Does the recent lull in crisis headlines mean that bankers can relax about funding issues and concentrate on a return to business as usual?

It's a tempting proposition at a time of improving market confidence. But in fact, this is not only a time for continued vigilance, but also a time for sweeping review and modernization of bank liquidity management.

The essential problem is that banks lent far beyond their domestic deposit resources in recent years, creating pronounced dependencies on what we now know to be less reliable funding alternatives, such as foreign deposits and the capital markets.

It will take a lot longer to rebuild core funding. In the meantime, there is much to be done to safeguard against future disruptions.

Underscoring the continuing liquidity challenge, our analysis of the largest U.S. banks shows a wide variation in balance-sheet strengths and structures. There are five priorities for management teams looking to achieve best practices in liquidity management: overhauling metrics, refining cash flow assumptions, improving stress tests, fortifying contingency plans, and re-emphasizing liquidity in balance-sheet strategy.

Metrics. One of the problems with simple metrics is that they can mask critical details, leaving the bank with insufficient warning about budding issues and insufficient guidance on the best way to respond.

What is needed is a cash flow model that provides line-by-line measurements of asset and liabilities. Such a model includes cash flows for the entire balance sheet for periods ranging from overnight through, say, five years. The assumed behavior of these accounts is then modeled to reflect anticipated changes in the funding environment according to increasingly severe stress assumptions.

Assumptions. Recent market upheavals present a significant opportunity to analyze the behavior of wholesale funds suppliers, depositors and borrowers in actual stress scenarios. Such data can be used to calibrate the liquidity behavior embedded in different types of deposit accounts by size, longevity, deposit type and market.

Most liquidity models have been calibrated on the basis of user judgment, since there have been few sources of behavioral information. Now these models can capitalize on live data drawn from the experiences of similar institutions operating under stress.

Additionally, there is a material ongoing benefit in parsing the behaviors of major customer groups. Within the CD portfolio, for example, there typically is a pool of "sticky" accounts that reasonably can be counted on to roll over in most circumstances. Many other accounts, by contrast, exhibit varying degrees of price and risk sensitivity.

Stress tests. There is a clear need for worst-case liquidity scenario analytics that stretch the limits of what is imaginable. Scenarios must include many potential outcomes that until recently would have been considered impossible. Along with changes in loan and deposit behavior, they should consider changes in securitization markets and off-balance-sheet instruments.

Contingency plans. Once the bank has clarified its worst-case assessment of a potential stressed liquidity situation, actionable contingency liquidity plans are needed to guide the steps that might need to be taken to remain in business.

Precision in identifying possible scenarios provides additional guidance on how to prevent their occurrence. Policies should be linked with cash flow measurements that establish specific limits on acceptable risk levels.

Balance-sheet strategy. The incorporation of liquidity risk into balance-sheet strategy starts with an alignment of liquidity targets with the institution's risk appetite.

For some types of strategies, the market expects banks to maintain the highest risk rating. Liquidity risk exposure must be kept extremely low, with few, if any, scenarios that expose the institution to even the perception of a potential illiquid situation. Conversely, other strategies may permit a more flexible liquidity posture that, while still conservative, provides room to maneuver.

Effective reporting is needed to assess liquidity position relative to strategy. Liquidity should also be an explicit component of loan and deposit pricing, in alignment with the risk appetite and balance-sheet strategy.

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