For several years now US banking institutions have been tasked with modelling Contingency Liquidity Stress testing scenarios. Many of these scenarios centered around events like the loss of a major employer in the area, a significant economic downturn, or decline in property values. How many of us had accounted for a global pandemic with nationwide stay at home orders? But that is today’s reality.
To date, the Federal Reserve and industry regulators are taking extreme steps to provide liquidity to the banking industry. These include dropping the Fed Funds target rate to near zero, committing to seemingly unlimited bond purchases, and providing numerous credit facilities. Through the Cares Act and its follow-ons, the government is providing tons of liquidity to individuals and small and medium sized employers in an attempt to keep them afloat during this time of nationwide stay-at-home orders. Unfortunately, no one knows how long this economic shutdown will last, how many small businesses will survive and what the eventual economic recovery will look like.
Despite all these efforts, the liquidity concerns for banks remain. How many loan payments will be missed? Which loans will need to be modified or extended, and which will default? How much will deposit accounts be drawn down to offset income interruptions? Will there be additional circumstances that might trigger a run on deposits?
Clearly, keeping a close eye on your daily liquidity situation is imperative. Here are suggestions on some things you should be doing:
- Ensure that contingent funding facilities are available and accessible.
- Seek additional funding sources as necessary
- Track trends in loan and deposit customer behaviors and adjust your liquidity projections
- Reflect your loan modifications in your financial projections
- Run multiple liquidity scenarios of varying severities and durations
- Maintain good records of customer behaviors to assist in modelling future liquidity situations that may arise.
For perspective, in non-stress times, we repeatedly hear examiners telling management they need to ensure that liquidity stress tests are conducted regularly for institution-specific and market-wide events across multiple time horizons. The outcomes should be used to identify and quantify sources of potential liquidity strain and to analyze possible impacts on the institutions cash flows, liquidity position, profitability and solvency. This isn’t creative writing – it's lifted right from the Policy Statement from 2010. The Financial Institution should use the results to form a plan of action for when events like COVID-19 arise. However, it does ask us to be creative. We used to think about stress events as short-term and localized: hurricanes, labor disputes, bad press, mortgage bubble. Assumptions that are reality as of this writing are:
- Worldwide illness
- Small businesses shut down indefinitely
- Interest rates at or below zero
- 22 million unemployed, wiping out 10 years of job growth
- Oil trading at or below zero
Admittedly, 10 years ago these just weren’t on the radar. The difference in these assumptions vs. 10 years ago is there is no predictable longevity to them. Labor disputes might be solved in a matter of months. A pandemic doesn’t give us a clue as to how long the assumptions should be in play. We chuckled at the suggestion that cash flow modeling should extend to 24 months. I fear that examiners are now having the last laugh.
Now is the time to revisit your cash flow model and determine a) can it account for these complex assumptions, and b) does it mesh with the board approved policies and procedures. Like a lot of “to-do’s” in compliance, it is not interesting and doesn’t attract the next profitable relationship, but downstream, it could impact your ability to service the ones you have.
Related Reading:
4 Things For Businesses To Focus On Post-COVID
Cybersecurity For Colleges And Universities
COVID-19 Brings The Spotlight Back To Stress Testing
Potential Effects Of The COVID Pandemic On Regulatory Examinations
