Already in 2008, the ECB published a report on EU banks’ liquidity stress testing and contingency funding plans, offering market insights on how often institutions conduct dry runs. The report revealed that while large institutions typically executed annual dry runs, medium-sized and smaller institutions tended to “never test” their contingency funding plans (CFPs), also known as liquidity contingency plans. A wide variety of practices was found in terms of frequency, objective, scope, scenario design and horizon, length of the dry run and other operational aspects.

Fast-forward to 2016, the EBA guidelines take the expectations of stress testing and contingency funding plans to a far more sophisticated level. However, the guidelines do not specify the preferred frequency for conducting a dry run. They only state: “evidence on the regular testing of the liquidity contingency plan”. Past crises, both market-wide shocks and bank-specific experiences, have nevertheless shown that banks clearly benefit from a dry run as a fundamental element of liquidity contingency planning.

Eight years further down the road, in 2024, we observe that after some regional banking crises in the US and Switzerland that shook the market early last year, institutions are again increasingly focusing on dry runs and improving their contingency and recovery practices in general. This increased attention is without any doubt also influenced by the publication of the ECB's 'SSM supervisory priorities for 2024-2026', in which strengthening the asset and liability frameworks around liquidity & funding risk and IRRBB/CSRBB is a clear #1 priority.

In this blog, we would like to present our insights on and approach to designing and executing liquidity contingency dry runs and elaborate on how institutions can benefit from this. 

Design: what to test?

As the initial step to design the scenario, consider using the typical matrix to plot liquidity risks: (1) How fast or slow is the stress unfolding? and (2) Is it a market-wide stress or is it just happening to your institution? Most institutions (irrespective of their size) use this concept to identify their view on 'risk of liquidity', and consequently their mitigation measures. Any dry run thus needs to include consideration of the scenario that is to be tested. Our recommendation is to plan multi-year dry runs to address different relevant scenarios individually over time.

Any risk-inducing event will trigger breaches of early warning indicators (EWIs), provided they are well defined, and this in turn will trigger an escalation process to determine whether activation of the contingency funding plan is needed or not. Assuming a sufficient level of severity, the Crisis Management Team (CMT) will assemble, following a dedicated escalation process as defined in the CFP. Testing the ability to escalate and to come together in a timely manner (i.e., the response time) is fundamental.

After the stress event has been triggered and once the CMT is convened, the game is on. It is strongly advised to establish the rules of the game (e.g., the way of working, involvement of underlying teams, communication channels, logistics and IT, breakout rooms, et cetera) upon start, as well as to define clear boundaries such that the exercise progresses as designed, so it can be properly evaluated. 

A liquidity contingency dry run has multiple angles, and so it can be assessed from many perspectives. It is important to agree upfront on what angles are to be tested, without revealing any details on this (or on the actual scenario) to the actual dry run participants. Below, we list some:

  • EWIs, escalation and convening the CMT: The EWI panel has to maintain the right balance between quantitative and qualitative indicators in order to identify, for instance, social media rumor storms driving reputational damage and consequently bearing direct impact on the liquidity position. Employees need to be trained to identify EWIs, perform an initial assessment, apply the four-eyes principle controls and timely escalate and activate the CMT.

  • The CMT dynamic: While the dynamic often differ across institutions (e.g. proactive vs reactive, hierarchical vs flat structure, constructive vs accusatorial, agile vs bureaucratic, etc.) it plays a pivotal role in ultimately shaping the response. Role clarity, hands-on and decision-making capabilities, ability to facilitate and steer discussion and make formed decisions are for example essential factors in this dynamic.

  • The ability to obtain and present data: In an ad hoc, fast-moving environment, it is crucial to streamline the request and reception of updated information in real time. The information needs to be requested clearly, processed timely, and brought to the right level for it to be useful during CMT discussions (C and C-1 level). Whether it is of a technical nature (e.g., LCR, liquidity buffer, outflow rate, asset encumbrance ratio, et cetera) or of a reputational nature (e.g., media articles and press releases, social media activity, rating agencies communication, et cetera), it must be clear how data should be presented to ensure consistent and informed decision-making. 

  • The understanding of the CFP and how to execute the CFP in terms of deciding upon countermeasures: Clearly, this is at the core of the response, but it is surprisingly difficult to consider in a real dry run set-up. How fast can we sell off securities? Can we timely request emergency lines? How fast can we pledge additional collateral? Did we agree on taking any losses during sell-off? 

  • Communication: Both internal (e.g., What employees need to be informed of the ‘new reality’? and Which guidelines can be used to ensure consistency throughout the organization?) and external (e.g., How are supervisory board members, shareholders, regulators, market participants, customers and media addressed? and What is communicated, when, and via what channels?). Additional considerations, such as external legal advice or disclosure restrictions, need to be clear from the beginning. 

A crucial aspect of the design, which influences the aforementioned points, is the dry run set-up. Depending on CMT availability, desired complexity, and budget, dry runs can span from three to four hours to two to three days of dynamic events and changes of direction. Longer configurations typically allow for more realistic simulations, where concrete measures can be more thoroughly reproduced and tested (e.g., executing specific transactions, moving balances from/to different cash accounts, steering outflow payments, requesting emergency lines to the central bank, et cetera).

Typical weaknesses

During recent dry runs, KPMG has identified several weaknesses. Some of the most common ones are:

  • Lack of predefined, standardized templates and layouts to support different areas during execution (e.g., communication, available information, decision-making process, et cetera)

  • Missing information and contact details from key internal/external parties

  • Unclear end-to-end communication protocols (both internal and external)

  • Suboptimal means of presenting data and information for decision-making

  • Insufficient and/or uncoordinated involvement of underlying teams in operational tasks

  • Lack of knowledge/practical experience when facing extreme and potentially backfiring choices upon getting closer to the recovery and/or resolution realms

  • Overlaps or missing linkage to other emergency plans in the bank, in particular to the recovery plan 

Playing the game is nerve-wracking, requires trust in yourself and your fellow CMT members, and might expose weaknesses in your own ability to timely acquire relevant knowledge from your own departments. Therefore, it is crucial to note that a dry run is designed to detect these points of improvement.

Being part of a dry run helps you and your team members to be better prepared. The dry run informs you on many of the elements that are written down in your CFP, but in a way that might need adjustment. The wild dynamic of a liquidity crisis can never be fully anticipated, nor perfectly managed. However, testing your plan and your own ability to respond is something that can be done and adds considerable value in the form of experience and confidence.

How KPMG can help

We strongly recommend that you engage an external party to assist you with your dry run. KPMG has an international team with proven experience and offers a comprehensive approach, which encompasses the design, facilitation, execution and assessment phases, and which creates a custom-made simulation with realistic outputs that are objectively assessed. We support institutions and provide relevant market insights and best practices from professionals combining experience in consulting institutions such as yours, and inside knowledge from regulatory bodies.

In conclusion

Testing your ability to act promptly and implement your contingency plan effectively is not only a regulatory obligation, but also essential for being thoroughly prepared for the unforeseen eventuality we hope never to be part of. Taking the dry run seriously often brings improvement to your contingency funding plan, clarity to your roles, and boosts capabilities and confidence. We all hope it remains 'just a dry run', but being prepared by conducting the exercise on a periodic basis is much better than being sorry.