FINRA Manual: Contents
|View Whole Section||Text only||Print Manager||Link|
15-33 Guidance on Liquidity Risk Management Practices
Referenced Rules and Notices
Regulatory Notice 10-44
Regulatory Notice 10-57
Risk Management Committee
Treasury and Finance Operations
Financial Stress Tests
Liquidity Risk Management Practices
Effective liquidity management is a critical control function at broker-dealers and across firms in the financial sector. Failure to manage liquidity has contributed to both individual firm failures and, when widespread, systemic crises. From an investor protection perspective, sound liquidity risk management practices enhance investor protection because they make it more likely that a firm's customers continue to have prompt access to their assets, even in times of stress.
FINRA is providing guidance on effective practices that senior management and risk managers at firms should consider and implement. This Notice is directed to firms that hold inventory positions or clear and carry customer transactions. Other types of broker-dealers may also find this Notice is of value to them when assessing their own liquidity risks.
Questions concerning this Notice should be directed to:
The primary role of liquidity-risk management is ensuring the availability of cash or highly liquid assets to support a financial institution's funding needs under both normal and stressed conditions. To do so, a financial institution needs a rigorous prospective assessment of its sources of funds to meet obligations, the amounts it will need when a stress occurs, the behavior characteristics of funding sources, and the limitations that funding sources may have or to which they may become subject.
Beginning in March 2014 and continuing into the first quarter of 2015, FINRA conducted a review of the policies and practices at 43 firms related to managing liquidity needs in a stressed environment. The review had two broad purposes: to understand better firms' liquidity risk-management practices and to raise awareness of the need for liquidity stress planning. The review included assessing firm management's knowledge and understanding of the liquidity risks that their firm faced, the firm's ability to measure liquidity needs in stress situations, management's preparedness and plans for addressing such a scenario should it arise, and the specific steps the firm would take to address its needs.
The firms reviewed comprised a wide range of clearing firms and large introducing firms with varying levels of capitalization. The business mix at these firms also varied, from firms that focused on one or two market sectors to firms that provide a full range of products and services. A number of the firms were affiliated with banks, including firms affiliated with non-U.S. banks. In some instances, the banking business was an adjunct to the broker-dealer business and in other instances the banking business was the primary business of the holding company group. Of the 43 participating firms, 28 were part of a bank holding company group1 (11 U.S. bank holding company (BHC) or financial holding company groups, and 17 non-U.S. groups). Of the U.S. firms, nine were associated with BHCs that had greater than $50 billion of total consolidated assets, and two were affiliated with BHCs that had from $10 billion to $50 billion in total consolidated assets.
The review consisted of two phases. The first phase required firms to calculate the impact on liquidity when five stresses were applied concurrently to the broker-dealer's business. The second phase allowed a firm to challenge the severity of the assumptions used in the test, describe mitigating action the firm would take and demonstrate the resources available to offset the stressed outflows of cash.
The results of our review of the 43 firms for effective and ineffective practices in meeting stressed outflows of funds are described in the Results section below. Planning for adverse liquidity conditions based upon stress tests is one way to protect against failure when extreme events occur. The practices described in this Notice are intended to inform senior management and risk managers at firms of steps that they should consider and implement.
In general, each broker-dealer should review its liquidity condition under possible stress events and determine which liquidity management practices are best suited to its particular business. Similar to Regulatory Notice 10-57, this Notice is directed to firms that hold inventory positions or clear and carry customer transactions. Other types of broker-dealers may also find this Notice is of value to them when assessing their own liquidity risks.
Financial Responsibility Rules
A fundamental purpose of the SEC's financial responsibility rules is to assure that broker-dealers have sufficient liquidity to conduct their business or to liquidate it without losses to customers. As part of a firm's obligation to supervise the businesses in which it engages, FINRA expects each firm to regularly assess its funding and liquidity risk management practices so that it can continue to operate under adverse circumstances, whether these result from an idiosyncratic or a systemic event. Sound liquidity risk management practices enhance investor protection because a firm's customers are more likely to continue to have prompt access to their assets.
Twice in the past, FINRA has issued Notices addressing liquidity practices. Notice to Members 99-92 reported on the results of a multi-year effort by examination staffs of the NASD, NYSE and SEC assessing broker-dealer risk management practices. This report set forth general risk management practices that were found to be sound, as well as describing shortcomings at certain firms.
Regulatory Notice 10-57 outlined a number of steps that firms should consider in managing liquidity and funding risks. In addition to criteria for immediate escalation to senior management, the Notice noted 10 areas where appropriate broker-dealer staff (e.g., treasury) should consider reviewing with senior management on a regular basis formal risk reports — both quantitative and qualitative — that summarize key measures of funding and liquidity.
Overview of the Stress Test and FINRA's Stress Criteria
FINRA's current review had two phases. First, each participating firm computed a stress test for a 30-calendar-day period using specific stress criteria. These criteria were selected based, in part, upon our review and analysis of a number of broker-dealers whose businesses had failed during the past 30 years.
The Phase 1 baseline stress test assumed limited or no mitigating action could be taken, so that the result in extreme stress could be observed. The test also assumed that the firm would fulfill all of its contractual obligations as would its counterparties. We believe that these assumptions reflect what may occur in a real idiosyncratic stress situation.
During Phase 2 of the stress test FINRA met with each participating firm to discuss baseline stress results. If any liquidity shortfall resulted during the 30-day period tested during Phase 1, the firm was given the opportunity to identify any mitigating action that it expected to take to ameliorate the shortfall. Phase 2 also involved a discussion of contingent funding sources that a firm expected to be available to offset any stressed outflows, including commitments and contingencies from affiliates and other lenders. A firm that is part of a holding company group, as many of the firms are, was expected to conduct this analysis and have contingency funding plans at the broker-dealer level.2 Planning at the broker-dealer level supplements the corporate group's planning at the holding-company level. Assessing funding and liquidity risks at the broker-dealer level enables the governing boards and senior management of broker-dealers to measure, monitor and control risks that relate specifically to the broker-dealer.3 Further, this level of analysis can help broker-dealers plan for the challenges they would face should access to funding from affiliated entities become limited or unavailable.
The five specific concurrent stresses in the Phase 1 review are described below. In performing the required computations, the firm was asked to include a daily analysis for the first 10 consecutive business days, and a weekly analysis for the remainder of the 30-day stress period.
At the conclusion of both phases of the stress test, FINRA evaluated the liquidity risk management practices of each of the participating firms based on four different criteria. The criteria and basis for evaluation and effective and ineffective practices for managing liquidity stress are described below.
The areas of evaluation and factors we considered under each phase were:
Observations Regarding Effective and Ineffective Practices
|Haircuts by Asset Class|
|U. S. Treasury Bills, Notes and Bonds||Agency and GSE asset backed pass-through securities||Agency and GSE Debentures||Investment grade corporate bonds rated A & Above||Corporate bonds rated BBB||Listed Equities||Municipal Bonds||High Yield Corporate Bonds|
We evaluated each of the participating firms' capacity and readiness in the areas described under evaluation methodology. We also reviewed and evaluated firms upon the numerical outcomes of the stress test before and after applying the firm's proposed mitigants. With respect to the Understanding, Measurement, Planning and Contingent Funding evaluation criteria, we rated the firms as either well prepared, adequately prepared or insufficiently prepared. With respect to four specific mitigants that many firms indicated they would use, we rated the firms as either sufficiently prepared or insufficiently prepared (or N/A, if the mitigant was not applicable).
Of the 43 participants, staff considered the large majority, 37, of the firms participating as having sufficient resources, staff and liquidity plans to be likely to surmount the stress scenario posed. A firm was considered to be sufficiently prepared for significant liquidity stress if it was also able to demonstrate sufficient liquidity throughout the 30 days covered during the test.
A small number of smaller firms did not demonstrate convincingly their preparedness to surmount the stress scenario for 30 days. These six firms could not demonstrate sufficient knowledge and understanding of the impact of the stressors on its business, or could not survive 30 days without running out of liquidity. It is FINRA's belief that of these six firms,5 three have subsequently improved their liquidity plans such that they now appear likely to withstand the stress scenario. We continue to work with the remaining firms as they develop their plans and mitigating strategies. While each of these three firms generally remains in compliance with the net capital and other financial responsibility rules, they continue to be subject to financial and operational surveillance in accordance with criteria described in Regulatory Notice 10-44.
Our evaluation of these areas is summarized in the tables below.
|Contingent Funding Plan||10||27||6|
Number of Firms Sufficiently
Number of Firms Insufficiently
|Factor Not Applicable|
|Committed loan facilities and access to a liquidity pool||37||4||2|
|Responding to customer withdrawal of funds||15||9||19|
|Funding firm inventory||23||10||10|
|Plans for Liquidating Inventory||43||-||-|
The test was intended to serve as a tool to understand the preparedness at firms to employ effective practices so that they could withstand significant idiosyncratic stresses. As part of the review we expected to observe practices that we considered effective for addressing stresses and to assist firms in understanding areas in their own preparation and planning that had weaknesses so their management could address those areas. Firms that implement liquidity risk metrics should ensure that conservative and appropriately difficult assumptions are used in designing the risk measurement and management systems. Failure to do so could well cause the risk management framework to fail in a real liquidity crisis.
Based on this review, FINRA expects that each firm would:
As a result of the many benefits that accrued to the firms participating in this review, FINRA intends to review firm liquidity risk planning and will use stress tests with various designs from time to time in the future, either with a group of firms or as part of the examination of individual firms where appropriate. We strongly encourage all firms to conduct a self-assessment of their businesses and incorporate firm wide liquidity stress testing into their risk and business planning.
1 Fifteen firms were not affiliated with BHCs although several were part of groups that had non-deposit taking trust companies and one was affiliated with a bank but not via a BHC.
2 Bank supervisory agencies routinely conduct stress tests of banks and their holding companies. In the United States these are mandated by the regulations adopted pursuant to the Dodd-Frank Act, 12 CFR part 252, subparts E and F. Recently, the Board of Governors of the Federal Reserve System released "Dodd-Frank Act Stress Test 2015: Supervisory Stress Test Methodology and Results March 2015." The European Banking Authority also conducts stress tests. See, e.g., EBA publishes 2014 EU-wide stress test results. Similarly, the Bank of Japan evaluates funding liquidity risk as part of its semi-annual Financial System Report.
3 The Securities and Exchange Commission has proposed that ANC broker-dealers and nonbank securities based swap dealers approved to use internal models be subject to liquidity risk management requirements. Exchange Act Release No. 34-68071. An ANC broker-dealer is one that is permitted to use the alternative internal model-based method for computing net capital.
4 None of the firms in the review currently do the reserve computation on a daily basis.
5 The six that were insufficiently prepared are not among our 50 largest firms as measured by net capital and none are part of a bank holding company group.