Contingency Funding Plan: Banking Busywork or Essential Management Tool?
by Rachel Bryant, CFA, Capital Markets Examiner, Federal Reserve Bank of Atlanta
A contingency funding plan (CFP) is, at its core, a liquidity
crisis management instrument. The document is prepared as
a directive for a future emergency and stands ready to be referenced,
someday, as a response plan and potential forecast
of how a distant liquidity event may unfold. But then, the
scenarios presented in the CFP may not occur. The next liquidity
crisis may be an event that not a single bank management
team could have ever imagined. After all, clairvoyance
is not typically listed as a required banking skill.
Luckily, the objective of the contingency planning process is not to predict the future. Rather, the CFP’s great value lies in its utility both as a crisis management document and a regular deep dive into the bank’s liquidity profile. As an assessment tool, the contingency planning process provides additional insight into the community bank’s liquidity strengths and weaknesses beyond the bank’s normal reporting activities. In this role, the CFP serves as a comprehensive evaluation, similar to a person’s annual health examination, which complements ongoing asset/liability monitoring. This endeavor can provide new risk mitigation knowledge that management can use to protect the bank both in an emergency and in the day-to-day competitive arena.
Even without the additional benefit as a risk assessment tool, establishing a rainy-day plan is a worthy exercise on its own. Of course, bank management teams do not intend for their banks to experience severe distress or, more tragically, failure. However, liquidity events can materialize in a variety of unexpected ways. For instance, a correspondent bank may go out of business, a terrorist attack may disrupt the payment system, or the primary employer in the bank’s hometown could decide to relocate. If the bank has an established CFP with descriptive roles, responsibilities, and action plans, management will be better prepared to execute a controlled response to unforeseen stress events. Further, scenario analysis may identify an undesirable liquidity position before a crisis begins.
Supervisory guidance provides direction for creating and maintaining a CFP. Federal Reserve SR Letter 10-6, "Interagency Policy Statement on Funding and Liquidity Risk Management," is akin to a CFP handbook because nearly half of the letter is devoted to the topic of CFPs.1 Real-life liquidity crises reveal the importance of this supervisory guidance.
Contingency Funding Plans in Action
In 2011, a community bank that appeared to have ample
liquidity and stable funding nearly failed because of a run on
deposits. The bank had been in business for over 15 years,
was active in the community, and enjoyed a solid reputation.
However, after an erroneous media report indicated that
closure of the bank was imminent, a significant volume of deposits
was withdrawn in four days. Operating cash was nearly
depleted, and depositors were frenzied.
Fortunately, the bank had an effective CFP, which helped mitigate the crisis. Responsibilities were clearly outlined, and each team member executed his or her role as planned. Communication lines remained open within the bank and with the community. Senior management officials talked with large depositors to quell fears, and a designated individual responded to inquiries from local news reporters with a calming and informative message.
As reputational risks were addressed, management monitored the inherent liquidity position closely. Informational reporting systems permitted continuous analysis of the bank’s liquidity with increased reporting frequency. Management had also preestablished access to the discount window and Federal Home Loan Bank (FHLB) advances, which was particularly beneficial because the registration process can take weeks. These sources provided critical liquidity backstops that aided in navigating the temporary funding crisis and allowed the bank to emerge successfully.
Around this same time, the directors at another community bank met late into the night. The bank had battled credit deterioration for months; liquidity was not previously a concern. Rate-hungry brokered depositors had been abundant and lined up to put money into the bank, not take it out. But lately, brokered depositors were no longer the abundant liquidity source they once were. The mounting credit losses were becoming more publicly known, and core depositors were growing concerned with the eroding capital and margins. The growth in volatile funding sources escalated an otherwise credit-related problem into a liquidity crunch. Core depositors wanted their money back, and even assurances of Federal Deposit Insurance Corporation (FDIC) coverage were not persuading all of them to stay.
A liquidity squeeze was under way, and the directors wanted explanations as to why conditions were continually worsening. After all, the bank had a CFP.
Yes, the bank held a document that was titled "Contingency Funding Plan." But without key components, the CFP failed to serve as an operational guide. The plan lacked the necessary descriptions of roles and responsibilities, action plans, and alternative funding sources. Questions arose that could have been addressed beforehand in the CFP: Who is responsible for raising funds, and what approvals are needed? Which funding alternatives should be pursued first? Who will initiate intraday liquidity reporting? Who will speak to customers, and what will the message be? While the bank did present quantitative projections in its CFP, the plan lacked essential qualitative guidance.
Further, the quantitative projections were not employed as risk assessment tools. Among other benefits, the CFP’s quantitative component should serve as a risk appraisal that identifies how various assets and liabilities may react to stress. But in this case, the ensuing liquidity event was not identical to any of the projected scenarios. Management therefore concluded that the CFP could not be implemented and put it aside when specific events captured in the document did not occur.
Liquidity became a critical safety-and-soundness concern; the bank’s viability was in danger. Management strived to restore funding capability, but by this point, sources were scarce. Their efforts failed, and FDIC receivership was the final result. A CFP that contained all the major elements as set forth in supervisory guidance may have helped the bank avoid this outcome.
Building a Quality Community Bank CFP
Fundamentally, a CFP is a bank’s battle plan as well as a primary tool for assessing liquidity risk. A CFP uncovers cross-exposures, funding concentrations, and operational strengths and weaknesses, which are beneficial pieces of information in any environment. Supervisory guidance is clear about the need for a CFP at every institution. SR Letter 10-6 states, "All financial institutions, regardless of size and complexity, should have a formal CFP that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations."
SR Letter 10-6 further emphasizes that a complete CFP consists of both quantitative and qualitative components. This means that numerical projections must be accompanied by a qualitative narrative so that everyone understands how to react in a stressed environment. Projections are decidedly important, but the actual step-by-step process for carrying out the projections needs to be detailed as well. These steps may not be so obvious when a crisis is on the bank’s doorstep.
The Qualitative Components of a Complete CFP
When firefighters combat a raging fire, not every person in the truck blitzes the burning building. Someone needs to manage the hose. The ladder will not raise itself. Victims probably should not be left to sit alone. Roles and responsibilities are clarified before arrival to avoid chaotic action or, just as perilous, crippling indecision. In the same manner, bankers should consider the qualitative description of roles and responsibilities as one of the most critical components of the bank’s CFP.
Some bankers assume that these roles are simply understood. The bank has a treasurer; therefore, that person will take care of the problem. But will the treasurer speak to the press as local news crews start calling? Will he or she stand in the lobby and talk to panicked depositors? Will this person also sit outside the vault and meticulously count cash? One person or even one department cannot control a liquidity crisis. The CFP should span the full institution and provide for a comprehensive crisis management team with clearly defined roles. Action plans and the assignment of responsibility for carrying out these plans should be realistic and formalized in writing.
A CFP should identify all material contingent liquidity sources and discuss the order in which these alternatives will be pursued. Certain sources require that legal agreements be set up in advance (e.g., FHLB advances and the discount window). Others may become prohibitive as the bank’s level of pledged assets approaches maximum levels and no more liquid assets can be spared. Collateral calls can also strain access to some funding sources because market devaluations may reduce the value of a given pledged asset and trigger the need for additional collateral. In identifying funding sources, the narrative should address potential barriers, such as these, to accessing funding alternatives.
Similarly, the CFP should not assume that all contingent liquidity will come from one source. Funding diversification is not only a worthy goal but is also a forced outcome in a crisis. To assume otherwise would ignore the reality that liquidity pressures tend to spread from one funding source to others. The CFP document should discuss multiple funding options and avoid undue concentrations.
Quantitative Analysis and Support
Scenario analysis and the CFP are fundamentally linked. Contingent liquidity events should be simulated to inform management’s views of liquidity exposures before an event occurs. The purpose of this exercise is not to create a numerical prophecy of exactly what a contingency event will look like and exactly how assets and liabilities will be affected to the dollar. There are many possible stress scenarios, but the CFP projects only a tiny subset of this universe. Bankers should not toss the CFP aside just because it envisages events that are different from the one currently occurring. Reality often differs from projections. Scenario analysis is worthwhile because it requires management to go through the steps of considering how each asset and liability might behave in a disruption. Possible side effects are also exposed because changes in one asset or liability class may affect other areas of the balance sheet. Scenario analysis can reveal an undesirable liquidity position and give management the opportunity to address it before a crisis develops.
In choosing scenarios and accompanying time horizons, the CFP should consider a range of events. A proper CFP includes considerations for short-, intermediate-, and long-term scenarios, as well as idiosyncratic and market-wide events. Liquidity risk is not limited to the possibility of a five-day run on the bank; rather, liquidity stress can span many months and take many forms. Bank management should consider events that best reflect the institution’s business activities, operations, and liquidity risk exposures. While supervisory guidance encourages banks to create their own scenarios, SR Letter 10-6 specifically calls for all institutions to consider certain cases, such as losing well-capitalized status and subsequently having to meet prompt corrective action (PCA) limits. Management should incorporate this consideration into the CFP.
When projecting the chosen scenarios, assumptions can make or break the analysis. Outrageously optimistic assumptions are not the primary danger because farfetched assumptions can be easily spotted and corrected. Instead, contradictory assumptions are the less obvious sources of weakness in otherwise healthy CFPs. Assumptions should be mutually supportive. For example, if the scenario simulates a reputational crisis, projections should not assume an increase in core deposits. If the bank might lose its well-capitalized status, brokered deposit assumptions should not be made as if PCA rules do not exist. Scenarios assuming market disruptions should not ignore the likelihood of decreased collateral values and impending collateral calls. Scenarios depicting deposit erosion should also consider deposit mix changes. Furthermore, SR Letter 10-6 notes that assumptions should be documented, reviewed, and formally approved.
Triggers are another important element of the CFP. The best CFPs recognize that bank management is not psychic. A crisis day will likely begin like any other. No one will call and warn the bank’s management team that a liquidity event will begin at noon, last for one week, and conclude on Friday. Normal market corrections happen, as do seasonal decreases in deposits. How will management know if today’s event warrants implementing the CFP? There is no way of knowing with perfect foresight that the projected scenarios are actually happening. Thus, early warning indicators are crucial in monitoring potential liquidity problems and enacting the CFP with appropriate timeliness. Like a stoplight, changing conditions first trigger "yellow" warning levels and prompt appropriate mitigating actions. If conditions continue to deteriorate, indicators move into "red" status, prompting further mitigation. These predetermined and objective triggers avoid the possibility that the CFP will be implemented too late.
Finally, the CFP should not neglect reporting needs. The document should describe the type and frequency of reports that will be delivered to key personnel in a crisis. Liquidity reports in a normal environment are usually delivered according to a schedule, perhaps biweekly. However, regardless of the bank’s complexity, management should have the ability to increase the frequency of liquidity reporting quickly if a stressful event occurs. The bank may have an otherwise excellent CFP in place, but without swift and responsive reporting, management may not fully know how a liquidity crisis is affecting the institution and therefore how to implement the CFP.
Updating and Maintaining a CFP
A CFP is not a one-time project to be retired to a desk drawer until a liquidity problem arises. Like a business continuity plan, the bank’s CFP merits revisiting on a regular basis.
As a first step, community banks should expect their board of directors’ involvement. While the board may not create the CFP, the directors should understand and periodically review the full document. At a minimum, the CFP should be reviewed annually, with the stipulation that certain conditions may warrant more frequent review.
Management should also periodically test the operational components of the CFP, including documentation, procedures, and access to contingent liquidity sources. Management may consider enacting the full plan in a practice drill. Some institutions schedule this type of testing before the annual presentation of the CFP to their board, which allows the bank to strengthen the CFP before the directors’ review. However, if employees know the drill is coming, they will understandably take steps to prepare and perhaps shore up documentation or operational practices that otherwise would have been revealed as weaknesses in a true crisis. Therefore, bank management should choose the testing period wisely and discreetly. Additionally, some circumstances may merit unscheduled testing if, for example, management can feel the rumblings of an impending economic disturbance. Proactive testing is effective preventive medicine.
Realistically, it may be impossible to test every component of the CFP; for example, fully testing the liquidation of assets is not viable. However, the bank can test the operational process for liquidating the assets, just as it should test the other elements of the CFP. Testing should ensure that contingent liquidity lines have been established and are quickly accessible. Participating bank employees should understand their roles without needing excessive guidance during the liquidity event. Management should validate that legal and operational documentation is in place where needed and confirm the mobility of cash, collateral, and other assets as called for in the CFP.
Testing may conclude with results that are not pretty. Ultimately, the purpose of testing is to uncover weaknesses, holes, or inefficiencies so that any glitches may be addressed forthrightly. Conversely, the board of directors should be wary of annual testing that does not unearth a single opportunity for improvement. As any athlete would concur, practicing once a year is unlikely to result in perfect performance. Also, a lot can change in a year, and testing will help identify how the CFP should evolve to complement the bank’s development.
The Value of a CFP
In banking, liquidity risk offers a fast path to trouble. Deterioration
in asset quality may be the most common banking
affliction, but the ensuing decline normally transpires over a
long period of time. Poor liquidity management, however, can
sink the bank quickly with only a small push in the wrong
direction. A CFP is valuable because the acts of building and
maintaining it provide a continually updated risk assessment
tool in addition to a crisis control guide. Documentation for
the sake of documentation is not the goal. Community banks
should embrace the contingency planning exercise as an opportunity,
and the board and senior management will hopefully
sleep better at night knowing that the bank is protected
with a quality CFP.
- 1 SR Letter 10-6 is available at www.federalreserve.gov/boarddocs/srletters/2010/sr1006.htm.