Asset Liability

Management 101
Presented by

Shirley Austin
Director, Consulting Services
Our Goal as Credit Unions?

Maximize Member Value

Reasonable Loan Rates
Competitive Share Rates
Convenient and Efficient Service

But how do we do it?

EFFECTIVE ASSET LIABILITY
MANAGEMENT
EQUALS

MAXIMUM MEMBER VALUE

ALM History

Date Event State of ALM

Pre- 1960s Good Ole Days Asset Management and
Portfolio Matching
1961 Non-Reg Q CDs Advent of Liability
Management
1975 Stagflation Birth of Gap Analysis
1982 PCs Advent of Simulations
1984 Value Recognition Duration Analysis
1988 Options Proliferation Prepayment Models
Now Complexity and Rope Risk Management
Inherent Risks

Credit Risk
Liquidity Risk
Market Risk
Operations Risk
Legal Risk
Interest Rate Risk
Interest Rate Risk

The risk that changes in current interest

rates can adversely affect:
Assets
Liabilities
Capital
Income
Expense
In other words… the entire balance sheet
Components of Interest Rate Risk
(IRR)

Repricing Risk
Basis Risk
Yield Curve Risk
Option Risk
Repricing Risk

Risk of rates moving up or down.

Also called mismatch (i.e. gap).
Mismatches usually exist as a result of
transactions that have not yet matured.
Most common scenario-
Using short term shares to fund long-term
assets, such as mortgage loans.
Basis Risk

Risk of rates for some instruments

changing more or less than rates for
other instruments.
Usually incurred because rates paid on
liabilities are determined differently from
the rates received on assets.
Typically comprise 25% to 50% of
losses to earnings.
Basis Risk Example Year 1

 ARM LOAN  MEMBER CERT

 Loan Rate = 1 yr  1 Year Maturity
CMT plus 200 bps  Renewable Annually
 Resets Annually at Prevailing Rate
 Initial Rate  Initial Rate
1 yr CMT 1.25% 1.40%
Spread 2.00%
Rate 3.25%

SPREAD = 185 BP
Basis Risk Example Year 2

Rates Increase 100 BP

 ARM Loan  Member Cert
 Rate  Rate
1 YR CMT 2.25% 2.25%
Spread 2.00%
Rate 4.25%

SPREAD = 200 BP
Basis Risk Example Year 3

Rates Decrease 125 BP

 ARM Loan  Member Cert
 Rate  Rate
1 YR CMT 1.00% 1.25%
Spread 2.00%
Rate 3.00%

SPREAD = 175 BP
Yield Curve Risk

Risk of short-term rates changing by

more or less than the change in long-
term rates.
Rule of Thumb
Short term rates are often more volatile
than intermediate and long-term rates.
Option Risk

Risk that rate changes prompt changes

in the amount or maturity of
instruments.
Often referred to as “embedded
options.”
Cashflows/Prepayments
Variable Interest Rates
Call Features
IRR Observations

Interest Rate Risk is inherent in all

credit unions and all balance sheets to
some degree.

Credit, Liquidity and Interest Rate Risk

are all interdependent.
Balance Sheet

LOANS
 Types
Consumer
Mortgage
Credit Card
Share Secured
Home Equity
 Embedded Options
Variable Rate
Caps and Floors
Prepayments
Balance Sheet

INVESTMENTS
 Types
Certificates of Deposit
Overnight Funds
Money Markets
Governments/Agencies
Mortgage Backed Securities
 Embedded Options
Variable or Adjustable Rate
Callable
Caps/Floors
Prepayments
Balance Sheet

SHARES
 Types
Regular Shares
Share Drafts
Club Accounts
Share Certificates
Money Markets
 Options
Variable Rate
Early Withdrawals/Cashflows
How Do We Measure Interest Rate
Risk?

Gap Analysis
Income Simulation
Net Economic Value
Other Reports
Liquidity Needs and Sources of Funds
Yield and Cost Report
Spread Analysis
Gap

 Gap is the dollar difference between rate-sensitive

assets and rate-sensitive liabilities with respect to a
specific time frame.
 Gap has three components - assets, liabilities, and
time, and Gap management involves the
management of all three.
Gap Management

 Gap management is those actions taken to measure

and match, within reason, rate-sensitive assets to
rate-sensitive liabilities.
 Rate-sensitive assets and liabilities are any interest-
bearing instrument that can be repriced to a market
rate in a given time frame.
Gap Management

 There are three possible gap positions – negative,

positive and matched.
 A negative gap is created when rate-sensitive
liabilities exceed rate-sensitive assets in a given
time period.
 A positive gap occurs when rate-sensitive assets
exceed rate-sensitive liabilities in a given time
period.
 A matched gap occurs when rate-sensitive assets
and rate-sensitive liabilities are equal in a given
time period.
Gap Management

 A negative gap position will cause profits to decline in

a rising interest rate environment and a positive gap
will cause profits to decline in a falling interest rate
environment. Under either scenario, profits suffer.
 To avoid volatile profits as a result of interest rate
fluctuations, management must match, within reason,
interest rate sensitivities while pricing both the asset
and liability components to yield a sufficient interest
rate spread. The result would be profits that remain
relatively consistent across interest rate cycles.
Typical Gap Report

Total Assets: $10,000

12+
1 mo 3 mos 6 mos 12 mos Total
mos
RSAs $500 $500 $2,000 $2,500 $3,500 $9,000
RSLs $1,500 $2,000 $2,000 $2,000 $500 $8,000
Gap $(1,000) $(1,500) 0 $500 $3,000 $1,000
Cumulative Gap $(1,000) $(2,500) $(2,500) $(2,000) $1,000
% of Assets (10)% (25)% (25)% (20)% 10%
Gap Analysis

Upside
 Conceptually simple
 Easy to explain to board members
 Relatively easy data accumulation
 Doesn’t require sophisticated and expensive
software models
 Provides an indication of the direction and degree
of IRR (Interest Rate Risk)
Gap Analysis

Downside
 Doesn’t quantify risk
 Assumes asset and liability characteristics are
symmetrical
Static cash flows (regardless of interest rates)
Parallel relationship among all indices (but all
shocks do this)
Open-ended repricing (caps and floors)
Common rate calculation basis
OFTEN provides misleading results
Gap Analysis

 Useful as a primary IRR measurement tool only for

those credit unions with simple balance sheets.
 In other words, if a credit union has any material
balances in mortgage-related loans or investments or
any investments with uncertain maturities (for
example, callables), they should move beyond gap
analysis
Gap Analysis

However, if they’re one of the lucky few for whom gap is

sufficient, here are the risk categories from the
regulators: Low Moderate High
Percent change in any given +/-10
period, or cumulatively over > +/-
+/-10% to
12 months 20%
20%

Even if gap is acceptable, the regulators will still

expect the credit union to perform some degree of
income simulation analysis.
Income Simulation

 A forecast of how net interest income (NII) will react

to changes in interest rates.
 NCUA and the state regulators encourage credit
unions to perform at least rudimentary NII simulation
testing even if they’re using gap analysis.
Income Simulation

Characteristics of NII modeling

 Quantifies risk in terms of income and (by
extension) future capital accumulation.
 Relatively short-term.
Though NCUA encourages up to 5-year
testing, 1 to 2 years is the optimal modeling
period.
The longer the period, the less reliable the
results.
Income Simulation

 Simple to complex
 The complexity of the modeling should be governed
by the complexity of the credit union’s balance sheet.
 If the balance sheet contains mortgage related
products or “complex” investments, the model
should be able to incorporate the instruments’
characteristics - “embedded options.”
The Lingo
(Part One)

Embedded Options
 Characteristics within the underlying financial
instrument that can cause the timing and amount of
cash flows to change.
 Recognizing and measuring embedded options is
important because they can cause an instrument’s
principal and/or interest cash flows to vary with
changes in interest rates.
 Embedded options make cash flows uncertain – and
uncertainty equals risk.
Embedded Options

Examples
Call options – can drastically speed up cash
flows if the owner of the option elects to
exercise.
Prepayment options – can speed up or
slow down cash flows as holders alter their
payment stream in relation to changes in
interest rates (commonly related to mortgage-
backed products).
Embedded Options

Rule of Thumb

Unless properly managed, call and prepayment

options will be exercised at the worst possible time
for the owner of the instrument.
Income Simulation

Static – Used to measure interest rate risk.

Dynamic – Used to manage the credit union’s

balance sheet and earnings.
Income Simulation

Static model
 Use of growth and mix assumptions can cloud or
even conceal IRR.
 Parallel shifts of the yield curve (regulatory).
 Non-parallel shifts (more informative).
 Primary assumption is the rate-sensitivity of non-
maturing deposits.
Income Simulation

Dynamic model
 What-if
Best case
Worst case
Most likely
Strategic analysis
 Strategic risk mitigation
 Budgeting and forecasting
Income Simulation

Here are the NII risk categories

(Static models)
Low Moderate High
Percent decline in NII over a 20 to
projected 12-month horizon <20% >30%
30%
Percent decline in NI over a 40 to
projected 12-month horizon <40% >75%
75%

Changes in NII are calculated under immediate, sustained,

and parallel shifts in the yield curve of up and down 100,
200, and 300 basis points and are measured from the base
model (rate shocks)
The Lingo
(Part One-and-a-half)

Rate Shock

An immediate, sustained, parallel shift in the yield curve.

Rate Shock

18%
16%
14%
12% Base
10%
8%
6%
4%
2%
0%
ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs
Rate Shock

18%
Up 300
16%
14%
12% Base
10%
8%
6%
4%
2%
0%
ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs
Rate Shock

18%
Up 300
16%
14%
12% Base
10%
8% Down 300
6%
4%
2%
0%
ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs
Income Simulation

Upside
 Conceptually simple
 Easy to explain to board members
 Quantifies risk in terms of earnings and future
capital accumulation
 Static modeling requires little, if any, subjective
assumptions
 Simple modeling can be relatively inexpensive and
uncomplicated
Income Simulation

Downside
 Short-term: the full risks presented by longer-term
instruments could remain hidden.
 Dynamic modeling requires increased subjective
assumptions.
Net Economic Value

 Net Economic Value (NEV) is simply the present

value of asset cash flows minus the present value of
liability cash flows.
 This just means that NEV is the present value of net
worth.
 NEV takes a longer-term, more comprehensive view
of financial risk since it includes the cash flows of all
financial instruments over their entire lives.
ALM REGULATORY UPDATE

 http://www.ncua.gov/ref/investment/alm.html
 NCUA Letters to Credit Unions
 99-CU-12 (Real Estate Lending and Balance Sheet Risk
Management)
 00-CU-10 (ALM Exam Procedures)
 00-CU-13 (Liquidity and Balance Sheet Risk Management)
 01-CU-08 (Liability Management – Highly Rate Sensitive and
Volatile Funding Sources)
 02-CU-05 (Examination Program Liquidity Questionnaire)
 03-CU-11 (Non-maturity Shares and Balance Sheet Risk)
 03-CU-15 (Fixed Rate Mortgages and Risk Measurement)
NCUA’S IRR REVIEW

 Step 1: ALM Policies Review

 Step 2: Integration of ALM into Strategic
Planning
 Step 3: Quality of ALCO Oversight
 Step 4: Internal Controls, Staff
 Step 5: Assessment of IRR Measurement
Tools
SUMMARY

 ALM is an Ever Evolving Process.

 The steps and complexity of the ALM
program should fit the needs of the credit
union.
 Board and Senior Management commitment
and involvement is critical to success.
 ALCO does not reside in a vacuum- should
provide policy guidance.
Thank you
Consulting Department

 Shirley Austin- Director, Consulting Services

 (800) 342-0203, extension 6811
 saustin@secorp.org

 Ben Mauldin- SVP, Risk Management and

Consulting Services
 (866) 661-6848
 bmauldin@secorp.org