8 Costly Risks inAsset Liability ManagementHow to Avoid theUnintended ConsequencesAB E S TP R A C T I C E SR E P O R T
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DCG 8 Costly Risks in Asset Liability ManagementAbout Darling Consulting GroupDarling Consulting Group (DCG) is an ALM consulting firm that has provided industry-leading, independentsolutions to financial institutions throughout the country for more than 30 years in the areas of: Interest Rate Risk Liquidity Capital Planning/Stress Testing Assumption Development and Support Financial Performance Regulatory ComplianceThe breadth of professional expertise, proprietary technology and unmatched client support distinguish DCG asthe premier provider of ALM solutions to the banking industry.All of DCG’s risk management services are founded on the education of the client. Some of our more popularservices include:ALM Consulting Balance Sheet Consulting Risk Analyzer PlusModel Validation Large Institution Community Bank Credit UnionDeposits360 (Non-Maturity Deposit Analysis & Online Tool)Prepayments360 (Loan Prepayment Studies & Analytics)Liquidity360 (Liquidity Management and Contingency Planning)Liquidity ReviewsCapital PlanningCredit Stress-Testing Solution
DCG 8 Costly Risks in Asset Liability Management
DCG 8 Costly Risks in Asset Liability ManagementTable of ContentsIntroduction. 1Comprehensive Modeling. 3Rigorous Assumptions. 4Risk Assessment. 5Strategy Development. 6ALCO Action. 7Contingency Planning. 8Board Involvement. 9Customized Policies. 10Conclusion. 11DCG ALM Advisory Service. 12How DCG Can Help. 13
DCG 8 Costly Risks in Asset Liability Management
DCG 8 Costly Risks in Asset Liability Management1.IntroductionDeveloping a complete ALM process (modeling, reporting and strategy development and decision making) has alwaysbeen a daunting task, and with all of the regulatory emphasis, focus and guidance, including the issuance of the 2010Interagency Advisory on Interest Rate Risk Management and the Interagency Policy Statement on Funding and LiquidityRisk Management, the task has only become more difficult.At DCG, we view the ALM model as the foundation upon which strategy development is built. If the foundation is weak,the entire ALM structure is in jeopardy.Once a model accurately reflects the current risk profile (a process that is difficult and time consuming initially and onethat needs to continuously be managed), the process of using that information should come to the forefront. However,even the best information becomes useless if not expressed in a manner that makes it fully understood by the key stakeholders or if used incorrectly.How does your institution view ALCO? Is it a regulatory appeasement exercise performed only to “check off the box” oris true value assigned to the modeling process? Are decisions made and strategies implemented?In our more than 30 years leading the industry, we have provided effective ALM solutions to more than 1,500 financialinstitutions across the U.S. and abroad whose assets range from 20 million to 200 billion and who represent all chartersand regulatory agencies. It is this experience that serves as the basis for this report – to provide guidance on what it takesto develop an effective ALM process. Following are actual examples of situations through which our 80 employees havehelped manage our clients as we are immersed every day in providing modeling, reporting and strategic guidance to ouroutsourcing clients, helping clients get the most out of their internal processes as well as training the examiners.Whether you have a model that is managed internally, an outsourced process or find yourself searching for a solution thatbest fits your needs, the examples that follow will provide perspective into what it takes to manage a “Wholistic” ALCOprocess that gives your institution the best chance to succeed. Maybe you find yourself looking in the mirror and askinghow your process measures up – does it meet the new significantly expanded regulatory expectations and, more critical toyour institution’s success: does it meet your own?DCG’s “Wholistic” Approach to Balance Sheet Management
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DCG 8 Costly Risks in Asset Liability Management3.Comprehensive ModelingHow limited modeling capabilities left one institution unaware of their true exposure.Background:A mid-sized community bank was facing an upcoming examination, and they assumed all the bases were covered – theyran a one year NII simulation for /- 100, 200 and 300bps, an EVE calculation and were in compliance with their policylimits. When bank management sat down with the lead examiners for the exit interview, they were surprised by the findings that were presented to them.Management was asked about running stress tests on their model assumptions, more extreme rate movements and alternative yield curve “twists” and how they simulated potential strategies prior to implementation. Management embarrassingly admitted that they did not get that information from their model provider. Needless to say, the examiners were notsatisfied with that answer, noting not only were these analyses required in the guidance, but they went on to question howstrategic decisions were made without first knowing the implications to their risk profile.Potential Risk:By limiting analysis to only the base NII scenarios, the bank never recognized it had exposure to yield curve risk and optionality that emerged as a result of running more stressful rate environments of which they were not aware. Additionally,by only looking out one year, management missed the longer-term embedded exposure in the balance sheet, which actually was the opposite of the near-term exposure. ALCO meetings were focusing on managing to the near-term risk profile,without knowledge that they were exacerbating the true exposure of the balance sheet beyond the first year.Relative to the impact on balance sheet strategies, the exercise of stress testing assumptions is vital to ensure that thoseassumptions incorporated in the model are accurate and providing reliable results upon which to make the strategic decisions. Management had no appreciation for the impact the model assumptions had on results and by not testing andvalidating them there was no confidence in the output of the model upon which to develop strategies. Once those strategies have been determined, an effective ALM process will simulate the results of any potential balance sheet strategiesto gauge the impact on the risk profile prior to executing the transactions – and management was making these decisionswithout a true understanding of their impact on their risk profile. Without the ability to simulate strategies, the decisionmaking process is flawed.The DCG Solution:A thorough ALM process includes far more than the preparation of a base model and reporting the results to management.As part of our quarterly review process, we provide, in addition to our “core scenarios,” a selection of more extreme ratemovements and alternative yield curve shifts (flattenings or steepenings of the curve) as well as stress tests on the keymodel assumptions to assure the model results are complete and accurate. And in order to view the full impact of the balance sheet cashflows and assumptions working through the model, we provide the results in a five-year simulation, allowing our clients to manage to the short-term while continuing to plan for the longer-term. By performing these analyses, itenables management to quantify the impact of the causes of interest rate risk: mismatch risk, option risk, basis risk andyield curve risk.
DCG 8 Costly Risks in Asset Liability Management4.Rigorous AssumptionsHow a disregard of model assumption development resulted in years of making the wrongstrategic decisions.Background:The assumptions that are input into your interest rate risk model are the single most important determinant of producingcorrect model results – and many institutions take too casual of an approach in their development. One such example isof an institution that input model assumptions when the model was initially built, but has not updated them in the timesince. Cashflow reinvestment, optionality and deposit pricing remained unchanged since the implementation of the model,despite changes in the balance sheet, market factors and customer behaviors.The initial assumptions development process was simply a “rollover” of all existing cashflows into the same products atrates equivalent to portfolio levels, and the deposit pricing assumptions were “best guesses” based upon the CFO’s experience at his former institution. There was no support for these assumptions relative to studies or input from key personnel(i.e. lending, retail and treasury). The assumptions were considered just another step in the modeling process and not muchattention was paid to their impact.Potential Risk:By not incorporating any historical analyses or studies, the prepayment and deposit pricing assumptions varied so significantly from actual experience that the model results were showing exposures that were opposite to actual risks. Themodel output was never back tested, which led to management being unaware that the model was not representing actualbusiness practice, something that would have been identifiable when comparing model results to actual income levels.The consequence of developing assumptions with no basis for stress-testing or documented support or input from thepersonnel who truly understand the portfolios on the balance sheet is an inaccurate risk assessment. An inaccurate viewof the risks inherent in the balance sheet led to poor strategic decisions being made by the management team – causingthis institution to lose money not only from implementing strategies that were contrary to what they should have beenconsidering but also from missed opportunities that they never even considered as options.The DCG Solution:At DCG, we consider the assumption development process and ongoing testing to be paramount to an effective ALM process. Our quarterly assumptions discussions involve the key decision makers in the institution representing all aspects ofthe balance sheet – lending, retail and treasury. We get input from each group as to what they are seeing in the marketplace,what products are being marketed and what they see for ongoing demand. This ensures that replacement assumptions arereflective of actual business activities.In order to support the assumptions that are input into the model, we utilize a state-of-the-art data warehousing systemto analyze historical trends relative to new lending activity and deposit products as well as to track prepayment activityand core deposit behavior to help develop and support the model assumptions. We have the ability to prepare analyses onprepayment activity in the loan portfolio and deposit metrics (i.e. pricing betas and core balances) to assist in the modelingof these key factors in the various rate environments as well as provide support for these assumptions.And more importantly, our analysts and consultants educate our clients on the importance of these critical assumptionsand explain how they impact results. Additionally, these assumptions are continually stress-tested to ensure the model isaccurately reflecting the risk profile of the balance sheet and that the client understands and appreciates the impact eachof the assumptions have on the results and the level of error those assumptions can contribute.
DCG 8 Costly Risks in Asset Liability Management5.Risk AssessmentHow a lack of analysis left one institution more exposed than it ever thought.Background:Institutions with very rudimentary analyses of risks inherent in their balance sheet find themselves exposed to potentialloss and increased levels of regulatory scrutiny. One instance that illustrates this point involves an institution that preparedone year simulation of shocks of /- 100 through 400bps and EVE. The securities portfolio was “tainted” due to the saleof HTM securities, and they had no liquidity contingency plan or stress testing of any kind. Their first exam with the newregulator was eye-opening as they indicated that the institution required a more robust risk measurement process that examined all risk on the balance sheet, not just interest rate risk. Risk measurements vary by the complexity of the organization, and the processes this bank had in place were not sufficient to adequately capture the risk relative to IRR or liquidity.Potential Risk:This institution was not aware of what their overall risk profile looked like beyond one year and, therefore, could not makeinformed decisions about the types of strategies that best fit with their position. By employing shocks vs. ramps, they wereoverstating potential benefit/exposure during the first year, and the EVE analysis did not provide a reliable representationof the long-term risk profile of the balance sheet.Additionally, the institution did not have a suitable measurement of the current liquidity position, nor did it understandhow the sale of the HTM securities impacted current and future liquidity levels. The institution relied on the securities inthe portfolio as collateral for wholesale funding, and there was no measurement process in place to gauge the impact areduction in collateral value would have on future funding requirements – no early warning system to alert managementwhen policy limits were being approached and no liquidity stress-testing process in place to help make decisions whensituations like this arose.This institution did not have additional funding sources in place as it had always relied on funding sources that utilizedthe security collateral; however, they were now faced with the dilemma of having to determine the best way to fund futurebalance sheet growth with alternative means of funding. And without a real understanding of the risk profile of the balancesheet from an IRR perspective, management could not determine whether the best funding alternatives were short-term orlonger-term – and how the changes in wholesale funding would impact both liquidity and IRR exposures.The DCG Solution:Understanding the inherent risks in your balance sheet is the first step in developing and implementing strategies aimed atincreasing income while managing those risks. However, without the appropriate tools to measure the risks, it makes theprocess of assessing the correct strategic direction of the institution a much more challenging undertaking.At DCG, we understand the importance of measuring and managing to all of the risks within the balance sheet. Whilemost ALM companies will focus solely on IRR, we implement our philosophy of “Wholistic” ALCO and examine howinterest rate risk, liquidity risk and capital risk impact each other. The ability to access various funding sources can belimited due to capital constraints, and those choices will impact ongoing interest rate risk levels as well. It is impossibleto implement the most appropriate strategic decisions for the institution without first having a complete understanding ofall risks inherent within the balance sheet.
DCG 8 Costly Risks in Asset Liability Management6.Strategy DevelopmentHow a lack of understanding of how to utilize information cost an institution.Background:The primary purpose of an ALM model is to provide accurate information to management and the board upon which todetermine the best strategic course for the institution. Most institutions have a model that provides them with some level ofdetail regarding NII sensitivity to identify their exposure to changes in interest rates. Even with the highest quality modeloutput, if management does not know how best to utilize the information, the ALCO process will stall.One institution had a rather pronounced exposure to rising rates. The management and board had a history of viewing borrowing as a “weakness,” so it had not established any borrowing lines with the FHLB or FRB. Funding was based entirelyon deposits, with specials driving borrowers where the bank wanted them to be. Additionally, nobody was familiar withderivatives as a hedging instrument, so that topic was never discussed at ALCO meetings. And those meetings really didnot have a strategic focus as the institution had limited funding options and management lacked the market knowledge tocreatively manage the balance sheet.Potential Risk:This institution had backed itself into a corner relative to its ability to most effectively manage earnings and exposure. Bytaking a short-sighted approach to borrowings as a “weakness”, management and the board limited the options to mostcost effectively leverage the balance sheet. Essentially, the bank was forced to pay higher rates on deposit accounts toattract funds when they wanted to execute any sort of leverage strategy. Deposits also take time to attract with promotingproducts and positioning a product in the marketplace, and there is no guarantee the bank will attract the required level offunds at the desired cost – something easily attainable with wholesale funding.And in this institution’s case, the best option to hedge against rising rates was to execute an interest rate swap. Had theyhad the expertise to add the swap at the optimal time, the benefits to income would have been significant. The board wasagainst entering into any sort of derivative as they “didn’t understand those sorts of things.” That ended up costing thisbank with both a continued exposure to a rising rate environment and a missed opportunity to benefit with the utilizationof off-balance sheet instruments.This institution ended up missing opportunities and unnecessarily increasing expenses due to a lack of understanding ofhow to best manage risk and a short-sighted approach to borrowings.The DCG Solution:DCG recognizes the importance of looking at the overall balance sheet position in developing and implementing strategiesaimed at increasing income while managing levels of risk. We are aware that in order to maximize income, institutionsmust take on some degree of risk – but the keys are to measure and monitor that risk in all aspects of the balance sheet andto make sure that the instit