Banks, thrifts and credit unions should be able to explain how they will manage the liquidity risk associated with bank-owned life insurance arrangements.

Federal agencies have included that suggestion in proposed interagency guidance concerning funding and liquidity risk management.

The Office of the Comptroller of the Currency, the Federal Reserve System, the Federal Deposit Insurance Corp. and the National Credit Union Administration published the proposed guidance today in the Federal Register.

The proposed guidance summarizes “the principles of sound liquidity risk management that the agencies have issued in the past and, where appropriate, brings them into conformance with the Principles for Sound Liquidity Risk Management and Supervision issued by the Basel Committee on Banking Supervision in September 2008,” officials write in a summary of the proposed guidance.

The guidance applies to insurers that are regulated by federal agencies as banks, thrifts, bank holding companies, or thrift holding companies as well as to companies that operate mainly as banks or thrifts.

At all affected financial institutions, “an institution’s liquidity management process should be sufficient to meet its daily funding needs, and cover both expected and unexpected deviations from normal operations,” according to the text of the proposed guidance. “Accordingly, institutions should have a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of the critical importance to the viability of the institution, liquidity risk management should be fully integrated into the institution’s risk management processes.”

Policies at affected financial institutions “should clearly articulate a liquidity risk tolerance that is appropriate for the business strategy of the institution considering its complexity, business mix, liquidity risk profile, and its role in the financial system,” according to the guidance draft. “Policies should also contain provisions for documenting and periodically reviewing assumptions used in liquidity projections. Policy guidelines should employ both quantitative targets and qualitative guidelines.”

Affected financial institutions should provide specific information about “asset concentrations that could increase liquidity risk through a limited ability to convert to cash,” according to the guidance draft.

Examples of assets that could be difficult to convert to cash include complex financial instruments, “less marketable loan portfolios,” and bank-owned life insurance, according to the draft.

A copy of the proposed guidance is available here.