How banks can manage liquidity risk in 2024

Banks are facing liquidity risk management challenges in today’s interest rate environment. They were comfortable with abundant and cheap liquidity in 2020 and 2021. Things changed quickly, though.

Between March 14, 2022, and March 14, 2023, the two-year rate on the daily U.S. Treasury yield moved from 1.87% to 4.20%, and the 10-year rate moved from 2.14% to 3.64%. Rates have continued to stay elevated throughout 2023 and the start of 2024, and that’s had various impacts on bank balance sheets, including spoiling the cheap liquidity.

Competition for deposits is in full swing, leaving some banks feeling a liquidity squeeze. As yields increased throughout 2022 and 2023, banks were forced to increase deposit rates. The average rate that banks paid on money market accounts increased from 0.08% to 0.66% between February 2022 and April 2024. The increased rates put pressure on banks to pay up for deposits or see them walk out the door.

Another reality banks have faced is tougher economic conditions for customers — and the resulting impacts on liquidity. Bank customers may be dealing with increased loan payments on variable-rate loans, decreased savings rates due to inflation and general uncertainty about economic conditions.

Aggregated call report data shows that deposit growth slowed substantially in 2022 and 2023, after two years of unprecedented growth. At the same time, banks grew brokered deposits and FHLB advances in 2022 and 2023 to offset the slowing deposit growth.

Source: BankTrends

In 2020 and 2021, banks also grew securities that were susceptible to unrealized losses. Securities growth was 29.91% in 2020 and 22.44% in 2021. In 2021, securities repricing > 3 years grew from 73.03% to 77.56% of all securities. In 2023, banks unwound some of the longer-term securities, as securities repricing > 3 years decreased to 71.93%.

As rates increased, these longer-term securities were prone to unrealized losses. Banks may collect interest and principal from cash flows, but long-term securities with large unrealized losses are not typically sold. To do so would mean realizing a loss against net worth. Typically, long-term investments on bank balance sheets with large unrealized losses do not represent true accessible liquidity, except for by pledging the asset to a third party at market value.

Things changed quickly. And if you aren’t staying up on your liquidity monitoring, it can put your bank in a tough spot. So how can you manage these elevated risks?

1. Increase the frequency of liquidity monitoring

Your liquidity policy should specify the frequency of liquidity reporting. While the board may receive quarterly liquidity risk reports, reporting for management should be more frequent, especially if you are dealing with decreasing liquidity. Consider moving to weekly or monthly management reporting.

Make sure to also monitor the liquidity triggers from your contingency funding plan. When a crisis happens, it’s difficult to know right away, so it’s important to frequently monitor liquidity triggers. Changing conditions could indicate increasing liquidity risks.

For example, a 2% outflow of non-maturity deposits might be normal or “green,” while 5% might be outside normal business fluctuations or “yellow,” and 10% might be a major crisis or “red.” If there was a 5% outflow of non-maturity deposits, you don’t want to wait until month-end or quarter-end to discover the issue. 

2. Review pro-forma cash flow analysis, and stress test your cash flows

Regulatory guidance says banks should have robust methods for projecting cash flows from their balance sheet. Pro-forma cash flow models are a critical liquidity tool, especially in uncertain times. Looking at your current balance sheet is not good enough; you need to develop realistic expectations of future liquidity.

In addition, the regulatory guidance says banks should conduct stress tests regularly for a variety of institution-specific and marketwide events across multiple time horizons. The stress testing should be layered on top of the pro forma cash flow model, and management should develop plans to address any cash flow shortfalls. If you are dealing with decreasing liquidity, your liquidity stress testing may inform management’s tactics in addressing the situation.

3. Understand your funding risks

An important piece of managing liquidity risk is to understand how the bank is funding its balance sheet. Typically, banks will fund the balance sheet with a mix of core deposits, non-core deposits, other wholesale funding and equity. Management should understand concentration risks, including large depositors, concentrations to certain industries, concentrations of noninsured deposits or concentrations in certain types of wholesale funding. Part of the CFP should be potential responses to those concentration and funding risks, including identifying other sources of potential funding.

A study of historic deposit behaviors can also help the bank understand the expected maturities on its deposits, or if the bank has surge deposits that it should expect to run off quicker than the rest of its deposit base. Understanding these risks is a critical piece of managing your liquidity position.

4. Review your contingency funding plan (CFP)

At its core, a CFP is a crisis management tool. The tool should set out the strategies management expects to use to address liquidity shortfalls. The requirements of a CFP are addressed in the Interagency Policy Statement on Funding and Liquidity Risk Management. If you are facing mounting liquidity pressure, it is a good time to review your CFP at your asset liability committee meeting and board meeting, as well as a good time to test the operational components of your plan.

5. Get an independent review of your liquidity risk management

Management should be sure an independent party reviews and evaluates your bank’s liquidity risk management processes. The reviews should evaluate the process and determine whether it complies with both supervisory guidance and industry sound practices.

How Wipfli can help

Wipfli’s liquidity risk review can pinpoint areas of liquidity management risk in your institution and provide recommendations for how to mitigate that risk and strengthen your institution’s liquidity and overall stability. Contact us to learn more.