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Liquidity Risk Management

"...satisfying liquidity needs in the most cost-effective way possible and without unduly sacrificing income potential..."

Liquidity Risk Management

Risk Management Manual of Examination Policies

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Section 6.1 - Liquidity and Funds Management

Last Updated 02/21/2005 supervision@fdic.gov

Introduction

Liquidity represents the ability to fund assets and meet obligations as they become due. Liquidity is essential in all banks to compensate for expected and unexpected balance sheet fluctuations and provide funds for growth. Liquidity risk is the risk of not being able to obtain funds at a reasonable price within a reasonable time period to meet obligations as they become due. Because liquidity is critical to the ongoing viability of any bank, liquidity management is among the most important activities that a bank conducts.

Funds management involves estimating and satisfying liquidity needs in the most cost-effective way possible and without unduly sacrificing income potential. Effective analysis and management of liquidity requires management to measure the liquidity position of the bank on an ongoing basis and to examine how funding requirements are likely to evolve under various scenarios, including adverse conditions.

The formality and sophistication of liquidity management depends on the size and sophistication of the bank, as well as the nature and complexity of its activities. Regardless of the bank, good management information systems, strong analysis of funding requirements under alternative scenarios, diversification of funding sources, and contingency planning are crucial elements of strong liquidity management.

The adequacy of a bank's liquidity will vary. In the same bank, at different times, similar liquidity positions may be adequate or inadequate depending on anticipated or unexpected funding needs. Likewise, a liquidity position adequate for one bank may be inadequate for another. Determining a bank's liquidity adequacy requires an analysis of the current liquidity position, present and anticipated asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs, and options for reducing funding needs or obtaining additional funds.

To provide funds to satisfy liquidity needs, one or a combination of the following must occur:
  • Disposal of assets.
  • Increase in short-term borrowings and/or issuance of additional short-term deposit and deposit-like liabilities.
  • Increase in long-term liabilities.
  • Increase in capital through earnings, capital injection, stock issuance, or issuance of other capital instruments.


Liquidity has a cost, which is a function of market conditions and the risk profile of the bank. If liquidity needs are met through holdings of high quality short-term assets, generally the cost is the income sacrificed by not holding longer term and/or lower quality assets. If funding needs are not met through liquid asset holdings, a bank may be required to incur additional liabilities, possibly under adverse market conditions at an undesirable cost.

**Regulatory/Statute and Regulations Codified Bank Secrecy Act § 103.120 31 CFR Ch. I (7–1–06 Edition)*