Best Practice Ideas from the Asset-Liability Management Trenches

6/21/2023 - By Terry Treadwell, CPA

Recent industry uncertainties have highlighted the need to further question and research your Asset Liability Management (ALM) practices especially related to modeling Interest Rate Risk (IRR) and Liquidity. We recommend you evaluate the following areas:

Related to Policy

For IRR. Review both the NII and EVE current policy limits. Is the Bank at risk of a net loss and/or a decline in market value that is below current book value? If so, evaluate if further limitations are needed.

For Liquidity. Now is the time for re-evaluating contingency funding early warning trigger levels, policy limits or determining if new triggers or limits are needed. Also, consider addressing in policy the liquidity monitoring processes and reporting in place.

Related to General Reporting

Reporting to the ALCO and/or Board. Does the reporting help ALCO and the Board understand the Net Interest Income (NII), Net Income (NI), Economic Value of Equity (EVE) and Liquidity risks? Is there an awareness of where the “fall off the cliff’ line is for liquidity stress? Are these risks and related discussions adequately covered in the related meeting minutes?

Overall Reasonableness of Modeling Results

Falling rate scenarios are back on the modeling radar. Include falling scenarios through the 400 basis points (bps) level. Reevaluate the new/reinvestment volume rate floor assumptions associated with loans, securities and deposits. In determining these floor assumptions, it is helpful to look back to the historical rates before market rate increases began.

The EVE/Book value ratio may indicate assumptions adjustments are needed. The current rate environment may distort base case market value measurements. Especially consider the following areas: non-maturity deposit premiums (even some discounts) and loan discount/premiums; non-maturity deposit decay lives; discounting assumptions (typically using spreads to yield curves - primarily treasury, FHLB, SOFR, OIS or Libor swap); cost of servicing application (for non-maturity deposits); and book equity adjustments related to the securities AFS portfolio.

NII Year One static balance sheet forecast. Does the NII forecast for year one reasonably compare with the most recent model period historical month annualized and, if not, is there a reasonable explanation?

Modeling Assumptions

Decay Life Assumptions: Average account balance historical analysis is often used in decay studies to evaluate the deposit base for possible surge balances and applied to the decay life assumption. Many clients evaluate and track this internally at the product level. If you are not yet tracking you can a quick reasonableness gauge by reviewing the average non-maturity balance increases between the current period and December 31, 2019 (segmenting between large and regular accounts).

Beta Factor Assumptions: Review the correlation between market rate increases since March 2022. Generally, most clients did not begin to increase deposit pricing until after the first 200 bps market rate increase. The more recent months’ pricing responses correlated with the increase in market rates may represent a more accurate beta assumption for rate increases from this point forward. For falling rates, if you have history from the last couple of falling rate cycles, use that. If not, consider that the pricing down may not follow the same path up. There may be a lag in price decreases.

Liquidity: Evaluate using a dynamic cash flow forecast based on management’s most recent cash flow expectations. Develop the stress testing scenarios using the base case and applying increasingly restrictive concurrent cashflow assumptions. Consider the mitigation strategy for each stress scenario and determine the adequacy of the resulting liquidity position and ratios.

Large Account Considerations and Stress Testing

Quantifying uninsured and/or large depositor balances. Would new tracking ratios be helpful? Is ALCO comfortable with the current levels of these deposits? If not, what does the reduction plan look like? What is the funding plan to replace these deposits if they leave? Are large portions of these balances assumed to leave as part of the alternative assumptions stress testing exercise? If balances are significant, how are these monitored daily for indications of a possible deposit decline trend and what might those possible “early-warning” indicators be?

For IRR stress testing. Consider the impact of the runoff of large deposits with replacement by a wholesale funding source and related impacts on NII and EVE sensitivity.

For Liquidity stress testing. Consider a worst-case scenario with a significant amount of large deposits component as run-off funded by the most likely sources of funds.

Questions?

If you have any questions about Asset Liability Management (ALM), don't hesitate to contact our Financial Institution Consulting team.

About the Author | Terry Treadwell, CPA

Terry is a senior consultant in the Financial Institution Advisory Group at Saltmarsh, Cleaveland & Gund. She has more than 25 years of experience serving financial institutions, including 10 years as the senior vice president of finance for a Florida-based savings bank. Terry began her career with an international public accounting firm and also served as a bank consulting associate for Stogniew & Associates, she provided internal audit services to community banks. Terry’s primary areas of concentration are asset/liability management including interest rate risk modeling, strategic balance sheet planning and liquidity management.