Question

In Bank Management, what are the objectives of a bank’s contingency funding plan? Give a detailed description of what it includes and the purpose of each component?.

Answer 1

ANS.

A contingency funding plan (CFP) is, at its core, a liquidity crisis management instrument. The document is prepared as a directive for a future emergency and stands ready to be referenced, someday, as a response plan and potential forecast of how a distant liquidity event may unfold. But then, the scenarios presented in the CFP may not occur. The next liquidity crisis may be an event that not a single bank management team could have ever imagined. After all, clairvoyance is not typically listed as a required banking skill.

The liquidity contingency plan addresses alternative sources of funds if initial projections of funding sources and uses are incorrect. As it is not feasible to hold funds to such an extent that it covers least likely events as well, the contingency plan will act as the bridge between the actual liquidity that is being held by the entity and the maximum that would be needed in the event of a run on liquidity.

Planning will encompass:

• Identifying and developing potential funding sources
• Setting up plans for assigning responsibilities under various defined hypothetical liquidity need situations
• Predefining triggers that would initiate liquidity management and remedial action plans

General requirements for a liquidity contingency plan

• The plan must be workable, i.e. it must contain sufficient depth to ensure that it is actionable in times of stressed liquidity. It must be responsive to changes in market conditions.
• The plan must include separate actions for different need environments.
• The guidance provided by the plan needs to be specific regarding the actions that will be taken if hypothetical events were to occur. This is essential for a quickened response time.
• However the guidance mentioned above should be a menu of alternative actions that may be taken rather than rules that need to be enforced if the event occurred. The actions taken will depend on the exact causes, durations or seriousness of the liquidity crisis and the specific guidance of the plan will be used as guidelines in the management of the situation.
• Previous experiences should not be allowed to overly influence contingency planning.
• The plan must include an appropriate level of detail with regard to identification of early warning signals, assignment of crisis management responsibilities and various alternative courses of action. The level of detail should enable the company to respond early, quickly and effectively to deteriorating liquidity conditions but must not be too detailed that it impedes decision making.
• The contingency plan must be directly or indirectly coordinated with all of the company’s risk monitoring and risk management activities, particularly those monitoring market conditions as well as critical credit risk information. The need is to maintain a perception of liquidity at all times to avoid or survive a crisis.

Specific requirements for a liquidity contingency plan

The plan must reflect:

• A variety of different need environments. Need environments that will be addressed in the plan include:

Ordinary course of business or “going concern” need for liquidity. This includes: Operational needs such as surges in loan demand, seasonal needs, etc

crisis or company specific funding crisis, Systemic and cyclical crisis such as recessions or credit crunches, capital market disruptions, etc.Specific measures of mismatch liquidity.

Specific measures of contingent liquidity that can be obtained along with the time frames required to obtain the funds, including applicability to the various need environments.Specific measures for enhancing the liquidity of assets and the stability of liabilities, including applicability to various need environments.

    Objectives of a bank’s contingency funding plan:-

(i) The main objective of the contingency planning process is not to predict the future. Rather, the CFP’s great value lies in its utility both as a crisis management document and a regular deep dive into the bank’s liquidity profile.

(ii)It is an assessment tool, the contingency planning process provides additional insight into the community bank’s liquidity strengths and weaknesses beyond the bank’s normal reporting activities. In this role, the CFP serves as a comprehensive evaluation, similar to a person’s annual health examination, which complements ongoing asset/liability monitoring. This endeavour can provide new risk mitigation knowledge that management can use to protect the bank both in an emergency and in the day-to-day competitive Scenario.

(iii) Even without the additional benefit as a risk assessment tool, establishing a rainy-day plan is a worthy exercise on its own. Of course, bank management teams do not intend for their banks to experience severe distress or, more tragically, failure. However, liquidity events can materialize in a variety of unexpected ways.

(iv) the bank has an established CFP with descriptive roles, responsibilities, and action plans, management will be better prepared to execute a controlled response to unforeseen stress events.

(v) The management monitored the inherent liquidity position closely. Informational reporting systems permitted continuous analysis of the bank’s liquidity with increased reporting frequency.

The Qualitative Components of a complete contingency funding plan (CFP):-

(i)A CFP should identify all material contingent liquidity sources and discuss the order in which these alternatives will be pursued. Certain sources require that legal agreements be set up in advance.

(ii) The CFP should not assume that all contingent liquidity will come from one source. Funding diversification is not only a worthy goal but is also a forced outcome in a crisis. To assume otherwise would ignore the reality that liquidity pressures tend to spread from one funding source to others. The CFP document should discuss multiple funding options and avoid undue concentration.

(iii) Scenario analysis is worthwhile because it requires management to go through the steps of considering how each asset and liability might behave in a disruption. Possible side effects are also exposed because changes in one asset or liability class may affect other areas of the balance sheet.

(iv) A CFP is not a one-time project to be retired to a desk drawer until a liquidity problem arises. Like a business continuity plan, the bank’s CFP merits revisiting on a regular basis.

(v) Deterioration in asset quality may be the most common banking affliction, but the ensuing decline normally transpires over a long period of time. Poor liquidity management, however, can sink the bank quickly with only a small push in the wrong direction.

(vi) Community banks should embrace the contingency planning exercise as an opportunity, and the board and senior management will hopefully sleep better at night knowing that the bank is protected with a quality CFP.