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Managing Liquidity Risk and Funding Costs During a Crisis

Liquidity risk can spin out of control amid an extreme event. But financial institutions can take a three-pronged, multi-scenario approach to assess both liquidity and funding threats in volatile times.

Friday, February 24, 2023

By Alla Gil

During economic crises, liquidity risk can spread throughout the financial system, leading to credit crunches and severe downturns. Banks must therefore that have adequate liquidity and funding to withstand extreme events.

Regulators have placed a strong emphasis on managing bank liquidity ever since the Global Financial Crisis (GFC). After all, it was the primary reason behind banks' defaults.

However, the existing regulatory measures of liquidity risk – including the Basel Committee on Banking Supervision’s liquidity coverage ratio (LCR) and net stable funding ratio (NFSR) – are flawed. Specifically, these prescriptive approaches have a short-term focus that is insufficient for gauging banks' specific vulnerabilities. What’s more, they are too complex for small and mid-size banks to implement.

But is there a better solution? A more flexible measure of both funding and market liquidity is the loan-to-deposit ratio (LDR). While it is certainly not perfect, this metric is a key determinant of a bank's ability to secure loans from FHLB and other funding sources.

alla-gilAlla Gil

It is important to remember that funding risk – e.g., the difficulty a bank faces in obtaining the necessary funding to support its operations – is a core component of an overall liquidity risk framework. The LDR illustrates a bank's capacity to finance its loans through deposits – the preferred source of funding for banks.

A high LDR implies that a bank depends greatly on short-term funding to support its long-term assets, including loans. Conversely, a low LDR suggests that a bank has a more secure funding foundation and can endure short-term liquidity disruptions.

As with all other point-in-time measures, this metric is quite volatile. U.S. banks' LDR initially decreased after the start of the pandemic – but started steadily increasing in 2022 amid continued loan growth and a drop in deposit balances.

How can a bank be prepared for such swings in this important indicator? And what actions can be taken to address longer-term considerations and to optimize the cost of funding?

A Three-Step Approach

Neither the point-in-time value of LDR nor its month-to-month changes are good indicators of its future dynamics, because they don’t account for deposit behavior, the riskiness of loans or the cost of funding.

Loan levels and deposit volumes can be driven by a wide variety of factors – including yield-curve tenors, oil prices, equity-market returns, unemployment rates and housing prices – at different financial institutions. So, every bank must have an adequate picture of its specific LDR behavior, consistent with its potential funding risk.

A comprehensive three-step approach is needed to account for all funding-risk sources:

1. Identify

A bank needs to recognize the macroeconomic and market variables that are driving its specific demand for loans and deposit behavior for each respective product type and market segment. Current practices still rely on standard regression to connect the dependent variables, like loans levels and deposit volumes, with yield-curve movements or other explanatory variables. (The latter are selected by modelers based on their experience and intuition.)

However, when macroeconomic conditions change abruptly, these dependencies tend to break down. Consequently, it’s important to adopt more sophisticated yet transparent techniques (like regression with regularization) that can better forecast the outliers and that can pinpoint the variables that are driving loan and deposit behavior amid turbulent markets.

2. Project

Forecasts for all of the explanatory and dependent variables must be made using the full range of forward-looking, long-term scenarios (covering at least three years). It is widely acknowledged that yield-curve stress tests based on a single factor are inadequate; risk-neutral probabilities are therefore often employed to simulate yield-curve scenarios.

Since increases in LDR and liquidity risk can be driven by unusual shapes of the yield curve and by altered relationships between the risk drivers, it is critical to construct the scenarios with real-life probabilities and realistic assessments of tail risk.

3. Observe

A bank should keep track of the distribution of a point-in-time LDR and related funding ratios, as well as the potential accumulation of deposit runoffs over time. Simultaneously, it can weigh the pros and cons of various contingent funding sources and can assess both the cost of short- and long-term funding and the value of potential collateral eligible for pledging.

By following these three steps, a financial institution can clearly explain its liquidity risk management strategy (as well as the measures it is taking to address potential funding shortfalls) to regulators, investors and other stakeholders.

The “Discount Window” Funding Dilemma

Short-term funding may become expensive or scarce when a bank's LDR is high. So, it’s no surprise that as deposits declined, there was recently a surge in the amounts borrowed by U.S. banks from the Fed’s discount window (DW).

The DW is intended to provide a source of liquidity to banks and help alleviate funding risks. However, there is a certain stigma associated with such borrowing, because it might highlight a bank’s liquidity shortfalls and its need for a quick cash infusion.

Banks may be reluctant to use the DW, because that approach could harm its reputation, leading to additional liquidity and funding concerns. To reduce the stigma associated with using DW and to encourage more institutions to use it, the Federal Reserve has increased the confidentiality period and lowered the interest rate charged on DW loans.

A bank that wants to use the DW should proactively and transparently communicate its reasons for taking advantage of this program. If a bank explains, for example, that it is applying DW funding to contingent liquidity planning for a potential downturn (rather than for an immediate shortage), then it will not be stigmatized.

Parting Thoughts

Financial institutions need to adopt a more comprehensive and flexible strategy for managing funding liquidity risk. By going beyond compliance and the static, one-size-fits-all approach, they can better prepare for potential funding shortfalls and market disruptions, reducing their vulnerability to liquidity risk.

During these uncertain times, it is critical for banks to obtain a holistic view of their balance sheets and their income statements. This can only be achieved through the use of full-range scenarios that weigh the impact of potential changes in macro conditions.

Hundreds of banks failed as a result of the GFC. To avoid a repeat of this horrible history, banks should employ customized stress-testing analyses that incorporate longer-term funding scenarios and more prolonged disruptions to funding markets.

 

Alla Gil is co-founder and CEO of Straterix, which provides unique scenario tools for strategic planning and risk management. Prior to forming Straterix, Gil was the global head of Strategic Advisory at Goldman Sachs, Citigroup, and Nomura, where she advised financial institutions and corporations on stress testing, economic capital, ALM, long-term risk projections and optimal capital allocation.




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