liquidity risk with confidence.

FAQ: Liquidity Risk Management