Liquidity Risk

Liquidity risk is the potential that an institution will be unable to meet its obligations as they come due because of an inability to liquidate assets or obtain adequate funding (referred to as "funding liquidity risk") or that it cannot easily unwind or offset specific exposures without significantly lowering market prices because of inadequate market depth or market disruptions ("market liquidity risk").

Regulatory Guidance

Basel Committee - Sound Practices for Managing Liquidity in Banking Organizations offsite link

Joint Agency Advisory on Brokered and Rate-Sensitive Deposits

Supervisory Guidance on Complex Wholesale Borrowings

Risk Committee Liquidity Risk Observations

Liquidity at most Seventh District banks is considered satisfactory. However, the Chicago Fed's September 2008 Risk Committee identified two key liquidity risks facing District financial institutions:

Contingent Liquidity Risk
Ineffective Liquidity Metrics

Contingent Liquidity Risk

During the current financial turmoil, the funding structure at many banks has changed. Many regional banks have faced difficulty in issuing debt beyond the very short term, with longer-term debt offerings expensive or impossible to execute. In addition, complex instruments, such as debt with embedded options or debt tied to collateral viewed as undesirable, are difficult to place in the market. As a result, banks are turning to other funding sources, such as the overnight inter-bank market, the Federal Home Loan Bank (FHLB) System, and brokered deposits. Finally, competition for retail deposits continues to increase in many areas, as market sources of funding become less available or more expensive.

These changes have brought increased liquidity risks. For example:

Increased levels of short-term, unsecured funding can create higher roll-over risk — the risk that a bank will not be able to renew funds at a reasonable cost, or at all, as they come due.
Increasing FHLB advances require additional collateral. The amount that can be borrowed against this collateral can be affected by bank-specific or overall market events.
Increases in brokered deposits can create concentrations in a credit-sensitive funding source or lead to higher funding costs, due to increased competition.
Risks associated with the more-competitive retail deposit environment include increasing costs and consequent earnings pressures, as well as increasing volatility in retail-deposit levels, as depositors become more sophisticated and move funds more frequently in search of better opportunities.
Due to regional economic weaknesses, some larger correspondent banks are reducing their exposure in certain geographic areas by terminating federal funds lines or requiring collateral for them. This is affecting parts of the Seventh District.

Rising short-term, unsecured funding sources, combined with declining collateralized borrowing capacity to replace those sources if necessary, could result in a bank being unable to fund itself. At some banks, the combination of securities and loan collateral would be insufficient to cover their deficit position if they are unable to roll over their overnight funding.

Following are risk management suggestions for reducing contingent liquidity risk:

Banks should ensure they have a realistic, written contingency plan that is supported with some quantified stress testing;
They should estimate how much additional funding capacity they have, based on their level of unencumbered, easily marketable (or pledged) securities or loans, compared to the level of short-term, unsecured funding;
They should have adequate management and board reporting on the term structure of their liabilities; and
They should make advance arrangements to borrow at the Federal Reserve Discount Window, but not rely unrealistically on this source as an exclusive or long-term solution.

For more information on current liquidity issues, please see the Federal Reserve Bank of New York's guide to recent changes in Federal Reserve liquidity programs, offsite link

as well as the Basel Committee on Banking Supervision's analysis of recent liquidity challenges offsite link

and final guidance on sound liquidity risk management. offsite link

In addition, the FDIC has issued a supervisory letter offsite link

on liquidity risk management.

Ineffective Liquidity Metrics

District banks are continually looking for additional, less-expensive sources of funding. These funding sources can be either completely new or can be familiar sources with potentially complex characteristics. Additionally, assets being funded are increasingly non-traditional and/or more complex. While the availability of diverse funding sources can reduce liquidity risk, traditionally defined liquidity metrics (such as loans to deposits, non-core funding dependence and an overall "liquidity ratio") may misrepresent the true liquidity position of a bank. To ensure that its liquidity metrics are effective, an institution should:

Develop an understanding of customer and product behavior in various environments;
Customize metrics to match its balance sheet and its specific customer base;
Document and support any assumptions; and
Ensure that assumptions are consistent with those made in other risk areas (e.g., interest rate risk).

The Federal Deposit Insurance Corporation has published an article providing additional guidance on liquidity analysis. offsite link