By Dave Koch
I’ve spent years claiming that modeling interest rate risk at community institutions is flawed—and that prior regulatory expectations deserve part of the blame.
For decades, we allowed institutions to model risk using unrealistic sets of assumptions and scenarios to quantify risks to net interest margin and net income. Despite all the rhetoric and analysis, we continued to see a decline in the overall net interest margin level. Now, many forces combine to influence that result, but as interest rates increased and decreased, the industry rarely saw benefit. The typical analysis of immediate, parallel and permanent rate movements fails to show real risks or change institutional behavior. Did we ever assess the risk of more realistic rate changes? Is our management committed to the process of risk assessment?
In a survey our firm conducted of 150 community financial institution CEOs and CFOs, more than 70 percent reported that they aren’t using the interest rate risk forecasts for planning profitability. There is a common belief that modeling is something done to satisfy a regulatory need, not for its own value. As evidence, most financial institutions look at risk levels, assuming that the balance sheet will remain exactly the same for the next two years. The balance sheet assumption, combined with immediate rate movements, are simply not good starting points in a world with flat or inverted yield curves and changing balance sheet levels.
Finding value in ALM beyond regulatory compliance
What does it take to add value beyond satisfying the regulatory approach, and is it worth the effort? To answer this, let’s begin with a look at the overall goal.
Asset/liability management is the process of choosing the mix of loans and investments, funded by deposits and borrowings, such that the institution can reach its financial goals even when market conditions change.
To do that, we need our risk forecasting to include realistic predictions, such as the possible real movements in market interest rates and their potential effect on margins and capital. These forecasts help us to identify the likely level of earnings and pressure in expected environments, as well as expose potential gains or flaws. Think of this as the beginning of a robust budgeting and planning process.
Where does your projection for net interest income come from if not from your ALM model? If not in conjunction with profitability planning, then how are you using your risk management tools? Managing regulatory requirements is often a separate discussion from how we manage our business.
If your bank wants to make its asset/liability committee more useful, it shouldn’t abandon the use of the immediate and parallel rate shocks. Instead, understand their role and augment them with more realistic results, including gradual rate movements and movements where the different tenors of the curve move at different speeds and amounts. Without attacking the idea of modeling a changing balance sheet, you can begin by looking at how the speeds and size of rate changes affect the perceived risk levels.
Regulatory guidance is clear about the need for rigorous stress testing to determine whether you have sufficient levels to meet minimum capital requirements. Testing must be done, but the guidance remains vague on how these tests are to be reconciled and applied to the institution’s overall decision–making. We believe that a combination of the “shock” tests and more realistic—yet severe—reality tests help management define both the level of risk and how imminent the risk is.
Shift your approach to create more value
For many institutions, the current interest rate risk reports show that the profitability of the institution will improve in the event of rising interest rates. This asset-sensitive position led many to hold off on several potential strategies, fearing that if rates did rise, they might not be able to increase the return. While the models show performance improvement, they don’t account for lost income waiting for rates to rise. This obsessive focus on rising rate risk management has led many institutions to underperform their earning potential. Think about it this way: If your analysis says you make more money if rates rise or fall, doesn’t that mean that you aren’t making enough money now?
It is for this reason that we believe that the current practices by many financial institutions do not meet the real regulatory need for safety and soundness.
Risk management is a trade-off. When one risk is actively managed, it usually comes with expectations for increased levels of return. When we focus the entire ALM process based on the results of a single measure of risk (interest rate risk), we often ignore the opportunity cost associated with many other factors. The regulatory assessment framework is built on the CAMELS rating approach. CAMELS measures each risk area individually and then assesses a subjective rating for management, the only area of risk without an objective rating.
The CAMELS approach looks at the current and past performance of the key metrics outlining overall institutional health. But it is crucial that the ALCO processes historical data and uses it to change future performance. Trends should not be purely historical—they need to be able to look at the extended trends given market conditions and expected actions. That fits our definition of asset/liability management above. It is also significantly different from the results we show with a static balance sheet under an immediate change in rates of 400 basis points overnight.
Changes to key assumptions—such as depositor preference or credit conditions—will affect results. There will never be a perfect approach to building foolproof assumptions. But isn’t the idea of trying to measure our performance under more realistic business conditions, and assessing those risks more compelling then measuring what we know won’t happen?
Making the ALM process more valuable to your institution involves defining a value proposition. First, most will need to admit that the current allocation of resources to this process is for risk management and compliance—not for decision-making. How much would you invest in something that can help to improve performance, versus just complying with regulatory requirements?
Define success for your bank
Most banks’ goal is to achieve the desired growth, profitability, and capital targets set by their board and management. Therefore, the goal of your ALM process should be to show the potential risks and obstacles that could impede your institution from achieving that goal. By finding what could go could go wrong by performing what-if analyses, your institution will know how to respond quickly if adverse conditions arise, such as changing economic conditions or unexpected changes in markets or customer preferences. That’s contingency planning and stress testing. We must know what issues are most important to our success, and we stay on top of them.
Your bank’s ALCO is a key part of the institution’s success. Think of the ALCO process as the coaching and skills development needed to get your team to win.
When it comes to maximizing value out of your ALM, challenge your ALCO to consider incorporating fresh perspectives on traditional risk management measures. Find the real risks in ideas that you may have rejected in the past without much analysis. Consider how your institution should meet opportunities that seem lucrative, while also understanding, balancing, and controlling the associated risk.
As we dive further into this new year, reflect on what stands in your way of a more effective ALCO. Is your team willing to make the change to see better results? If so, do you have the right tools, talent, and data? Do you have a shared set of assumptions on what might be possible in the future? Once you identify what you want and where the hurdles are, it becomes a lot easier to fill the gaps.
Banks are already expending a lot of effort on ALM. Thinking differently can ensure that effort converts to value, and that value lasts over time.
Dave Koch is managing director of advisory services at Abrigo.