Your asset/liability committee shouldn’t just be handling today’s ‘coronavirus’ economy. It should be shifting from a cost center to a catalyst for growth and profitability in the long term.
Following the financial crisis, the importance of having a prudent asset/liability management committee in place became abundantly clear. The Fed’s recent emergency rate cut in response to the coronavirus’s risk to the economy has many ALCO committees across the country ramping up efforts to support their credit unions’ performance. The event has highlighted the importance of creating a proactive—versus a reactive—committee. In the long term, credit unions will benefit from transforming their ALCOs from backward-looking, reporting-focused cost centers into dynamic, outcome-based committees that inform profitable decision-making.
Comprised of key decision-makers, ALCO members often include board members, the credit union’s president or CEO, the chief financial officer, the head of compliance, and other senior team members, ALCOs are often viewed as a check-the-box regulatory requirement, responsible for overseeing balance sheet risk management. By implementing the seven steps below, credit unions can shift their ALCOs from cost centers to a catalyst for growth and profitability.
Step 1: Review capital planning
Keeping the right level of capital at a credit union requires building a balance among growth, risk, and return. Credit union boards and ALCOs must actively assess risks and hold capital levels commensurate to those risks. The first step in supporting a dynamic ALCO is for the board and senior management to review your credit union’s capital planning process. Does it combine the credit union’s strategic planning goals with its market opportunities to arrive at planned growth, earnings and capital levels? Is the board assessing potential risks within the plan to ensure it has held enough of a buffer to withstand unforeseen changes?
A robust strategic financial planning process takes your board and management team through capital planning to set realistic and achievable financial goals and outline a strategy to meet these goals. A primary objective is to align on top priorities, which act as guideposts for the asset/liability team during challenging conditions. The strategic financial plan should yield a high-level, three- to five-year plan for financial performance with goals and priorities integrated into asset/liability policies; it should be reviewed and updated annually.
Step 2: Assess Risks in Plans
After setting target performance levels and identifying priorities and objectives, both the board and your ALCO should quantify risks in the current balance sheet that may impact the credit union’s ability to meet its goals. This involves the development of a dynamic forecast using a solid ALM model.
Major financial risks to be managed include:
- Earnings at risk
- Current value at risk
- Forecast value at risk, showing long-term risks in executing the plan
- Liquidity risks
- Credit risks
Many ALM models will allow financial institutions to assess these risks effectively; however, internal issues—such as lack of resources, talent, or time—are often the enemy of an effective ALM tool. If your credit union’s ALCO has remained unchanged over the years, consider the ways it can be improved or modified to offer a broader look at the future by identifying the gaps in your current approach.
Step 3: Develop Key Assumptions for Risk Assessment
Asset/liability models depend on external sources for major assumptions that impact risk. Such assumptions as prepayment speeds, non-maturity behaviors and pricing formulas have traditionally come from the market. The problem with market assumptions, however, is that they may have little resemblance to institution-specific behaviors and actions. This is one area where regulators have spent a significant amount of time pressing credit unions and other financial institutions for greater understanding of the impact these assumptions have on a risk profile.
A more effective ALCO will depend greatly on the variance of institution-specific behaviors compared to market assumptions for critical components. Key assumption areas include:
- Non-maturity core deposit behaviors
- Prepayment and early withdrawal analysis
- Loan pricing assumptions
- Deposit pricing
- Credit risk assessment
Step 4: Review and Redevelop Policies
Currently, many institutions have a series of board policies to manage different risks, independent of other risks. The industry’s shift toward enterprise-wide risk management brings the demand for redeveloping these polices. Your ALCO can support a full review of board limits and make recommendations for changes or additions to ensure the board has proper controls on management and risks are measured and managed per the capital plan.
Step 5: Incorporate Sensitivity Stress Testing
Many financial institutions employ a sensitivity test for stress testing, where key assumptions are modified to show how a change in their value impacts the performance of the institution. Changes are made primarily to determine which assumptions have the greatest influence on the outcome, like a ranking system, but are not based on any type of assumption about market conditions, expectations or reality.
Sensitivity stress testing is a measure of how a quick jump in rates could influence the level and direction of earnings. We run similar tests for other key financial risks, like credit and liquidity. While important, having your ALCO do sensitivity testing on each area individually is not the most effective way to manage a credit union to meet capital plan goals. Implementing a more comprehensive approach to stress testing is described next.
Step 6: Incorporate Scenario Stress Testing
Another form of stress testing, scenario testing, considers how changes in various circumstances can affect different risk levels. ALCOs should develop scenarios based on expected and unexpected economic and market forecasts and explore how these possible scenarios could impact the credit union’s performance relative to the capital plan objectives.
Scenario testing is an extension of a good projection process. Projections, like the annual budget, make some assumptions about market conditions, risk levels, growth, and pricing. Scenario testing takes the combined result of the projection and includes the forecast with information from individual sensitivity tests. For example, a forecast may look satisfactory in the initial projection, but if the projection is recalculated in scenario testing to include changes to the top two or three risk factors, will the credit union’s financial performance remain on track?
Step 7: Educate and Train
To understand new roles, regulations, responsibilities and controls, both the board and the credit union’s staff must understand the changes and how they will be. To create a more dynamic ALCO, it’s important to establish a regular cadence of one-on-one training and regular education for key stakeholders to ensure alignment with responsibilities and consistent decision-making.
While the continued use of stand-alone ALM solutions may suffice for regulators, it may not meet the needs of shareholders. It may also leave opportunities on the table that can help drive our economy. Willingness to manage risk has long been the hallmark of local decision-making, and to ensure that is done well, a broader, more comprehensive approach to risk measurement must be taken.
Financial institutions have the opportunity to manage risk and add strategic value in the ALCO process if they take the time to develop an ALCO process that goes beyond simply “checking the box” of compliance. By following these seven steps, your credit union can identify the areas of highest need in your ALCO process in order to take your asset/liability risk management to a more robust and meaningful level.
Dave Koch is managing director of advisory services for Abrigo, Austin, Texas.