Regulatory expectations for ALM and liquidity stress testing have intensified – community banks and credit unions must respond

After several years of relative complacency, during which financial institutions enjoyed ample liquidity and historically low interest rates, regulatory focus on liquidity is intensifying. The alarming bank failures of 2023 only increased this focus, leaving many industry leaders wondering how to proceed.

Banks and credit unions must rise to this challenge by understanding regulatory guidelines and establishing an asset and liability management (ALM)-centric culture.

To understand how the industry got to this point, and to shed light on why many smaller financial institutions have not yet developed adequate ALM and stress testing protocols, it is important to look back to the 2008 global financial crisis. After the passage of the Dodd-Frank Act, financial institutions with $10 billion or more in assets were required to conduct stress test assessments to determine whether they were sufficiently capitalized to absorb losses during stressful conditions, while meeting obligations to creditors and continuing lending operations. This threshold was raised significantly to $250 billion in 2018.

This shift may have given smaller banks and credit unions a false sense of security. The 2023 bank failures demonstrated that financial institutions with fewer assets than the 2018 threshold were not immune to ALM challenges, with both Silicon Valley Bank and Signature Bank falling below that threshold. As a result of these events, increased regulatory scrutiny of risk management and governance is now taking place.

During a panel discussion at The Clearing House annual conference in late 2023, representatives from the Federal Reserve, Officer of the Comptroller of the Currency (OCC) and Treasury Department underscored their renewed focus on ALM, credit risk, cybersecurity and operational risk, emphasizing that this new regulatory era is not just coming soon, but has arrived.

Create a culture of risk management

Responding to regulatory expectations can be challenging for community banks and credit unions because the guidelines are not just rigorous but varied. For example, formal stress testing is not required for smaller banking organizations, but the FDIC expects that banks with significant concentrations in commercial real estate or subprime lending will conduct stress tests.

Interagency guidance issued last year also stresses the importance of liquidity risk management and contingency funding planning for all depository institutions, whether big or small. These varying approaches can be confusing but must be addressed. The OCC has been sufficiently thorough, and the FDIC has proposed additional guidance for institutions as small as $10 billion in assets, signaling a return to the heightened risk management expectations initially set forth in the Dodd-Frank Act.

With these expectations in mind, community bank and credit union management and boards need to establish a culture that puts liquidity stress testing and ALM at the forefront of their strategic planning.

Strength in numbers: Targeted committees and essential tech partners

Establishing a strong and knowledgeable ALM committee is essential for effective risk management, especially as smaller financial institutions learn how to navigate this new regulatory environment. While regulators may take varying approaches to the analysis of a financial institution’s ALM program, a committee should establish goals that are consistent across varying regulatory agencies.

Technology can support this strategic planning with tools and solutions that do not just ensure compliance but provide financial institutions with real-time insights and scalability while driving profitability and growth. ALM and liquidity stress testing are often burdened by manual processes, including cumbersome spreadsheets and countless human working hours. With the right partner, small to medium-sized financial institutions can take better control of their balance sheets and strengthen their competitive edge.

With the high-profile bank failures of 2023 still top of mind for industry leaders, and with the ongoing effects of changing interest rates, inflation and geopolitical uncertainty, regulatory scrutiny is expected to continue. Smaller banks and credit unions must meet the challenge of this scrutiny and position themselves for a resilient future.

Tammy Campbell is Principal Compliance Counsel at Finastra.