Institution’s liquidity- and funding-specific stress testing

Competent authorities should assess whether an institution has implemented adequate liquidity-specific stress testing, in accordance with the EBA Guidelines on institutions’ stress testing⁵⁵ :

• a. to understand the impact of adverse events on its risk exposure and to be able to assess the adequacy of its liquid assets, counterbalancing capacity and funding structure;
• b. to cover risks that may crystallise during different types of stress scenarios and/or to address risks posed by control, governance or other deficiencies.

⁵⁵ EBA/GL/2018/04

Competent authorities should take into account whether the framework permits the institution to:

• a. determine the institution’s survival horizon given its existing liquidity buffer and stable sources of funding, and taking into account the institution’s risk appetite, during a severe but plausible liquidity stress period;
• b. analyse the impact of stress scenarios on its consolidated group-wide liquidity position and on the liquidity position of individual entities and business lines;
• c. understand where risks could arise, regardless of its organisational structure and the degree of centralised liquidity risk management.

Competent authorities should ensure that the institution provides the modelled impact of different types of stress scenarios (as explained in the EBA Guidelines on institutions’ stress testing), as well as a number of sensitivity tests (on the basis of proportionality). The stress scenarios and shocks simulated in them should not only be based on the past, but also make use of hypothetical stress scenarios based on expert judgement. Competent authorities should analyse whether the following scenarios are considered as a minimum:

• a. short-term and prolonged;
• b. institution-specific and market-wide (occurring simultaneously in a variety of markets);
• c. a combination of (a) and (b).

An important aspect that competent authorities should consider when assessing the institution’s stress testing framework is the modelling of the impact of the hypothetical stress scenario(s) on the institution’s cash flows and on its counterbalancing capacity and survival horizon, and whether the modelling reflects the different impacts that economic stress may have on both an institution’s assets and its in- and outflows.

Competent authorities should also assess whether the institution takes a conservative approach to setting stress testing assumptions. Depending on the type and severity of the scenario, competent authorities should consider, as relevant, the appropriateness of a number of assumptions, in particular:

• a. the run-off of retail funding;
• b. the reduction of secured and unsecured wholesale funding;
• c. the correlation between funding markets and diversification across different markets;
• d. additional contingent off-balance sheet exposures;
• e. funding tenors (e.g. where the funding provider has call options);
• f. the impact of any deterioration of the institution’s credit rating;
• g. FX convertibility and access to foreign exchange markets and correspondent banking accounts;
• h. the ability to transfer liquidity across entities, sectors and countries;
• i. estimates of future balance-sheet growth;
• j. due to reputational risks, an implicit requirement for the institution to roll over assets and to extend or maintain other forms of liquidity support.

Competent authorities should assess whether the management framework of the institution’s liquidity-specific stress testing is appropriate and whether it is properly integrated into the overall risk management strategy. They should take into account:

• a. whether the extent and frequency of stress tests are appropriate to the nature and complexity of the institution, its liquidity risk exposures and its relative importance in the financial system;
• b. whether the outcomes of stress testing are integrated into the institution’s strategic planning process for liquidity and funding and used to increase the effectiveness of liquidity management in the event of a crisis, including in the institution’s liquidity contingency and recovery plan;
• c. whether the institution has an adequate process for identifying suitable risk factors for conducting stress tests, having regard to all material vulnerabilities that can undermine the liquidity position of the particular institution;
• d. whether assumptions and scenarios are reviewed and updated sufficiently frequently;
• e. where the liquidity management of a group is being assessed, whether the institution pays adequate attention to any potential obstacles to the transfer of liquidity within the group.

Liquidity and funding risk internal control framework

Competent authorities should assess whether the institution has a strong and comprehensive internal limit and control framework, and sound safeguards to mitigate its liquidity and funding risk in line with its risk appetite and to ensure the availability of a diversified funding structure. They should take into account whether the limit and control framework is adequate for the institution’s complexity, size and business model and reflects the different material drivers of liquidity risk and the outcomes of liquidity stress tests.

Competent authorities should consider whether the institution has limits to ensure consistency between the currency denomination of their liquid assets and the distribution by currency of their net liquidity outflows in accordance with Article 8(6) of Commission Delegated Regulation (EU) 2015/61.

Competent authorities should assess whether the limits are approved and regularly reviewed by the competent bodies of the institution and communicated to all relevant business lines. This process, along with how the institution monitors compliance with limits and the escalation process for breaches, should be clearly documented in its procedures.

Competent authorities should assess whether the institution has implemented an adequate transfer pricing system as part of the liquidity risk control framework, which incorporates all relevant liquidity costs, benefits and risks. Competent authorities should take into account whether the transfer pricing mechanism allows management to give appropriate incentives for managing liquidity risk, and whether the system and its calibration are reviewed and updated appropriately given the size and complexity of the institution. In addition, competent authorities should assess whether the institution’s policy on incorporating the funds transfer pricing (FTP) methodology into the internal pricing framework is used for assessing and deciding on transactions with customers (this includes both sides of the balance sheet, e.g. granting loans and taking deposits).

Competent authorities should assess whether the institution has adequate controls regarding the liquid-assets buffer, including concentration limits and appropriate ongoing monitoring of the adequacy of the buffer and for changes in market conditions that could affect the institution’s ability to liquidate its assets quickly. Liquidity contingency plans

Competent authorities should assess whether the institution’s liquidity contingency plan (LCP) adequately specifies the policies, procedures and action plans for responding to severe potential disruptions to the institution’s ability to meet its liquidity needs and fund itself. They should take into account the content and scope of contingency funding measures included in the LCP, and in particular factors such as:

• a. whether the LCP adequately explains governance arrangements for its activation and maintenance;
• b. whether the LCP appropriately reflects the institution’s liquidity- and funding-specific and wider risk profile;
• c. whether the institution has a framework of liquidity early warning indicators, including among others those established as liquidity indicators in the EBA GL on recovery plan indicators that are likely to be effective in enabling the institution to identify deteriorating market circumstances in a timely manner and to quickly determine what actions need to be taken;
• d. whether the LCP describes clearly that the LCR liquidity buffer is designed to be used in case of stress, even if that leads to LCR values below 100%, including that it is part of the expected management of liquidity risk under stress that subsequent communications to senior management take place if established lower LCR values are reached. The LCP should clearly reflect and describe how liquidity risk should be managed under stress to steer towards targeted LCR levels as closely as possible;
• e. whether the LCP clearly articulates all material (potential) funding sources, including the estimated amounts available for the different sources of liquidity and the estimated time needed to obtain funds from them;
• f. whether the measures are in line with the institution’s overall risk strategy and liquidity risk appetite;
• g. the appropriateness of the assumptions regarding the role of central bank funding in the institution’s LCP. Examples of factors competent authorities may consider could include the institution’s views on:

I. the current and future availability of potential alternative funding sources connected to central bank lending programmes; II. the types of lending facilities, the acceptable collateral and the operational procedures for accessing central bank funds; III. the circumstances under which central bank funding would be needed, the amount required and the period for which such a use of central bank funding would probably be required.

Competent authorities should assess whether the actions described in the LCP are feasible in relation to the stress scenarios in which they are meant to be taken. They should take into account factors such as:

• a. the level of consistency and interaction between the institution’s liquidity-related stress tests, its LCP, its liquidity early warning indicators and, where applicable, its liquidity related recovery plan;
• b. whether the actions defined in the LCP appear likely to enable the institution to react adequately to a range of possible scenarios of severe liquidity stress, including institution-specific and market-wide stress, as well as the potential interaction between them; and whether the actions defined in the LCP are prudently quantified in terms of liquidity-generating capacity under stressed conditions and the time required to execute them, taking into account operational requirements such as pledging collateral at a central bank.

Competent authorities should assess the appropriateness of the institution’s governance framework with respect to its LCP. They should take into account factors such as:

• a. the appropriateness of escalation and privatisation procedures detailing when and how each of the actions can and should be activated;
• b. whether the institution has adequate policies and procedures with respect to communication within the institution and with external parties;
• c. the degree of consistency between the LCP⁵⁶ and the institution’s business continuity plans.

Funding plans

⁵⁶ In case the LCP is fully integrated into the recovery plan, this will be incorporated into the liquidity ORC score. In case the LCP is not incorporated into the recovery plan and the two documents are separate, the LCP needs to be analysed separately.

Competent authorities should assess whether the funding plan is feasible and appropriate in relation to the nature, scale and complexity of the institution, its current and projected activities and its liquidity and funding profile. They should take into account factors such as:

• a. whether the funding plan addresses alternative scenarios. Competent authorities should pay particular attention to the robustness of the plan for supporting the projected business activities under adverse scenarios;
• b. the expected change in the institution’s funding profile arising from the execution of the funding plan and whether this is suitable given the institution’s activities and business model;
• c. whether the funding plan supports any required or desired improvements in the institution’s funding profile;
• d. their own view on the (changes in) market activity planned by institutions in their jurisdiction on an aggregated level, and what that means for the feasibility of individual funding plans; and
• e. whether the funding plan is:

I. integrated with the overall strategic plan of the institution;

II. consistent with its business model;

III. consistent with its liquidity risk appetite;

In addition, competent authorities may consider:

• a. whether the institution adequately analyses and is aware of the appropriateness and adequacy of the funding plan given the institution’s current liquidity and funding positions and their projected development. As part of this, competent authorities may consider whether the institution’s senior management can explain why the funding plan is feasible and where its weaknesses lie;
• b. the institution’s policy for determining what funding dimensions and what markets are significant to the institution (and whether it is adequate);
• c. the time horizon envisaged by the institution for migration to a different funding profile, if required or desired, bearing in mind that there may be risks involved if migration towards the end state is either too fast or too slow;a
• d. whether the funding plan contains different strategies and clear management procedures for timely implementation of strategy changes.

Competent authorities should assess whether the institution’s funding plan is appropriately implemented. As a minimum, they should take into account:

• a. whether the funding plan is properly documented and communicated to all the relevant staff;
• b. whether the funding plan is embedded in the day-to-day operations of the institution, especially in the funding decision-making process.

In addition, competent authorities may take into account whether the institution is able to reconcile the funding plan with the data provided to competent authorities in the funding plan template.

Competent authorities should consider the quality of the institution’s processes for monitoring the execution of the funding plan and its ability to react to deviations in a timely manner. For this assessment, competent authorities should take into account factors such as:

• a. the quality of the updates to (senior) management regarding the current status of the execution of the funding plan;
• b. whether the funding plan envisages alternative fall-back measures to be implemented if there are changes in the market conditions; and
• c. the policy and practice of the institution regarding the regular review, back-testing, and updating of the funding plan when the actual funding raised significantly differs from the funding plan.