DATE:	July 30, 2008
MEMORANDUM TO:	Sandra L. Thompson, Director
	Division of Supervision and Consumer Protection
FROM:	Russell A. Rau [Electronically produced version; original signed by Russell A. Rau]
	Assistant Inspector General for Audits
SUBJECT:	FDIC’s Examination of Liquidity Risk (Report No. AUD-08-012)

This report presents the results of our audit of the FDIC’s supervision and examination of liquidity risk at FDIC-supervised institutions. The FDIC’s Division of Supervision and Consumer Protection (DSC) is responsible for performing risk management examinations for FDIC-supervised financial institutions.

The audit objective was to assess how the FDIC addresses institution liquidity risk through various regulatory and supervisory activities. Specifically, we reviewed (1) risk management examinations; (2) institution and examination policies, procedures, and guidance; and (3) examiner training. We conducted this performance audit in accordance with generally accepted government auditing standards. Appendix 1 of this report discusses our audit objective, scope, and methodology in detail.

BACKGROUND

Liquidity represents a financial institution’s ability to fund assets and meet obligations as they become due and is essential in all banks to compensate for expected and unexpected balance sheet fluctuations and provide funds for growth. Liquidity risk is the risk of not being able to obtain funds at a reasonable price within a reasonable period to meet obligations as they become due. Because liquidity is critical to the ongoing viability of any financial institution, liquidity management is among the most important activities conducted by an institution.

Funds management involves estimating and satisfying liquidity needs in the most cost-effective manner possible and without sacrificing income potential. Effective liquidity management requires financial institutions to measure the liquidity position of the financial institution on an ongoing basis and to determine how funding requirements may change due to various scenarios, including adverse situations. The formality and sophistication of liquidity management depends on the size and sophistication of the financial institution, as well as the nature and complexity of its activities. Regardless of the institution, adequate management reporting, strong analysis of funding requirements under alternative scenarios, diversification of funding sources, and contingency planning are crucial elements of strong liquidity management.

Examiners’ assessment of a financial institution’s adequacy of liquidity is based on the Uniform Financial Institutions Rating System (UFIRS), which assigns component ratings, referred to as CAMELS ratings, from “1” to “5” based on a financial institution’s financial condition and operations. A “1” indicates the highest rating, strongest performance and risk management practices, and least degree of supervisory concern, while a “5” indicates the lowest rating, weakest performance, inadequate risk management practices, and the highest degree of supervisory concern. The component factors address the adequacy of Capital, quality of Assets, capability of Management, quality and level of Earnings, adequacy of Liquidity, and Sensitivity to market risk. The ability of financial institution management to identify, measure, monitor, and control the risks of its operations is also taken into account when assigning each component rating. Determining an institution’s liquidity adequacy requires an analysis of its current liquidity position, present and anticipated asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs, and options for reducing funding needs or obtaining additional funds.

In general, a financial institution’s funds management practices should ensure that the institution is able to maintain a level of liquidity sufficient to meet its financial obligations in a timely manner and to fulfill the legitimate banking needs of its community. Such practices should reflect the ability of the institution to manage unplanned changes in funding sources, as well as react to changes in market conditions that affect its ability to quickly liquidate assets with minimal loss.

Liquidity-related Guidelines

Liquidity is a key determinant of the soundness of the banking sector. The contraction of liquidity has been a factor in actions taken by international and domestic organizations, such as the Basel Committee on Banking Supervision (BCBS),1 the Senior Supervisors Group (SSG),² the Financial Stability Forum (FSF),³ the Board of Governors of the Federal Reserve System (Federal Reserve), and the federal financial institutions regulatory agencies⁴ (the “agencies”). Actions taken to enhance liquidity-related guidelines for effective liquidity risk management include the following.

• BCBS issued Liquidity Risk: Management and Supervisory Challenges, dated February 2008; and proposed guidance, Principles for Sound Liquidity Risk Management and Supervision, dated June 17, 2008.
• SSG issued Observations on Risk Management Practices during the Recent Market Turbulence, dated March 6, 2008.
• FSF issued the Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, dated April 7, 2008.
• The agencies are taking steps to enhance liquidity risk management guidance. Specifically, the agencies are currently involved in an interagency initiative to issue guidance to supervised institutions, examiners, and other supervisory personnel on sound practices for managing liquidity risk, pending the issuance of final liquidity risk management guidance by the BCBS. The Conference of State Bank Supervisors is also involved in the interagency effort.

During the strained credit market of 2007 and 2008, the Federal Reserve introduced three new lending facilities5 to provide liquidity to the financial markets and alleviate funding pressures. Those facilities include the Term Auction Facility, the Term Securities Lending Facility, and the Primary Dealer Credit Facility. Of these three lending facilities, only the Term Auction Facility, announced December 12, 2007, is available to depository financial institutions, and those institutions must be eligible to borrow under the Federal Reserve’s primary credit program.

FDIC Examination Guidance Related to Liquidity Risk Management

DSC has issued liquidity-related guidance to FDIC examiners to assist in evaluating the adequacy of an institution’s liquidity position. According to DSC’s Risk Management Manual of Examination Policies (Examination Manual), examiners should consider the current level and prospective sources of liquidity compared to funding needs, as well as the adequacy of funds management practices relative to an institution’s size, complexity, and risk profile. The Examination Manual also states that an examiner’s evaluation of a financial institution’s funds management practices should ensure that liquidity is not maintained at a high cost or through undue reliance on funding sources that may not be available during times of financial stress or changes that adversely affect market conditions.

The FDIC has also provided examiners the following liquidity-related guidance.

• the Risk Management Examination Manual of Credit Card Activities,
• the Risk Management Credit Card Securitization Manual,
• the Case Manager Procedures Manual,
• the Examination Documentation (ED) Modules (examiner use is optional),
• Regional Directors (RD) memoranda, and
• FDIC Rules and Regulations.

FDIC Enforcement Authority

The Formal and Informal Action Procedures Manual (FIAP Manual) provides guidance on the informal actions that the FDIC can accept from financial institutions and formal actions that the FDIC can impose on institutions. Formal actions are notices or orders issued by the FDIC against insured financial institutions and/or individual respondents to correct noted safety and soundness deficiencies, ensure compliance with federal and state banking laws, assess civil money penalties, and/or pursue removal or prohibition proceedings. Informal actions are voluntary commitments made by an insured financial institution’s board of directors (BOD) and may include bank board resolutions (BBR) and memoranda of understanding (MOU). Such actions are designed to correct noted safety and soundness deficiencies or ensure compliance with federal and state laws. Section 8 of the Federal Deposit Insurance (FDI) Act provides enforcement authority for formal actions, such as cease and desist (C&D;) orders and termination of insurance.

RESULTS OF AUDIT

The FDIC actively addresses institution liquidity risk through regulatory and supervisory activities. For the 40 financial institutions in our sample, the examiners complied with applicable examination guidance for assessing an institution’s liquidity and associated risk management and reported on those assessments in their work products and examination results. Specifically, we found that:

• Examiners reported on significant liquidity risk management controls, including BOD and senior management oversight, written policies and procedures, management reporting, internal controls, and contingency liquidity plans (CLP); and sources of funding for each of the 40 financial institutions in our sample, frequently making suggestions and recommendations for improvement.
• Seventeen of the 40 financial institutions were subject to informal or formal enforcement actions, 13 of which included provisions to improve liquidity risk management.

The FDIC’s efforts, including examination recommendations and enforcement actions, have provided a means to address liquidity risk and indicate the FDIC’s emphasis on controlling such risk (FDIC Examination of Liquidity Risk).

In addition, the FDIC has issued liquidity guidance to both examiners and FDIC-supervised financial institutions and provided liquidity-related examiner training. The FDIC has recognized that liquidity guidance and training need to be updated and has taken steps to (1) issue a revised ED module on liquidity risk examination procedures, (2) participate in interagency efforts to provide additional examination and institution guidance, and (3) expand examiner training. Furthermore, we reviewed contingency liquidity planning for 31 of the 40 institutions we sampled and identified variations in the type of information included in those plans. With regard to ongoing efforts to update guidance to institutions on liquidity risk management and CLPs, we compared FDIC institution guidance to other liquidity risk guidance and (1) determined that FDIC examiner guidance is more extensive than the financial institution guidance and (2) identified the following practices that could assist FDIC-supervised financial institutions in identifying, measuring, monitoring, and controlling liquidity risk. These practices are provided for the FDIC’s consideration in its update process.

• Providing detailed descriptions of sound liquidity risk management controls, including the content of CLPs.
• Suggesting liquidity reports and identifying red flags that are useful in assessing liquidity and that can be used as leading indicators for liquidity risk.

The FDIC plans to issue updated institution guidance after the international BCBS has issued final liquidity risk management guidance and related interagency efforts are completed (FDIC Examination and Financial Institution Guidance for Liquidity Risk).

Because we noted no matters warranting additional management action, we made no recommendation related to the audit objective.

FDIC EXAMINATION OF LIQUIDITY RISK

The FDIC’s regulatory and supervisory activities to address liquidity risk include conducting risk management examinations and taking supervisory and enforcement actions to improve financial institutions’ liquidity risk management. We sampled 40 FDIC-supervised financial institutions with increased liquidity risk6 and determined that the examiners had assessed liquidity and associated risk management during those examinations, reported on liquidity in applicable Reports of Examination (ROE), and frequently made suggestions and recommendations for improvement. In addition, the FDIC included liquidity-related provisions in supervisory and enforcement actions related to 13 of the 17 actions taken for the 40 financial institutions.⁷ Accordingly, we concluded that for the institutions we sampled, examiners complied with current examination policies and procedures to evaluate the adequacy of a financial institution’s liquidity position and funds management practices and had taken action to strengthen liquidity risk management controls at FDIC-supervised institutions.

We found that examiners (1) reported on one or more of the liquidity risk management control elements, including BOD and senior management oversight, BOD-approved written policies and procedures, management reporting, internal controls, and CLPs; (2) evaluated sources of funding used by the institutions; and (3) identified issues needing bank management attention and made suggestions or recommendations for improvement for the 40 sampled institutions. The ROEs for these institutions contained examiner comments, suggestions, and recommendations as noted in the following examples.

• Management had not devoted sufficient time and attention to the oversight of the institution and had not provided clear guidance for acceptable risk exposure levels or ensured that appropriate policies, procedures, and practices had been established. The CLP was inadequate given the bank’s size and complexity. Management also did not employ stress testing techniques, although the bank heavily relied on potentially volatile liabilities to fund operations. The institution was rated “3” for liquidity.
• The institution should formally adopt a comprehensive, BOD-approved CLP and identify the types of events for which the institution should be prepared, including systemic events that would have a significant impact on the institution’s liquidity. The CLP should provide for realistic action plans to address liquidity needs for differing levels of stress. For each potential event identified, the CLP should: (1) evaluate funding needs and funding capacities, (2) specify progressive actions and procedures to be implemented, (3) identify alternative contingency funding sources, and (4) measure the institution’s ability to fund operations over an extended period of liquidity stress. The institution was rated “2” for liquidity.
• The bank’s adopted investment policy did not address all the required areas, and current practice did not comply with the institution’s stated policy. Guidelines for the types of investments, maturities, ratings, internal controls, and liquidity risks were not defined. The examiner recommended that the institution revise the investment policy, increase reporting to the BOD, and develop strategies on available funding sources. The institution was rated “2” for liquidity.

In addition, supervisory or enforcement actions were in place for 17 of the 40 financial institutions, of which 13 actions—BBRs, MOUs, and C&Ds;—included liquidity-related provisions to assist bank management in improving liquidity risk management. Those actions applied to 1 institution rated “2” for liquidity and 12 institutions rated “3,” “4,” or “5” for liquidity. Those liquidity-related provisions included, but were not limited to, (1) developing, revising, and implementing a written liquidity and funds management plan; (2) restricting the use of brokered deposits;8 and (3) restoring all aspects of the financial institution to a safe and sound condition, including asset quality, capital adequacy, earnings, management effectiveness, and liquidity.

FDIC EXAMINATION AND FINANCIAL INSTITUTION GUIDANCE FOR LIQUIDITY RISK

DSC has issued liquidity-related guidance to FDIC examiners and FDIC-supervised financial institutions and provided liquidity-related examiner training. These actions help the FDIC in ensuring that examiners have guidance to determine whether financial institutions have liquidity risk management controls to identify, measure, monitor, and control liquidity risk. The FDIC’s financial institution guidance helps institutions to implement CLPs for Federal Reserve discount window programs9 and addresses the eligibility of asset-backed commercial paper (ABCP) liquidity facilities.¹⁰ In addition, the FDIC is participating in ongoing interagency efforts to strengthen guidance to provide greater assurance that institutions needing to develop or strengthen their liquidity risk management controls will have more detailed guidance to assist in those efforts.

DSC Risk Management Manual of Examination Policies

FDIC examiners for the 40 FDIC-supervised financial institutions we sampled complied with examination guidance to evaluate the adequacy of the institutions’ liquidity position and funds management practices. During risk management examinations, according to the Examination Manual, examiners should consider the current level and prospective sources of liquidity compared to funding needs, as well as the adequacy of funds management practices relative to the institution’s size, complexity, and risk profile. Those practices should:

• ensure that an institution is able to maintain a level of liquidity sufficient to meet its financial obligations in a timely manner and to fulfill the legitimate banking needs of its community;
• reflect the ability of the institution to manage unplanned changes in funding sources, as well as react to changes in market conditions that affect the ability to quickly liquidate assets with minimal loss; and
• ensure that liquidity is not maintained at a high cost or through undue reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions.

Section 1.1 of the Examination Manual also provides information to examiners (detailed in Table 1 on the next page) to assist in evaluating liquidity and determining the appropriate rating for the “L” component in CAMELS.

For institutions that present increased risk for liquidity, examiners are to consider whether the institution should be rated a “3,” “4,” or “5” for the “L” component of the CAMELS ratings. These ratings indicate that a financial institution’s liquidity risk and funds management practices need improvement, are deficient/inadequate, or are critically deficient and threaten the viability of the institution.

Section 6.1 of the Examination Manual states that the formality and sophistication of liquidity management depends on the size and sophistication of the financial institution as well as the nature and complexity of the institution’s activities. In addition, Section 6.1 states that a financial institution should have a BOD that understands the nature and level of the institution’s liquidity risk, establishes the institution’s tolerance for liquidity risk, and approves significant policies related to liquidity management. Further, Section 6.1 states that financial institutions should have liquidity risk management control elements that include:

• BOD-approved written policies and procedures for the day-to-day management of liquidity and that should be communicated throughout the institution;
• management reporting systems adequate to measure, monitor, and control liquidity risk and that provide regular reports to the BOD and senior management;
• adequate internal controls to ensure the integrity of the institution’s liquidity risk management process; and
• a CLP that (1) addresses alternative funding if initial projections of funding sources and uses of those funds are incorrect or if a liquidity crisis arises and (2) is updated regularly.

Section 6.1 also provides information on mechanisms to monitor various internal and market indicators of liquidity problems at the institution. In addition, the Examination Manual provides specific information on retail funding sources such as core deposits11 and wholesale funding sources, such as federal funds, public funds, Federal Home Loan Bank (FHLB) advances,¹² foreign deposits, brokered deposits, and deposits obtained through the Internet or certificate of deposit listing services.

DSC Financial Institution Guidance

The FDIC has issued financial institution letters (FIL),13 specifically, FIL-59-2003 and FIL-74-2005 that provide liquidity-related guidance to FDIC-supervised financial institutions. The FILs are to be used by financial institutions as the basis for the development of a CLP that incorporates the Federal Reserve’s discount window programs, as well as other viable sources of liquidity funds, and as clarification on applying of the asset quality test for liquidity facilities.

• FIL-59-2003, Use of the Federal Reserve’s Primary Credit Program in Effective Liquidity Management, dated July 23, 2003, presents information on these programs and provides directors, management, examiners, and supervisors of depository institutions guidance on the appropriate use of primary and secondary credit in effective liquidity management, with particular focus on the primary credit program.14
  
  In addition, FIL-59-2003 states that the agencies have advised financial institutions that sound liquidity risk management requires well-established strategies, policies and procedures, liquidity risk measurement systems, adequate internal controls, and contingency liquidity planning. Adequate contingency liquidity planning is critical to the ongoing maintenance of the safety and soundness of any depository institution. Such planning starts with an assessment of the possible liquidity events that an institution might encounter. A fundamental principle in designing contingency plans is to ensure adequate diversification in the potential sources of funds to be utilized.
• FIL-74-2005, Capital Standards, Supervisory Guidance on the Eligibility of Asset-Backed Commercial Paper Liquidity Facilities and the Resulting Risk-Based Capital Treatment, dated August 4, 2005, addresses the eligibility of ABCP liquidity facilities.

During our audit, we noted: (1) variations in the type and extent of information included in financial institutions’ CLPs, (2) examiner guidance that is more extensive than financial institution guidance, and (3) variations in the type and extent of guidance issued by the FDIC as compared to the other agencies. These areas are described in detail in the following paragraphs.

Contingency Liquidity Planning. DSC officials provided CLPs and related documentation for 31 of the 40 financial institutions included in our sample. Of those 31 financial institutions, 15 were rated “2” for liquidity, and 16 were rated “3,” “4,” or “5” for liquidity. According to the Examination Manual, CLPs help management to monitor liquidity risk, ensure that an appropriate amount of liquid assets is maintained, measure and project funding requirements during various scenarios, and manage access to funding sources. Based on our analysis of the contingency liquidity planning for those 31 financial institutions and our review of the 13 plan elements listed in the Examination Manual (as stated in Appendix 2 of this report), we determined that the institutions’ contingency planning actions widely varied as noted in Table 2 below.

Our review of the actions to address contingency planning for 31 financial institutions determined that some of the 13 CLP elements included in the Examination Manual were not always specifically covered in the contingency planning actions. However, we also determined that financial institutions included other elements to assist the institutions in managing liquidity risk. Those elements included, but are not limited to:

• identifying new customers or funding sources and maximizing current customer deposit business,
• monitoring demand deposit and time deposit activities of the largest customers,
• selling all unpledged securities that are at break-even or at a profit and investing proceeds in federal funds,
• limiting lending facilities if liquidity risk increases at the financial institution and directing the institution to take action in the following order:
  • temporarily cease commercial lending,
  • discontinue loans to new customers, and
  • refuse short-term, working capital loans to existing commercial customers or short-term loans to consumer customers.

Extent of Examiner Guidance Compared to Financial Institution Guidance. The FDIC has provided liquidity-related guidance to its examiners. However, the FDIC’s institution guidance provides limited information on liquidity risk management controls that institutions should use to identify, measure, monitor, and control liquidity risk. In contrast, FDIC examiner guidance contains comprehensive information to assist in the evaluation of FDIC-supervised financial institutions’ liquidity risk and outlines specific liquidity risk management controls that examiners should consider during risk management examinations.

FIL-59-2003 discusses the use of the Federal Reserve’s discount window and provides guidance, to some degree, on liquidity risk management controls, including CLPs. Specifically, the FIL (1) provides interagency guidance on the need for financial institutions to develop CLPs that incorporate the Federal Reserve’s discount window programs, as well as other viable sources of liquidity funds, and (2) informs depository institutions that sound liquidity risk management requires the four elements listed in Table 3 below.

The majority of the guidance on CLPs in FIL-59-2003 relates to the Federal Reserve’s discount window, in general, and the primary and secondary credit programs, in particular. More specifically, FIL-59-2003 does not provide detailed guidance on:

• BOD and senior management oversight,
• policies and procedures,
• management reports,
• internal controls, and
• warning indicators.

In contrast to the FIL, examiner guidance in the Examination Manual stresses the importance of financial institutions’ policies and procedures established by a sound liquidity and funds management policy and provides detailed information on the types of institution policies and procedures needed (see Figure 1). The Examination Manual also provides detailed examiner guidance related to other liquidity risk management controls, including internal controls and management reporting.

Figure 1: Examples of Policies and Procedures Included in Examiner Guidance But Not in Financial Institution Guidance Establishment of an asset/liability committee. Periodic review of the bank’s deposit structure. Policies and procedures that address funding concentration in, or excessive reliance on, any single source or type of funding, such as brokered deposits, Internet deposits, and other similar rate sensitive or credit sensitive deposits. Method of computing the bank’s cost of funds.

Source: Examination Manual, Section 6.1.

Appendix 3 provides additional information on our comparison of the FDIC’s examiner and financial institution guidance.

Other Agencies’ Liquidity Risk Management Guidance. The FDIC and the other agencies have addressed liquidity risk in various ways. More specifically, all of the agencies have issued joint and individual liquidity-related guidance to the respective institutions they supervise. For example, the agencies jointly issued guidance related to the use of the Federal Reserve’s discount window, ABCP liquidity facilities, and a Joint Agency Advisory on Brokered and Rate Sensitive Deposits, dated May 11, 2001,15 which supplements each agency's existing supervisory and examination guidance on funding and liquidity issues.¹⁶

However, unlike the FDIC, the other federal regulatory agencies have issued more extensive liquidity-related institution guidance that provides detailed information on liquidity risk management controls. For example, other agency guidance includes detailed information on sound practices for liquidity management, suggested liquidity reports, and red flags (see Figure 2) that may be used as leading indicators of liquidity-related problems.

Red Flags That May Indicate Problems Related to Liquidity Risk Management Exceeding liquidity risk limits established by the financial institution’s BOD. Changes in significant funding sources. Rapid asset growth funded by rate and/or credit sensitive funding, such as brokered deposits or deposits obtained through certificate of deposit listing services. Eliminated or decreased credit line availability from lenders. Ineffective CLPs that are not current and commensurate with the complexity of the financial institution’s funding activities.

Source: OCC financial institution guidance, Detecting Red Flags in Board Reports—A Guide for Directors.

Appendix 4 of this report contains additional information on guidance provided by the other federal regulatory agencies.

Conclusion

The FDIC has initiatives underway to review and enhance financial institution and examiner liquidity-related guidance based on forthcoming BCBS guidance. The FDIC plans to issue updated institution guidance after the BCBS has issued final liquidity risk management guidance and related interagency efforts are completed. Because we noted no matters warranting additional management action, we made no recommendation related to the audit objective.

CORPORATION COMMENTS

On July 23, 2008, the Director, DSC, provided a written response to the draft report. DSC’s response is provided in its entirety as Appendix 5 of this report. In its response, DSC acknowledged the FDIC’s role in the BCBS’ Working Group on Liquidity, which is in the process of developing updated guidance expected to be issued later in 2008 and is planning to issue domestic interagency guidance shortly after the BCBS guidance is finalized. DSC also stated that the FDIC:

• is involved with international and interagency partners in providing industry guidance as well as training to examiners; and
• plans to issue updated financial institution guidance shortly that provides detailed descriptions of sound liquidity risk management controls and suggests key liquidity reports and typical red flags that are useful in assessing liquidity and that can be used as leading indicators for liquidity risk.

Objectives and Scope

The audit objective was to assess how the FDIC addresses institution liquidity risk through various regulatory and supervisory activities. Specifically, we reviewed (1) risk management examinations; (2) institution and examination policies, procedures, and guidance; and (3) examiner training. We conducted this performance audit from November 2007 through May 2008 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our significant findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Methodology

To obtain an understanding of DSC guidance for liquidity risk, we interviewed DSC officials in Washington, D.C., and reviewed the following FDIC financial institution and examiner guidance related to liquidity:

• two FILs issued to financial institutions,
• the Risk Management Examination Manual of Credit Card Activities,
• the Risk Management Credit Card Securitization Manual,
• the Case Manager Procedures Manual,
• ED Modules,
• RD memoranda, and
• Parts 325 and 337 of the FDIC Rules and Regulations.

In addition, we reviewed a non-statistical sample17 of 40 FDIC-supervised financial institutions, which consisted of 20 institutions for which the liquidity rating had been lowered from “1” to “2” at the most recent examination and 20 institutions with a liquidity rating of “3,” “4,” or “5.” The sample was selected as of December 31, 2007 and included the 10 largest institutions rated “2” in liquidity and the 10 largest institutions rated “3,” “4,” or “5” based on total asset size. The sample also included 10 randomly-selected institutions from each of those two categories. For those 40 financial institutions, we obtained supervisory documentation from the FDIC’s Virtual Supervisory Information on the Net (ViSION)¹⁸ System that included:

• ROEs and visitation reports;
• state regulatory agencies’ examination results;
• supervisory documentation that included pre-examination planning data; liquidity ratios; targeted risk areas; supervisory plans; FDIC supervisory comments on various supervisory issues, including enforcement actions, progress reports, correspondence, and offsite reviews; problem bank memoranda; and supervisory and enforcement actions; and
• supervisory comments on large insured depository institutions,19 if applicable.

We limited our review to information readily obtainable from ViSION and did not review any examination work papers or regional or field office correspondence except information related to CLPs for 31 of the 40 sampled financial institutions.

We developed a data collection instrument focusing on broad categories of liquidity and management controls described in examiner guidance included in DSC’s Examination Manual. Those categories included:

• BOD and senior management oversight,
• written policies and procedures,
• management reporting to the institution’s BOD and senior management,
• internal controls,
• CLPs, and
• sources of funding.

Internal Control

To obtain an understanding of relevant internal controls, we interviewed DSC officials and reviewed FDIC policies and procedures provided to financial institutions and examiners in the following:

• FILs—issued by the FDIC to the institutions it supervises, address issues such as the use of the Federal Reserve’s primary credit program (FIL-59-2003, dated July 23, 2003) and the eligibility of ABCP liquidity facilities (FIL-74-2005, dated August 4, 2005).
• DSC’s Examination Manual—provides guidance to assist examiners in evaluating the adequacy of a financial institution’s liquidity position, taking into consideration the institution’s current level and prospective sources of liquidity compared to funding needs, as well as the adequacy of funds management practices relative to the institution’s size, complexity, and risk profile.
• Risk Management Examination Manual of Credit Card Activities—provides guidance to assist the examiner’s review of the credit card activities process, including its relationship to liquidity. The manual addresses various areas that examiners should consider during examinations, including but not limited to, funds management policies, CLPs, cash flows for credit card lending, brokered and rate-sensitive deposits, securitization, asset management, and funding concentrations.
• Risk Management Credit Card Securitization Manual—serves as guidance for examiners in their review of the credit card securitization process, including its relationship to liquidity. The manual discusses the principals involved in the credit card securitization process such as ABCP conduits and their roles and liquidity facilities. According to the manual, examiners should review the liquidity implications of the institution’s securitization activities in relation to the bank's normal liquidity management process, including contingency planning.
• ED Module, Liquidity—is designed to assist examiners in providing consistency and standardized procedures and decision factors during risk management examinations. The ED module provides core, expanded, and impact examination procedures. Examiner use of the module is discretionary.
• RD Memoranda—address the following liquidity-related topics.
  • Federal Home Loan Bank Advances, Transmittal Number 2000-046, dated August 22, 2000.
  • Revised Examination Guidance for Liquidity and Funds Management, Transmittal Number 2002-01, dated November 19, 2001.
  • Wholesale Funding, Transmittal Number 02-039, dated August 28, 2002.

Reliance on Computer-processed Information

For purposes of the audit, we did not rely on computer-processed information to support our findings, conclusions, and recommendations. Our assessment centered on the review of:

• The FDIC’s ROEs and visitation reports and state regulatory agencies’ examination results for the most recent examination conducted as of December 31, 2007;
• supervisory documentation that included pre-examination planning data and liquidity ratios, targeted risk areas, supervisory action plans, FDIC supervisory comments, and problem bank memoranda;
• supervisory and enforcement actions; and
• supervisory comments on large insured depository institutions, if applicable.

We determined that information system controls were not significant to our audit objectives. Accordingly, we did not consider it necessary to develop procedures to assess those controls. In addition, the FDIC OIG is currently conducting an audit entitled, ViSION System’s Data Reliability and Security Controls. The objective of that audit is to assess the reliability of key supervisory information in the FDIC’s ViSION system.

Compliance with Laws and Regulations

We coordinated with the Counsel to the Inspector General to identify the laws and FDIC regulations related to liquidity risk and to determine specific requirements that would apply to FDIC-supervised institutions, in general, and DSC examinations, in particular. We determined that there are no laws and regulations applicable to liquidity risk, in general. However, there are specific laws and regulations that relate to restrictions placed on financial institutions based on capital level categories established by Section 38 of the FDI Act, the use of funding sources such as brokered deposits in compliance with Section 29 of the FDI Act, and borrowings from the Federal Reserve Banks in compliance with Section 10B of the Federal Reserve Act and Section 41 of the FDI Act. During the course of the audit, no instances of noncompliance come to our attention.

We assessed the risk of fraud and abuse related to the audit objective in the course of evaluating audit evidence.

Performance Measurement

The Government Performance and Results Act of 1993 directs Executive Branch agencies to develop a strategic plan that sets performance goals and objectives for agency management. We reviewed the FDIC’s 2005-2010 Strategic Plan, the 2008 Annual Performance Plan, and DSC’s divisional performance objectives to determine whether the Corporation and/or DSC had performance goals, objectives, and indicators or targets that specifically relate to the examination of financial institutions for liquidity risk.

We did not identify any specific performance goals related to liquidity risk. However, according to the FDIC’s 2008 Annual Performance Plan, the FDIC has established the following strategic goal, objective, performance goals, and indicators and targets related to the risk management components of the FDIC’s Supervision Program, which relates to the examination and supervision of financial institutions’ liquidity risk management.

Table 4: The FDIC’s Activities to Address the Government Performance and Results Act
Strategic Goal	Strategic Objective	Annual Performance Goals	Indicators And Targets
FDIC-supervised institutions are safe and sound.	FDIC-supervised institutions appropriately manage risk.	Conduct on-site risk management examinations to assess the overall financial condition, management practices and policies, and compliance with applicable laws and regulations of FDIC-supervised depository institutions.	Indicator: Percentage of required examinations conducted in accordance with statutory requirements and FDIC policy. Target: 100 percent of required risk management examinations are conducted on schedule.
		Take prompt and effective supervisory action to address issues identified during the FDIC examination of FDIC-supervised institutions that receive a composite uniform financial institutions rating of “4” or “5” (problem institution). Monitor FDIC-supervised insured depository institutions’ compliance with formal and informal enforcement actions.	Indicator: Percentage of follow-up examinations of problem institutions conducted within required time frames. Target: 100 percent of follow-up examinations are conducted within 12 months of completion of the prior examination.

Source: The FDIC’s 2008 Annual Performance Plan.

Prior Coverage

In an August 1996 audit report entitled, Audit of the Effectiveness of Deposit Restrictions on Institutions That Are Not Well Capitalized (Audit Report No. 96-083), the FDIC OIG reported on the effectiveness of deposit restrictions on institutions that were not well capitalized, as defined in Section 29 and 11(a)(1)(D)(ii) of the FDI Act. Section 29, Brokered Deposits, restricts the acquisition of brokered and high-rate deposits by all but well-capitalized financial institutions. Section 11, Insurance Funds, reduces the amount of deposit insurance coverage available for retirement and other employee benefit plan deposits when an institution is restricted from accepting brokered deposits. Both of these provisions were designed to contribute to the reduction of losses to the Deposit Insurance Funds by limiting problem institutions’ access to certain sources of volatile deposits that may allow weak institutions to continue funding operations. The OIG concluded that Section 29 and Section 11 had not always been effective in restricting less than well-capitalized banks’ access to volatile deposits and reducing insurance fund losses, respectively. In addition, the OIG concluded that interest rate restrictions in Section 29 were so complex that implementation of this restriction was difficult and burdensome to administer. The report made several recommendations to address identified deficiencies.

DSC’s Examination Manual presents information on CLPs and 13 elements that the plans should include. The Examination Manual states that a CLP helps ensure that a financial institution can prudently and efficiently manage routine and extraordinary fluctuations in liquidity. The Examination Manual also states that each institution’s liquidity policy should have a CLP that addresses alternative funding if initial projections of funding sources and uses are incorrect or if a liquidity crisis arises. Such a plan also helps management to monitor liquidity risk, ensure that an appropriate amount of liquid assets is maintained, measure and project funding requirements during various scenarios, and manage access to funding sources. As specifically stated in the manual:

The contingency plan should be updated on a regular basis and:

• Define responsibilities and decision-making authority so that all personnel understand their role during a problem-funding situation.
• Include an assessment of the possible liquidity events that an institution might encounter. The types of potential liquidity events considered should range from high-probability/low-impact events that can occur in day-to-day operations, to low-probability/high-impact events that can arise through institution-specific, systemic market, or operational circumstances.
• Assess the potential for erosion (magnitude and rate of outflow) by funding sources under optimistic, pessimistic, and status quo scenarios.
• Assess the potential liquidity risk posed by other activities such as asset sales and securitization programs.
• Analyze and make quantitative projections of all significant on- and off-balance sheet fund flows and their related effects.
• Match potential sources and uses of funds.
• Establish indicators that alert management to a predetermined level of potential risks.
• Identify and assess the adequacy of contingent funding sources. The plan should identify any back-up facilities (lines of credit), the conditions related to their use, and the circumstances where the institution might use them. Management should understand the various conditions, such as notice periods, that could affect access to [the] back-up line and test the institution’s ability to borrow from established back-up [line] facilities.
• Identify the sequence in which sources of funds will be used for contingent funding needs. The uncertainty of the magnitude and timing of available resources may call for different priorities in different situations.
• Assess the potential for triggering legal restrictions on the bank’s access to brokered deposits under PCA [prompt corrective action] standards and the effect on the bank’s liability structure.
• Accelerate the timeframes for reporting, such as daily cash flow schedules, in a problem liquidity situation.
• Address procedures to ensure funds will meet the overnight cash letter.20
• Include an asset tracking system that monitors which assets are immediately available for pledging or sale and how much a cash sale of these assets will generate.

This appendix contains detailed information related to actions taken by the OTS, OCC, and Federal Reserve to address institution liquidity risk, discussed in our report section entitled, FDIC Examination and Financial Institution Guidance for Liquidity Risk. Those actions include guidance that each agency has issued individually, as discussed below.21

OTS Guidance

The OTS has issued Sound Practices for Liquidity Management at Savings Associations-Thrift Bulletin 77, which includes specific guidance for management and the BOD of thrift institutions on liquidity management and states that:

• Each institution should have a written strategy for the day-to-day management of liquidity.
• The liquidity strategy should define the institution’s general approach to managing liquidity, including various quantitative and qualitative targets.
• The liquidity strategy should cover specific policies on the composition of assets and liabilities, the use of wholesale funding, and strategies for addressing temporary and long-term liquidity disruptions.

In addition, Bulletin 77 provides detailed information, including suggested sound liquidity practices, on each of the components of liquidity risk management, including, but not limited to:

• BOD and senior management oversight,
• policies and procedures,
• management reporting to the institution’s BOD and senior management,
• measuring and monitoring liquidity,
• scenario analysis,
• contingency planning, and
• managing access for funding sources.

OCC Guidance

The OCC has provided the following extensive liquidity-related guidance to its financial institutions to assist in identifying, measuring, monitoring, and controlling liquidity risk.

The Director’s Book—The Role of the National Bank Director. The handbook (1) contains general concepts and standards for the safe and sound operation of a bank; and (2) outlines the responsibilities of the BOD, highlighting areas of particular concern, and addresses, in broad terms, the duties and liabilities of the individual director. Examples from the handbook follow:

• The BOD must make certain that the bank’s liquidity risk position is reasonable and does not compromise the bank’s ability to maintain earnings and protect capital.
• Such risks must be commensurate with management’s expertise and the bank’s balance sheet flexibility, especially since rapidly changing market conditions can have a substantial impact on the bank’s position.
• Management should provide regular reports to the BOD on all off-balance sheet activity. These reports should explain the types and amount of risk involved and indicate which internal controls and audit and monitoring functions are in place to manage risks.
• Management should provide the BOD with relevant and appropriate financial information. Useful reports are likely to include the following information: budgeted compared to actual performance; portfolio activity, including classified asset trends, significant loans, past dues, and renewals; liquidity trends; off-balance sheet exposures, including derivatives activities; large depositor listings to determine volatile liabilities; and interest rate sensitivity reports.

Detecting Red Flags in Board Reports—A Guide for Directors. The OCC issued this guide to assist the BOD of a financial institution in assessing risk prospectively. This guide identifies various leading indicators of increasing credit risk, liquidity risk, and interest rate risk that should be a part of ongoing BOD reports.

Additionally, the guide states that the BOD should regularly receive reports on liquidity risk. To effectively use financial information, directors should review the trend and level of individual measures and the interrelationships among capital, asset quality, earnings, liquidity, market risk, and balance sheet growth. The BOD and institution management should ensure that the institution has a realistic CLP in case of market disruptions.

The guide includes the following suggested reports that should assist the directors in assessing the bank’s liquidity risk:

• Liquidity risk report—shows the level and trend of the financial institution’s liquidity risk by a variety of appropriate measures. The report should indicate how much liquidity risk the institution is assuming, whether management is complying with risk limits, and whether management’s strategies are consistent with the BOD’s expressed risk tolerance.
• Funds provider report—lists large funds providers and identifies funding concentrations.
• Projected needs and sources report—projects future liquidity needs for a prescribed timeframe and compares these projections to available sources of funds.
• Funds availability report—states the amount of borrowing capacity based on established lines of credit and indicates the amount of funding the financial institution can obtain based on its financial condition and qualifying collateral.
• Cash flow or funding gap report—reflects the quantity of cash available compared to the quantity of cash required within the same periods. The difference between the available and required amounts is the cash flow or funding “gap.” The report may also include growth projections and the impact of rate changes on cash flows.
• Funding concentration report—reflects significant funding from a single source or from multiple sources that have common credit or rate sensitivity. A funding concentration occurs when a single decision or factor might cause a significant and sudden withdrawal of funds.
• CLP—may incorporate the funding gap report or may be an outgrowth of that report. The CLP forecasts funding needs and funding sources under varying market scenarios resulting in rapid liability erosion.

The OCC guide also provides a list of liquidity ratios and red flags the institution’s BOD can use as leading indicators of problems related to liquidity risk. The red flags include the following:

• Exceeding liquidity risk limits established by the financial institution’s BOD.
• Frequent exceptions to the financial institution’s liquidity risk policy.
• Change in significant funding sources.
• Funding concentration from a single source or multiple sources with a common credit or rate sensitivity.
• Rapid asset growth funded by rate and/or credit-sensitive funding, such as brokered deposits, or deposits obtained through certificate of deposit listing services.
• Large purchases in the brokered funds or other potentially volatile markets.
• Eliminated or decreased credit line availability from lenders.
• Mismatching funds by funding long-term assets with short-term liabilities.
• Ineffective CLPs that are not current and commensurate with the complexity of the financial institution’s funding activities.

Federal Reserve Guidance

The Federal Reserve has provided liquidity-related guidance to the financial institutions it supervises in various Supervision and Regulation (SR) Letters.22 For example, the SR Letter entitled, Bank Holding Company Funding and Liquidity (SR-90-20), dated June 22, 1990, provides information on (1) the avoidance of funding strategies or practices that could undermine public confidence in liquidity or stability and (2) prudent financial practices for bank holding companies, including establishing and maintaining reliable funding and contingency plans. An excerpt from the guidance follows:

• Bank holding companies should establish and maintain reliable CLPs to meet ongoing liquidity needs and to address any unexpected funding mismatches that could develop over time. Such plans could include reduced reliance on short-term purchased funds, greater use of longer-term financing, appropriate internal limitations on parent company funding of long-term assets, and reliable alternate sources of liquidity.
• Prudent internal liquidity policies and practices should include specifying limits for, and monitoring the degree of reliance on, particular maturity ranges and types of short-term funding. Special attention should be given to the use of overnight money since a loss of confidence in the issuing organization could lead to an immediate funding problem.