Contingency Funding Plans

Diana Bonfim and Sandra Pinheiro

Hope for the best; be prepared for the worst: this logic is well suited to explaining why drawing up contingency funding plans is critical for an adequate risk management policy. Any discussion on liquidity risk management entails thinking about a worst-case scenario. While it is necessary to manage a bank’s liquidity on a day-to-day basis, we know that liquidity is something that can dry up very quickly. Most of the tools to manage liquidity risk discussed in the previous chapters attempt to provide mechanisms to insure against the risk of this type of market-freeze scenario. Good management of liquidity risk should ensure that financial institutions are better equipped to deal with such scenarios. Further, risk mitigation tools should reduce the impact of these shocks, should they materialise.

Still, the worst may always happen. If, despite all the regular risk management efforts, this day arrives, risk managers will be able to react in a much faster and reasoned way if they have a contingency funding plan up their sleeve.

If liquidity suddenly evaporates, managers have a very limited amount of time to act. A sufficiently large shock may bring a solvent institution to the