Why a Robust Liquidity Stress Testing Process is Critical in Today’s Volatile Environment

In an era marked by rapid interest rate shifts, evolving depositor behavior, and geopolitical uncertainty, financial institutions can no longer afford to treat liquidity risk management as a static, check-the-box exercise. A robust liquidity stress testing framework is no longer optional, it's a strategic imperative.

While regulatory expectations have emphasized liquidity coverage and contingency planning for years, recent market events have exposed the fragility of funding assumptions at many institutions. The collapse of several mid-sized banks in 2023, largely due to unanticipated deposit outflows, underscored how quickly confidence can erode and how vital it is to understand your liquidity position in real time, and under stress.

Below, we highlight two critical pillars of a sound liquidity stress testing process:

(1) a deep understanding of your deposit base and its stickiness, and

(2) a clear-eyed assessment of available funding sources and their reliability under adverse scenarios.

1. Understanding Your Deposit Base: Stickiness Is Not Static

Deposits remain the primary funding source for most banks and credit unions. However, not all deposits behave the same way, especially under stress. It is essential to segment, monitor, and model depositor behavior with nuance and precision.

Key considerations:

Segmentation by type: Retail vs. commercial, interest-bearing vs. non-interest-bearing, core vs. brokered, each segment exhibits different sensitivity to rate changes and stress events.

Behavioral analysis: Historical averages can be misleading. Are your small business clients more rate-sensitive than expected? Do your digital-only customers show different runoff patterns? Behavioral deposit studies should be refreshed regularly and recalibrated to reflect current market dynamics.

Early warning indicators: Rising reliance on high-yield savings, increases in deposit migration, or new patterns in mobile transfers may indicate weakening stickiness. A stress test should simulate how these behaviors amplify under different scenarios, such as rate shocks or a localized reputational event.

Lesson: Don’t assume your deposits are sticky because they’ve been stable in the past. Depositor loyalty is often situational and can shift quickly, especially in a high-rate, high-transparency environment.

2. Knowing and Testing Your Available Funding Sources

When deposits begin to flow out, your institution must be ready to tap diverse and reliable secondary funding sources. Stress testing is the tool that brings these contingency plans to life, showing not just what’s available on paper, but what’s realistically usable under duress.

What to evaluate:

Uncommitted vs. committed lines: Know the difference - and model availability accordingly. Uncommitted lines may disappear just when you need them.

Counterparty behavior under stress: In a systemic crisis, will your counterparties still lend? Will haircuts increase? Will drawdowns trigger covenants?

Operational readiness: Have you tested the mechanics of drawing down the FHLB line or accessing the discount window? If it takes 48 hours instead of 4, that’s a material risk.

Interdependencies and liquidity buffers: How reliant are you on market-based funding? Do you have enough high-quality liquid assets (HQLA) to weather a multi-day or multi-week event?

Best practice: Incorporate these funding sources into reverse stress scenarios. Ask: under what circumstances would this facility become unavailable - and how would we respond?

Making the Stress Test Matter

Too often, liquidity stress tests are performed once a year and filed away for examiners. To be effective, the process should:

• Be conducted regularly (e.g., quarterly or more often in volatile environments).

• Involve realistic, institution-specific scenarios tailored to your business model, balance sheet composition, and market.

• Translate into actionable contingency funding plans with clearly defined triggers and escalation protocols

Final Thoughts

Liquidity risk management is about more than satisfying regulatory requirements - it’s about survival and resilience. The institutions that weather stress most effectively are those that prepare for it in detail, with a sober understanding of their vulnerabilities.