Opportunity cost issues arise in the ALCO process most often when income opportunities are left uncaptured, in favor of lower-earning investment strategies.
Should a chief risk officer become an “agent of missed opportunity” in the ALCO process? Is that an appropriate role? And if it is, how does a bank go about assessing it and guiding balanced decision-making?
In this article, I’ll discuss why I believe that a CRO should support, encourage, and even introduce reasons to potentially increase perceived risk in the ALCO process.
CRO introduces more risk?
This is not everyone’s view, of course.
Much depends on the dynamics within the existing ALCO process at your bank. ALCO management is directed at helping to create consistent earnings while meeting the liquidity needs of the bank and preserving capital. Indeed, consistent earnings capacity is the bank’s best source of capital by far and is a fundamental goal of overall management.
A bank that finds the right balance through a well-honed ALCO process is a safer bank—which of course is a key goal of the bank’s CRO.
So why might the recognition of opportunity cost need a special advocate in the ALCO process? Think in terms of “mission.”
ALCO is very good at building risk measures. In a way, that’s its purpose. Therefore ALCO by its nature leans towards conservative actions. Nobody ever sees the income not recorded (opportunity cost), so nobody tends to worry about it. Perhaps properly so, because it may not be worth the risk.
But it may be worth the risk, and we should have regular mechanisms to facilitate thinking about it.
After all, banks do so when considering a loan, or a new product. For a loan, pricing models drive ROA or ROE output (fully risk-adjusted, please!) For new products, projections show expected revenues, costs, net income, and ROI. Benefits are clearly put forward and risks are weighed, leading to what should be well-informed decisions.
The ALCO process lacks a similar routine.
Specific investment strategies taking into account income and risk are modeled by the CFO. What may be lacking is the inducement to seek out those strategies, especially when interest rates are viewed as unusually low.
Set a baseline of “normal”
Here’s a suggestion. Determine a norm for the interest rate risk that you model in your investment portfolio over a full economic cycle.
1. Take into account all the items considered relevant to your bank’s particular balance sheet structure.
2. Set up a normal duration or other measure you determine appropriate, along with a standard mix.
3. Estimate the yield on an investment book of the same mix and the standard duration under current conditions.
4. Create a report that establishes a standard duration; calculate the implied yield and earnings; and compare to the current position.
If the difference calculated is negative, it means there is a cost to the current investment portfolio composition in the current environment compared to a long-term norm.
That’s what should engender a discussion.
This kind of condition arises most appropriately when there is a perception that interest rates will rise over the next one, two, or three years. We are naturally prone to think that rates will rise when the then-current rates are particularly low.
That has been the case since 2008, and at long last it seems rates will rise this year.
In the meantime, many banks have bypassed significant earnings, waiting for that to happen.
Does your ALCO take the wide view?
Most often, though, rates are low because the economy is dragging, and loan performance is below par. That is exactly when earnings from the investment portfolio are most needed. Therefore, management should consider the overall credit and interest rate environment in the ALCO process.
One good measure of the cost of remaining short is a chart depicting implied forward rates.
While most bankers involved in the ALCO process know well that the chart is a poor predictor of future interest rates, it is by definition a tool that shows the path interest rates need to take for say, successive one-year investments to yield the overall income as compared to a single three-year investment.
From an implied forward rate chart, management can begin to judge the likelihood that rates will increase at the indicated pace to help decide if the shorter investment or longer investment is suitable.
None of this is intended to support undue risk taking in the investment portfolio, when a bank in a flat rate environment decides to go well beyond its historic norms for duration in the investment portfolio to sustain earnings. For example, adopting a ten-year duration is inappropriate when the loan portfolio has a two-year duration and the liability side of the balance sheet has perhaps at most a three-year duration. That’s not good, and is the subject of regulatory scrutiny today.
But sometimes mismatches arise because management, early in a low interest rate cycle, stays overly short. When rates don’t rise as management expected—even hoped for—pressure mounts to support earnings. The discussion begins to focus on how long such a low-interest-rate environment can exist, and therefore remaining short may continue to appear the best alternative. Eventually, though, the pressure to support earnings becomes so powerful that modest movements just won’t do, and significant longer-term investment positions are built.
Much of this dynamic can be avoided by paying attention in the first place to the cost of staying short. So comparison to the norm, use of an implied forward rate chart, calculation of foregone earnings, and robust discussion of risks and rewards in the ALCO process are likely to lead to smoother decision making and investment portfolio performance.
Inside or outside of the kitchen?
Again, the question is, does the CRO belong in this process?
That depends on the dynamics within your bank’s existing ALCO process. If the pressures are always significant to extend maturities to support earnings, then probably not. But if the CEO and CFO are concentrated on the risk of rising rates, and are keeping the portfolio particularly short, then maybe so.
In this article I put forward a vision of the role of the CRO that may not be in line with what many think, including many accomplished professionals. Supporting a balanced, quantified decision-making process after robust discussion is a view of the CRO’s role that is calculated to add to long-term value, and one that should be pursued. Your thoughts are welcome and encouraged.