Master Course: Liquidity Management: Liquidity Contingency Funding Plan

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Contingency Funding Plan

The liquidity contingency plan addresses alternative sources of funds if initial projections of funding sources and uses are incorrect. As it is not feasible to hold funds to such an extent that it covers least likely events as well, the contingency plan will act as the bridge between the actual liquidity that is being held by the entity and the maximum that would be needed in the event of a run on liquidity.

Planning will encompass:

  • Identifying and developing potential funding sources
  • Setting up plans for assigning responsibilities under various defined hypothetical liquidity need situations
  • Predefining triggers that would initiate liquidity management and remedial action plans

General requirements for a liquidity contingency plan

  • The plan must be workable, i.e. it must contain sufficient depth to ensure that it is actionable in times of stressed liquidity. It must be responsive to changes in market conditions.
  • The plan must include separate actions for different need environments.
  • The guidance provided by the plan needs to be specific regarding the actions that will be taken if hypothetical events were to occur. This is essential for a quickened response time.
  • However the guidance mentioned above should be a menu of alternative actions that may be taken rather than rules that need to be enforced if the event occurred. The actions taken will depend on the exact causes, durations or seriousness of the liquidity crisis and the specific guidance of the plan will be used as guidelines in the management of the situation.
  • Previous experiences should not be allowed to overly influence contingency planning.
  • The plan must include an appropriate level of detail with regard to identification of early warning signals, assignment of crisis management responsibilities and various alternative courses of action. The level of detail should enable the company to respond early, quickly and effectively to deteriorating liquidity conditions but must not be too detailed that it impedes decision making.
  • The contingency plan must be directly or indirectly coordinated with all of the company’s risk monitoring and risk management activities, particularly those monitoring market conditions as well as critical credit risk information. The need is to maintain a perception of liquidity at all times to avoid or survive a crisis.

Specific requirements for a liquidity contingency plan

The plan must reflect:

  • A variety of different need environments. Need environments that will be addressed in the plan include:
    • Ordinary course of business or “going concern” need for liquidity. This includes:
      • Operational needs such as surges in loan demand, seasonal needs, etc
    • Name crisis or company specific funding crisis,
    • Systemic and cyclical crisis such as recessions or credit crunches, capital market disruptions, etc.
    • A range of stress levels
      The plan would need to predefine levels of severity for each of the liquidity need environments given above. For example, stress level 1 for a company specific need environment event could be a one notch reduction in the company’s credit rating. Stress level 2 could be a further one notch reduction within six months of the first down grade.
    • Specific measures of mismatch liquidity
    • Specific measures of contingent liquidity that can be obtained along with the time frames required to obtain the funds, including applicability to the various need environments.
    • Specific measures for enhancing the liquidity of assets and the stability of liabilities, including applicability to various need environments

The plan will contain the following key elements:

  • Scope of the contingency plans contents. This consists of
    • Names of persons responsible for crisis management and clear identification of responsibilities
    • Identifying minimum liquidity needs
    • Establishing procedures to ensure prompt, complete and on going reporting of all information senior managers need to make decisions
    • Specifying early warning signals or triggers to be used as signs of approaching crisis
    • Specifying steps to be taken at each trigger point that occurs
    • Establishing mechanisms to facilitate regular monitoring and reporting of the current status of early warning signs or triggers
    • Identifying and prioritizing alternative sources of funds
    • Identifying specific liquidity sources and time frames associated with each source
    • Identifying the expected reliability of each liquidity source for different potential need environments
    • Identifying the cost and impact on capital for each liquidity source
    • Outlining procedures or action plans for altering asset and liability behaviour
    • Prioritizing customer relationships to establish an order for withdrawing lines of credit for specific customers
    • Detailing plans for communicating with the company’s staff
    • Detailing plans for communicating with the media, the company’s customers and the general public
    • Periodic or annual review of the plan
  • Identification and use of triggers

Triggers are specific early warning signs for each stage in a liquidity crisis. They will be selected in advance, and will be described in the plan. The plan will also specify what liquidity management events would need to be started if a predefined trigger event occurred.

Examples of events that can be considered triggers that identify the onset of a need from more liquidity are given below:

  • A decline in earnings
  • A deterioration in any measure of asset quality (e.g. an increase in the level of non performing assets)
  • An increase in the level of loan losses
  • A down grading by a rating agency
  • Increase in the spread paid for borrowed funds, asset securitizations, etc
  • Significant asset growth or acquisitions
  • Turndowns of borrowing requests
  • Legal, regulatory or tax changes

Such early warning indicators should merely trigger a heightened awareness of the evolving situation. Responses to them may be appropriately limited to

  • a special discussion of liquidity by the Asset and Liability Management committee of the board
  • a step up in the scope or frequency of liquidity reporting,
  • a review of contingent funding and available collateral,
  • a modest increase in liquidity mismatch cushions

Examples of events that can be considered triggers that identify later stages of a crisis are given below:

  • successive quarterly losses
  • levels of problem loans or loan losses that continue to grow
  • successive ratings downgrade
  • customers who used to pay for services with balances but shift to pay with fees are another important sign of declining confidence

Such triggers can be responded to by:

  • building up liquidity by specifying quantitative targets and deadlines
  • lengthening liability terms
  • new funding sources can be added
  • authorization of good relationship management and communications to deal with rumors
  • more frequent reporting
  • implement asset sales
  • trigger other contingent plans
  • aggressive measures to materially reduce or eliminate short-term and unsecured borrowings

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