In managing expected cash flows, a credit union may experience various situations that can increase its liquidity risk. These include mismatches between sources and uses of funds, market constraints on the ability to convert assets into cash or to access sources of funds (market liquidity), and contingent liquidity events. Changes in economic conditions or exposure to credit, market, operational, legal, and reputation risks also can affect an institution’s liquidity risk profile. Examiners consider these risk factors when assessing liquidity risk. None of these risks are mutually exclusive and interrelated risks may contribute to increased liquidity risk, such as:
Reputation risk—If a credit union is unable to meet member loan and share demand, the membership could develop a negative outlook or perception of the credit union, potentially leading to a decline in share balances and the membership base. If alternative sources of liquidity cannot offset the decline in shares, costs to replace such funding may rise.
Credit risk—If the quality of a credit union's loan or investment portfolio deteriorates, asset cash flows may decrease and affect liquidity. Liquidating these assets may result in loss, or if market conditions are severe, liquidation may not be possible. In addition, a credit union may not be able to pledge poor quality assets as collateral, which could limit its ability to borrow to meet liquidity needs. Credit losses that are severe enough to cause losses to net worth and a downgrade in CAMELS ratings may cause external funding sources to reduce lines of credit or term borrowing availability.
Interest rate risk—Changes in interest rates can drive share and loan behavior, which can affect cash flows, reinvestment rates, and the value of assets, for example, loans and investments. Together, these factors can reduce a credit union’s liquidity level and net interest margin. Large mismatches between liability maturities and asset maturities cause greater earnings exposure to changes in interest rates. Changes in market conditions are often unpredictable and sometimes severe. These changes can make it difficult and raise the cost for a credit union to maintain its existing sources of funds, obtain additional funding, and manage the maturity of its funding structure. Also, declining asset values generally reduce market liquidity if assets are being pledged to secure funding or if the decline in market value would cause the credit union to take a loss if the asset is sold.
Strategic risk—If a credit union implements a new strategy—for example, new programs to attract shares or increase loan volume—without considering and planning for the impact on cash flows, its liquidity position may be subject to a greater degree of risk.
Concentration risk—A concentration of funding sources, both secured and unsecured, can affect liquidity risk if the funding sources and maturities are not diversified. Sources of liquidity concentration risk can be from either internal sources—for example, large single member deposits; or external sources—borrowings or non-member deposits. A credit union can mitigate concentration risk by diversifying its funding sources. Ongoing communication and credit line testing with existing providers will help ensure continued credit line availability and competitive pricing.
Concentrations in certain loan products can also increase liquidity risk. For example, a credit union with a significant portfolio of non-conforming mortgages or sub-prime consumer loans can recognize and address these shortcomings in its liquidity planning.
Last updated April 29, 2022