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Financial Institution Letter Federal Deposit Insurance Corporation 550 17th Street NW, Washington, D.C. 20429-9990 FIL-84-2008 August 26, 2008 LIQUIDITY RISK MANAGEMENT Summary: The FDIC is issuing this guidance to highlight the importance of liquidity risk management at financial institutions. Liquidity risk measurement and management systems should reflect an institution’s complexity, risk profile, and scope of operations. Institutions that use wholesale funding, securitizations, brokered de
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    Federal Deposit Insurance Corporaonti 550 17th Street NW, Washington, D.C. 20429-9990  Financial Institution Letter FIL-84-2008August 26, 2008 LIQUIDITY RISK MANAGEMENT Summary:   The FDIC is issuing this guidance to highlight the importance of liquidity risk management atfinancial institutions. Liquidity risk measurement and management systems should reflect an institution’scomplexity, risk profile, and scope of operations. Institutions that use wholesale funding, securitizations,brokered deposits and other high-rate funding strategies should ensure that their contingency funding plansaddress relevant stress events. The requirements governing the acceptance, renewal, or rolling over ofbrokered deposits are applicable to all insured depository institutions. Distribution: FDIC-Supervised Institutions (Commercial andSavings) Suggested Routing: Chief Executive OfficerChief Financial Officer Related Topics: Part 337.6 of the FDIC’s Rules and Regulations -Brokered DepositsLiquidity Risk Management   Attachment: “Liquidity Risk Management” Contact: Kyle Hadley, Senior Financial Analyst, or (202) 898-6532 Note: FDIC financial institution letters (FILs) may beaccessed from the FDIC's Web site receive FILs electronically, please visit copies of FDIC financial institution lettersmay be obtained from the FDIC's PublicInformation Center, 3501 Fairfax Drive, E-1002,Arlington, VA 22226 (1-877-275-3342 or 703-562-2200).  Highlights: ã Recent disruptions in the credit and capital markets haveexposed weaknesses in liquidity risk measurement andmanagement systems. ã Institutions using liability-based or off-balance sheet fundingstrategies, or that have other complex liquidity risk exposures,should measure liquidity risk using pro forma cash flows/scenarioanalysis, and should have contingency funding plans. ã Contingency funding plans should incorporate events that couldrapidly affect an institution’s liquidity, including a sudden inabilityto securitize assets, tightening of collateral requirements or otherrestrictive terms associated with secured borrowings, or the lossof a large depositor or counterparty. ã The FDIC limits the use of brokered deposits by insuredinstitutions that are less than well capitalized, and also limits theeffective yield that these institutions may offer on all theirdeposits. These limits are set forth in Part 337.6 of the FDICRules and Regulations and should be incorporated incontingency funding plans. ã Contingency funding plans should outline practical and realisticfunding alternatives that can be implemented as access tofunding is reduced, including diversification of funding and capitalraising initiatives. ã Institutions that use volatile, credit sensitive, or concentratedfunding sources are generally expected to hold capital aboveregulatory minimum levels to compensate for the elevated levelsof liquidity risk present in their operations. ã Examiners will continue to evaluate an institution’s ability tomaintain access to funds and liquidate assets in a reasonableand cost-efficient manner in both normal and stressed markets.  Liquidity Risk Management This guidance describes the FDIC’s expectations for insured institutions thathave shifted from asset-based liquidity strategies (i.e., maintaining pools of highly liquidand marketable securities to meet unexpected funding needs) to liability-based or off-balance sheet strategies (i.e., funding partly through securitization, brokered/Internetdeposits, or borrowings). Increased use of liability-based and off-balance sheet strategieshas elevated the liquidity risk profile of some insured institutions and highlights theimportance of a forward-looking approach to liquidity planning. 1  For banks using liability-based or off-balance sheet liquidity strategies, traditionalmeasures of liquidity, such as the ratio of loans to deposits or non-core fundingdependency, may not provide an accurate view of the institution’s true liquidity position.Such institutions should augment traditional liquidity risk measures with pro forma cashflow and scenario analysis, and should have realistic contingency funding plans that areresponsive to changes in liquidity risk exposure. The FDIC expects institutions to useliquidity measurement tools that match their funds management strategies and thatprovide a comprehensive view of an institution’s liquidity risk. Risk limits should beapproved by an institution’s Board of Directors and should be consistent with theeasurement tools used.m Some institutions have underestimated the difficulty of obtaining or retainingfunding sources during times of financial stress. The terms associated with wholesaleborrowings (both secured and unsecured) can become more restrictive when aninstitution faces either real or perceived financial difficulties. Institutions that becomeless than well capitalized 2 may face limits on the ability to accept, renew, or roll overbrokered or high-cost deposits. 3 Institutions using securitization can face earlyamortization events resulting from market disturbances, deterioration in the institution’sfinancial condition, or the performance of securitized assets. These risks are morepronounced for institutions that have concentrated business lines or funding sources. Pro forma Cash Flows Institutions using liability-based or off-balance sheet funding strategies, that holdsignificant amounts of assets with cash flows that depend on choices borrowers can maketo prepay or extend their obligations, or that have off-balance sheet funding commitmentsshould use pro forma cash flow statements as part of their liquidity analysis. Otherinstitutions may also benefit from the use of pro forma cash flow statements when 1 Institutions should refer to the FDIC’s existing supervisory guidance and examination procedures regarding soundliquidity risk management found in the FDIC’s Risk Management Manual of Examination Policies, Section 6.1 –Liquidity (February 21, 2005). The evaluation factors for rating liquidity are described in the Uniform FinancialInstitutions Rating System (UFIRS) (December 19, 1996).   2 For purposes of these restrictions (established under part § 337.6, of the FDIC’s Rules and Regulations) the terms Well Capitalized, Adequately Capitalized, and Undercapitalized  shall have the same meaning as to each insureddepository institution as provided under regulations implementing Section 38 of the Federal Deposit Insurance Act. 3  The  Joint Agency Advisory on Brokered and Rate-Sensitive Deposits , May 11, 2001, reminds institutions that risk management systems must be commensurate in complexity to the liquidity and funding risks faced by an institution.   1  managing liquidity risk. Pro forma cash flow analysis shows the institution’s projectedsources and uses of funds under various liquidity scenarios, identifying potential fundingshortfalls or gaps. Institutions should work to limit these exposures, should report theexposures to the Board of Directors, and should have plans established to addresssignificant potential funding shortfalls. Such analysis and reporting should becommensurate with the complexity of the institution’s liquidity risk profile.Management’s pro forma cash flow analysis should incorporate multiple scenarios thatconsider the general and unique risks faced by an institution.Assumptions used in pro forma cash flow projections should be reasonable andappropriate. Assumptions should consider a wide range of potential outcomes withregard to the stability of both retail and larger deposits, brokered deposits, public funds,borrowings, Internet deposits, and the retention rate of funds obtained through depositspecials. Institutions that rely on securitization should perform sensitivity tests tomeasure the effects that material changes to assumptions would have on related accounts. Contingency Funding Plan (CFP) Funding decisions can be influenced by unplanned events. Such events include,but are not limited to, the inability to fund asset growth; difficulty renewing or replacingfunding as it matures; the exercise of options by customers to withdraw deposits or todraw down lines of credit; legal or operational risks; the demise of a business line; andmarket disruptions. Funding and investment strategies that are concentrated in onebusiness line or relationship typically are at greater risk of being disrupted by adverseevents. Institutions should examine contracts and arrangements associated with majorlines of business and funding sources to identify low-probability/high-impact events thatcould adversely affect liquidity. Institutions should work to minimize exposure to suchevents and should have plans in place that incorporate practical solutions that can beadopted quickly to address such contingencies should they arise.The CFP should be customized to the liquidity risk profile of the institution andidentify the types of stress events which may be faced. Possible stress events mayinclude a change in credit rating, a deterioration in asset quality, becoming less than wellcapitalized, funding unplanned asset growth, the loss of access to market funding sources,recognizing operating losses, suffering negative press coverage, or other events that maycall into question an institution’s ability to meet its obligations. The overall impact of agiven stress event should be considered, including both direct and indirect effects.Institutions that rely on liability-based and off-balance sheet liquidity strategiesshould ensure that their CFP includes the following: ã   Defines responsibilities and decision-making authority so that all personnelunderstand their role during a problem-funding situation. ã   Includes an assessment of the possible liquidity events that an institution mightencounter.2  ã   Details how management will monitor for liquidity events, typically through stresstesting of various scenarios in a pro forma cash flow format. ã   Assesses the potential for triggering restrictions on the bank's access to brokered andhigh-cost deposits and the effect on the bank's liability structure. ã   Identifies and assesses the adequacy of contingent funding sources. The plan shouldidentify any back-up facilities (lines of credit), the conditions and limitations to theiruse, and the circumstances where the institution might use such facilities.Management should understand the various legal, financial, and logistical constraints,such as notice periods, collateral requirements, or net worth covenants that couldaffect the institution's ability to use back-up facilities.CFPs are particularly important in institutions that rely on securitization or othersrcinate-to-distribute business models. Particular attention should be directed toscenarios where securitization or asset sales become rapidly unavailable. Securitizinginstitutions should also have plans in place to address: ã   Disruptions in the capital markets that would result in delayed sales of receivables/loans. ã   Increased volume of putbacks. The monitoring of this risk should becommensurate with the nature of assets sold or securitized. ã   Required increases in retained interests and other credit enhancements. ã   Early amortization events. Restrictions on the Use of Brokered and High-Rate Deposits CFPs should account for the limitations set forth in Part 337.6 of the FDIC’s Rulesand Regulations for both brokered and high-rate deposits, specifically that these limitscan result in deposit run-off. In particular, institutions falling to adequately capitalized 4  must obtain a waiver from the FDIC in order to use a deposit broker, and institutions thatbecome less than adequately capitalized are precluded from using a deposit broker. Inaddition, all institutions that are less than well capitalized are precluded from offeringdeposit interest rates that are significantly higher than the prevailing rates in theinstitution’s normal market area or the national rate, as may be appropriate.Individuals responsible for managing a bank’s liquidity should be familiar with allaspects of the applicable restrictions and limitations set forth in the FDIC’s rules andregulations. If a bank uses a deposit broker or pays above normal interest rates to attractdeposits, or plausibly could become less than well capitalized, it is important formanagement to be aware of whether the Part 337.6 brokered deposit restrictions andinterest rate limits could constrain its ability to attract deposits and plan accordingly.CFPs should address the potential ramifications that reduced capital levels could have onthe institution’s ability to use brokered and high-cost deposits. 4Including those reclassified as adequately capitalized for being subject to a written agreement, order to cease anddesist, capital directive, or prompt corrective action directive which includes a capital maintenance provision.. 3
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