FINRA Releases Guidance on Liquidity Risk Management Practices

WASHINGTON — The Financial Industry Regulatory Authority (FINRA) announced that it has released Guidance on Liquidity Risk Management Practices, the results of a year-long review of firms’ contingency plans and processes related to managing liquidity needs in a stressed environment. Beginning in March 2014 and continuing into the first quarter of 2015, FINRA conducted a review of 43 firms’ plans and readiness for addressing liquidity during financial stress. This review amplifies the guidance provided in Regulatory Notice 10-57, Funding and Liquidity Risk Management Practices, by measuring how well firms are prepared for liquidity stress events.

The review had two broad purposes: to better understand firms' risk controls over liquidity risk 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 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.

"Understanding how firms plan for and manage liquidity risk has been a priority for FINRA and other regulators since the financial crisis in 2008. The ability for a broker-dealer to navigate stressed liquidity conditions is an effective way to protect against failure when extreme events occur," said Bill Wollman, Executive Vice President, Member Regulation, Risk Oversight and Operational Regulation.

Liquidity risk exists when firms employ leverage using short-term borrowings to fund longer-term, less-liquid assets. Liquidity risk played a large role in prior broker-dealer failures, such as Lehman Brothers and MF Global.

FINRA found the following to be examples of some of the more effective controls and practices in place at the reviewed firms.

• Management's understanding of possible changes in counterparty behavior during a stress period;
• Designating a group to ensure that systems and reports are available for use by responsible personnel to understand and manage the firm's funding and liquidity process;
• The ability to anticipate and measure cash outflows under particular stress scenarios and have reports that enable management to consider the impact of stresses;
• Having a governance process around stress test results and use of contingency funding plans; and
• Establishing clear criteria for when a firm should shift from "business as usual" to contingent funding mode.

"The practices described in in this Notice are intended to inform senior management and risk managers at firms of steps that they should consider and implement to combat stressed liquidity conditions," said Wollman. "If firms do not contemplate a sufficiently severe stress environment, they may face problems during the next crisis."

FINRA, the Financial Industry Regulatory Authority, is the independent regulator for all securities firms doing business in the United States. FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services. FINRA touches virtually every aspect of the securities business – from registering and educating all industry participants to examining securities firms, writing rules, enforcing those rules and the federal securities laws, and informing and educating the investing public. In addition, FINRA provides surveillance and other regulatory services for equities and options markets, as well as trade reporting and other industry utilities. FINRA also administers the largest dispute resolution forum for investors and firms. For more information, please visit www.finra.org.