Liquidity & funding risks: Turbulent times

April 2023

Not only behind the background of recent events, liquidity and funding risks are one of the fundamental categories of risk facing any bank, alongside credit risk, market risk and operational risk. Managing liquidity risk is a key element of everyday banking practice, but it tends to drop off the agenda of banking leaders — and supervisors — when financial markets are stable and external funding is readily available at affordable rates.

The experience of recent years illustrates this well. With super-accommodative monetary policy flooding global markets with cheap liquidity, banking leaders focused much of their attention on pandemic-related credit risks, cyber threats, weak profitability and emerging climate-related risks.

Recent events amid the banking crisis fallout have changed that, as inflation and base rates climb and financial market liquidity tightens. The gradual withdrawal of TLTRO III1 or even sudden and co-ordinated withdrawal of deposits could also cause significant disruption to banks’ current funding patterns. Despite the current fears in the market, now more than ever, it is integral for global banks to revisit stress test scenarios.

This situation creates two connected sets of challenges for banks.

First, banks face economic risks from the withdrawal of TLTRO III and the tighter liquidity outlook. These include rising funding costs, greater exposure to market volatility, and the need to develop alternative sources of funding.

Second, banking supervisors are increasingly focused on liquidity-related risks. Funding risk has been identified within the European Central Bank’s (ECB) top three supervisory priorities for 2023-25, and highlighted as a key focus in a recent keynote speech by Andrea Enria, Chair of the Supervisory Board of the ECB. Key planned supervisory activities on the topic include:

• Conducting targeted reviews of Targeted Longer-Term Refinancing Operations (TLTRO) III exit strategies for selected banks with a material reliance on this source of funding;
• Reviewing banks’ broader liquidity and funding plans, with targeted on-site inspections (OSIs) where appropriate; and
• Following up on any findings to verify the existence and execution of adequate remediation plans.

How should banks respond to these interrelated challenges? We see four key priorities.

First and most importantly, banks should ensure they have a robust and holistic funding plan in place. A holistic funding plan is not just an economic necessity. It is key to helping to optimise the Internal Liquidity Adequacy Assessment Process’s (ILAAP) influence on Supervisory Review and Evaluation Process (SREP) scores, and to minimise the chance of negative findings arising from future OSIs.

A robust funding plan should do more than bridge the gap between current funding and anticipating lending plans. It should establish a consistent, joined-up framework that includes all assets and liabilities, covering different maturities and currencies, and tested against a range of potential scenarios. Banks should conduct a gap analysis against regulations and best practice, then develop an action plan to remedy any potential weaknesses.

The next three priorities are more specific. Banks should:

• Diversify their funding sources, developing a range of options that can avoid excessive concentration and mitigate any over-reliance on central bank funding.
• Challenge previous assumptions over the future stability and availability of consumer deposits as a source of funding in light of recent events.
• Increase scrutiny of the links between funding models, lending plans and profitability projections to develop a better understanding of the implications for profitability of an altered funding environment.

In addition, banks should understand that a clear, aligned enterprise-wide framework for funding governance and oversight is a prerequisite for achieving an effective, holistic view of liquidity and funding risk.

In current markets, there is a strong economic rationale for all of these steps. However, banks should also consider how they can leverage their actions to strengthen regulatory compliance and meet enhanced supervisory expectations. That might include strengthening the internal harmonisation between parallel workstreams, or ensuring consistency when simulating liquidity metrics like the liquidity coverage ratio (LCR) or net stable funding ratio (NSFR), and capital ratios like minimum requirement for own funds and eligible liabilities (MREL) or total loss absorbing capacity (TLAC). Communicating proactively with joint supervisory teams (JSTs) about planned measures to improve liquidity and funding management can also be beneficial.