Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 11. Contingency Funding Planning

Presented by: Sudhanshu

Module 1. Contingency Funding Planning

Module 2. Components of A Contingency Funding Plan

Module 1. Contingency Funding Planning

Topic 1. Relationship between Contingency Funding Planning and Liquidity Stress Testing

Topic 2. Best Practices in the Design of a Sound Contingency Funding Plan

Topic 1. Relationship between Contingency Funding Planning and Liquidity Stress Testing

  • Interconnectedness 

    • Contingency funding plans (CFPs) are closely linked with liquidity stress testing.

    • CFPs are essentially an extension of earlier work on liquidity risk management, liquidity stress testing, and early warning indicators.

    • The results from liquidity stress tests and other relevant data are used as inputs for CFPs.

    • CFPs are specifically designed to manage high-severity, low-frequency contingent liquidity events.

  • Limits and Escalation 

    • The relationship is further defined by limits and escalation levels.

    • Liquidity risk measures from normal periods serve as a baseline for creating early warning indicators (EWIs).

    • Stress scenarios for CFPs should be consistent with those used for liquidity stress tests and should also be tied to recovery provisions.

    • CFPs can also examine additional liquidity stress scenarios beyond a firm's typical scope of analysis to strengthen contingency plans for less likely events.

Practice Questions: Q1

Q1. Which of the following statements regarding contingent funding plans (CFPs) is correct?

A. CFPs are linked to liquidity stress tests through their limit structures.

B. CFPs are used for high-severity, high-frequency conngent liquidity events.

C. CFPs allow for a means to control contingent liquidity events in normal times.

D. Liquidity risk measures used during stressed times are a baseline for developing early warning indicators (EWIs) for CFPs.

Practice Questions: Q1 Answer

Explanation: A is correct.

CFPs should be clearly liked to the liquidity stress tests through its limit structure and escalation levels. CFPs are used for high-severity, low-frequency events (not high-frequency events). CFPs allow for a means to control for contingent liquidity events in times of extreme stress (not normal times).

Liquidity risk measures used during normal times (not stressed circumstances) are a baseline for developing EWIs.

Topic 2. Best Practices in the Design of a Sound Contingency Funding Plan

  • Key Design Considerations 

    • There are five key design considerations for a sound CFP.

    • These include:

      • Alignment to business and risk profiles.

      • Integration with broader risk management frameworks.

      • An operational, actionable, and flexible playbook.

      • Inclusivity of appropriate stakeholder groups.

      • Support by a communication plan.

  • Alignment and Integration 

    • Alignment: A CFP must be aligned with a firm's business activities, products, asset classes, and geographic reach. It should use quantitative early warning indicators, limits, and escalation levels that align with the firm's risk appetite statement.

    • The CFP should be part of the firm's strategic planning process so it can adapt to both internal and external changes over time.

  • Integration: The CFP should be included in a firm's liquidity risk management, enterprise risk management (ERM), capital management, and business continuity and crisis management programs. This integration makes the CFP more effective by allowing it to work within the firm’s existing internal control systems.​

  • Playbook and Stakeholders : Operational, Actionable, and Flexible Playbook: The CFP should be ready to be put into action quickly during a sudden crisis. It should outline numerous stress scenarios, each with potential contingent actions that vary based on severity levels. Since it’s impossible to predict every scenario, the CFP must be flexible enough to allow for logical, sudden decisions during a crisis.

    • Inclusive Stakeholder Groups: The CFP should involve groups like management committees, business units, corporate treasury, and risk management. Involving a range of stakeholders ensures the plan is operationally ready and provides an opportunity to identify and remedy potential problems.

  • ​Communication Plan
    • Communication is Crucial: A sound CFP needs a communication plan to efficiently disseminate information to stakeholders during a crisis.

    • Damage Control: Communicating with external stakeholders helps to protect the firm's reputation and acts as a form of damage control to contain negative financial impacts.

    • Centralized and Coordinated: A good communication plan is managed centrally to ensure consistent messaging. However, certain groups, such as investor relations or legal teams, should be allowed to maintain communication with stakeholders they already have relationships with.

Practice Questions: Q2

Q2. What is a key design consideration in developing a contingency funding plan (CFP)?

A. Aligned to business profile.

B. Supported by a backup plan.

C. Inclusive of all shareholder groups.

D. Can be used in both normal and stressed states.

Practice Questions: Q2 Answer

Explanation: A is correct.

CFPs should be aligned to the firm’s business and risk profiles. Examples include business activities, products, and asset classes. CFPs should be inclusive of appropriate stakeholder groups, which include shareholders but also include many other groups such as management committees, business units, and operations. CFPs, by nature, are meant to be used only in stressed states.

Module 2. Components of a Contingency Funding Plan

Topic 1. Governance and Oversight

Topic 2. Scenarios and Liquidity Gap Analysis

Topic 3. Contingent Actions

Topic 4. Monitoring and Escalation

Topic 5. Data and Reporting

Topic 1. Governance and Oversight

  • Stakeholder Involvement 

    • A strong contingency funding plan (CFP) requires the involvement of various internal stakeholders.

    • Business units can discuss their performance in different economic and stressed situations.

    • Corporate treasury and risk management can discuss managing funding and liquidity risk in both normal and stressed periods.

    • Four key roles are involved in developing and using CFPs: corporate treasury, the liquidity crisis team (LCT), the management committee, and the board of directors.​

  • Key Roles and Responsibilities 

    • Corporate Treasury: Oversees the firm’s risk, funding, and liquidity in normal times. The corporate treasurer may activate the CFP based on stress test results and market conditions.

    • Liquidity Crisis Team (LCT): Engineers the CFP, presents it for approval, and has a general coordination and communication role with internal and external stakeholders. The LCT also continuously monitors the firm's liquidity and makes implementation suggestions.

  • Management Committee: Composed of senior management, it oversees the LCT during a crisis. The committee also analyzes the firm's liquidity and approves recommendations for CFP implementation.

  • Board of Directors: Provides leadership to the LCT and management committee during a crisis. Well-versed board members are best positioned to advise on CFP implementation.​

  • Communication and Readiness 

    • Communication and Coordination: Business units must be coordinated and interdependent to provide timely data for decision-making. A robust, centrally managed communication plan is vital for maintaining confidence and control during a crisis.

    • Testing and Readiness: Key parts of the CFP should be tested regularly to ensure their usefulness during a crisis. This can include testing activities that generate liquidity, such as issuing debt or selling securities. Testing can also enhance operational effectiveness and uncover weaknesses in the plan.

Practice Questions: Q1

Q1. In the context of governance and oversight of a contingency funding plan (CFP), which role has direct oversight of the liquidity crisis team (LCT)?

A. Board of directors.

B. Risk management.

C. Corporate treasury.

D. Management committee.

Practice Questions: Q1 Answer

Explanation: D is correct.

The management committee (comprising senior management) is responsible for direct supervision of the LCT. The board of directors does advise and provide assistance to the LCT as needed, but does not directly supervise the LCT.

Topic 2. Scenarios and Liquidity Gap Analysis

  • Scenario Consistency 

    • CFP stress scenarios must be consistent with the scenarios used for liquidity stress testing.

    • The CFP scenarios should also be linked to recovery provisions.

    • Liquidity stress testing covers systemic and idiosyncratic risks, as well as market and funding liquidity for both short and long-term stress periods.

  • Beyond Normal Analysis 

    • The CFP’s purpose is to alert management to an impending crisis and provide feasible solutions.

    • While considering the results of standard liquidity stress tests, the CFP may also examine additional liquidity stress scenarios beyond the firm's typical scope.

    • These additional scenarios help strengthen the contingency plans by preparing for possible, though less likely, events that could negatively affect liquidity.

Topic 3. Contingent Actions

  • Implementing Actions 

    • After a liquidity gap analysis is performed, a firm can identify appropriate contingent and capital actions.

    • These actions must be consistent with the size and timing of the capital shortfall and the capital inflow they will generate.

    • The type and effectiveness of contingent actions depend on the nature (e.g., systemic or idiosyncratic) and magnitude of the stressed event.

  • Examples of Contingent Actions

    • To increase liquidity:

      • Keeping credit lines with attractive rates and minimal restrictions.

      • Offering higher rates on deposits to attract customers.

      • Increasing securitization activities.

      • Disposing of liquid assets or business units.

      • Issuing subordinated debt or callable loans.

  • To reduce liquidity outflows:

    • Lowering capital distributions or implementing cost-cutting measures.

    • Choosing not to reinvest securities when they mature.

    • Reducing lending activity by imposing stricter underwriting standards.

  • Factors Reducing Ability to Act

    • Several factors can hinder a firm's ability to take contingent actions.

    • These include the closure of securitization markets, reduced access to repo funding, credit downgrades, and higher funding costs.

    • Firms must consider the potential impact of their actions on customers, lenders, and counterparties, as some early actions might send a negative message and exacerbate a long-term crisis.

Practice Questions: Q2

Q2. Which of the following items is an example of increasing a firm’s ability to take a contingent action during a stress situation?

A. Securitizing assets.

B. Decreasing lending rates.

C. Increasing capital distribuons.

D. Shifting from longer-term to shorter-term funding sources.

Practice Questions: Q2 Answer

Explanation: A is correct.

Securitizing assets is a source of cash (increases liquidity) for a bank. Decreasing lending rates encourages the growth of loans issued by the bank, which is an outflow of cash (reduces liquidity) for a bank. The same is true for increasing capital distributions (reduces liquidity). Shifting from shorter-term to longer-term sources of funding is a contingent action, not the other way around.

Topic 4. Monitoring and Escalation

  • Early Warning Indicators (EWIs)

    • The CFP should leverage the firm’s process for tracking and measuring liquidity risk.

    • These measures form a set of EWIs that provide an early heads-up about potential liquidity issues.

    • EWIs are split into two categories: market and business measures, and liquidity health measures.

  • Types of EWIs

    • Market and Business Measures: These are broad, macroeconomic (e.g., market volatility) and microeconomic (e.g., firm revenues) indicators. Examples include a sudden decline in stock indices, credit downgrades, negative publicity, and increased spreads on the firm's debt.

    • Liquidity Health Measures: These are more specific, directly reflecting the firm's current and future liquidity strength. Examples include the ratio of non-core funding to long-term assets and the firm's funding maturity profile.

  • Escalation Levels 

    • Level 1: This is the starting point, triggered by factors like stress test results indicating an undesirable reduction in liquidity. It involves increased management oversight of market conditions and their effect on the firm.

    • Level 2: This is a more elevated level where systemic and/or idiosyncratic events are actively and negatively affecting the firm's business and liquidity. The focus shifts to analyzing the reasons for the deterioration and planning for the near future.

    • Level 3: The firm is now focused on survival and remaining a going concern. At this stage, significant activities to increase liquidity would have already been undertaken.

    • Movement between escalation levels should be considered and approved by the LCT.

Practice Questions: Q3

Q3, Which level of escalation within a contingency funding plan (CFP) has more emphasis on analyzing the causes of liquidity deterioration closely?

A. Level 1.

B. Level 2.

C. Level 3.

D. Level 4.

Practice Questions: Q3 Answer

Explanation: B is correct.

Level 2 is a more elevated level where systemic and/or idiosyncratic events are clearly having a negative effect on the firm’s business and liquidity. There should be detailed analysis of current liquidity and reasons for deterioration.

Topic 5. Data and Reporting

  • Reporting Frequency and Content

    • It's often beneficial for firms to have frequent reporting, such as daily, on liquidity throughout the organization.

    • Reports should include qualitative information in addition to numerical data to help in understanding the firm’s liquidity profile.

    • Reporting should detail how liquidity coverage is determined for future liabilities and cash outflows, as well as how much coverage is needed.

  • Comprehensive Reporting

    • Reporting should also account for:

      • Intraday liquidity positions.

      • Contingent liabilities.

      • The usage of funding sources.