Lecture Materials

ASSET/LIABILITY MANAGEMENT – YEAR 1

Dwight R. Larsen National Bank Examiner

Office of the Comptroller of the Currency Minneapolis, Minnesota

dwightrlarsen@hotmail.com 202-597-1329

August 4, 2017

1

Asset Liability Management -Year 1

(aka “The Nuts and Bolts of ALM”)

Graduate School of Banking

Madison, Wisconsin

Dwight R. Larsen

Today’s Outline

• Overview of the Section

• What is ALM?

• Why is ALM important?

• The “ALCO”

• Liquidity Risk and Management

2

Overview of the ALM Section

• Purpose? (see “Course Description”)

• Try and provide a basic understandingof the major ALM areas.

• Become “conversational” (not fluent)

• If not today, you may become involvedin ALM in the future!!! (POLL)

What is ALM?

3

A/L Management - Definition

• The process of planning, organizingand controlling asset and liabilityvolumes, mixes, maturities, rates, andyields with the objective of maximizingreturns and minimizing risk.

• Technically, encompasses all riskcategories (credit, IRR, liquidity,transaction, etc.)

What is ALM? (continued)

• Pre-session reading materials…?

• 1. “Active mgmt of the balance sheet”– Setting rates, terms, maturities on loans

• And, making loans that get repaid!!!

– Setting rates, terms, maturities on deposits

– Determining what types of investment securities topurchase, given liquidity or income needs

– Ensuring adequate (but not too much) liquidity

– ENSURING ADEQUATE CAPITAL LEVELS!!!

4

What is ALM? (continued)

• 2. Understanding how changing market interest rates impact the bank’s net interest income, net income, and capital.

What is ALM? (continued)

• Five main areas to be covered:– Liquidity risk and management (today)

– Investment portfolio management (next Monday)

– Interest rate risk and management (today)

– Capital Planning & Management (next Monday)

– Funding (alternatives, options) (today, next week)

• Case Studies in ALM (next Monday)

Examples!!!

5

Liquidity RiskExample #1 – Cash Flows “Match Up”

Loan

• $100

• 8%

• 1 Year

CD

• $100

• 4%

• 1 Year

So…in this example, equal amounts of cash come to the bankand leave the bank at the same time; no liquidity risk!!!!

Liquidity RiskExample #2 – Cash Flows do not match up!

Loan

• $300

• 8%

• 1 Year

CD

• $100

• 4%

• 1 Year

In this more realistic example, the cash flows coming into the bankand going out of the bank do not match up…

6

Interest Rate RiskExample #1 – Repricing Risk is minimal

Loan

• $100

• 8%

• 1 Year

CD

• $100

• 4%

• 1 Year

In this example, the Loan and CD will each reprice in one year, which should allow the bank to maintain the spread (possibly higher or lower).

Interest Rate RiskExample #2 – Repricing does not match up

Loan

• $100

• Prime + 1%

• 1 Year

CD

• $100

• 4%

• 2 Years

In this example, the Loan (whose rate will vary over time) and CDreprice at different times, so, the spread could change over time!

7

Capital Planning & ALM?

14

8

Banking Business Model(“Balance Sheet”)

“Sources/Uses” of Funds “Sources/Uses” of Funds

AssetsCash & Due From Accts.Fed Funds SoldInvestmentsLoansReserve for Loan Losses

(contra asset)Other Real Estate Owned

(OREO – foreclosed property)

Premises and EquipmentOther Assets

AnyBank

LiabilitiesDDA (checking accts.)Savings AccountsMMDAsCDsBorrowed Funds*Other Liabilities

CapitalCommon StockSurplusUndivided Profits

*Borrowed funds include fed funds purchased, brokered CDs, FHLB advances; also termed “other borrowed money”

“Typical” Income Statement

+Interest Income

-Interest Expense

Net Interest Income

-Provision for Loan Losses

+Non-interest income

-Non-interest expense

Pre-tax operating income

-Taxes (40%)

Net Income

$4,000,000

(1,500,000)

$2,500,000

(250,000)

400,000

(1,600,000)

$1,050,000

(420,000)

$ 630,000

As interest rateschange, net interestincome and net income will beimpacted…

How much is thequestion!!!

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Key Performance MeasuresROAA, ROAE, NIM

• ROAA = Return on Avg. Assets (Net Income/Avg. Assets)

(measures utilization of assets)

• ROAE = Return on Avg. Equity (Net Income/Avg. Equity)

** (is the optimal measure for shareholders) **

It is probably impossible to “maximize” all of these performance indicators at the same time!!!!!

• NIM = Net Interest Margin (Net Int. Inc./Avg. Earning Assets)

(measures spread & volume; net yield on earning assets)

All Roads Lead to Capital!

Remember!!!

10

Why is ALM Important?

Bank ROA’s – By Asset Size

Source: www.fdic.gov

Earnings are flat…

*Through March 31, 2017

-0.20%

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017>$1B $100MM - $1B < $100MM

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Bank NIM’s – By Asset Size

Source: www.fdic.gov

Through March 31, 2017

NIM’s are getting squeezed!!!

2.50%

2.75%

3.00%

3.25%

3.50%

3.75%

4.00%

4.25%

4.50%

4.75%

5.00%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

>$1B $100MM - $1B < $100MM

Why is ALM Important?(Summary)

• Many smaller banks are struggling for more earnings; trends in performance indicators are not entirely positive.

• Many business sectors not seeing meaningful upticks/expansions.

• Situation results in banks taking on unwarranted risks that may impact earnings and capital for many years!

• Prudent ALM becomes very important!!!

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“ALM” - KEY POINTS• Earnings are maximized through proper

balance sheet management (“A/L management”).

• Earnings drive shareholder value.• Asset growth increases earnings (generally).• Capital levels dictate asset growth.• If earnings are retained on balance sheet,

must grow over time or shareholder value will decline.

• A small increase in earnings has a large impact on shareholder value.

The ALCOAsset Liability Committee

“Driver” of ALM

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ALM Roles of Different Groups

• Board of Directors – set targets, risk limits, etc.

• Senior management – day-to-day oversight and implementing pricing guidelines

• Middle management – Implements pricing set by ALCO, assists ALCO analysis, etc.

• Asset Liability Committee (ALCO) – establishes pricing guidelines and makes liquidity decisions based on analysis of performance, trends, competition, etc.

The “ALCO” - Purpose

• Function/purpose of ALCO? – Overall goal is to stabilize/increase profits– Must make decisions regarding the pricing

of loans and deposits, as well as funding strategies

– ALCO not just in place to review compliance with various policy guidelines (IRR, Liquidity, etc.)

Time to visit the ALCO at First Dysfunctional Bank…

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ALCO Members

• Should include individuals who have direct involvement in pricing the bank’s earning assets and sources of funds

• Actual decision-making group should be small (<10 is best)

• Odd numbered decision-making committees work best (for voting reasons)

• Meet monthly or quarterly

The “ALCO”• Need to remain knowledgeable of the

major factors influencing ALM that are beyond their control:– Interest rates, business cycles, accounting

changes, etc.

• Need to remain diligent and disciplined on ALM issues they “can” control:– Pricing, terms of loans, deposits, etc.– Forecasting liquidity needs/excesses, etc.

15

The ALCO Meeting & Process

Remember ever seeing this?

DATA(facts)

INFORMATION (answers to questions) DECISIONS!

Make sure the ALCO (or any committee) is reviewing information, not just a bunch of data. We can make better decisions with information.

The ALCO Meeting and Process(continued)

SO:Data Information

Decisions!

Rates/Yield CurveFed Funds FuturesEcon. Trends * Employment *Demographics*

* national, regional, and local

Current Performance MeasuresIRR Models (NII, NI, NIM, etc.)Liquidity Models (short/excess)Actions of CompetitorsLoan/Credit IssuesCapital Issues

PRICING LOANS!PRICING DEPOSITS!BUY/SELL FUNDS!

16

ALCO MEMBERS “MUST” UNDERSTAND HOW

CHANGING INTEREST RATES IMPACT BANK EARNINGS!

Interest Rates 1980 – June 2017

Source: St. Louis Federal Reserve

0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

25.0%

1980 1985 1990 1995 2000 2005 2010 2015

prime fed funds

17

Today’s Yield Curve is ?????

Source: U.S. Department of the Treasury

0%

1%

2%

3%

4%

5%

6%

7%

3 mo 6 mo 2 year 5 year 10 year 30 year

8/25/2000

7/17/2007

6/19/2017

“ALCO” Meeting Information

• Has evolved; now covers more than traditional interest rate risk and liquidity issues

• Pricing and risk issues change over time; should you be reviewing different information?

• ALCO info depends on ALCO “focus”

18

“ALCO” Meeting Information(continued)

• Meeting Information “may” include:

– Current Yield Curve; very key information!!!

– Recap and trend of NIM, ROAA, ROAE, efficiency ratio, cap ratios, etc. including comparison to budgets and competition

– Trends on pricing of loans and deposits (i.e. avg yields, rates paid, and strategies for changes)

– Earnings exposure to changes in rates (IRR)

“ALCO” Meeting Information(continued)

• Meeting Information “may” include:(continued)

– Projected sources/uses of funds (liquidity)

– Funding Capacity Recap

– New products and/or strategies

– Material loan/credit issues

– Earnings Credit Rate, Funds Trans. Pricing

– Capital Planning & Management– Recap of compliance with policy guidelines

for interest rate risk and liquidity!

19

“ALCO” Meeting Information(continued)

• Ask “What are we trying to accomplish?

• What are the key issues? What do we need to allow us to focus on these issues?

• Are we measuring and reporting risk positions with the most appropriate and practical tools?

• Are we evaluating the risks and rewards of strategies to improve performance?

“Liquidity Management”Discussion Agenda

• Objectives, recap of historical liquidity management, recent trends

• Liquidity Planning Techniques– Internal Funding Analyses

– “Projected Sources & Uses of Funds”

• Funding Alternatives & Monitoring

20

Liquidity Management (Defined)

• Objective is to be able to obtain funds at a “reasonable” cost; can usually obtain funds, but not at reasonable costs!!!!

• Better management of liquidity provides more stability to the Bank’s NIM and your blood pressure!

• Should be “forward-looking”

The “Costs” of Liquidity

• Unplanned, or last minute requests to purchase funds to meet loan demand, deposit run-off, etc. can be more expensive than you think.

• Carrying “too much” liquidity on the balance sheet results in “costing” your bank lost income!– Many banks tend to be countercyclical

investors (have cash when rates are low).

21

Two Types of LiquidityAsset Liquidity Liability(“Luxury”) Liquidity

• Fed Funds Sold• Unpledged securities• Saleable Loans

• Fed Funds Purchased• Fed Discount Window• Repo Agreements• Borrowed Funds (FHLB)• Rate Boards for CD’s• Brokered Deposits• Trust Preferred Sec’sPositives: Sales controlled by

mgmt; not credit sensitive.

Negatives: Reduced profits.

Positives: Availability, flexibility

Negatives: Very credit sensitive,can be expensive.

LIQUIDITY TRENDS

• Generally, liquidity has been adequate since 2000…

• TREND IS SHOWING THAT LIQUIDITY IS “GETTING TIGHTER” AT THIS TIME….HOW DOES THAT IMPACT YOUR BANK?

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0

100

200

300

400

500

600

700

800

900

1,000

1,100

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Mil

lio

ns

of

Do

llar

s

UBB Agent Fed Funds Pool

A general “tracking” of liquidity trends since 2003

Fed Funds Sold to UBB by Community Banks (2003 – 2015)

Liquidity Management (Process)

• Is a “forward-looking” process

• Step 1 – Understand your bank’s general liquidity trends.

• Step 2 - Estimate liquidity/funding needs (or excess) in future periods

• Step 3 - Determine/track alternatives

23

Internal Liquidity Analysis(Step 1 - Your Bank’s Liquidity Patterns)

• Certain banks have clear loan and deposit cycles; what are your bank’s cycles???

• Use software for daily statements to obtain monthly average balances

• Use Call Report quarterly averages for loans, deposits, fed funds, investments

Tracking Deposit Patterns

24

Step 2 - “Projected Sources and Uses” Report

• Management of liquidity should be forward looking (not just a review of liquidity ratios at previous quarter-end)

• Need to develop a “liquidity planning tool”– Identify “Shortage” and “Excess”

situations

Projected Sources/Uses of Funds(Where is “cash” coming from AND going to)

“Source of Funds” “Use of Funds” (“Needs”)

• Decrease in assets OR

increase in liabilities

– Liquid assets (Fed Funds Sold)

– Loan payments/payouts

– Bond pymts/maturities

– New deposits

– Additional “borrowed funds”

• Increase in assets OR

decrease in liabilities

– Funding loans

– Buying bonds

– Paying off depositors

– Paying off borrowed funds

EXAMPLES EXAMPLES

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Projected Sources/Uses of Funds

• Refer to handout– Generally is much easier to identify the

“uses” versus the “sources”– Like most modeling, is not a finite number – Purpose is to identify direction and

magnitude of the trend in liquidity– Very helpful in setting up a “funding ladder”

First State BankAnalysis of Sources & Uses of Funds

Projection as of:

In 000's04/11/07 05/11/07 06/10/07 07/10/07 08/09/07 09/08/07

Anticipated Sources of Funds: 30 60 90 120 150 180

Estimated Monthly Loan Repayments 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000

Federal Home Bank Advances 5,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

Investment Maturities / Calls 1,000,000 1,000,000 500,000 1,150,000 500,000 500,000

Federal Funds Purchased - Bank #1

Federal Funds Purchased - Bank #2

Federal Funds Purchased - Bank #3

National Brokered CD's 5,439,000 4,110,000 3,141,000

Local Market Deposits - Net Gain 5,000,000 500,000 500,000 500,000 500,000 500,000

Qwick Rate Brokered CD's

Public Fund CD's - Net Gain 5,000,000 5,000,000

Total Sources 18,000,000 14,939,000 18,110,000 12,791,000 9,000,000 14,000,000

March 12, 2007

Low

Deg

ree

of

Co

ntro

l

Hig

h

Time Period

REFER TO HANDOUT!!!

26

First State BankAnalysis of Sources & Uses of Funds

Projection as of:

In 000's04/11/07 05/11/07 06/10/07 07/10/07 08/09/07 09/08/07

Anticipated Uses of Funds: 30 60 90 120 150 180

Investment Purchases 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

Federal Home Bank Advances - Repay 5,000,000 500,000 500,000 1,000,000 500,000 500,000

Estimated Loan Funding 8,500,000 8,500,000 8,500,000 8,500,000 8,500,000 8,500,000

Public Fund CD's 419,000 36,000 4,111,000 512,000 4,819,000

Federal Funds Sold - Bank #1

Federal Funds Sold - Bank #2 2,000,000

Federal Funds Sold - Bank #3

Local Market Deposits - Net W/D 5,000,000

Qwick Rate Brokered CD's - Maturities

National Brokered CD's - Maturities 5,439,000 4,110,000 3,141,000

Total Uses 14,919,000 22,475,000 18,221,000 14,153,000 10,000,000 14,819,000

Sources Over Uses / <Deficit> 3,081,000 (7,536,000) (111,000) (1,362,000) (1,000,000) (819,000)

Current Position (4,330,000) End of Period Cash Position (1,249,000) (8,785,000) (8,896,000) (10,258,000) (11,258,000) (12,077,000)

March 12, 2007

Low

Deg

ree

of C

ontr

ol

H

igh

Time Period

REFER TO HANDOUT!!!

Step 3 - “Funding Alternatives”• Use of alternative sources of funding been

growing for many years!

• Don’t forget to have policy guidelines, i.e. % of total deposits, capital, etc.

• Very helpful to develop a “tool” to aid in reviewing these alternatives. (see example)

• “Never pay more than you can borrow for…”

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First State BankAlternative Funding Sources WorksheetAs of: July 10, 2006

Source: 3 6 9 12 18 24 30 36 48 60

Federal Home Loan Bank 5.640 5.760 5.720 5.680 5.660 5.690

Qwick Rate

average top 10 5.691 5.818 5.737 5.911 5.768 5.765 5.652 5.751 5.727 5.773

average top 25 5.584 5.745 5.681 5.831 5.731 5.738 5.615 5.703 5.666 5.706 average top 50 5.499 5.683 5.634 5.782 5.693 5.702 5.469 5.655 5.577 5.626

Broker #1 5.450 5.550 5.650 5.752 5.803 5.854 5.905

Broker #2 5.450 5.550 5.650 5.700 5.750 5.800 5.850 5.850 5.900

Broker #3 5.450 5.550 5.650 5.700 5.750 5.750 5.750 5.800 5.800 5.800

Local Markets (high offering) nearest term 4.630 5.260 5.410 5.440 5.250 5.560 5.500 5.500 5.500 5.5007/10/2006

Average of Above 5.424 5.615 5.627 5.717 5.657 5.718 5.597 5.715 5.711 5.738

High of Above 5.691 5.818 5.737 5.911 5.768 5.800 5.750 5.850 5.854 5.905

Current Bank CD Rates 2.300 4.750 3.000 3.500 3.500 3.750 3.750 4.000 4.000

Term in MonthsREFER TO HANDOUT!!!

Liquidity Regulatory Guidance

• SR 03-15 – Interagency Advisory on Primary Credit & Effective Liquidity Management http://www.federalreserve.gov/boarddocs/srletters/2003/sr0315.htm

• FIL-84-2008 – Liquidity Risk Management http://www.fdic.gov/news/news/financial/2008/fil08084.html

• FIL-13-2010 – Funding and Liquidity Risk Management

• http://www.fdic.gov/news/news/financial/2010/fil10013.html

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“Sound” Liquidity Risk Mgmt.(from FIL-13-2010)

• Importance of cash flow projections.

• Diversified funding sources.

• Stress Testing.

• Cushion of liquid assets.

• Well-developed contingency funding plan.

Contingency Funding Plans(from FIL-13-2010)

• All institutions should have formal CFP.

• The detail should be commensurate with the complexity of the institution.

• Should identify stress events, funding sources/uses, and mgmt processes.

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A Final Comment on Liquidity

“GET LIQUIDITY WHEN THE MARKET WANTS TO GIVE IT TO YOU.”

Translation – Lock in funding during low rate environments!

“ALM” - FINAL POINTS

• Earnings are maximized through proper balance sheet management (“Asset Liability Management”).

• Earnings drive shareholder value.• Asset growth increases earnings (generally).• Capital drives asset growth.• If earnings are retained on balance sheet,

must grow over time or shareholder value will decline.

• A small increase in earnings has a large impact on shareholder value.

30

Bring your calculatorsfor “Case Studies”

Please completeclass evaluations!!!