After every significant banking crisis, it becomes clear what transpired and how it could have been avoided.
There are two key takeaways from the March bank failures that directors and their senior management team should capitalize on. They should put on a new set of lens and take a fresh look at:
- Enterprise risk management practices.
- Liquidity risk measurement and management.
What happened in March resulted mainly from a breakdown in management and governance. It is a reminder that risk management is highly interconnected among liquidity, interest rate, credit, capital and reputation risks. Risk management must be a mindset that permeates the entire institution, is owned by the c-suite and is understood by the board.
Here are a few things for directors to ponder while revisiting enterprise risk management governance:
- Be realistic about potential risks. Listen to, and address, data-driven model outcomes. Refrain from influencing results to reflect a preferred narrative.
- Understand key assumptions and their sensitivities. Assumptions matter.
- Bring data to the surface and breathe life into it; value data analytics.
- Accept that the days of “set it and forget it” policy limits and assumptions are over.
- Revisit attitudes regarding validating risk management processes and models: Are they a check the box “exercise” or a strategically important activity?
- Ask what could go wrong and what should we monitor? How thorough and realistic are preemptive and contingency strategies?
- Acknowledge that stress testing is not for bad times — by then, it’s too late.
- Cultivate an environment of productive, effective challenge.
Banks and their asset/liability management committees are under stronger regulatory microscopes. They will be asked to defend risk management culture, processes, risk assessments, strategies and overall risk governance. Be prepared.
Telling Your Liquidity Management Story
The March bank failures accentuated the critical importance of an effective liquidity management process — not just in theory, but in readiness practice. Your institution’s liquidity story matters.
Start with your liquidity definition. Most define liquidity by stating a few key ratios they monitor – but that’s not expressing one’s liquidity philosophy. Bankers struggle to put their liquidity definition into words, which can lead to an inadvertent focus on ratios that conflict with actual philosophy. This can result in suboptimal outcomes and unintended consequences. One definition banks could adopt is: “Liquidity is my bank’s ability to generate cash quickly, at a reasonable cost, without having to take losses.”
A bank can readily construct a productive framework around a meaningful definition. Given the notoriety around unrealized losses on assets and potentially volatile deposits, be clear that how the bank manages its liquidity does not depend on selling assets.
Construct a liquidity framework that supports this notion with four elements:
- Funding diversification.
- Concentration and policy limits.
- Collateral management.
- Stress testing and contingency planning.
Funding diversification should consider Federal Home Loan Bank, Federal Reserve programs, repurchase agreements (repos), brokered and listing service deposits and fed funds lines. The ability to manage larger relationships with insured deposit programs, such as reciprocal and one-way, FHLB letters of credit and customer repos is also an integral part of funding diversification. Make sure your institution tests all sources periodically and understand settlement timelines.
Funding concentrations must be on your radar. The board and executives need to establish policy limits for all wholesale deposit and borrowing sources, by type and in aggregate. There should also be limits that apply to specific customer deposit types such as public, specialty/niche, reciprocal and others. The bank should track and monitor uninsured deposits, especially those that are tied to broader, larger relationships, and reflect that in operating and contingency liquidity plans. Take a deep dive into your bank’s deposit data; there is a significant difference between doing a core deposit study and studying your deposits.
Collateral doesn’t matter unless it is readily available for use. Ensure all available qualifying loan and security collateral are pledged to the FHLB and Fed. Determine funding availability from each reliable source and monitor capacity relative to uninsured deposits, especially the aggregate of “whale” accounts.
Also, understand how each funding source could become restricted. Ensure your contingency liquidity management process captures this with well-defined stress tests that simulate how quickly, and to what degree, a liquidity crisis could materialize. Understand what it would take to break the bank’s liquidity, and ensure that key elements fueling this event are monitored and preemptive strategies are clearly identified.
Step back and look at your institution’s risk management policies, keeping in mind that they can become unnecessarily restrictive, despite good intentions. Avoid using “if, then” statements that force specific actions versus a thoughtful consideration of alternative actions. Your bank needs appropriately flexible policies with guardrails, not straightjackets.
The conversation on risk management and related governance at banks needs to change. Start with a fresh set of lens and a willingness to challenge established collective wisdom. Dividends will accrue to banks with the strongest risk management cultures and frameworks, with an appreciation for the important role of assumption sensitivity and overall stress testing. Ensure that clarity drives strategy — not fear.