Liquidity Stress Testing: Preparing Treasury for Shock Events

Brian: Foreign.

Narrator: Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis and insights in your car, at the gym, or wherever you decide to tune in.

Brian: Well, welcome back to another episode of the Treasury Update Podcast. Today we're sitting down again with Paul Galloway, Senior Director here at Strategic Treasure. Paul, welcome back to the show.

Paul Galloway: Thanks for having me again, Brian. Always, always enjoy these, uh, conversations we have.

Brian: Yeah. And so today we are talking about liquidity stress testing. Most treasury forecasts are built around expected operating conditions. Paul, what changes during a shock event and why do those times expose weaknesses that otherwise might stay hidden?

Paul Galloway: Yeah, so, you know, I think you gotta, you know, frame what the need is when it comes to stress testing. So when people forecast, they're typically assuming normal conditions or things will kind of stay the same. So they're, they're not taking into account anything that may disrupt or impact a particular data point that goes into a forecast. So in order to get something that might be more realistic in terms of, hey, if something happens, what does that mean to my forecast? There's a couple different ways to do that. One, you need to identify, you know, what variables matter because some variables, they can change and they may have little to no impact on your forecast. Where you may have other data points where a, uh, small change can have a big impact on your forecast. So you want to be able to determine how sensitive your data points are. And so you test that particular item with sensitivity testing. So you change one variable up and down to see what the impact on forecast is and how sensitive that particular variable is. If it's moving, you know, your forecast widely, then that's something you need to take into account. So you go through and you do this sensitivity testing on, uh, key variables that you have identified. The other one is to do scenario testing. So what scenario testing is, instead of holding everything else the same and testing one data point at, uh, a time, see how sensitive it is, you create scenarios. It could be bad and good because you could have a shock event that could have a rule positive impact on your forecast. It just depends on your particular organization. But you run scenario tests where you change a set of variables or data points that you know to mimic potential outcomes in terms of what's going to happen. Either maybe you're negotiating with somebody for like an M and a transaction or capital funding and you're looking at different scenarios of how you fund or, uh, raise capital, or it's your business and you're trying to determine what market factors are going to have an impact and Ah, so you change several variables and you have multiple scenarios of different variables. You change them different directions. You, uh, utilize different potential outcomes to see what impact that might have on your forecasts. The other thing that, huh, people need to do is they need to monitor market conditions. And as market conditions change, they'll need to make updates or adjustments where necessary to the forecast. So monitoring market conditions can have an impact on how you forecast down the road. So you want to make sure that you're tied into what's going on in the market. So stress test events tend to reveal vulnerabilities to your organization. And so by going through this process, you can learn, you can, uh, make adjustments, and you can also work to mitigate the risks of a, uh, particular shock. So, so it gives you that information of, hey, you know, this matters if I'm really concerned about it. You do something to hedge yourself so that uh, if that particular event occurs that uh, you don't have a disruption in your forecast, you've protected that particular forecasted item that, uh, is sensitive to a shock event.

Brian: Yeah, that's a good point that you brought up that not all shock events are negative. Right? I mean, some of them could be positive. Some of them could be a boon to the business.

Paul Galloway: It could.

Brian: And you also brought up that at bottom, these stress tests are meant to illumine potential vulnerabilities in the organization. Are there vulnerabilities that could be illumined that might show up during a boon eventually?

Paul Galloway: Yeah, there's definitely, uh, vulnerabilities that an organization can, um, experience. And if they haven't gone through the particular items, the data points where your forecasted items are sensitive to changes in those data points, then, uh, the organization could be vulnerable to, um, a shock event. So by going through this process, you, you reveal those vulnerabilities and that allows you to make adjustments, uh, to help protect your organization. So kind of that I was talking about earlier, the hedging, you know, you hedge yourself or you position yourself in negotiations or take other steps to protect the company from any of these areas where, um, there's potential for weakness and you put in, um, something that helps mitigate that particular risk to being vulnerable.

Brian: Would any of the vulnerabilities that would show up involves supply chain. I'm just thinking if I'm in an organization that, uh, let's say benefits, so to speak, if we want to use that word from a war, and our orders are increased exponentially, do we have, and we may not have the supply chain to supply that to Support that. Would a stress test illumine that?

Paul Galloway: Yeah, it definitely could. If you're an organization that relies on supply chain for, for your business, maybe you're a manufacturer or, um, you are an end user of a particular, you know, maybe it's a mineral, uh, maybe it's, um, you know, it's a fossil fuel. Um, maybe it's something else that you're an end user and you modify it and sell it to the public. If you have a disruption in the supply of that input, that can be a big issue for organizations. And so we've talked about supply chain financing in the past. We've also talked about the need to diversify with your supply chain so that you have a backup in the instance that, uh, there is a disruption and you have a need to, uh, you know, leverage or utilize another trading partner to get what you need. So, um, definitely, uh, with conflicts that we've seen, you know, whether it's, uh, in, uh, the Persian Gulf with the war in Iran, or you're dealing with anything else where there is a supply of something that could disrupt on a world basis. The war in Ukraine is another example. So we have grain, we have, uh, oil. You know, there's been disruptions there. Supply chains have had to make adjustments. And so countries have, uh, filled gaps by going through other avenues doing this kind of scenario. Sensitivity testing can reveal where some of the challenges might be if you're cut off from your supply chain. So organizations should take steps to shore up those loose ends and mitigate the risk of, hey, I don't have access through this avenue. What are my other options? You don't want to be standing there going, what are my other options? When the shock event happens, you want to be, oh, I've got these other options. This supply chain is temporarily down. Where do I go? I've got these other relationships. You lean on, uh, those partners to get what you need. So you do, uh, have the opportunity to make adjustments.

Brian: Yeah, grain wood or sheep, those are all important resources. So today we're talking about liquidity stress testing in a corporate treasury context. How is that distinct from the regulatory stress testing we often hear about in banking?

Paul Galloway: You know, when we talk about regulatory stress testing versus, uh, you know, a company or corporate doing stress testing on liquidity. There is a clear distinction. So corporate stress testing looks at the financial health of the company when stress is applied to the forecast. Now corporations, they have leeway to stress test however they want. Doing a, uh, financial forecast. They're not burdened by necessarily regulatory, uh, stress Testing in this particular instance. It doesn't mean though that uh, there aren't organizations that have regulatory requirements. They do. And so there are organizations that will have to look at the impact of stress on a regulatory basis. So they may run a financial forecast and say oh well now we got to run it through these other models. It could be rating agencies, it could be you're an insurance company and uh, you have certain requirements. Risk based capital happens to be uh, an item important to insurance companies and your insurance regulator, that's an important thing with them and also your rating agencies. So you do your corporate stress testing and then you might have to apply that to rating agencies and your insurance regulator as well. So you have like multiple forecasts that could be impacted based on stress. So corporations have multiple touch points and they have some leeway in terms of how they do their financial forecasting for expenses and for the products that they sell or the services they sell. A uh, bank regulatory stress testing assumes adverse economic conditions and they want to see if the bank that they're stress testing, you know, that's being stress tested, has enough capital to cover losses and continue to make loans. So when they're looking at banks trust testing, they're looking at those assets that back up the liabilities, the loans, um, or what you, you know as a bank you've extended a loan to somebody, they've agreed to pay you back over a period of time to back that they have assets that back it and those assets, they'll look at those assets and see how risky they are, how much the value of those assets move based on certain adverse economic conditions. So it's that level of capital. I said assets, assets and liabilities are important at a bank. Assets, I. E. Capital, you want to make sure you have enough to cover all those losses and still be able to make loans. So that's what a bank regulator looks at. It's you know, certainly much different than oh I've got a forecast. Um, you know, I'm an insurance company, I'm a manufacturer, whatever it is that you do. Um, I'm a, I am uh, some other kind non bank financial or you know, maybe I'm you know, I suck, sell clothes, I sell shoes, I, I'm uh, like a target, a Walmart or any of those. I mean it's, they're much different. All these businesses are different. Banks are uh, going to have to adhere to the same stress test. All banks have this bank regulatory stress testing and it's all around, it's do they have enough capital to survive.

Brian: So what are some of the most practical stress scenarios that treasury teams should be modeling today? Whether that's market driven events like rate and FX shocks or operational disruptions like fraud or system outages?

Paul Galloway: Well I think you know they need to actually do all these things. So market shocks, interest rates can uh, certainly impact corporations for various reasons. It might be uh, on um, borrowing or the ability to borrow. Foreign exchange can have an impact on earnings. There could be uh, something tied to exchange, uh, rates that has an adverse impact on uh, assets or earnings of a company. And you know, in a credit tightening event, organizations that rely on the ability to tap capital when needed, either for organic growth, uh, mergers and acquisitions or development of new products and services, they want to be able to access liquidity or capital to continue to fund the business. A lot of times you'll find organizations will do market shops like this and that will help inform, you know, do they have the right capital on the balance sheet which will include a component of what I like to call contingent capital. It's, they're not using it today but they might have to use it in the future. And so that's where maybe you have a credit facility, a revolver or you actually have something that's more longer term debt structure in place. It's a contingent uh, capital facility. So you know, I think these market shocks are super important. Likewise to many organizations, operational disruptions are really important to recognize and understand. You have problems with systems and if you're an organization that is kind of a system based platform, let's say, you know, can use just a key example of uh, we do a lot of work for our clients around treasury technology. If they have treasury technology or third party provider that has an issue with their system and the client's not able to access that system, that could cause disruptions and problems for payments making payments, uh, getting data, uh, for reconciliation or accounting, or be able to position cash appropriately. So that could be a problem for organizations that systems are down or it could lock out customers if, let's say something's um, happened with their system, their backup's not available and they don't have that level of redundancy that they need to continue to operate the business and the customer is not able to access that particular business if it's like an online business or something like that. Uh, so system disruptions can be a uh, problem fraud. If you end up having uh, fraud that's committed against your organization that results in a loss, that could be a problem for your organization in the sense that it could be a, uh, damage, not only financial damage to you, but it could be reputation that gets damaged as a result of the fraud. It could be, could be a financial loss. It could be data that was stolen, uh, by fraudsters or hackers. So that could be a real problem. You need to understand. What does that mean? Uh, we talked about supply chain earlier and uh, supply chain is definitely something that is a risk to organizations that rely on it for products or services that they provide. So you know, you really need to understand both sides, market shocks, operational disruptions, because it could result in something that is uh, adverse to the organization.

Brian: Okay, so how should we think about counterparty and funding risks during a stress event? And what role do contingency funding plans play in maintaining liquidity access?

Paul Galloway: Yeah, it's a great question. So I'm uh, looking in two parts. One is counterparty, uh, the other is uh, funding risks. So let's talk about counterparty. So counterparties are really important to a lot of organizations. So it doesn't matter whether you know you're a non bank financial or you're a manufacturer. Your counterparties are key uh, relationships to your organization to do the things that you want to do day in and day out. So let's uh, let's think about trade. You know, it could be trade supply chain, uh, could be uh, loan, it could be derivative contracts, it could be credit, it could be a variety of things out there on the counterparty side. So let's think about supply chain first. So supply chain, you hear supply chain financing. There are some options you have with supply chain financing that's beneficial to your organization in terms of how you pay, when you pay and uh, when the supplier gets paid. And so there's a relationship there where you can create a win win that builds um, stronger relationships with your supplier. Now it doesn't mean that you aren't looking at the sustainability of that particular counterparty. You should, so you got to run checks on your counterparty. But building that relationship can be super beneficial. If you extend uh, loans or you have derivative contracts. I'll start with loans first. You're a bank, you extend loans to consumers. Consumers pay you back over time. They're looking at the credit risk of the individual. If you are a company that needs a loan, uh, I'm using. So when I say a company needs a loan, I'm going to talk about capital funding. So that's credit, facility, revolver, senior debt, equity, any of that, uh, you become a counterparty to either shareholders or the lenders and so they're looking at you as a counterparty. So it's kind of reverse. When you engage in derivative contracts, there's kind of this bilateral agreement between you and the other person. With a derivative contract. Each party is looking into each other to see what the credit worthiness of that particular organization is. Because on derivative contracts, you think about it, you know, you're hedging. Maybe, uh, it's foreign currency, maybe it's interest rates, maybe it's uh, you're hedging yourself against market indices. There's a counterparty to that. And so it's like a zero sum game. One party wins, the other party loses. So on derivatives contracts, oftentimes you have collateral and so you might, you'll be moving, you do marks every day. You'll be moving collateral back and forth between you and the counterparty. Some days you're given collateral to them that could be in the form of cash or securities and uh, vice versa. They could be sending it back to you. So there is risk between both counterparts parties there. And so you're wanting to, you know, manage that. They could fail to deliver the security of the cash. And so you. It's a real thing that could happen on both sides. It could be a failure on your side, it could be a failure on the counterparty side. The next thing I want to talk about is credit risk. Credit risk is, you know, the credit worthiness of an organization. So you get a lot of organizations that are publicly traded that will be reviewed by various organizations that are rating agencies. The rating agencies look at the credit risk of an organization, uh, that is issuing senior debt, issuing any other type of credit that they're utilizing to run the business. Credit, uh, risk is looked at by uh, rating agencies and also the counterparty who is loaning the funds to the organization. The systemic risk, so unsystemic and systemic risk is going to be, uh, looked at the amount of that. So there's things that you can't change and there are things that you can change in the instance that uh, there's a risk of an organization. For instance, uh, during the Great Recession there was a lot of risk out there with large banks, we had bank failures. Um, and so when you get large financial institutions, there is a risk that's associated with that. Coming out of the Great Recession there was a lot of regulatory stuff that came out of that. And um, it was this idea of the too big to fail was uh, a concept back then that was talked about quite a bit. And um, now it's like you gotta, you Gotta make sure that these large financial institutions don't fail because they have huge downstream ramifications. Not only for, you know, let's say the US if it was to happen here, but it could be a global impact. So it's, it's really a big thing from a funding standpoint. It's looking at liquidity. What's the amount of liquidity you have? Uh, do you have illiquid assets on your balance sheet? If you need to raise capital, what do you have available that you could sell? Refinancing, perhaps you are looking at what you have for your capital structure and you're going to refinance it. And that could come in various forms. Maybe it's debt, maybe it's equity, uh, maybe it's uh, your return of capital to your investors or investors are making withdrawals. You know, what does that mean to your organization? Does that put liquidity stress on the company? Tight credit markets, being able to access capital, that can be a big problem for companies in times of stress. You need to understand, you know, what those risks are and what you can do to prepare yourself in the event that something happens that was unexpected. So doing these scenario sensitivity types of tests can help you identify those vulnerable aspects and work to mitigate those risks.

Brian: Okay, so once stress testing identifies vulnerabilities, how do we translate those findings into action? Maybe particularly around liquidity buffers, credit facilities, uh, escalation paths and decision triggers?

Paul Galloway: Yeah, so um, first thing I'll hit on is the concept of contingency funding plans. So it's taking steps to manage, you know, liquidity shortfalls during emergencies or times of shock. One thing you can do is uh, set up a contingent capital facility. I talk about that earlier. There is also like insurance companies utilize Federal Home loan bank, other organizations do as well. It's kind of a bank of banks or bank of non bank financial organizations to post, uh, collateral and uh, leverage that collateral to have access to liquidity. From a bank perspective, it's kind of the last resort for banks and is um, the Fed window. They utilize the Fed window to fill gaps in liquidity. And so that kind of that bank stress testing I talked about earlier, that regulatory testing, um, on banks, you know, they're wanting to make sure how much liquidity uh, they actually have. You know, it's been talked about in the past that going to the Fed window is frowned upon. It generally is. Uh, but there are banks from time to time that go to the Fed window and utilize it to uh, fill short term gaps. So uh, what kind of liquidity buffers and credit access are there out there. What do you do to ensure that you have liquidity buffers and access to credit? You want to make sure that you have a buffer. So how do you do that through your stress testing? You know, you, you do the market shocks, you look at scenarios and sensitivities and that tells you, you know, how much capital and cash you have, uh, to buffer yourself to weather a storm. And so once you identify that and you determine, oh, I have a buffer or no, I don't have a buffer, then it's like, okay, what can I do to reduce risk? What kind of access to liquidity do I have or need to have? What kind of liquid assets do I have that I could uh, lean upon? Leverage? Either Kind of like the scenario I talked about. Federal home Loan bank use as collateral to get advances or sell assets to raise cash or capital. What's my line of credit look like? You look at the leverage that an organization might have and so counterparties are going to look at, you know, character, capacity, capital conditions and collateral to understand what the uh, position is of the organization and the ability to extend credit to them. Understanding that, uh, can help you be positioned, uh, along with uh, mitigating risks. You know, you don't want to have trapped capital or trapped cash, meaning you have cash at other locations or sources. It could be outside the country, but it's uh, you know, it's either regulatory trapped or it's trapped because if you were to repatriate, perhaps you're going to pay a lot in taxes or something else that would have an adverse impact on the organization. So the cash is considered trapped. There's, you know, you want to try to avoid that or mitigate that to the extent. You can't. Sometimes you just can't. But understanding what trapcash is out, you know, within your organization I think is important. Always have a contingent plan in place and understand, you know, that um, you should look at aligning compliance coverage and uh, your regulatory requirements, making sure that you have visibility to that and know what the thresholds are tied to that. So you have decision triggers and escalation paths that should be in place. So you think about a shock happens or something material happens that could have an impact on your organization. You need to understand what decisions do I make when this happens and how do I escalate it. This could be time based, it could be service level breaches, it could be system outages, it could be safety violations, or you triggered some kind of limit from standpoint that regulatory, uh, limit, maybe it's a covenant within, you know, the debt that you issued or agreements that you have with your counterparties for revolvers. You need to understand that. You also need to understand customer and stakeholder sensitivity. What kind of impacts will happen to them. That's going to be really important to you, uh, because that's a key part of your business. Perhaps it's resource constraints. It could be people, it could be inputs to products you develop, it could be technical expertise. So you want to have some kind of escalation path. You know, maybe it starts out with the frontline people and your functional leadership and your managers, and then it goes up to your executives or technical leaders and then to the C suite and the board. So you understand the escalation path and, uh, the ability to give each level the ability to act upon, making decisions and escalating things when and where it needs to happen. Uh, you could have an escalation matrix as well. And that could be, you know, who owns a particular, uh, issue, you know, what are those triggers, you know, uh, that create the challenges and might make a move to the next level, Making sure that your people, those tiers, know what triggers are and what would move it to a point that you got to escalate. Uh, response time should be defined and of course you want to document everything that's occurring. Uh, when there is a challenge that comes up due to, uh, market shocks.

Brian: You gave a list of characteristics that could be used to evaluate the credit worthiness of a particular organization, one of which was character. What did you mean by that?

Paul Galloway: So that's kind of like the reputation, uh, of the firm. And so there's a lot of different things that could go into the character of a firm. But, uh, a lot of it has to do with how much they share, how they treat their customers, the relationships they have with their counterparties, uh, their vendors. Um, all this comes into play. And so an organization that is upfront and more transparent versus one that might hold things tight and keep things from counterparties and customers, you know, goes into the factor of what the character of that organization might be.

Brian: Okay, that makes sense. Where would I go to find that information though?

Paul Galloway: Well, a lot of that, you know, is, you know, analyst type work where they're digging into information on the organization. They're looking for anything that's headline news, positive or negative. They're looking at history of reports that they put out, especially if they're publicly traded. They're going to look at all the reports, uh, they're Going to do analysis on the organization that is not necessarily, it's not, it's qualitative, not quantitative. And so they're looking at things that are more of the soft things, you know, for lack of better terms. So it's not numbers, it's the way they communicate and how they work with the relationships that they rely on.

Brian: Okay, got it. Wrapping up. For organizations that may not have a uh, formal stress testing framework today, what's the best way for them to start?

Paul Galloway: Simple.

Brian: Build sophistication over time and embed stress testing into their regular treasury planning processes.

Paul Galloway: Yeah, so I'll start with like frequency and ownership of testing. So for large complex companies, uh, you might see them do stress testing on a monthly basis, at least quarterly, at a minimum. Some companies may do it at the monthly basis. I've been organizations where uh, we did it quarterly. That's really kind of the minimum. The other factor in uh, testing or frequency of testing is more of an ad hoc. So that uh, ad hoc approach is you do it on ad and needed basis. Maybe it's due to uh, what's going on in the market or other conditions. It uh, could even be in the case. When I worked on a corporate development team, some of our mergers and acquisitions that we would do would step it up to the level that we would have to look at the impacts of that within the testing confines that we would normally do on a quarterly basis because we knew it could potentially have regulatory impacts because we were regulated. So I say regulatory, it's rating agencies, it's the insurance regulator. But we also were looking needed to look at what's the impact on financials, earnings per share. We publicly traded investors are going to want to know, the analysts that cover us are going to want to know. So there's impacts that could be there. So the ad hoc could happen. You just need to have a process in place to uh, actually facilitate the ad hoc analysis when and where needed. Now you talked about starting simple and increasing in sophistication. It's a good way to go because you know, if you start out of the gate, trying to build a sophisticated model right away oftentimes be very challenging for organizations because one, they might not have the technical skills to do that, two, they might not have the capacity to do that. And three, uh, while it may be nice to have sophisticated testing process, it may be better for organizations to grow into it over time by taking key variables or data points that matter to the organization, focusing on those first and then building your sophistication over time. So starting simple tends to be a better way to go and focus on a couple key things that matter, and then you can build on that from there. Once you have the simple in place and it's working, running smoothly, you can start adding variables and doing other things to make it more sophisticated. The last piece I wanted to talk about is embedding stress testing into your planning process. I think this is an important component. Uh, you want to make sure this is common practice, uh, that it's known within the organization. Anybody that would touch stress testing, you want to make sure that it's communicated, and then it's part of the normal practice. So you want to insert into your plans the analysis and the reporting of it. So embedding that stress testing can be real beneficial to the organization that is making strategic decisions or decisions that, uh, could have an impact on the organization, uh, writ large.

Brian: All right, well, liquidity stress testing, it's a relevant and timely topic. Paul, thank you for walking us through it.

Paul Galloway: Yeah, thanks for having me again. Appreciate it.

Brian: Absolutely. And thank you for listening to this episode of the Treasury Update podcast. This is your host, Brian Weeks. We'll talk to you next time.

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