assets and liabilty management
TRANSCRIPT
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Asset LiabilityManagement 101
Presented by
Shirley Austin
Director, Consulting Services
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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
Risk ManagementComplexity and RopeNowPrepayment ModelsOptions Proliferation1988
Duration AnalysisValue Recognition1984
Advent of SimulationsPCs1982
Birth of Gap AnalysisStagflation1975
Advent of Liability
Management
Non-Reg Q CDs1961
Asset Management and
Portfolio Matching
Good Ole DaysPre- 1960s
State of ALMEventDate
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Inherent Risks
Credit Risk
Liquidity Risk
Market Risk
Operations Risk
Legal RiskInterest Rate Risk
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Interest Rate Risk
The risk that changes in current interest
rates can adversely affect:
Assets
Liabilities
Capital
IncomeExpense
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 bpsResets Annually
Initial Rate1 yr CMT 1.25%
Spread 2.00%
Rate 3.25%
MEMBER CERT
1 Year Maturity
Renewable Annuallyat Prevailing Rate
Initial Rate1.40%
SPREAD = 185 BP
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Basis Risk Example Year 2
ARM Loan
Rate1 YR CMT 2.25%
Spread 2.00%
Rate 4.25%
Member Cert
Rate2.25%
Rates Increase 100 BP
SPREAD = 200 BP
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Basis Risk Example Year 3
ARM Loan
Rate1 YR CMT 1.00%
Spread 2.00%
Rate 3.00%
Member Cert
Rate1.25%
Rates Decrease 125 BP
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/PrepaymentsVariable 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
MortgageCredit 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 RateCallable
Caps/Floors
Prepayments
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Balance Sheet
SHARES Types
Regular SharesShare 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, andtime, 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 giventime 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 remainrelatively consistent across interest rate cycles.
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Typical Gap Report
Total Assets: $10,000
1 mo 3 mos 6 mos 12 mos12+
mosTotal
RSAs $500 $500 $2,000 $2,500 $3,500 $9,000
RSLs $1,500 $2,000 $2,000 $2,000 $500 $8,000
Gap $(1,000) $(1,500) 0 $500 $3,000 $1,000
Cumulative Gap $(1,000) $(2,500) $(2,500) $(2,000) $1,000
% of Assets (10)% (25)% (25)% (20)% 10%
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Gap Analysis
UpsideConceptually simple
Easy to explain to board members
Relatively easy data accumulation
Doesn’t 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
DownsideDoesn’t quantify risk
Assumes asset and liability characteristics are
symmetricalStatic 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 they’re one of the lucky few for whom gap is
sufficient, here are the risk categories from the
regulators: Low Moderate High Percent change in any given
period, or cumulatively over 12 months
+/-10%
+/-10
to
20%
> +/-20%
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 simulationtesting even if they’re using gap analysis.
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Income Simulation
Characteristics of NII modelingQuantifies 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 theresults.
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Income Simulation
Simple to complex
The complexity of the modeling should be governed
by the complexity of the credit union’s balance sheet.
If the balance sheet contains mortgage relatedproducts or “complex” investments, the model
should be able to incorporate the instruments’
characteristics - “embedded options.”
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The Lingo(Part One)
Embedded OptionsCharacteristics 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 instrument’s
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
ExamplesCall 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 timefor the owner of the instrument.
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Income Simulation
Static – Used to measure interest rate risk.
Dynamic – Used to manage the credit union’sbalance sheet and earnings.
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Income Simulation
Static modelUse 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-Primary assumption is the rate-sensitivity of non-
maturing deposits.maturing deposits.
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Income Simulation
Dynamic modelWhat-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)
Low Moderate High Percent decline in NII over a
projected 12-month horizon <20%
20 to
30% >30%
Percent decline in NI over a
projected 12-month horizon <40%40 to
75%>75%
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
Base
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs
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Base
Up 300
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs
Rate Shock
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Base
Up 300
Down 300
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs
Rate Shock
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Income Simulation
UpsideConceptually simple
Easy to explain to board members
Quantifies risk in terms of earnings and futurecapital accumulation
Static modeling requires little, if any, subjective
assumptions
Simple modeling can be relatively inexpensive anduncomplicated
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Income Simulation
DownsideShort-term: the full risks presented by longer-term
instruments could remain hidden.
Dynamic modeling requires increased subjectiveassumptions.
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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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NCUA’S IRR REVIEW
Step 1: ALM Policies Review
Step 2: Integration of ALM into Strategic
PlanningStep 3: Quality of ALCO Oversight
Step 4: Internal Controls, Staff
Step 5: Assessment of IRR MeasurementTools
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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 creditunion.
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
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Consulting Department
Shirley Austin- Director, Consulting Services
(800) 342-0203, extension 6811
Ben Mauldin- SVP, Risk Management and
Consulting Services
(866) 661-6848