The Financial Industry Regulatory Authority (“FINRA”) has issued Regulatory Notice 15-33, which provides guidance on prudent practices that broker-dealers should consider and implement in order to effectively manage liquidity. In its notice, FINRA stressed that failure to manage liquidity has contributed to firm failures as well as wide spread systemic crises.
The notice described a review that FINRA recently conducted of the policies and procedures of 43 firms related to managing liquidity needs in a stressed environment. The purpose of this review was to understand firms’ liquidity risk management practices and to raise awareness of the need for liquidity stress planning. A range of firms were reviewed comprising clearing firms and large introducing firms with varying levels of capitalization.
The review had two phases. First, each firm computed a stress test for a 30-calendar-day period using specific stress criteria. During the second phase, FINRA met with each participating firm to discuss the results. If any liquidity shortfall resulted from the initial testing period, the firm was given the opportunity to identify mitigating action that it expected to take to relieve the shortfall. After both phases, FINRA then evaluated the liquidity risk management practices of each participating firm based on four criteria: (1) management and line staff understanding of issues that could reasonably be expected to arise in such events; (2) the capability of the firm to measure risk; (3) the firm’s plan for responding to stress events; (4) the effectiveness of the firm’s contingent funding plans.
FINRA noted that a number of firms had strong planning processes in place. However, others had not planned for limited funding or the occasion where counterparties were not conducting normal business practices. FINRA cautioned that counterparties may not continue to conduct business as usual during a stressed period. In addition, FINRA suggested that in a firm’s new product approval process, there should be an assessment of liquidity risk introduced by each new product under normal and stress scenarios. FINRA also advised that firms conduct regular stress tests that are tailored to the particular services and products that the firm offers. These stress test scenarios should be based on severe stresses that the firm could face or that other similar firms have faced in the past.
FINRA noted that firms should have well-developed contingent funding plans that should include a committed facility dedicated exclusively to the firm. Where loan facilities are from an affiliate, firms should ensure that they are not committed to multiple affiliates so that funding is available if and when needed. In addition, lending facilities that have terms and conditions that make the availability of funding unlikely should be appropriately discounted or excluded.
FINRA also noted that the vast majority of firms reviewed stated that they intended to promptly and significantly reduce inventory in liquidity stress positions. However FINRA pointed out that while reducing inventory is helpful in raising liquidity, it does not resolve the problem that less liquid securities may need to be marked down substantially in order to sell quickly. FINRA strongly urged firms to develop a cushion for losses as part of their liquidity management planning and calculations.
FINRA concluded that most of the firms reviewed had sufficient resources, staff and liquidity plans to likely be able to surmount the stress scenario that was posed. However, FINRA recommended that all firms rigorously evaluate their liquidity needs related to both market wide stress and stress specific to the firm. Firms should also devote sufficient resources to measure risks applicable to their businesses and develop contingency plans for addressing identified risks. Finally, FINRA advised all firms to conduct stress tests to evaluate the effectiveness of their contingency plans and have training available so that staff are aware of such plans.
