Why Stress Testing Liquidity is Critical Before a Potential Recession

While many major banks recently reported positive earnings announcements, the news certainly hasn’t been all good. Numerous market indicators point to possible signs of a recession. Some banks are proactively taking steps to prepare for a potential recession and it’s critical that all banks take a closer look at enterprise-wide liquidity.

Recession Signals Persist Despite Positive Earnings

At their March meeting, the Federal Reserve expressed concern that the impact of the SVB and Signature bank failures could cause “a mild recession.”  Leveraged loans have grown significantly while loan credit quality weakened after the fall of SVB and Signature Bank.  Defaults on high-yield bonds have increased.  Retail credit cards reported 5 straight months of growing charge-offs. And Janet Yellen recently stated that US banks are likely to tighten lending requirements, making it more difficult for highly leveraged companies to meet their debt obligations.

Understanding Liquidity Coverage in Preparation for a Recession

With the financial runs on SVB and Signature top-of-mind for many, risk managers should be reassessing credit risk and increasing high-quality liquid assets(HQLA). After the 2007-2008 banking crisis, new regulations including the liquidity coverage ratio (LCR) were put into place to reduce the risk of liquidity crises. The LCR protects banks from short-term, severe liquidity stress by requiring they have enough HQLA to cover 30 days’ worth of cash outflow.

Whilst many banks are meeting the Basel III Liquidity Coverage Ratio, digging a little deeper exposes trends that could be concerning. Forbes compared the current LCR rates of some of the major banks as well as the USLCR average to the rates in 2022, when the financial markets were stronger than they are now.  Starting with a weaker liquidity position in a weaker market could be an indicator of potential issues. As Forbes explains, “given how quickly liquidity concerns can arise, [these] trend[s] merits observation.”

·        JPMorgan’s bank liquidity coverage ratio of 140%is substantially higher than the 2022 US average, but it is still lower than their own LCR ratio in 2022.

·        Citigroup, Wells Fargo, and PNC all meet the minimum LCR requirement but their LCRs are lower than the US LCR average in 2022.

·        PNC’s 103% average LCR is only slightly above the 100% minimum requirement.

While the four of the largest banks hold a significant number of banking assets, the LCR ratios of the remaining top 10 as well as the middle-tier and smaller banks will be important to understand.

Why Stress Testing is Critical for Liquidity Coverage

While mid-tier and smaller banks are not subject to the same level of stress testing regulatory requirements, that could change. And regardless of regulations, all banks should be thoroughly evaluating liquidity in preparation for any potential recession to avoid being the next bank to fail.

An integrated view of risk across the bank’s entire portfolio is critical to truly understanding the impact of potential recession scenarios. Yet, stress testing often occurs in separate, disconnected risk models. Stress testing in a consistent manner across an entire enterprise can be challenging for some banks when different risk models live in silos across a financial institution.

Since risk management departments are highly dependent on Excel for risk management, siloed models are a common scenario. Banks have recognized for quite some time the limitations of Excel but risk managers and staff are reluctant to move away Excel. And for good reason — Excel offers an unmatched level of flexibility to create complex business logic without programming expertise.

A Better Way to Conduct Reliable, Accurate Stress Testing

Spreadsheet interoperability is key to understanding the impact of potential changes within a single, integrated risk profile. While interoperability may sound impossible when you have siloed spreadsheets, it is achievable without an intensive or intrusive enterprise software implementation.

By quickly and easily converting complex spreadsheets into code which can be integrated with any downstream system able to consume APIs platforms like Coherent Spark enables spreadsheets to be controlled in a centralized manner. Models can be quickly integrated into existing cloud-based systems, or your team can build, model, and test directly in the Coherent platform.

Need More Visibility into Your True Liquidity Situation?

With Coherent Spark, silos disappear. Visibility and transparency into a broader, bank-wide view of risk and liquidity emerges, ensuring your bank is prepared for a recession or any scenario. To learn more, explore our free sandbox and turn your own spreadsheet models into enterprise-wide code in seconds.