Managing a credit union comes with its rewards and challenges. And in today’s market, one of the most prevalent challenges is managing the various types of risk credit unions face. There’s credit risk, interest rate risk, concentration risk and reputation risk – just to
name a few. However, one particular risk factor that has loomed in the distance, but is now quickly moving up the ranks, is liquidity risk.
Liquidity risk is the danger that a financial institution may be unable to meet short-term financial demands. This usually occurs when a security or hard asset can’t be converted to cash without losing capital and/or income in the process. Liquidity is an inherent concern for most credit unions. At times, you may need to transform the maturity structure of deposits into loans, which in itself, creates a liquidity vulnerability. Additionally, members can demand their deposits back at any time, and your credit union has to be able to fund those withdrawals. How do you prepare for such scenarios? With an up-to-date liquidity policy and a robust contingency funding plan.
As of March 2014, the NCUA requires every federally-insured credit union to have a liquidity policy in place to help measure, monitor, and manage its liquidity and liquidity risk. In addition, all federally insured credit unions with assets over $50 million must have a formal, written contingency funding plan. The NCUA suggests, however, that this is a sound practice for all credit unions, regardless of size.
A contingency funding plan helps ensure that your credit union can manage routine and unexpected fluctuations in liquidity. As an integral component of your overall risk management plan, it is also useful for:
- Helping management monitor liquidity risk
- Ensuring the appropriate amount of liquid assets is maintained
- Measuring and projecting funding requirements during various scenarios
- Managing access to funding sources
In addition to your regulators’ requirements, you may want to consider the following when creating or updating your credit union’s contingency funding plan:
- Specify comfortable liquidity levels.
- Set funding limits and subsequent actions when those limits are met.
- Address and implement alternative funding sources and assess their adequacy in contingency situations.
- Identify and test any back-up facilities (lines of credit or issuing requirements). Match potential sources with uses of funds.
- Establish indicators or triggers that alert management when a predetermined level of potential risk is reached.
- Identify and outline specific risk tolerances.
- Analyze and project quantitatively all significant on- and off-balance sheet flow of funds and their related effects.
- Identify the sequence in which sources of funds will be used for contingency needs. The uncertainty of the magnitude and timing of available resources may call for different priorities in different situations.
- Accelerate the timeframes for reporting – such as daily cash flow schedules– during a liquidity shortage.
- Include an asset tracking system that monitors which assets are immediately available for pledging or sale and how much a cash sale of these assets will generate.
- Establish a proactive risk management culture, starting with your management team and board members. Define responsibilities and decision-making authority, so that all personnel understand their role during a problem-funding situation.
The objective of the contingency funding plan is not to predict the future. Rather, the great value of such a plan is its dual functionality as both a crisis management document and an in-depth liquidity profile evaluation. As an assessment and action tool, the contingency planning process provides additional insight into your credit union’s liquidity strengths and weaknesses, which complements ongoing asset/liability monitoring efforts.
In a crisis situation, management has little time to plan its strategy, so it’s imperative to have a well-developed contingency funding plan in place. Services such as Catalyst Corporate’s liquidity stress analysis can help your credit union test your plan by projecting and identifying liquidity shortfalls across various stress scenarios.