Liquidity Management – 6 Habits Your Financial Institution Should Consider

The cost of doing business is increasing, loan demand remains strong, and consumer skepticism is soaring, so it’s easy to see why liquidity management is in the spotlight. The Federal Reserve and FDIC released their response and breakdown of recent bank failures — and at the top of the list is mismanagement of basic interest rate and liquidity risk.

Financial institutions need to have adequate liquidity to meet day-to-day operational expenses, loan demand, and potential unexpected cash outflows — including declines in deposits. The ability of a financial institution to manage liquidity effectively can have significant implications on profitability, stability, and reputation.

As interest rates continue to rise, depositors are looking for higher-yielding accounts, including new competition from FinTechs and other companies that previously did not offer such products. The cost of funds for financial institutions has increased with the need to pay higher interest rates to attract deposits and remain competitive. Inevitably, this puts pressure on a financial institution’s liquidity position.

To manage liquidity effectively, financial institutions need to develop a comprehensive strategy that accounts for various scenarios. Here are six practices your institution can adopt to help manage its liquidity position.

1. Adjust accordingly

The reports from the Federal Reserve and FDIC concluded poor management was a root cause of the recent bank failures. In light of evolving conditions in the market, industry, and your community, assess your institution’s approach to liquidity and interest rate management — and what monitoring changes have occurred. You can increase the effectiveness of your approach by periodically testing your contingency funding plan.

2. Perform stress testing

Stress testing involves analyzing your institution’s liquidity position under various hypothetical scenarios, such as a sudden increase in interest rates, a significant decline in deposits, or unexpected losses. This testing helps financial institutions identify potential liquidity gaps and develop strategies to address them before they become a problem.

For example, the Federal Reserve stated, “social media enabled depositors to instantly spread concerns about a bank run, and technology enabled immediate withdrawals of funding.” Has your institution considered the viral nature of social media or the ability to move funds almost instantaneously in your stress testing scenarios?

3. Diversify funding sources

Financial institutions need to diversify funding sources to reduce reliance on any one type of funding. For example, relying heavily on short-term deposits may create vulnerability to liquidity shocks if depositors suddenly withdraw their funds. By diversifying funding sources, a financial institution can mitigate this risk and maintain access to funding even if one source dries up — including pledging additional investments or mortgages to secure lines of credit, non-customer deposits, or subordinated debt.

4. Monitor and plan for liquidity risk

Financial institutions should regularly review their liquidity position, considering current economic conditions and potential changes. Monitoring liquidity risk can allow financial institutions to identify potential problems early on and address them. In addition to monitoring, institutions should have future cash flow projections reviewed at least monthly to properly prepare for future decisions.

5. Manage asset and liability maturity

A bank or credit union that relies heavily on long-term loans may face liquidity problems if it needs cash quickly to meet unexpected demands. Balancing the maturity of assets and liabilities can help maintain sufficient cash to meet obligations.

6. Maintain sufficient liquidity buffers

Liquidity buffers can include cash reserves, unpledged high-quality liquid assets, and committed credit lines. These buffers can help financial institutions weather unexpected liquidity shocks and provide flexibility to take advantage of new lending opportunities.

Given the almost systemic impact on liquidity in the industry, you should test contingent funding sources. One institution’s recent testing revealed availability had been completely removed from three backup lines of credit and one other line had its availability reduced by half.

How we can help

Liquidity management is a critical aspect of banking that has an increased emphasis in today’s operating environment. Assessment and response to liquidity and interest rate risks will very likely be a topic of conversation at your institution’s next regulatory examination.

CLA can work with you to develop a comprehensive liquidity management strategy that can be adjusted in response to competing pressures in the market. Adopting leading practices can provide evidence of active management over liquidity and help meet operational needs, lending demands, and unexpected cash outflows.