COVID-19 Impact on Bank Liquidity Risk Management and Response

COVID-19 impact on bank liquidity risk management and response

Overview

As a result of COVID-19 and the actions In response to the recent adverse market the economy during adverse situations taken by governments and businesses activity, the Federal Reserve Board such as the impacts of COVID-19 and to to help mitigate the impact, financial (the Fed) has taken steps to stabilize the enable banks to continue lending. The Fed is institutions have been challenged in their financial markets through the purchase of encouraging banks to use their capital and ability to manage and report on their Treasuries and government guaranteed liquidity buffers as they make loans available liquidity positions and funding capabilities. mortgage-backed securities, reviving to households and businesses affected by Regulatory requirements put in place the Primary Dealer Credit Facility to offer the COVID-19 restrictions, assuming this after 2008 were designed to improve loans to securities firms, reestablishing lending is done in a safe and sound manner2. banks’ ability to meet funding obligations the Money Market Mutual Fund Facility, by establishing liquidity buffers, and to and substantially expanding its repo Industry challenges in liquidity implement contingency funding plans operations1 The Fed has also encouraged and funding risk management (CFPs) to guide banks during times of crisis. banks to start borrowing from its discount However, recent equity market volatility, window and regulators have extended the Although the Fed has taken steps to stabilize liquidity tightening, widening funding timeline for certain regulatory requirements the market and make funding available, spreads, operational fails, and (e.g. the Current Expected Credit Losses many banks have already activated their other challenges have put significant implementation) in an effort to reduce CFPs and are actively managing and pressure on bank liquidity some pressure on bank resources. The reporting on their liquidity positions, often risk management. capital and liquidity buffers that banks now to the C-suite and executive committees. have in place were designed to be available As a result, banks are facing a number sources of capital and liquidity to support CENTER for REGULATORY STRATEGY AMERICAS COVID-19 impact on bank liquidity risk management and response

of challenges related to their liquidity financial market crisis and in some cases creating new options for utilizing collateral. risk management: updated for more recent liquidity events and These new options may require firms to market dislocations. However, many of the modify and enhance collateral databases to Liquidity stress management reporting disruptions in the liquidity markets that the support eligibility determination. A number of requirements put in place banks are seeing today were not captured after the financial market crisis required in these model assumptions. In addition, Actions banks should consider that banks establish processes for the declines in price visibility may lead to production of near real-time liquidity increased liquidity risk via changes to haircut Given the challenges that banks are likely management reporting during periods of assumptions. This and the market impacts experiencing, organizations should take stress that may likely provide a full view of may result in inaccuracies and large daily certain steps to address these challenges a bank’s liquidity position across various movements in liquidity positions and stress promptly to effectively manage current entities and regions, and holistically across testing results. liquidity risk and better prepare for longer- the organization. Intraday liquidity reporting term actions. requirements should also have incentivized Transition from monthly to more banks to develop intraday liquidity frequent FR 2052a reporting Rapidly assess and take action monitoring and management capabilities. As per the FR 2052a guidelines, the Fed has on liquidity challenges and However, some institutions are still finding already requested that monthly filers submit management requests themselves without sufficient reporting FR 2052a data on a more frequent basis. The As during the financial market crisis, capabilities, and therefore management may reality is that not all banks are well positioned preserving cash and access to liquidity have reduced visibility of liquidity availability to support more frequent reporting and is the overarching goal for banking and shortfalls across the organization. these banks may face constraints on data organizations. Understanding the size, Even those banks that have developed this availability and resourcing to support process timing, and funding of cash requirements reporting may have missed the importance cycle times. Submission procedures that will likely be the highest priority request of reporting on the impact of market fails rely on manual processes, observed more from senior management. Quick and that have been a result of the increase in frequently in monthly than daily filers, may effective responses may require a focused, trading volume and volatility. be overwhelmed, resulting in a deterioration dedicated team (e.g., a task force) that can of controls and quality. Institutions subject react quickly to offer innovative approaches Liquidity preservation and to this transition may also be faced with and adjust processes. contingency funding responding to the Federal Reserve while also In the current market, banks have most managing crisis-related resource constraints Cross-functional teams comprised of first likely reduced liquidity buffers and have and dislocation challenges. and second lines of defense, operational already considered implementing actions and technical resources should be documented in their CFPs to preserve Collateral management sponsored by executive management. liquidity. Banks should consider a number The potential for disorderly markets Careful consideration should be given to of factors as they begin to take action, increases the challenges in determining the ensuring that ongoing and business-as- starting with obtaining an accurate view of value, availability, and eligibility of collateral. usual operational needs continue to be projected cashflow and liquidity shortfall A continuation of the volatility seen in recent met, while dealing with crisis-related issues. across entities and businesses. The size, weeks may result in extreme swings in value, Supplementary skilled and experienced location, and expected duration of these increasing the financial and operational resources may be required to provide shortfalls will impact decisions on liquidity pressures in monitoring collateralization additional capacity. preservation actions in the short term and of asset/liability values and in managing banks will need to decide whether to seek and controlling calls for collateral delivery Strengthen liquidity monitoring and alternative sources of funding in the and receipt. reporting capabilities longer term. It’s critical that banks utilize accurate and Collateral availability monitoring may become updated information to manage liquidity Liquidity stress testing assumptions more complicated due to increased needs during a crisis. Tactical solutions leveraging In compliance with Regulation YY, banks for secured funding combined with increased existing reporting, data, processes, and have implemented liquidity stress testing levels of collateral substitution as firms resources implemented after 2008 can be models using assumptions for inflows call back high-quality collateral. Availability leveraged to enhance the scope, depth, and and outflows related to existing sources monitoring will likely be further complicated timeliness of liquidity and funding reporting. of funding that may likely be impacted by the need to monitor rehypothecation Bespoke tactical approaches can be used during periods of market and firm-specific rights against counterparty credit ratings and to overcome liquidity monitoring challenges (idiosyncratic) liquidity stress. Models events (e.g., downgrades). arising from segregated data, incompatible were primarily based on data taken from data structures, and fragmented monitoring idiosyncratic and market events during the Regarding eligibility, the Fed’s expansion of and reporting capabilities. its practice of securing lending facilities is 2 COVID-19 impact on bank liquidity risk management and response

Monitoring improvements should assumptions including asset haircuts and Contacts focus on currently available liquidity cash flow timing (e.g., roll-off, drawdown management tools, forecasts on expected assumptions) should be assessed in the Joan Cheney and potential inflows and outflows, early context of the current environment. As Managing Director | Deloitte Risk & warning indicators and risk limits. Liquidity market pricing observability declines, Financial Advisory monitoring should also cover collateral, haircuts and related assumptions should Deloitte & Touche LLP specifically availability (encumbrance and be updated. Consulting subject matter [email protected] rehypothecation rights), haircut behavior, resources on assumption reasonableness credit quality, calls for delivery, calls for is encouraged. In addition, banks should Ryan Hittner receipt, substitution capacity and risk and consider whether in-house modeling Managing Director | Deloitte Risk & eligibility for the Fed’s lending programs. teams have the capacity to keep pace with Financial Advisory necessary revisions and consider whether Deloitte & Touche LLP Establish processes for coordinating supplemental resources may be needed [email protected] regulatory responses to overcome constraints or skill gaps, and Banks should implement processes to address the most impactful changes as Christopher Hogan respond efficiently to regulatory inquiries efficiently as possible. Senior Manager | Deloitte Risk & Financial and changes in reporting requirements. Advisory Using the financial market crisis as a Conclusion Deloitte & Touche LLP precedent, banks should expect inquiries [email protected] based on existing reporting regimes as The market turbulence and economic well as inquiries that extend or build upon impacts resulting from the COVID-19 crisis Phillip Wang those regimes. These inquiries are likely are ongoing and continually evolving. Bank Manager | Deloitte Risk & Financial to compete with internal requests for liquidity teams will need to ensure that they Advisory information. Liquidity task force teams understand the current and continuing Deloitte & Touche LLP should assess whether existing regulatory effects, and put in place tactical solutions [email protected] reporting teams are capable of supporting that can be supported for a potentially regulatory responses and internal needs extended duration. Impacts to liquidity concurrently, and whether supplemental and funding availability, risk management, resources should be brought in to enhance reporting and management, and regulator existing capabilities. requests should be prioritized to enable resources to quickly and effectively a Revise cash flow forecasts and liquidity ddress challenges and requests on an model assumptions ongoing basis. Liquidity model and cash flow forecast modifications will likely need to be made As the crisis resolves, lessons will be to more accurately reflect current and learned. Tactical fixes that are put in projected conditions given the COVID-19 place today could lay the foundation for crisis (and in the aftermath, as the more robust and innovative solutions in economy adjusts and recovers). Modeling the future.

Endnotes

1. https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm; also “What’s the Fed doing in response to the COVID-19 crisis? What more could it do?”, Brookings, Jeffrey Cheng, Dave Skidmore, and David Wessel, March 23, 2020,https://www.brookings.edu/research/fed-response-to-covid19/ .

2. https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm.

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