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. Contingency Funding Planning and Liquidity Stress Testing

Topic 2. Sound Contingency Funding Plan

Topic 1. Contingency Funding Planning and Liquidity Stress Testing

  • Contingency funding plans (CFPs) translate liquidity stress-test results and other key data into governed, actionable funding decisions, outlining available contingent liquidity actions and decision triggers.
  • Contingent liquidity events span from low-severity/high-frequency to high-severity/low-frequency, with CFPs designed specifically for the latter.

  • CFPs provide a structured framework to manage contingent liquidity events during periods of extreme stress

  • CFPs and liquidity stress testing are linked through limits and escalation frameworks, with normal-time liquidity risk measures serving as the baseline for early warning indicators (EWIs).

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. Sound Contingency Funding Plan

  • Five 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 to business and risk profiles: A CFP must be aligned with a firm's business activities, products, asset classes, and geographic reach.
    • It should use quantitative EWIs, limits, and escalation levels that align with risk appetite statement.
    • The CFP should be part of the strategic planning so that it can adapt to both internal and external changes over time.
  • Integration with broader risk management frameworks: The CFP should be included in liquidity risk management, ERM, capital management, 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.

  • An operational, actionable, and flexible playbook: The CFP must be rapidly deployable, with multiple stress scenarios and severity-specific contingency actions defined in advance.

    • ​The severity levels should be tied to EWIs, triggers, and contingency actions.

    • Since all liquidity crisis scenarios can not be anticipated, a CFP must be flexible-clearly outlining predefined contingency actions while still allowing timely, rational decision-making as unexpected conditions emerge during a crisis.

  • ​Inclusive of appropriate 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.
  • ​Supported by a communication plan: A communication plan provides a structured and efficient dissemination of information to stakeholders during a crisis.
    • ​Clear and timely communication, particularly with external stakeholders, helps protect the firm’s reputation and acts as damage control, limiting potential negative financial impacts during periods of stress.

Topic 2. Sound Contingency Funding Plan

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. Key Components of a Contingency Funding Plan

Topic 2. Governance and Oversight

Topic 3. Stakeholder Involvement, Roles, and Responsibilities

Topic 4. Communication and Coordination

Topic 5. Policies and Procedures

Topic 6. Testing and Readiness Assessment

Topic 7. Scenarios and Liquidity Gap Analysis

Topic 8. Contingent Actions

Topic 9. Monitoring and Escalation

Topic 10. Market and Business Measures

Topic 11. Liquidity Health Measures

Topic 12. Data and Reporting

Topic 1. Key Components of a Contingency Funding Plan

  • Key components of a contingency funding plan include:
    1. Governance and Oversight
      1. ​Stakeholder Involvement, Roles, and Responsibilities

      2. Communication and Coordination

      3. Policies and Procedures

      4. Testing and Readiness Assessment

    2. Scenarios and Liquidity Gap Analysis
    3. Contingent Actions
    4. Monitoring and Escalation
      1. ​Market and Business Measures

      2. Liquidity Health Measures

      3. Escalation Levels

    5. Data and Reporting

Topic 2. Governance and Oversight

  • Key components of a governance and oversight include:

    1. Stakeholder Involvement, Roles, and Responsibilities

    2. Communication and Coordination

    3. Policies and Procedures

    4. Testing and Readiness Assessment​

Topic 3. Stakeholder Involvement, Roles, and Responsibilities

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

    • For example,

      • ​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.​

  • 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): 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.
    • Members of LCT include executives, business unit leaders, and other senior management.

  • 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.​

Topic 3. Stakeholder Involvement, Roles, and Responsibilities

  • Business units should be well-coordinated and interdependent to deliver timely, reliable data for crisis decision-making.

  • A robust communication plan builds internal confidence and reinforces control during stress.

  • Stakeholders expect clear, credible plans for both crisis management and post-crisis actions.

  • Communication should be centrally managed to ensure consistency and alignment.

  • Select functions (e.g., investor relations, legal, compliance) may lead communications with stakeholders where pre-existing relationships exist.

Topic 4. Communication and Coordination

  • Documentation of a CFP could include the following general elements

    • ​Introduction (e.g., overview and purpose, related policies).

    • Governance (e.g., roles/responsibilities, approval).

    • Stress testing and scenarios overview.

    • Monitoring and escalation (e.g., liquidity gap analysis, contingent action)

    • Reporting (e.g., frequency).

Topic 5. Policies and Procedures

  • Regular testing of key CFP components ensures reliability during stressed conditions.

  • Liquidity-generating actions (e.g., debt issuance, asset sales) should be periodically tested.

  • Operational effectiveness (governance, escalation, and reporting) must be assessed.

  • Simulations of plausible stress scenarios help speed up decision-making in crises.

  • Testing reveals gaps and weaknesses, enabling continuous improvement of the CFP.

Topic 6. Testing and Readiness Assessment

  • CFP stress scenarios should be consistent with liquidity stress-testing frameworks.

  • CFP scenarios must be clearly linked to recovery and remediation actions.

  • Liquidity stress testing covers systemic and idiosyncratic risks, including market and funding liquidity, across short- and long-term horizons.

  • The CFP’s core role is to alert management early to emerging liquidity crises.

  • CFPs outline practical and feasible actions to restore liquidity under stress.

  • CFPs may include additional, less-likely stress scenarios beyond standard analyses to strengthen overall preparedness.

Topic 7. Scenarios and Liquidity Gap Analysis

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.

  • Use liquidity gap analysis to identify appropriate contingent and capital actions.

  • Ensure actions align with the size, timing of the capital shortfall, and the expected capital inflows from each contingent measure.

  • Examples of contingent actions include:

    • Keeping credit lines that do not have significant borrowing restrictions and offer attractive rates.

    • Reducing lending activity and increasing securitization activities.

    • Offering higher rates on deposits to increase deposit activity by customers.

    • Choosing not to reinvest securities when they mature.

    • Moving from less shorter-term to more longer-term funding sources.

    • Disposing of liquid assets.

    • Issuing subordinated debt and callable loans

    • Selling receivables (e.g., loans, credit cards)

    • Disposing of business units.

    • Lowering capital distributions.

    • Implementing cost-cutting measures.

Topic 8. Contingent Actions

  • The type (systemic vs. idiosyncratic) and severity of stress events determine which contingent actions are feasible and how effective they will be.

  • Factors that may reduce a firm’s ability to take contingent actions include

    • ​Closure of securitization markets.

    • Reduced access to repo funding.

    • Credit downgrades combined with higher collateral deposits.

    • Counterparties engaging in harmful margin and collateral behavior.

    • Custodian banks mandating higher cash deposits.

    • Higher funding costs.

    • Funding no longer being rolled over by counterparties.

    • Deposit run-off.​

  • The firm should assess the likelihood of these factors and design measures to mitigate their adverse effects.

Topic 8. Contingent Actions

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 distributions.

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 9. Monitoring and Escalation

  • The CFP should be based on the firm’s liquidity risk tracking and measurement framework.
  • These measures act as EWIs, providing early signals of potential future liquidity stress.

  • EWIs can be subdivided into:

    1. Market and business measures, and

    2. Liquidity health measures.

Topic 10. Market and Business Measures

  • Market and business measures can be both macroeconomic and microeconomic. They should include measures that are relevant in financial system risks and overall liquidity.

  • Market and business factors include: 

    • Large and sudden decline in stock market indices.

    • Credit downgrades of U.S. Treasuries and/or other sovereign debt.

    • Large surge inmarket volatility.

    • Sudden catastrophic events.

    • Accelerated increase in assets financed by unstable liabilities.

    • Negative publicity.

    • Asset quality deterioration.

    • Falling earnings and earnings projections.

    • Credit rating downgrades.

    • Loans being withdrawn or not renewed.

    • Increased spreads on the firm’s debt and credit default swaps.

    • Greater collateral to be provided by the firm.

    • Counterparties avoiding unsecured or long-term transactions with the firm.

    • Deposit run-off.

  • Liquidity health measures (e.g., credit rating, ratio of short-term funding to long-term funding) reflect the strength of a firm’s current and future liquidity.

  • Liquidity health measures include:

    • Projected net funding requirements to current unused funding capacity: Financing needed to cover the firm’s expansion of its lending business

    • Non-core funding to long-term assets: Less reliable financing sources that may not exist in stressed situations or could be prohibitively expensive.

    • Overnight borrowings to total assets: Measure of a less reliable source of funding.

    • Short-term liabilities to total assets: Financing sources that need to be renewed in the near future and are required to support assets.

    • Funding source concentration: Assesses reliance on a few liquidity providers, where withdrawal by one or more during stress can create significant liquidity risk.

    • Funding maturity profile: Assesses when funding sources mature, with heavy concentrations—especially in short-term financing—posing heightened liquidity risk.

Topic 11. Liquidity Health Measures

  • Liquidity health measures include:

    • Used capacity to total borrowing capacity: Available borrowings as a source of liquidity in the future.

    • Liquid assets to volatile liabilities: Buffer of liquid assets that exceeds the financing needs.

    • Unpledged eligible collateral to total assets: A firm’s capacity to raise funding by selling assets or pledging collateral when needed.

    • Loans to commitments: Funding needed in the future based on funding used till date 

Topic 11. Liquidity Health Measures

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 12. Data and Reporting

  • Recommended data and reporting practice includes:

    • Increase frequency of liquidity reporting (e.g., daily) across the firm.

    • Supplement metrics with qualitative insights to explain the liquidity profile.

    • Clearly describe liquidity coverage methodologies and required coverage levels for future cash outflows.

    • Capture intraday liquidity positions, contingent liabilities, and funding source utilization.