A Contingency Funding Plan (CFP) is a critical component of a financial institution's risk management strategy. It is a plan developed to ensure that the institution has sufficient liquidity to continue operations in the event of a crisis or unexpected event. The CFP outlines the actions that the institution will take to raise additional funds, such as by issuing new debt or tapping into credit lines, and the steps that the institution will take to conserve cash and reduce spending in the event that funding becomes scarce.
The importance of a CFP cannot be overstated. In the event of a financial crisis, a bank's ability to access liquidity can mean the difference between survival and failure. During the global financial crisis of 2008, many banks and financial institutions that lacked adequate CFPs were forced to seek government bailouts or were forced to merge or be acquired by other institutions.
A Contingency Funding Plan (CFP) invocation is the process of activating the CFP and utilizing the resources and steps outlined in the plan to secure funding in the event of an unexpected financial crisis or emergency. The specific steps involved in invoking a CFP will vary depending on the organization and the funding sources outlined in the plan. However, some common steps may include:
Assessing the situation: The organization will assess the financial crisis or emergency that has occurred and determine the extent of the funding shortfall.
Activating the CFP: The organization will activate the CFP and begin the process of securing funding.
Communicating with stakeholders: The organization will communicate with stakeholders, such as employees, shareholders, and investors, to inform them of the situation and the steps being taken to secure funding.
Securing funding: The organization will take the steps outlined in the CFP to secure funding, such as applying for loans, reaching out to potential investors, or negotiating funding agreements.
Monitoring and evaluating the CFP: The organization will closely monitor the progress of the CFP and evaluate its effectiveness in securing funding. If necessary, adjustments will be made to the plan to ensure that it is meeting the organization's needs.
It is important to note that in case of a crisis, the organization must act quickly and efficiently to secure funding and mitigate the impact of the crisis on the organization and its stakeholders.
Early warning indicators (EWIs) are tools that organizations can use to identify potential financial crises or emergencies before they occur. Under a Contingency Funding Plan (CFP), early warning indicators can be used to identify potential funding shortfalls and trigger the invocation of the CFP before the crisis becomes severe. Some common early warning indicators that organizations may use under a CFP include:
Financial ratios: Organizations can use financial ratios, such as liquidity ratios and leverage ratios, to identify potential funding shortfalls. For example, a low liquidity ratio may indicate that the organization is having trouble paying its bills and may be at risk of a funding shortfall.
Cash flow: Organizations can use cash flow analysis to identify potential funding shortfalls. For example, if the organization is consistently spending more cash than it is generating, it may be at risk of a funding shortfall.
Market indicators: Organizations can use market indicators, such as interest rates and exchange rates, to identify potential funding shortfalls. For example, a sudden increase in interest rates may make it more difficult for the organization to secure funding.
External factors: Organizations should also monitor external factors that may impact the organization such as natural disasters, pandemics or other events that may have a significant impact on the operations and finances of the organization.
It's important to note that early warning indicators are not always a sure sign of an impending financial crisis or emergency, but they can provide valuable information that can be used to make informed decisions about the invocation of the CFP.
CFP testing is the process of evaluating the effectiveness of a financial institution's Contingency Funding Plan (CFP) through the use of stress testing, scenario analysis, and other methods. The goal of CFP testing is to ensure that the institution's CFP is robust and can be successfully implemented in the event of a crisis.
CFP testing is an ongoing process and should be conducted regularly, typically at least annually, to ensure that the institution's CFP remains relevant and effective in light of changing market conditions and the institution's evolving business activities. The results of the CFP testing should be reported to senior management and the board of directors, and any issues identified during testing should be addressed promptly.
Additionally, it is important to note that CFP testing should be done in coordination with other types of testing such as capital adequacy testing and integrated into the overall risk management framework of the institution.
Dry Testing & Wet Testing
Dry testing and wet testing are two methods that organizations can use to test the effectiveness of their Contingency Funding Plan (CFP).
Dry testing is a simulation of a financial crisis or emergency that is conducted in a controlled environment, such as a training session or a tabletop exercise. During a dry test, the organization will go through the steps outlined in the CFP as if a real crisis were occurring, but without actually activating the plan or securing funding. This allows the organization to identify any weaknesses or gaps in the CFP, and make any necessary changes before a real crisis occurs.
Wet testing, also known as live testing, is a real-life test of the CFP. During a wet test, the organization will activate the CFP and take the necessary steps to secure funding, such as applying for loans or reaching out to potential investors. This allows the organization to test the effectiveness of the CFP in a real-world situation, and to identify any problems or challenges that may arise during the invocation process.
Both dry and wet testing are important for ensuring that the CFP is effective and that the organization is prepared for a financial crisis or emergency. Dry testing is useful for identifying and correcting any weaknesses or gaps in the CFP, while wet testing allows the organization to test the CFP in a real-world situation and identify any practical challenges that may arise during the invocation process.
It's important to note that wet testing is more complex, risky and expensive than dry testing, therefore organizations should consider the potential costs and benefits of each type of testing and plan accordingly.
An action horizon refers to the time frame within which a financial institution needs to take action to address a liquidity crisis. This time frame can vary depending on the nature of the crisis and the institution's ability to access liquidity. For example, in the event of a sudden market shock, an institution may need to take action within hours or days, while in the case of a more gradual decline in liquidity, the institution may have more time to respond.
A liquidity assessment is the process of evaluating the institution's liquidity position and identifying potential liquidity gaps. This assessment typically includes analyzing the institution's cash and cash equivalents, as well as its ability to access other sources of funding, such as credit lines or the sale of assets. The institution should also assess the potential impact of changes in interest rates, exchange rates, and credit spreads on its liquidity position.
When conducting a liquidity assessment, the institution should consider both the short-term and long-term liquidity needs. For short-term needs, the institution should consider the liquidity needed to meet its obligations over the next 30 days, while for long-term needs, the institution should consider the liquidity needed to meet its obligations over the next year.
The institution should also conduct stress testing and scenario analysis as part of its liquidity assessment to evaluate its ability to withstand a variety of potential financial shocks. This will help the institution identify potential liquidity gaps and develop strategies to address them.
Once the liquidity assessment is complete, the institution can use the information to develop a funding plan and cash conservation plan, which are key elements of the CFP. The institution should also establish limits on the level of risk that it is willing to take and develop contingency plans for addressing a liquidity crisis.
Cost assessment is an important element of a Contingency Funding Plan (CFP). It involves evaluating the potential costs associated with implementing the CFP, including the costs of raising additional funds and conserving cash, as well as the costs of any potential losses or other negative impacts that may result from a liquidity crisis.
When assessing the costs of raising additional funds, the institution should consider the costs of issuing new debt or tapping into credit lines, as well as the potential impact of changes in interest rates, exchange rates, and credit spreads on the cost of funding.
When assessing the costs of conserving cash, the institution should consider the costs of reducing or postponing capital expenditures, cutting back on discretionary spending, and reducing or eliminating dividends. The institution should also consider the potential impact of these actions on the institution's long-term growth and profitability.
In addition to these costs, the institution should also consider the potential costs of any potential losses or other negative impacts that may result from a liquidity crisis. These costs can include the costs of resolving problem assets, the costs of legal and regulatory actions, and the costs of reputational damage.
Once the cost assessment is complete, the institution can use the information to develop a funding plan and cash conservation plan that are both cost-effective and consistent with the institution's risk tolerance.
It is important to note that the cost assessment should be done in coordination with the liquidity assessment, and the institution should evaluate the potential trade-offs between the costs and benefits of different CFP strategies.
Regulatory expectations regarding Contingency Funding Plans (CFPs) vary depending on the country and the type of financial institution. However, in general, regulators expect financial institutions to have robust CFPs in place that are designed to ensure the institution's ability to continue operations in the event of a crisis or unexpected event.
Principle 11 of Basel Committee on Banking Supervision (BCBS) publication “Principles for Sound Liquidity Risk Management and Supervision” states that – A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.
In the United States, for example, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) have issued guidance on CFPs for banks. This guidance includes a number of expectations for banks. Similarly, the Basel Committee on Banking Supervision has issued the Basel III framework which include liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) that set out standards for liquidity risk management and stress testing, and require banks to hold a sufficient level of liquid assets to meet short-term and long-term liquidity needs.
In general, regulators expect financial institutions to have a well-defined CFP in place that addresses all potential sources of liquidity risk, includes a process for measuring and monitoring liquidity risk, and is integrated with the institution's overall risk management framework. Additionally, they expect institutions to review and update their CFPs regularly, and to conduct regular stress testing and scenario analysis to evaluate the effectiveness of their CFPs.
Global banks generally follow a number of best practices when it comes to developing and implementing Contingency Funding Plans (CFPs). Some of these best practices include:
Identifying potential sources of liquidity risk: Global banks generally take a comprehensive approach to identifying potential sources of liquidity risk, including market risks, credit risks, and operational risks. This allows them to develop a CFP that addresses all potential sources of risk.
Developing a robust funding plan: Global banks typically have a well-defined funding plan in place that outlines the actions that the institution will take to raise additional funds in the event of a liquidity crisis, such as issuing new debt or tapping into credit lines. They also consider the use of alternative sources of funding, such as asset sales or borrowing from the central bank.
Establishing a cash conservation plan: Global banks generally have a cash conservation plan in place that outlines the steps that the institution will take to reduce spending and conserve cash if funding becomes scarce. This can include reducing or postponing capital expenditures, cutting back on discretionary spending, and reducing or eliminating dividends.
Regularly reviewing and updating the CFP: Global banks generally conduct regular stress testing and scenario analysis to evaluate the effectiveness of their CFPs and update them accordingly. They also review and update their CFPs regularly to ensure that they remain effective and relevant in light of changing market conditions and the institution's evolving business activities.
Measuring, monitoring, and reporting liquidity risk: Global banks typically have a framework in place for measuring and monitoring liquidity risk, as well as stress testing and scenario analysis. They also report this information to senior management and the board of directors on a regular basis.
Integration with overall risk management framework: Global banks usually integrate their CFP with other types of testing such as capital adequacy testing and integrated into the overall risk management framework of the institution.
It's worth noting that best practices are constantly evolving, and banks are continuously updating their policies and procedures to align with the latest regulatory requirements and industry standards.
Developing and maintaining a contingency plan can be costly, and organizations may not have the resources to invest in one. It can be challenging to anticipate all potential disruptions and to plan for them accordingly. A well-designed contingency plan should be comprehensive and cover all aspects of the organization's operations. However, this can make the plan difficult to understand and implement.
Once a plan is in place, it must be regularly reviewed and updated to ensure that it remains relevant and effective. The plan's execution requires the participation of all the stakeholders, and if any of them does not participate, it will not be executed successfully. Additionally, testing a contingency plan can be difficult and expensive, and organizations may not have the resources to do so.
