As the second and third largest bank failures in history continue to reverberate throughout the headlines, community banks are left to contemplate the lasting impacts.
There has been considerable discussion on the mistakes of bank executives over liquidity risk management, along with questions over the regulatory supervision of the failed institutions. Regardless of where the blame rests, bankers can expect increased scrutiny over liquidity risk positions for the foreseeable future.
The immediate focus has been on regional banks, where funding strains have been driven by depositors seeking “safety” in the largest banks in the country. However, the ramifications of recent failures will be borne by community banks as well.
Recent Bank Failures Have Changed How We Perceive Liquidity Risk
The fundamentals of liquidity risk, which is defined 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 obligations, have not changed as a result of recent bank failures. What has changed, however, is the lens through which liquidity risk is and will be viewed.
To be clear, comparing the profiles of Silicon Valley Bank (SVB), Signature Bank (SB), and First Republic Bank (FRB), to community banks, in general, is like comparing apples to oranges. Their customers, funding compositions and concentrations are distinctively different. However, despite these differences, community bank executives should reflect on these recent failures, anticipate future changes, and consider improvements to their own liquidity risk management practices.
5 Ways Liquidity Risk Management May Change at Community Banks
Here are five reflections on the recent failures and how they may influence liquidity risk management at community banks.
1. A Modern-Day Bank Run
Deposits move at the speed of technology. We witness, time and time again, how fast news travels, especially bad news. Layer on technology that puts a bank branch in the customer’s pocket providing the ability to transfer funds from anywhere and you have a modern-day run on the bank.
The pace of the consumer has changed, and so should the liquidity risk management mindset of today’s community banker. Recent events have shown short-term stress events can have a meaningful impact to the bank’s liquidity position. Stress testing should now incorporate significant deposit run-off over short-term stress events and be aligned to bank-specific concentrations versus percentages of funding.
What on balance sheet funding concentrations should the bank be exposing to short-term run-off? If the institution lacks customer or industry specific concentrations, consider deposits at risk by comparing pre vs post pandemic deposit levels.
2. Concentrations Matter and Will Remain in Focus
With the failure of SVB, it has become apparent how concentrations can lead to unbalanced risk positions.
Generally speaking, community banks are more diversified in both asset and funding compositions, and uninsured deposits are less of a risk. But concentrations are an important part of business. In fact, one could argue they represent an area of strength or core competency of the institution. Nevertheless, concentrations remain a risk and therefore will be a regulatory focus of liquidity risk management in future exams.
- How robust is the bank’s monitoring of funding concentrations?
- Is the bank measuring concentrations outside of related interests, such as interrelated customers by industry, geography, etc.?
- In the case of funding concentrations, does the bank’s balance sheet liquidity (liquidity buffer) match the bank’s concentration risk(s)?
3. The Speed of Available Funding May be Paramount
Many contingency funding plans (CFP) have funding sources listed in order of priority or preference. While this thought process may remain appropriate, priority may need to be adjusted to reflect the speed at which funding may be available.
In the modern-day bank run, the timing of available funds is critical. Bankers should consider having open and honest discussions with their funding providers to determine how quickly funds will be available and the magnitude to which they will provide funding.
During times of industry stress, availability of all funding may not be accessible, which may be another component to consider when completing stress-testing scenarios. In addition, banks should ensure there is an oversight process in place for the intra-day liquidity position. This should include an understanding of cut-off times from funding sources and correspondent banking relationships.
4. Contingency Funding Plan Clean Up
Considering the robust liquidity levels following the COVID-19 pandemic, liquidity monitoring and CFPs may have been neglected and need some refreshening.
Over the last two years, balance sheets and interest rates have changed significantly. The bank’s CFP should reflect changes in asset and funding compositions (i.e., non-maturity deposits levels, asset vs. liability-based funding availability, etc.).
In addition, contact information for all funding sources should be verified, and all individuals with active roles in the CFP should be reviewed for appropriateness. Banks should also determine if short-term and long-term liquidity stress scenarios and related assumptions remain appropriate in light of changes in interest rates and balance sheet positions.
5. Practice Makes Perfect
Desktop exercises aren’t only for cybersecurity concerns. A desktop exercise for a liquidity event may be the best way to truly practice a liquidity stress. Stress tests on paper can be difficult to believe, though, especially under “break the bank” scenarios. Using recency bias, now may be the ideal time to practice a liquidity event.
Practice can be as simple as walking through the CFP all the way to developing scripts to communicate to large or influential customers/depositors or for communication via press releases/social media. Executives should understand the importance of their assigned roles within the CFP. The scope of the exercise will vary by size, complexity, and risk profile of the institution.
Navigating Future Challenges and Stresses in the Banking Industry
As we approach what appears to be the end of a historic move in interest rates, more challenges and stresses may emerge. This may include additional stress events and uncertainty across the industry. The last three years have suggested that the unpredictable can occur. As with any banking crisis, new risk-management expectations and potential regulations may emerge.
Our specialized team can help you review your liquidity risk management practices to make sure you’re prepared for the future.