Part 1 of 4: Liquidity Assessment and Stress: Preparing For an Unprecedented Future

As Financial institutions across the nation cope with market and economic challenges impacted by COVID-19, anticipating next steps to managing balance sheet “risks” AND to improving or protecting profitability will become increasingly difficult. Not to mention heighten regulatory exams will most likely hit key ALCO areas.  Capital, Asset Quality, Management, Earnings, Liquidity and Sensitivity could be fair game for revised ratings.  

Stress testing your liquidity is no longer an academic exercise!  The impact from COVID-19 has applied new stressors onto the financial system, and the fallout continues to spread through wall street and main street.  This pandemic has put significant pressure on financial markets, businesses and individuals, causing market distortions, cash flow interruptions and loss of employment.  Liquidity has quickly moved to the top concern of most financial institutions, and rightfully so, as COVID 19 has created new challenges:

• Cash Flow Interruption:  Most financial institutions are inundated with requests from borrowers for interest-only or total payment deferral for periods of three to six months.  Some financial institutions are also seeing significant draws on unfunded lines of credit as businesses look to hoard liquidity to ‘weather the storm’.  This is an extreme and historically rare occurrence to see a spike in borrowing compounded with a spike loan payment deferrals.  Borrower cash flow interruption will vary both by severity and duration and, long-term, could result in asset quality deterioration as some borrowers may be unable to recover from the slowdown. 

• Deposit Outflows:  As cash flow interruption persists, and credit availability tightens, a customers’ next source of liquidity will come from their liquid assets, i.e. stocks, bonds, and deposits.  Institutions could very well see deposit balances decline as consumers begin to live off their savings.  This would only compound the liquidity stresses noted above.  Additionally, some institutions could see varying degrees of large cash withdraws as business and retail depositors become nervous about the safety of their money. 

First and foremost, Don’t Panic!  While challenges are unprecedented, those institutions who have adopted sound contingency funding plans and liquidity stress testing practices should have a strong understanding of their current and long-term access to liquidity.  Be prepared for a more comprehensive discussion about your current and future access to liquidity in the event asset quality deterioration accelerates.  Know how each funding source reacts during periods of stress and adjust your funding mix as the environment changes.

Secondly, given the dislocation in the marketplace, there are a variety of wholesale funding options available with differing maturities, collateralization, and, at times, significantly different rates/pricing. The FHLB continues to be a reliable source of funds and the Federal Reserve is actively urging all financial institutions to use their credit facilities.  Understanding which assets are eligible for pledging can significantly help your liquidity assessment management process.  When looking at policies and aggregate limits, one needs to make sure that they can effectively measure/manage their on- and off-balance sheet liquidity while being mindful of how these sources can change over time in a stressful environment.

Taylor Advisors helps executives by providing strategies and tools to effectively measure, manage and stress test liquidity.  Here are additional resources if you would like to read a liquidity success story or ask us a question about your liquidity process and how we might be of some help.