34 JULY / AUGUST 2018 It shouldn’t come to much of a surprise that liquidity risk management is a major focus for all the regulatory agencies. The economy has improved since the financial crisis of 2008, and banks have been steadily adding loans to their balance sheets. As a result of the increase in loan demand, overall liquidity levels have decreased, as more liquidity is now tied up in loan portfolios. Additionally banks need to consider how the vast amount of surge deposits in the industry might behave, as the Fed continues to raise rates, and deposit competition heats up. Is it possible those depositors will leave in search of higher rates? Or will they leave the banking system altogether? In April 2010, the Federal Financial Institutions Examination Council issued a policy statement to provide for sound practices for managing funding and strengthening liquidity risk management practices. This guidance is now eight years old. However, with the renewed focus on liquidity risk management, some banks are playing catch-up to ensure they are in compliance. For years, the concept of liquidity stress testing seemed irrelevant, as most banks were flush with deposits, cash liquidity and tepid loan demand. Fast forward to 2018, and stress testing our liquidity levels seems much more plausible. The question becomes, “How do I stress test my liquidity?” First, take a look into the regulatory guidance. The aforementioned 2010 guidance states the following: “Institutions should conduct stress tests regularly for a variety of institution-specific and market-wide events across multiple time horizons. The magnitude and frequency of stress testing should be commensurate with the complexity of the financial institution and the level of its risk exposures.” There are a few more sentences after those two but, all in all, the guidance doesn’t give us a whole lot of … well, guidance. Second, take a look at some ways to conduct liquidity stress testing. Here is where you need to be creative. A brainstorming starting point is the question, “What would keep our ALCO up at night from a liquidity risk perspective?” Liquidity stress testing should address both institution-specific, as well as market-wide events. Start by looking at the bank’s balance sheet and its potential seasonality. Some institutions experience more seasonality than others, and seasonality can come from both sides of the balance sheet. However, there is one area that will affect any institution: the loss of customer deposits. Modeling a scenario where you lose varying levels of deposits is a must. Stress testing a loss in deposits is just one of many scenarios to consider when running a liquidity stress test. Once again, regulators want to see both institution-specific, as well as market-wide stress events. Liquidity Stress Testing Is it stressing you out? Dale S. Sheller Vice President, Financial Strategies Group The Baker Group dsheller@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. DIRECTORS / SENIOR MANAGEMENT
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