061005 Slides Color - Webinars, Webcasts, LMS, eLearning...

1

ALM Basicsfor Community Financial Institutions

FMS WebinarOctober 5, 2006

Jim Wilkinson, Ph.D.Wilkinson Financial, LLC

ALM Basics - October 5, 2006

2

Asset/Liability Management

Definition: Process of managing assets, liabilities, and derivatives to obtain a risk - return trade-off that is optimal for your institution.

2


3

Goals of ALM Process

• Earnings growth and stability • Equity growth and stability• Risk management

– Interest rate risk– Credit risk– Liquidity risk– Leverage

• “No surprises” in our performance


4

Competing Goals

• ALCO goals can conflict with each other– Want higher earnings– Need to control risk– Trade-off between risk and return

• ALCO decisions involve balancing competing objectives

• Process of optimization

3


5

Example: Competing Objectives

• Want higher earnings– Earn higher net interest income by funding

longer assets with shorter liabilities

• Need to control risk– Funding longer assets with shorter liabilities

generates losses if interest rate risks rise


6

Constraints on ALM Process

• Economic, financial market conditions

• Local market conditions

• Institution’s characteristics

• Regulatory environment

4


7

ALM Decisions

• Balance sheet optimization– Composition of assets– Composition of liabilities– Intensity of capital utilization– Capital allocation to asset classes

• Pricing strategies• Risk management strategies


8

Asset/Liability Management

• Focus of ALCO is usually on interest rate risk management

• However, this is only a part of balance sheet optimization process that makes up asset/liability management

5


9

Overview of Course

• Effects of interest rate risk

• Effective risk management process

• Measuring interest rate risk

• Risk measurement challenges

• Strategies for managing interest rate risk


10

Risk Measurement Systems

• IPS Sendero• ProfitStar• Plansmith/Compass• Farin/Sam• BancWare

• Risk Analytics/FIMAC• CUNA Model Mgt• HNC• Other

Polling Question

What type of risk measurement system does your institution use?

6


11

Interest Rate Risk

Definition of Interest Rate Risk (IRR):

Adverse changes in interest rates can reduce your institution’s future income or economic value of equity.

Economic value of equity (EVE) is economic value of assets less economic value of liabilities.


12

Risk is about the Future!

• Risk management is about preparing for what might happen in the future

• You must be willing to live with changes in interest rates

• Once rates move, you cannot avoid the impact

• Your institution must make adjustments before interest rates change

7


13

Interest Rate Risk

Types of interest rate risk:

• Gap risk (timing or repricing mismatch)

• Options risk

• Basis risk

• Yield curve risk


14

Gap Risk (Earnings Perspective)

• Source: assets, liabilities have different maturities or repricing dates

• Rising rates reduce income for institutions with longer maturity assets– Replace short liabilities with higher cost liabilities.

• Falling rates reduce income for institutions with longer liabilities– Reinvest in lower earning assets while still paying

current (high) rates on liabilities.

8


15

Gap Risk (Economic Value)

• Longer maturity assets, liabilities have larger value change when rates change.

• Rising rates reduce economic value of institutions with longer maturity assets.– Value of assets falls more than value of liabilities

• Falling rates reduce economic value of institutions with longer maturity liabilities.– Value of liabilities rises more than value of assets


16

Gap Risk Example

• A bank funds 2-year 4% bullet maturity loan with 3-month CD at 2%

• Bank allocates 8% equity to transaction

• If bank continues to roll the CD, it earns 2% for 2 years if rates do not change

• If rates rise 100 basis points, banks earns only 1% after first 3 months

9


17

Loan Example:Original Interest Rates

Cash flowPresent Value Cash Flow

Present Value

Difference in PVs

Q1 10.00 9.90 4.60 4.58 5.32 Q2 10.00 9.80 4.60 4.55 5.25 Q3 10.00 9.71 4.60 4.53 5.17 Q4 10.00 9.61 4.60 4.51 5.10 Q1 10.00 9.51 4.60 4.49 5.03 Q2 10.00 9.42 4.60 4.46 4.96 Q3 10.00 9.33 4.60 4.44 4.89 Q4 1,010.00 932.72 924.60 888.43 44.28

Sum 1,000.00 920.00 80.00

Loan Cash Flows CD Cash Flows


18

Loan ExampleInterest Rates Rise 100 bps

Cash flowPresent Value Cash Flow

Present Value

Difference in PVs

Q1 10.00 9.90 4.60 4.58 5.32 Q2 10.00 9.75 6.90 6.80 2.96 Q3 10.00 9.63 6.90 6.75 2.89 Q4 10.00 9.52 6.90 6.70 2.82 Q1 10.00 9.40 6.90 6.65 2.75 Q2 10.00 9.28 6.90 6.60 2.68 Q3 10.00 9.17 6.90 6.55 2.62 Q4 1,010.00 914.45 926.90 873.12 41.34

Sum 981.10 917.73 63.38

Loan Cash Flows CD Cash Flows

10


19

Loan Example

• What happened to bank’s net interest income?

• What happened to value of bank’s equity investment in this transaction?

• What was percentage decline in economic value of equity in this transaction?


20

Options Risk

• Caused when assets, liabilities have embedded options that can be exercised by customers or counterparties.

• Examples:– Mortgages, installment loans– Callable agency securities– Callable advances– Deposits

11


21

Options Risk• When customer can exercise the option, the

institution is said to be “short” the option.• Customer exercises the option when it is in

his or her interest, usually the worst time for the institution.

• Example:– When rates fall, a thrift is holding mortgages with

above market rates. Customers exercise option to prepay the mortgages, and the thrift loses valuable assets.


22

Options Risk

Do clients, counterparties ever exercise their options when it is in the institution’sinterest to do so?

12


23

Basis Risk• Risk that poor correlation between

changes in rates on assets and liabilities will adversely impact earnings/capital.

• Example: Prime-based loans funded by LIBOR-based floating rate advances

• Example: Deposit rates are reset more slowly than other rates, especially when interest rates rise


24

Basis Risk

Prime-LIBOR Spread

Year Average Year Average1990 1.71 1997 2.701991 2.49 1998 2.791992 2.43 1999 2.58 High = 3.601993 2.70 2000 2.71 Low = 1.381994 2.39 2001 3.13 Average = 2.611995 2.80 1H02 2.84 St Dev = 0.371996 2.76 (Weekly data)

Bank with Prime assets and LIBOR liabilities is affected by spread between these rates

13


25

Yield Curve Risk• Risk of loss due to change in shape of

market yield curves– Yield curve shows relationship between

interest rates and maturities

• Changes in yield curve shape– Steeper, flatter −−−− Curvature

• Risk caused by concentrations of assets, liabilities at different points on yield curve


26

Curvature Change

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

0 2 4 6 8 10 12 14 16 18 20

Years

Curve 2

Curve 1

14


27

Relative Importance of Risk

• Repricing mismatch risk has potential for causing greatest loss

• However, financial institutions manage this risk

• Empirical evidence suggests that risks from options, basis, yield curve risks can lead to losses equal to mismatch risk


28

Questions?

Select *1 now to ask a live question through the phone

OR

Type your question into the chat box in the lower left corner of the screen and click on

the “Send” button located right below the box.

15


29

Overview of Course

• Effects of interest rate risk


• Measuring interest rate risk

• Risk measurement challenges

• Strategies for managing interest rate risk


30

Effective Risk Management Process

• Shifting market conditions continually change available risks and returns

• Must be able to evaluate its risk-return trade-offs on a regular basis

• Must adjust asset, liability balances and pricing, hedging for appropriate trade-off

• Requires an on-going process with board and senior management

16


31

Elements of an Effective Risk Management Process

• Active board, management oversight

• Adequate risk management policies, limits

• Appropriate risk measurement and reporting systems

• Comprehensive internal controls


32

Active Board and Senior Management Oversight

Responsibilities of Board of Directors:– Determine the institution’s risk tolerance– Approve policies that reflect and

communicate attitude toward risk – Monitor performance and risk profile – Ensure Board has or has access to risk

management expertise– Periodically, review risk management

process, policies, and limits

17


33


Responsibilities of Senior Management:– Translate board’s attitude into operations

and measurable standards

– Implement policies and procedures with:• Clear lines of authority• Appropriate risk limits• Adequate systems for measuring risk• Comprehensive risk reporting system• Effective internal controls


34


Responsibilities of Senior Management:– Ensure risk management staff is

competent and has sufficient depth

– Maintain independence between risk takers and risk monitors, to extent possible

– Periodically review risk management procedures and measurement systems

18


35

ALCO Membership

• Management ALCO– Senior management and staff only

• Board ALCO– Management and outside directors


36

ALCO in Your Institution

What type of ALCO does your institution have?

• Management ALCO• Board ALCO• Both Management and Board ALCOs

Polling Question

19


37

ALCO in Your Institution

How often does the ALCO at your institution meet?

• Weekly• Monthly• Quarterly

Polling Question


38

Adequate Risk Management Policies and Limits

• Policies specify Bank’s attitude and approach to risk management

• Identify constraints and limits– Numerical limits for interest rate, credit, and

liquidity risk– Procedures for dealing with limit violations– Limits should be consistent with bank’s approach

to risk management

• New product review

20


39

Appropriate Systems for Risk Measurement and Reporting

Risk measurement system

– Robust enough to adequately measure all of institution’s risks

– Must be able to measure risks of all instruments acquired

– Stress testing, back testing, model validation


40

Back-Testing

• Compare predicted outcome from earlier period with actual results from current model

• Purpose is to check model operations and accuracy of assumptions

• Difficulties:– Actual change in rates?– Compensating for changes in balances, spreads,

volatilities, other factors

• Errors in model vs Errors in back-testing!

21


41

Independent Model Validation

• Independent entity validates model – Audit department (if it has expertise)– Outside party (external auditor or consultant)

• Validation Guidance– OCC Bulletin 2000–16 – Check inputs & assumptions, processing

systems, outputs & reports– Validation policy


42

Appropriate Systems for Risk Measurement and Reporting

Risk reporting system– Reports provide information in form easily

understood by management and board• Charts, tables, graphs

– Reports should clearly identify risk exposures and violations of limits

– Too much information is as bad as too little

22


43

System of Internal Controls• Maintain strong control environment

• Internal controls should promote effective operations, reliable reporting, and compliance with laws, regulations, and policies

• Internal audit should evaluate:– Effectiveness of controls– Compliance with limits– Reliability, timeliness of management reports– Independence of risk management process


44

Reports to Review at ALCO

• Balance Sheet Composition

• Earnings Performance

• Risk Reports

23


45


• Balance Sheet Composition– Loan composition and growth– Securities portfolio– Deposit composition and growth– Wholesale funding– Yields on assets, rates on liabilities

• Capital Ratios


46


Earnings Performance• Current earnings• Earnings ratios

– ROE, ROA, trends– Earnings, expenses as pct of assets– Compare to peer

• Yields on assets, rates on liabilities

24


47


• Interest Rate Risk Reports– Income simulations– Economic value analysis– Exposures vs limits– Exposure Trends

• Liquidity Risk Reports• Funds Management Reports


48

Summary• Asset/liability management involves

managing the balance sheet composition and pricing to optimize risk-return tradeoffs

• Sources of interest rate risk


• Reports to review in ALCO

25


49

Next Week …

• Measuring interest rate risk– Gap Analysis– Income Simulations– Economic Value Analysis

• How the models work• Key assumptions


50

Questions?

Select *1 now to ask a live question through the phone

OR

Type your question into the chat box in the lower left corner of the screen and click on

the “Send” button located right below the box.

26


51

Your feedback is important to us!Don’t forget to complete the seminar survey.

1. Simply click on the “Seminar Survey” in the LINKS area to the left of this slide.

2. From the drop-down box at the top of the survey, choose the “ALM Basics” series.

3. Complete the survey and click on “Submit” to send us your responses

This concludes the first of four sessions. Thank you for your participation.

061005 Slides Color - Webinars, Webcasts, LMS, eLearning...

Documents

Transcript of 061005 Slides Color - Webinars, Webcasts, LMS, eLearning...