Contingency Fund Planning (CFP).

After, Global Financial Crisis (GFC) outbreak in 2008- 2009, banking industry realized the importance of liquidity risk. Different regulators and stakeholders (Basel Committee, Central banks, etc.), Board of Directors (BOD) and Senior Management of financial institution (FI) focus on such risk especially they witnessed the fall of “too big to fail” FIs and banks (i.e. Lehman brothers, AIG, etc.). One of the tools, which was developed to manage liquidity risk, is Contingency Fund Planning (CFP).

What is Contingency Fund Planning (CFP)?

It is a framework which assists a financial institution to identify the main action plans, which should be taken, when it faces a liquidity shortfall (i.e. how to increase cash inflow (source of funds) at minimum cost, how to minimize the cash outflow; to fulfill financial obligation). CFP scope is handling high severity-low frequency liquidity risk incidents.?

CFP framework components are the following:

?? Governance and oversight:

o?? CFP should state the concerned stakeholders (i.e. Board of Director , Senior Management, corporate treasury, etc.)

?? Communication and coordination:

o?? CFP should state different aspects of communication strategies (i.e. escalation, coordination, reporting incidents, etc.) and how to communicate information on timely manner?

?? Policies and procedures:

o?? To define scope of CFP, to define the roles and responsibilities of each stakeholder, to conduct stress testing and the scenarios, to manage monitoring, escalation and reporting aspects. Such governance should be documented as well.

?? Testing CFP and assess its readiness:

o?? Periodically, CFP should be tested and assessed to ensure they are updated and mitigate the current and potential risks and CFP’s operation should be assessed as well.

?? Scenarios and liquidity Gap Analysis:

o?? Liquidity stress testing should be consistent with CFP to ensure FI’s liquidity situation is monitored and managed properly.

o?? CFP may contain additional stress tests to monitor FI’s liquidity limits and ensure they are effective and updated.

?? Contingent Actions:

o?? An institution should answer the following questions:

§? What if a liquidity shortfall takes place?

§? How would manage our bank’s liquidity?

§? How can we manage/preserve bank’s liquidity position?

o?? There are proposed contingent actions that should be included in CFP to answer the mentioned questions above and they are the following (but not limited to):

§? Increasing the pricing (interest rate) of saving accounts and other depository products – i.e. time deposits (TDs), certificate deposits (CDs), etc. – to attract clients to deposit proceeds at the bank and increase liquidity & cash inflow.

§? Increasing granting loans/credit facilities standards to reduce the velocity of cash outflow.

§? Selling liquid assets/investments.

§? Selling consumer loans and/or credit card receivables to Special Purpose Vehicles (SPV).

In other words, the main aim of Contingent Actions is increasing source of funds (issuing/borrowing funds from consumer through CDs, TDs, etc (aka. cash inflow)) and reducing or discouraging the demand of liquidity (issuing loans, etc. AKA cash outflow).

However, triggering contingent actions may send negative signals to other market participants (FIs, rating agencies, etc.). Accordingly, the consequence of triggering contingent action may lead to catastrophic reactions of other bank and may prevent to obtain valuable funds from other banks as follows (but not limited to): ?

?? Increasing cost of funds – when banks borrow from each other.

?? Rating downgrading and accordingly demanding additional collaterals.

?? Requesting additional margins.

?? Increasing roll-over risks.

Therefore, it is challenging for banks to balance between triggering contingent actions and avoiding the associated negative perception.

?? Monitoring and escalation: it is essential to monitor FI’s liquidity profile continuously to understand the possible impact of current liquidity events. It is done through observing different Marco-economic factors, Early Warning Indicators (EWI) and liquidity health measures. ?

o?? Marco-economic factors: for instance, changes in interest rates, FX, etc.

o?? EWI: for example, unexpected drop in stock market, downgrading, etc.

o?? Liquidity health measures: for instance, to monitor funding source concentration.

?? Finally, reporting & data: it is essential the data should be ready for use to report to the concerned stakeholders in timely manner.