Prepare for Continued Regulatory Scrutiny of Liquidity Management

Regulatory pressure surrounding liquidity continued in 2024, driven primarily by low on balance sheet liquidity and higher reliance on non-core funding. Last January, the NCUA released an Advisory letter on Liquidity Risk Management and many of ALM First’s clients reported increased focus on liquidity risk management during recent regulatory examinations.

Is Relief Coming in 2025?

This trend of increased regulatory scrutiny is likely to continue in 2025. Industry wide liquidity metrics improved modestly in 2024; however, on balance sheet liquidity continues to be pressured by monetary policy (high rates), a competitive deposit landscape and strong loan demand.

The failure of Silicon Valley Bank (SVB) also remains a relevant topic and weaknesses in SVB’s risk management framework have shined a light on risk management around liquidity and interest rate risk at institutions of all sizes. This is an event that bank and credit union regulators will not forget anytime soon.

Although liquidity did improve within the industry, significant increases in liquidity, particularly when compared to pandemic levels, are unlikely. Higher interest rates are making for more competitive deposit pricing as savers have more options, a stable economy is driving continued loan opportunities and a lack of liquidity improvement will likely keep regulatory focus on liquidity risk management.

Through our work with hundreds of clients nationwide, we’re able to pinpoint industry trends and assist credit unions as they review their internal practices to ensure they are prepared for increased regulatory scrutiny in this risk area.

Common liquidity risk management examination findings seen in 2024 included:

Lack of, or insufficient frequency of liquidity stress testing;
Inadequate support for liquidity stress testing assumptions;
Need for policy limits around on-balance sheet liquidity, balance sheet leverage and available contingent funding;
Contingency Funding Plans that are supportive to the institution’s management of liquidity; and
Lack of, or insufficient short term (30-, 60-, 90-day) cash flow projections.

How Can Institutions Avoid Increased Regulatory Scrutiny?

The January 2024 Advisory letter highlighted the key pillars of liquidity risk management, all of which are already reflected in regulation and existing official regulatory guidance. Although no new regulatory requirements were issued, the letter contained valuable reminders for an effective liquidity risk management program, all of which remain applicable today and include:

Cash flow forecasting and backtesting;
Asset composition;
Structure of liabilities;
Liquidity risk governance practices; and
Funding sources.

ALM First encourages credit unions to consider the following when assessing their existing liquidity risk management practices amidst this increased regulatory focus.

Controlling Asset Composition With Risk-Based Pricing Discipline

Asset and liability composition can be difficult to manage in an environment with consistent loan growth and competitive deposit markets. Asset composition can quickly change when credit unions do not properly assess relative value when making loan and investment decisions. Poorly priced loans can lead to excess growth, which can lead to liquidity pressure and concentrations of credit risk. Lending functions and treasury teams should continue to work together to assess relative value among available asset allocation opportunities with consideration given to strategic priorities for balance sheet composition.

Proper Liability Structuring to Manage Asset Risk

As balance sheet composition has changed, liabilities should be structured to be congruent with asset growth. The January 2024 advisory letter reminds us that “Liabilities that can be relied upon for funding under a broad range of macro and microeconomic conditions are considered more stable and contribute to reducing liquidity risk. Examples of stable funding sources include regular shares and share drafts. More volatile funding sources, such as brokered deposits and uninsured shares, should serve specific needs and be well controlled and monitored.”

Managing and Forecasting Cash Flows

Institutions should be managing and forecasting cash flows under normal and stressed conditions. ALM models can be leveraged for periodic stress testing of a credit union’s liquidity resilience; however, sources and uses of cash should be monitored more frequently and used to project short-term funding needs. Cash usage can be determined by combining loan pipelines, planned investment purchases, and projected funding decay or maturities. These projected cash uses can then be paired with projected cash inflows from loans and investments along with projected funding inflow or procurement to determine any short-term funding gaps over 30-, 60- and 90-day time frames.

Backtesting

As with any financial model, backtesting is an important practice that is necessary to fine tune model performance and dependability for decision-making. Many clients have reported difficulties in obtaining actual cash flows from core systems but have been able to achieve sufficient backtesting by leveraging budget variance analyses.

Clearly Defined Liquidity Governance

Now is the time to revisit your credit union’s policies, procedures and committees. Is your framework up-to-date and clear to all parties involved, including regulators? It is also critical to ensure your institution has an effective contingency funding plan.

Well Diversified Funding Sources

Assessing the relative cost of funding sources remains imperative, especially as competition in some markets has driven certificate rates above wholesale funding rates. Additionally, we have observed instances where the cost of non-member certificates is less than FHLB borrowings. Credit unions should ensure funding sources are diversified and the cost of incremental funding is evaluated prior to enacting a funding strategy.

Remember, there is no “one size fits all” approach to liquidity risk management and each credit union will need to incorporate the unique aspects of their business model to effectively manage risk.