The recent economic crisis and the associated turmoil in the financial markets have exposed serious vulnerabilities in bank funding strategies. Many assumptions about how funding markets behave in a crisis proved to be too optimistic. Previously reliable short-term, secured sources such as the repo markets became more expensive to access for even well-capitalized, healthy market participants.
The best-managed banks read these market disruptions early and used their asset and liability management processes and contingency funding plans to navigate the funding obstacles. However, many remained vulnerable, particularly as their asset quality and earnings performance deteriorated.
Although the liquidity crisis appears to have subsided for now, the events of the past two years have prompted more bank regulatory attention during the field examination process.
In fact, international banking organizations, particularly those in the U.K. and Australia, are already adjusting to new regulatory guidance and standards. The Basel Committee on Banking Supervision issued proposals on capital and liquidity risk management in December. This proposal includes two liquidity risk measures that will apply to all internationally active banks.
While these proposals will not take effect for several years, the U.S. regulators are already taking aggressive actions relating to liquidity risk policies, contingency funding plans and the level of bank board understanding and involvement during field examinations of banks of all sizes.
Financial markets improved considerably in 2009. Money markets and certain term debt capital markets have returned to more normal conditions. The Federal Reserve is scaling back several of the unprecedented market-support programs it put in place during the crisis. Banks and investors alike will need to keep a close eye on the impact of the withdrawal of these programs.
Recent proposals including a "bank tax" raise the question of public policy implications of nondeposit sources of bank funding that are increasingly receiving both executive branch and congressional scrutiny.
Furthermore, it is hard to see the current investor distrust of ratings agencies diminishing.
Banks will need to address and manage the tough scrutiny of depositors, money market, debt and equity investors. An effective investor relations strategy will continue to be important.
Regulator demand for institutions to reduce reliance on wholesale funding sources is causing most regional and large money-center banks to recharge their retail deposit gathering programs. As debt and equity markets continue to recover, some level of deposits will flow out of the banking system. These trends undoubtedly will increase the competition for retail deposits and exert pressure on the pricing and availability of these types of deposits.
In addition, the risk of rising interest rates is already on regulators' radar screens, as evidenced by their Advisory on Interest Rate Risk Management issued earlier this month.
There will be no shortage of regulatory and market challenges facing bank CFOs and treasurers in 2010. However, there are several steps they can take to address them.
First, banks should review their liquidity policies to ensure that they incorporate and have updated, board-approved liquidity limits, including funds-provider and market-concentration limits. Best practices also include the use of liquidity stress triggers that alert management to impending liquidity issues and allow the institution to adjust strategies accordingly.
Second, examiners and informed investors will expect updated and robust contingency funding plans and associated asset and liability management strategies. Banks need to review their assumptions and ensure that these plans are updated and tested on a regular basis. These plans need to be living, realistic documents that take into account changes in market conditions as well as other internal and external factors impacting the institution's liquidity needs.
Third, banks should incorporate liquidity risk considerations in their strategic planning, capital management and financial forecasting processes. Some institutions should consider updating their transfer pricing methodology to ensure that a liquidity cost, much like allocated capital, is applied to businesses and products.
Regulators will continue to scrutinize banks' liquidity risk management practices even as markets return to the new normal.
Institutions that take regulatory guidance to heart and implement best industry practices will have an enhanced competitive advantage and the financial flexibility to weather the next crisis.