Southwest Corporate Investment Services

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Southwest Corporate Investment Services
Using Income Simulation Test Your
Ideas Presented By Mark DeBree
Amy Lin Senior ALM Analysts

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Overview

• Goal
• Basics of income simulation
• Running an income simulation model
• Data requirements
• Assumptions
• Understanding results and testing your ideas

Southwest Corporate Investment Services
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Overall Goal of Income Simulation

• Understand income simulation from data inputs to
  the end results
• Help credit unions make more informed business
  decisions

Southwest Corporate Investment Services
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Basics of Income Simulation

• What is it?
• A forecast of interest income and interest
  expense or net interest income (NII)
• Computed under multiple interest rate scenarios
• Computed over a specific time period
• Incorporates all embedded options
• Highly dependent on management inputs

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Basics of Income Simulation

• Why use it?
• Forward-looking
• Provides an insight of current risk position and
  risk position going forward.
• Enhances traditional Gap and NEV analysis in
  assessing risk exposure.
• Easy to understand and explain
• The results are shown in an income statement and
  balance sheet format.
• The effects of balance sheet growth, changes to
  asset mix, pricing strategies and interest rate
  assumptions can be easily identified.

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Basics of Income Simulation

• Why use it?
• To determine the interest rate risk exposure over
  a one to two year time period.
• To test new pricing strategies.
• To determine the impact of reallocations of
  assets or funds.
• The more complex the balance sheet, the greater
  need for income simulation.
• ---------------------------Risk---------------
  -----------
• Income Simulation Low Moderate High
• NII chg over any 12mo
• period after shock lt20 20-30 gt30
• NI chg over any 12mo
• period after shock lt40 40-75 gt75
• Risk Limit Guidelines by NCUA.

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Running Income Simulation
Setting up the Model

• Current Position Data
• - Balances, rates, maturities, repricing,
  optionality
• New Business Assumptions
• - Pricing/spread relationship, maturity inputs
• Other Assumptions (Current Position and New
  Business)
• - Prepayments, interest rate/yield curve
  scenarios, etc.

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Running Income Simulation

• Creating the Current Balance Sheet
• Provided by the credit union via data files.
• Data files must have the minimum required fields
  that define each instrument.
• Format of the data must be consistent across time
  periods.
• Quality of data is important.
• Accuracy and completeness of the data.
• Note As shown in handout.

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Basics of Income Simulation

• Incorporating New Business
• Assume flat (static) balance sheet, as balances
  mature or run-off, they are replaced with like
  instruments.
• Pricing (indices, spreads, cap/floor, etc.).
• Maturities.
• Note Pricing and maturities are based on
  management inputs.

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Bring it Together
New Business - Balance Sheet Structure -
Indices - Spreads - Maturities
Simulation Results - Balance Sheet - Income
Statement - Average Yields - Comparative
Projected Earnings Analysis
Current Position - Balances - Rates -
Maturities - Repricings - Optionality
Other Assumptions - Prepayments - Interest
Rates/ Yield Curve
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Running Income Simulation

• Verifying the Results
• Current position Accounts, balances, coupons,
  maturities, repricing, etc.
• Tying balances back to the General
• Ledger
• New business Accounts, balances, coupons,
  maturities,
• repricing, etc.
• Projected results
• Reasonableness of the assumptions.
• Results compared to previous periods.

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Simulation Results

• Current and Projected Balance Sheet
• Projected Income and Expense
• Current and Projected Asset Yield and Funding
  Costs
• Comparative Projected Earnings Analysis for
• Year 1 and 2
• Policy/recommended limits

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Understanding the Results

• Income Simulation attempts to provide a
  reasonable portrayal of all the components of net
  interest income (NII) under multiple rate
  scenarios.
• Understand the sensitivity of your earnings to
  changes in
• interest rates
• How and why has net interest income changed in
  each scenario?
• Are the results within policy/recommended limits?
• Is there a shift between Year 1 and Year 2?
  Why?
• Revisit your assumptions

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Testing Your Ideas Using What-Ifs

• Using What-Ifs to Validate Strategies
• Growth
• Incorporate growth and/or add new products.
• Pricing
• Flexing the yield curves - Ramps, Twists, Invert,
  Most Likely.
• Test the effects of strategy changes (Teasers,
  Incentive Pricing)
• Compare What-If results to the Base Case
  Scenario to see how results change due to shifts
  in strategy and/or external factors.

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Summary

• Establish the Current Balance Sheet
• Incorporate New Business
• Add Prepayments, Yield Curves, Other
  Assumptions
• Evaluate Results
• Are the results reasonable and realistic?
• Use What-Ifs to Test Your Ideas
• How will the proposed strategy be impacted by
  shifts in other factors (growth, New Products,
  Pricing)?

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Questions?
Mark DeBree Amy Lin Senior
ALM Analyst Senior ALM Analyst
debreem_at_swcorp.org
lina_at_swcorp.org [phone] (214)
703-7872 Southwest Corporate Investment
Services [phone]
Southwest Corporate Investment Services