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
Date Pre- 1960s 1961 1975 1982 1984 1988 Now Event Good Ole Days Non-Reg Q CDs Stagflation PCs Value Recognition Options Proliferation Complexity and Rope State of ALM Asset Management and Portfolio Matching Advent of Liability Management Birth of Gap Analysis Advent of Simulations Duration Analysis Prepayment Models Risk Management
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
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 scenarioUsing short term shares to fund long-term assets, such as mortgage loans.
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
Loan Rate = 1 yr CMT plus 200 bps Resets Annually Initial Rate
1 yr CMT Spread Rate 1.25% 2.00% 3.25%
1 Year Maturity Renewable Annually at Prevailing Rate Initial Rate
SPREAD = 185 BP
Basis Risk Example Year 2
Rates Increase 100 BP ARM Loan
1 YR CMT Spread Rate 2.25% 2.00% 4.25%
SPREAD = 200 BP
Basis Risk Example Year 3
Rates Decrease 125 BP ARM Loan
1 YR CMT Spread Rate 1.00% 2.00% 3.00%
SPREAD = 175 BP
Yield Curve Risk
Risk of short-term rates changing by more or less than the change in longterm rates. Rule of Thumb
Short term rates are often more volatile than intermediate and long-term rates.
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
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.
Types Consumer Mortgage Credit Card Share Secured Home Equity Embedded Options Variable Rate Caps and Floors Prepayments
Types Certificates of Deposit Overnight Funds Money Markets Governments/Agencies Mortgage Backed Securities Embedded Options Variable or Adjustable Rate Callable Caps/Floors Prepayments
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 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 is those actions taken to measure and match, within reason, rate-sensitive assets to rate-sensitive liabilities. Rate-sensitive assets and liabilities are any interestbearing instrument that can be repriced to a market rate in a given time frame.
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.
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 1 mo RSAs RSLs Gap % of Assets
$500 $1,500 $(1,000) (10)%
$500 $2,000 $(1,500) $(2,500) (25)%
$2,000 $2,000 0 $(2,500) (25)%
$2,500 $2,000 $500 $(2,000) (20)%
$3,500 $500 $3,000 $1,000 10%
$9,000 $8,000 $1,000
Cumulative Gap $(1,000)
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)
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
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
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 period, or cumulatively over 12 months +/-10% +/-10 to 20% > +/20%
Even if gap is acceptable, the regulators will still expect the credit union to perform some degree of income simulation analysis.
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.
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.
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.”
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.
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 mortgagebacked products).
Rule of Thumb
Unless properly managed, call and prepayment options will be exercised at the worst possible time for the owner of the instrument.
Static – Used to measure interest rate risk. Dynamic – Used to manage the credit union’s
balance sheet and earnings.
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 nonmaturing deposits.
What-if Best case Worst case Most likely Strategic analysis Strategic risk mitigation Budgeting and forecasting
Here are the NII risk categories (Static models)
Low Percent decline in NII over a projected 12-month horizon Percent decline in NI over a projected 12-month horizon <20% <40% Moderate 20 to 30% 40 to 75% High >30% >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)
An immediate, sustained, parallel shift in the yield curve.
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs Base
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs Up 300 Base
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs Up 300 Base Down 300
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
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
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.
Shirley Austin- Director, Consulting Services
(800) 342-0203, extension 6811 email@example.com
Ben Mauldin- SVP, Risk Management and Consulting Services
(866) 661-6848 firstname.lastname@example.org