Asset Liability Management 101

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Asset Liability Management 101
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Our Goal as Credit Unions?

• Maximize Member Value
• Reasonable Loan Rates
• Competitive Share Rates
• Convenient and Efficient Service
• But how do we do it?

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• EFFECTIVE ASSET LIABILITY MANAGEMENT
• EQUALS
• MAXIMUM MEMBER VALUE

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ALM History
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Inherent Risks

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

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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

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Components of Interest Rate Risk (IRR)

• Repricing Risk
• Basis Risk
• Yield Curve Risk
• Option Risk

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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.

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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.

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Basis Risk Example Year 1

• ARM LOAN
• Loan Rate 1 yr CMT plus 200 bps
• Resets Annually
• Initial Rate
• 1 yr CMT 1.25
• Spread 2.00
• Rate 3.25

• MEMBER CERT
• 1 Year Maturity
• Renewable Annually at Prevailing Rate
• Initial Rate
• 1.40

SPREAD 185 BP
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Basis Risk Example Year 2
Rates Increase 100 BP

• ARM Loan
• Rate
• 1 YR CMT 2.25
• Spread 2.00
• Rate 4.25

• Member Cert
• Rate
• 2.25

SPREAD 200 BP
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Basis Risk Example Year 3
Rates Decrease 125 BP

• ARM Loan
• Rate
• 1 YR CMT 1.00
• Spread 2.00
• Rate 3.00

• Member Cert
• Rate
• 1.25

SPREAD 175 BP
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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.

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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

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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.

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Balance Sheet

• LOANS
• Types
• Consumer
• Mortgage
• Credit Card
• Share Secured
• Home Equity
• Embedded Options
• Variable Rate
• Caps and Floors
• Prepayments

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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

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Balance Sheet

• SHARES
• Types
• Regular Shares
• Share Drafts
• Club Accounts
• Share Certificates
• Money Markets
• Options
• Variable Rate
• Early Withdrawals/Cashflows

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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

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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.

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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.

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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.

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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.

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Typical Gap Report
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Gap Analysis

• Upside
• Conceptually simple
• Easy to explain to board members
• Relatively easy data accumulation
• Doesnt require sophisticated and expensive
  software models
• Provides an indication of the direction and
  degree of IRR (Interest Rate Risk)

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Gap Analysis

• Downside
• Doesnt 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

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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

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Gap Analysis

• However, if theyre one of the lucky few for whom
  gap is sufficient, here are the risk categories
  from the regulators

Even if gap is acceptable, the regulators will
still expect the credit union to perform some
degree of income simulation analysis.
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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 theyre using gap
  analysis.

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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.

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Income Simulation

• Simple to complex
• The complexity of the modeling should be governed
  by the complexity of the credit unions 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.

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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 instruments
  principal and/or interest cash flows to vary with
  changes in interest rates.
• Embedded options make cash flows uncertain and
  uncertainty equals risk.

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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).

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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.

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Income Simulation

• Static Used to measure interest rate risk.
• Dynamic Used to manage the credit unions
  balance sheet and earnings.

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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.

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Income Simulation

• Dynamic model
• What-if
• Best case
• Worst case
• Most likely
• Strategic analysis
• Strategic risk mitigation
• Budgeting and forecasting

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Income Simulation

• Here are the NII risk categories(Static models)

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)
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The Lingo(Part One-and-a-half)

• Rate Shock
• An immediate, sustained, parallel shift in the
  yield curve.

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Rate Shock
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Rate Shock
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Rate Shock
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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

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Income Simulation

• Downside
• Short-term the full risks presented by
  longer-term instruments could remain hidden.
• Dynamic modeling requires increased subjective
  assumptions.

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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.

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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)

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NCUAS 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

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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.

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• Thank you