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Model Validation & MRM
Asset/Liability Management
  • Writer's pictureJudi Kenney

The Basics of Liquidity Modeling and Documentation

Ongoing Monitoring of your ALCO Model & Model Results

To keep pace with competition and what seem to be perpetually escalating regulatory expectations, many institutions have shifted their liquidity risk management philosophies from static methods that consider current and historic regulatory ratios to a dynamic, forward­-looking approach using financial forecasting models. Adopting a pro-forma approach to liquidity risk management provides an opportunity to improve business decisions (and hopefully augment returns), but there are potential risks and costs to consider. Through the MRM lens, building an effective (and compliant) modeling process may seem formidable. While it may not be easy, strive to keep it simple because unnecessary complexity may exacerbate the risks and amplify the cost.

As validators, DCG sees a wide range of liquidity modeling processes, from those that use internally constructed Microsoft Excel Workbooks to third party vendor software platforms. Each is very different in form and sophistication, factors that should be determined by the size and complexity of the institution. However, the best-in-class processes have a few things in common. Beyond a strong governance framework, key factors include:

  • Robust documentation

  • A forward-looking analysis through liquidity forecasting

  • Institution-specific stress testing

  • Effective remediation plans


We have all heard the saying, 'If a tree falls in the woods and no one is around to hear it does it make a sound?' Similarly, you could have the best process in place run by the most capable people. However, if it's not appropriately documented, you may find a regulator asking if it really exists. Joking aside, the fact is that robust documentation can simplify the modeling process and help make it more effective no matter who is running it. Documentation around a liquidity model should not only serve as an operating manual, but it should also tell a story about how liquidity risk is optimized, how stress may materialize, and how best to respond.

Model documentation comprises policies and procedures that together should provide a narrative to the liquidity modeling process. This includes establishing an environmental context around which modeled scenarios should be built. A base case should be clearly described, the framework for deriving stress assumptions that are reflective of potential risks faced by your institution should be articulated, and remediation plans should be established. The story told therein should be the foundation for liquidity modeling activities.

Documentation should also include evidence of validation activities and the effective challenge of the modeling process. It should be sufficiently detailed to provide for continuity of operations as well as track modeling recommendations and changes.

Supervisory Guidance on Model Risk Management states, "Documentation takes time and effort, and model developers and users who know the models well may not appreciate its value." It may seem like documentation expectations are hard to manage. However, we have seen first-hand the difficulties faced by institutions that do not take the time to adequately document modeling processes. In the end, doing so will help to simplify the process and make it more effective in the long run.

Liquidity Forecasting

Unlike IRR modeling, DCG believes that a base case liquidity forecast should be dynamic and include anticipated and planned activity. Others may argue that a static simulation provides a more effective foundation for contingency planning. Some institutions do both static and dynamic analyses. Believe it or not, the primary base case forecast for a handful is a liquidation model. By that, I mean liquidity projections represent anticipated cashflow from instruments currently on the balance sheet and do not include any new business assumptions (e.g., pro-forma loan and deposit production). While it is prudent to evaluate potential cash flow gaps from existing assets and liabilities, this type of analysis is incomplete. Since you are most likely operating as a going concern, we do not recommend this approach. Rather, we recommend modeling that is predicated on expected activity.

Whether it starts with a static or dynamic simulation, it is important to regularly run your strategic plan and/or budget through your liquidity model to ensure you understand your pro-forma liquidity risk profile. Additionally, alternative scenarios (not to be confused with stress scenarios) should be considered to provide insight into the liquidity implications (term structures, pricing, etc.) of potential deviations from plan. For example, what does your position look like in an improving economic environment wherein you achieve planned loan growth but come up short on retail deposits? Or, what capacity do you have to fund accelerated loan growth and retail deposit disintermediation? Do you have processes in place to support optimal funding strategies and tactics under expected and potential alternative conditions at your institution? (Again, not to be confused with stress testing – see below.)

Stress Testing

Regulatory guidance requires you to regularly stress test your institution's liquidity position to analyze the effects of potential adverse conditions. The conditions should be thoughtful interpretations of institution-specific and/or macroeconomic events that may have a significant impact on your institution's ability to generate and/or retain cash on reasonable terms. Your CFP should identify and describe these events and provide a framework to derive and support stress assumptions to be applied in your liquidity models.

Stress testing should incorporate scenarios that represent a range of probabilities and severity levels (i.e., from high probability/low impact to low probability/high impact), including, but not limited to, credit degradation, deposit attrition, higher collateral haircuts, and wholesale funding constraints. Interagency Guidance also suggests considering circumstances wherein your institution falls below well-capitalized thresholds, is prohibited from accessing brokered deposit markets, and is restricted by (unreasonable) deposit rate caps; and if funding markets detect potential exposure, access to other sources may be in jeopardy (e.g., reciprocal deposit and listing service networks). Moreover, we consistently encounter clients whose regulators want to know what types of events will "break the institution." Note that we also advise clients that the environmental context in liquidity stress scenarios should be congruent with those in capital planning and stress testing analyses.

Mitigation and Remediation

Stress testing results can provide a critical perspective of your liquidity risk profile and should be used to calibrate tolerance levels and corroborate current postures. They should also be used to help tune early warning systems, contingency plans, and response strategies and tactics. Carefully analyzing the results thereof should enable management to mitigate potential exposures to ensure compliance with the board's tolerance and ensure continued viability.

Illustrating the impact of stress is only one piece of the puzzle. Subsequently, remediation strategies and tactics should be considered (and, of course, documented in your CFP). It is critical to demonstrate and document that you have thought through and measured the actions necessary to provide relief, recalibrate your strategy, and avoid an all-out crisis. This should be done on an incremental basis.

Time and time again, we encounter liquidity stress testing that includes stress and relief assumptions in one and the same scenario. We believe this approach is disadvantageous. Like building growth into a net interest income model, it can mask potential exposures. We strongly encourage institutions to project liquidity under stress separately from proposed remediation tactics for each stress scenario analyzed. Does your liquidity stress testing process isolate the potential impacts of meaningful and supportable stress assumptions, and do you use the results to determine how best to respond to signs of a tightening liquidity position?


Collectively, model documentation, liquidity forecasts, and stress tests should tell a story, and executive reporting should provide the illustrations. Leading up to the global financial crisis, certain institutions failed to adequately envision and plan for contingencies brought about by something as basic to the business of banking as excessive credit risk in their real estate portfolios. These institutions (and their management teams) failed to tell and illustrate the story of the real risks they were taking and potential consequences thereof. Are you confident that your liquidity modeling process is meaningful and provides you with the information necessary to manage the real risks your institution is getting paid to take? Moreover, does your modeling process provide you with the illustrated narrative necessary to optimize your liquidity risk position? If not, we suggest you start planning now to make sure that your answer is a resounding "Yes."


Contact DCG today to speak with one of our balance sheet experts, schedule a software demo, or discuss your institution’s needs and goals. We look forward to hearing from you.


© 2023 Darling Consulting Group, Inc.


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