ALCO—for all the right reasons
It’s really not just about making examiners happy
- Written by ALCO Beat
By Mark Haberland, managing director, Darling Consulting Group
As 2014 ended, I found myself out on the speaking circuit, face to face with many C-suite bankers, as well as my share of examiners. My session always seemed to precede the “regulator panel,” so I was curious how their viewpoints on asset/liability management would differ from mine.
One day, at a bankers’ conference in December, I heard something that made all those plane trips worthwhile. An FDIC senior examiner on one of the panels said:
“I hope you all listened to Mark when he said, ‘You shouldn’t do ALM to appease the regulators, because he was absolutely right.’ If that is what you’re doing it for, you’re totally missing the point!”
Wow! He and his colleagues went on to expand on that comment, saying that it is critical for banks to have an ALCO process in place that facilitates decision making. To most effectively accomplish that goal, ALCO must understand its exposure to changes in interest rates and available liquidity today (and tomorrow). ALCO must also understand how the new capital landscape will impact a bank’s ability to grow through earnings pressures.
Interest rate risk issues
In order to identify exposure to changes in interest rates, one must first focus on how those rates will change.
1. How real are your rate shock exercises?
Many bankers perform interest rate shocks as their primary net interest income (NII) sensitivity measures. By shocks, most often we are referring to “instantaneous and permanent” changes in rates.
However, if the purpose of ALM is to identify the balance sheet’s risk to changes in rates, why would a bank look at such unrealistic scenarios as the basis for identifying that risk?
Looking back at the historical changes to the Fed funds rate over the past 40 years, we find that rates do not move both instantaneously and permanently. The average monthly change to the benchmark rate over that timeframe is 30 basis points (bps).
Why then are bankers basing their sensitivity to changing rates on the outcome of a +300bps instantaneous shock scenario?
It is unrealistic and, potentially, misleading. Exposure or benefit in the near-term could be overstated and any loan floors are rendered meaningless as rates “immediately jump” over floors.
Rather than managing to a “stress” scenario, bankers should focus their NII analyses on rate ramps, where changes in rates move gradually over time. By combining the ramped movement of rates with a variety of scenarios (i.e. steepenings, flattenings, more extreme increases in rates, etc.), ALCO has at its disposal a multitude of potential risk exposures.
2. How does ALCO avoid the dreaded “analysis paralysis”?
While ALM is not performed strictly as a means to appease the regulators, a thorough IRR process will go much beyond what will “appease.”
A sound process reviews ramps, shocks, and parallel and non-parallel scenarios. Such an approach will, by default, satisfy the requirements of the recent guidance on IRR while fulfilling its primary goal of giving ALCO an understanding of where it is exposed to changes in rates.
However, the time horizon that is reviewed is an important factor that often goes overlooked. This is especially important if the ALCO is reviewing only shocks.
The most common argument I hear when recommending longer-term rate-risk simulations is that anything beyond two years is unrealistic, and that you cannot count on those income levels in years four and five.
The objectors’ point is most certainly valid. However, one must remember that NII simulations are not budget exercises. They do not factor in growth. NII simulations are meant to identify trends in earnings projections and provide insight as to the timing and degree of exposure to changes in rates.
3. Is your bank using EVE properly?
A common long-term risk management tool used by banks is the economic value of equity (EVE) calculation. Very popular in the regulatory community and a staple with bankers, the EVE can identify if there are structural mismatches imbedded within the balance sheet.
However, as mentioned above, you cannot identify the timing and degree of any exposure. Pairing this with the impact the non-maturity deposit assumptions have on EVE exposure, oftentimes the sensitivity can contradict NII simulations, causing ALCO to have to decide which tool to focus on for strategic decision making.
Too many times I have seen banks manage to a perceived EVE exposure and make decisions that are detrimental from the perspective of NII and earnings perspective. So, understanding the true risk profile of the balance sheet is critically important.
4. Have you taken a hard and fresh look at your models?
The biggest variable that impacts potential exposure is the model assumptions, and for most community banks the assumptions for the non-maturity deposits trump all others. The importance of these assumptions highlights two processes that have been a focus of recent regulatory exams and are vital to the reliability of model results: deposit studies and stress-testing.
• Deposit studies are not worth the paper they are printed on if they simply “regurgitate” historical files.
There are many economic and market factors that impact deposit flows and additional qualitative analysis that must take place to truly understand the expected future behavior patterns of your deposit base. And as an ALCO, you must understand the genesis of deposit assumptions (betas, decay, volatility, etc). You have to own these assumptions and be able to explain their origin.
Yet assumptions are just that—not a definite. Therefore, in order to truly understand your risk profile and exposure to changes in rates, you must incorporate sensitivity/stress-testing of key assumptions into your regular ALM process.
This type of analysis both quantifies the impact these most important assumptions have on results and provides a range of potential outcomes that must factor into the decision-making process for rate risk—and liquidity.
Liquidity: No time for complacency
When I talk with bankers about what their liquidity measurement and management process entails, the most common responses I receive are “I have a spreadsheet,” and, “I’m not worried about liquidity today—we have more than we need.”
One byproduct of the financial crisis that shook the industry has been a significant influx of liquidity into the banking system. It seems the lower that banks’ deposit rates go, paradoxically, the more funds continue to come in.
When we discussed the importance of deposit studies a bit earlier and how they can provide support for key NII model assumptions, the results of that study can also be incorporated into your liquidity planning process. Potential “hot money” that could leave the bank impacts the reliance on wholesale funding sources as well as the ability to support longer-term assets—which can provide greater yield.
As part of an effective liquidity management process, ALCO must look into the future (i.e. two years) to see what impact loan originations, deposit migrations/outflows, etc., could have on available liquidity. And not to be overlooked is stress-testing liquidity levels.
Running multiple scenarios (of varying degrees of severity) will provide valuable information to ALCO as to the stability of its liquidity and what could potentially cause a liquidity crisis at the bank.
The other aspect of effective liquidity management is setting up an early warning system to alert ALCO prior to a liquidity crisis, and allowing actions to take place (per the bank’s Liquidity Contingency Plan) that prevent the crisis from occurring.
By running multiple scenarios for NII and liquidity and including stress-testing as part of the ALM process, ALCO can put into place strategies to prevent crises, manage potential risk, and maintain a strong bottom line—a key to capital preservation.
Capital: It’s a whole new game now
Who knew that the town of Basel, Switzerland, would have such a profound impact around your board room?
At the beginning of this year, the new capital requirements set forth from Basel III became official, with the hopes of preventing another financial crisis from plaguing the banking industry. New ratios, higher minimums, and a “capital conservation buffer” are all part of the new normal for bank ALCOs as they work to manage through earnings pressures and await the next rate cycle.
Capital planning and, again, stress testing have become much more common in ALCO discussions. When looking at a bank’s capital, ALCO must ask itself two questions:
• “How much growth can our capital support?”
• “How much loss can our capital absorb?”
Do most ALCOs have those answers?
That’s where capital planning comes into play as well as credit stress testing—gauging the potential impact of expected losses on capital levels under changing economic conditions.
I have seen these issues become more prevalent in recent regulatory exams for our clients, even the smaller community banks. Also, in talking with bankers on the road, these same themes come up again and again.
The importance of incorporating capital planning and, again, stress testing into your ALM process is greater than at any time before. If you do not have one in place, get the process started now before the next exam takes place.
Putting it all together: The ALCO Meeting
As I said at the beginning of this article, ALCO is not a regulatory “checkoff.”
Instead, ALCO is where the key decisions that will drive the ongoing success of the bank are made. Take advantage of the time you have those decision makers together at one meeting. Make sure you provide information on interest rate risk, liquidity, and capital.
Of all the rate scenarios that are prepared, only a handful will be used at ALCO to affect strategy development. The remainder primarily serve for regulatory compliance (i.e. shocks) or for ensuring the accuracy of the model (i.e. stress tests, backtests).
The purpose of the ALCO meeting should be on managing the risk, and that is best accomplished by providing “what if” simulations illustrating a variety of options and documenting each strategy, including:
• A description of the strategy and why it is being considered.
• The expected results of the strategy (i.e. improve income, reduce exposure, etc.).
• The potential risks involved (i.e. option risk, credit risk, counterparty risk, etc.)
With all of the facts presented, it makes it much easier for the ALCO to make the best decisions for the bank, manage the risk on the balance sheet, and maximize the earnings potential going forward.
By having a thorough IRR model with supported, defensible assumptions, reviewing the right scenarios over a long-enough time horizon, and considering the levels of liquidity and capital today (and tomorrow), banks will be in a position to make the right decisions at the right time—and by default have a process that gets you that “check” by the regulators.
About the author
Mark Haberland is a managing director at Darling Consulting Group. In this role, he works directly with financial institutions to strengthen their asset/liability management process. He provides support to clients in the areas of liquidity risk management, capital, ALM modeling and reporting, and regulatory compliance.
Haberland has been with DCG since 1997 and oversaw the operations of the company’s Financial Analytics Group for many years. He has over 20 years of experience in the banking industry in the areas of asset liability management and bank auditing.
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