lecture materials asset/liability management – year 2 · pdf filelecture materials...

Lecture Materials

ASSET/LIABILITY MANAGEMENT – YEAR 2

David Koch President & CEO

FARIN Financial Risk Management Madison, Wisconsin [email protected]

608-661-4217

August 3, 2017

© 2017

TYING IT ALL TOGETHER:IMPLEMENTATION OF A RISK/RETURN FRAMEWORK

1

David KochPresident\CEOFARIN & Associates, [email protected]

© 2017

Combining Yr. 1 & 2BPA – Taught financial drivers that ALCO managesCapital Planning – Teaching inter-relationship of financial goalsCore Funding – Importance of Pricing in Liquidity and profitability (IRR) risk Investments – Understand Risk/Reward in various investments

ALM Positioning-Profitability-Process:Understanding the key drivers of net interest income and their relationship with liquidity, interest rate risk, and capitalInterest Rate Risk: Measuring and Managing Margin RisksLiquidity – Managing sources and uses of funds in good and bad times

2

© 2017

Course Objectives – BPA & Funding Yr 1BPA• Assess management philosophy

and goals by evaluating the financial performance of a bankIdentify is a bank is performing well or poorly and explain major contributors these causesBe able to use the financial relationships to determine how changes in performance ratios from events like changes in interest rates will effect bank

• performanceMake recommendations to senior management on what financial concerns are contributors to the problem and possible remedies

Funding• Develop a deposit pricing strategy

for their institution• Choose between alternative

deposit strategies using marginal cost and benchmark rates in making decisions

• Understand the tradeoffs in use of wholesale funding

• Use a PC-based system to gather, interpret and analyze data that is a crucial input to deposit pricing decisions

3

© 2017

Course Objectives – ALM Yr 1• the purpose and responsibilities of an effective asset/liability

committee (ALCO)• the primary purposes of the bank’s investment portfolio• the types of securities commonly found in the bank’s investment

portfolio and their respective risk/reward characteristics• the basics of liquidity management, including the need to plan for

future liquidity needs (or determine excesses), using projected sources and uses of funding reports

• understanding funding alternatives to a bank’s normal deposit base• the basics of interest rate risk management, and some of the tools

banks use to monitor/manage these risks (i.e., GAP, duration analysis, income simulation, EVE, etc.)

• the impact of changes in market interest rates on the value of loans and investments, and “generally” understand terms such as durationwhy an adequate capital plan is so important in running a successful bank

4

© 2017

Course Objectives – ALM Yr 2• Understandthedriversofnetinterestincomeandthecomponentsofnetinterestmargin

• UnderstandwhatcausesnetinterestincomeandEVEtochange• Understandthevariousmeasuresoffinancialrisks• Describethestrengthsandweaknessesofearningssensitivityanalysis earnings‐at‐risk andEVE

• Evaluatetheimpactofembeddedoptions,suchasloanprepaymentsandcallablebonds,onfinancialinstitutionprofitabilityandrisk

• Describeaprocedureforestimatingtheratesensitivityofdeposits

• DevelopabasicunderstandingofstrategiestomanageIRR• Evaluateafinancialinstitution’sliquidityriskprofileandidentifyavailablesourcesofliquidity

5

© 2017 6

What Is Asset/Liability Management?Asset/Liability management (ALM):• theprocessofplanning,controlling&monitoringfinancialperformancetoachievefinancialgoalsofthecapitalplanwhilemanagingrisks.

Financial risks are measured to determine if plan can be met in reasonable risk situations• Whenchangesincreditqualityoccur• Whenmarketinterestratesmove• Whenliquidityneedsoravailabilitychange• Whenregulatorsmodifyexpectations

ALM should recognize we manage risk to make money! We are NOT risk minimizers.

© 2017

EVOLUTION OF ALCO

7

© 2017 8

Evolution of ALCOALCO’s job moving from • monitoringeachindividualriskareato• measuringandmanagingintegrationbetweenrisks,and…• runningreasonablestresstestsoneachriskareatobuildcapitalcomponentparts,and…

• Runningstresstestswithineach“model”todetermine“hiddenrisks”embeddedinmodelsusedtocalculaterisk– FFIECModelValidationGuidanceof2011

© 2017

ALCO Evolution

9

Primarily Interest Rate Risk Focused• Gap Reporting• Static Balance Sheet Projections• Immediate & Parallel Rate Shocks• Spread Reporting

Moving Towards• Dynamic Balance Sheet • Dynamic EVE Reporting• Non-Parallel Rate Projections• What If Comparisons• Integrated With Other Risk Tests

© 2017

OCC Definition from April 2010 presentation titled Capital Planning: The New Normal

10

© 2017 11

Managing Risk“Managing risk is not just about identifying, assessing, and monitoring all the things that could go wrong. It also is about understanding all the things that need to go rightfor a bank to achieve its mission and objective of safely and profitably serving its customers and community.“ Carolyn G. DuChene Deputy Comptroller Operational Risk

© 2017

Defining Capital & Risk Appetite

12

Regulatory requirement

Ris

k A

ppet

ite

Strategic risk buffer

Available Capital

Current risk needs

Excess capital

13.0%

6.0%

8.5%

11.0%Based on a change to assuming full risk

Based on a current levels of risk

Your definition of acceptable minimum levels

Proper stress testing helps us ID the necessary levels of capital for risk in today’s

exposures and tomorrow’s plans.

CREATE SYNERGY. DRIVE PROFITABILITY

Stress Testing a Short or Long Term Horizon

• Income at risk (IAR) measures are short term looks at risks to capital formation

• Value at risk (EVE) measures look at structural concerns on capital needs from balance sheet mix

– EVE levels can be changed over time– IAR risks are “stress events” on capital

13


Two Approaches to Stress Testing• Sensitivity Analysis: refers to assessment of

risk when certain variables, parameters, and inputs are "stressed" or "shocked."

– Unlike scenario analysis, this is performed without an explicit underlying reason or narrative in order to explore what occurs under a range of inputs and at extreme or highly adverse levels.

• Scenario Analysis: apply a historical or hypothetical scenario to assess the impact of various events and circumstances, including the most extreme situations.

– Examples include severe recession, failure of a major counterparty, loss of major clients, localized economic downturn, or a sudden change in interest rates brought about by unfavorable inflation developments. 14


Base Plan & Stress Tests• Run baseline stress

tests on all major risk areas separately (silo)

– Credit risk– Liquidity risk– Interest rate risk

• Change key assumptions in each analysis

– Which assumptions have greatest impact for small changes?

– What is the overall confidence level and documentation for those assumptions

– Where confidence or documentation is low, allocate resources to upgrade

• Not a test of institution’s capital or earnings!

– Goal of Sensitivity Tests: • determine most critical

assumptions in your plan!15

© 2017 16

Defining RiskThree Inherent Risks to all Financial Intermediaries

1. Creditrisk– Theobligationtopaybackdepositorsregardlessofwhetherloansarerepaid

2. Interestraterisk– Thetimingandsizeofchangesintheratesthattheyreceivefromtheir“assets”rarelymatchthetimingandsizeofratechangesfortheir“liabilities”

3. LiquidityRisk– Notenoughcashwillbegeneratedfrom“assets”tomeetdepositwithdrawalsorcontractualloanfunding


Sensitivity Testing• 2 applications for sensitivity testing

1. Within its own risk silo (credit, liquidity, IR) • adjusting key factors to determine that factor’s impact on overall results• Rank order in level of impact

2. Applied to a scenario test (like a base forecast result)• Modify most critical assumptions slightly to check performance if we are “wrong’• Used as a reality check to planning assumptions• Key ?: If we miss on key assumptions, can we still meet goals?

• Using sensitivities in the base forecast helps identify key things that must go RIGHT in the plan

– Not the usual focus of what can go wrong

• Note sensitivity testing is not the same as “scenario testing”.

17

© 2017 18

What Is Your “Efficient Earnings Frontier”Risk\Return concept is well defined and accepted by most as “true” in bankingBut, what’s missing from the “trade-off” talk is the concept of an optimal return.“Efficient earnings frontier” sets out a target for the highest potential return given a defined level of risk• Ortheexpectedlevelofriskforexpectedreturn• Itisthetargetforevaluatingrisk\returntrade‐offs• Returnsarenotinfiniteunlessriskcanbeexpanded!

© 2017

What is Asset\Liability All About?

19

© 2017

What is Asset\Liability All About?

20

© 2017

Market rate changes

21

Remember duration formulaChg MV = - Duration * Chg MR

Long term discount rate down 25-50 bp5 Yr duration * -50 by change = 2.5% Chg in mv

© 2017

Market rate changes

10Yr FHLB December 2015: 2.98March 2016: 2.59Change -0.39

22

© 2017

Market rate changes

10Yr FHLB December 2015: 2.98December 2016: 3.22Change +.24

23

© 2017

Market rate changes 10Yr FHLB December 2015: 2.98March 2017: 3.13Change +.15

24

© 2017

Optimal Earning Asset Matrix

Comparison of 5 different “model” balance sheet types• Riskaverse Option1• CRE Option2• Ag Option3• Thrift Option4• Balanced Option5

Is it right to expect the same level of earnings or growth for all 5 types in the coming years?Is the “natural” level of earnings and volatility in earnings the same for all 5?Is your “model” balance sheet established and managed?

25

EA Mix Example Cash Govt's Munis1-4

Family Const. CRE C&I Ag ConsOther Loans

Option1 25% 25% 5% 15% 5% 15% 5% 0% 5% 0%Option2 15% 15% 5% 15% 10% 30% 5% 0% 5% 0%Option3 15% 10% 0% 25% 0% 0% 2% 45% 3% 0%Option4 10% 10% 0% 40% 15% 20% 2% 0% 3% 0%Option5 10% 10% 0% 35% 15% 25% 2% 0% 3% 0%

© 2017

Optimal Earning Asset MatrixMapping each “mix” with earnings volatility to show realistic returns.Note that higher returns show higher levels of variance in returns.• Whatstrategyhashigherearningspotentialandless“risk”

26

Where is your current and projected performance vs. actual?Given your “risk appetite” what is your “domain” of optimal return?

Volatilityofearnings

MeasureofReturnRO

E/ROA

© 2017

CURRENT ISSUES IN CAPITAL PLANNING AND ALM

27

© 2017 28

Key Risk Questions in Today’s WorldInterest Rate Risk• If Market Rates Move, How much will Bank

Earnings Change?Credit Risk• If Market Rates Move, what will happen to loan

performance, charge-offs and potential volumes?Liquidity Risk• If market conditions change, what will happen to

depositors that have been sitting waiting for higher returns or business deposits that have been idle in slow times?

© 2017 29

Common ConcernsLong term assets on the rise

© 2017

Common Concerns

32

© 2017 33

Common ConcernsDeposit risks elevated

© 2017 36

What Does This Graph Imply?

Why did this happen?

© 2017 37

Historical Rate ComparisonIn the past has there ever been an immediate and parallel rate shock? What worries you more, all rates going up 3% or short term rates moving, more than long term rates?

Current concern is that rates may move as they did in ‘04-’07

© 2017 38

How Many Banks Are We Talking About?2004 Data

– 201Banks $1billionandlongtermassets 50%– 478Banks $1billionandlongtermassets 40%– 977Banks $1billionandlongtermassets 30%

• Asmallsamplesizeofbankswith 50%ofLTAssetsisnotthattelling

• Whatdoeshistoryteachus?– Itisnotaboutwhathappenedto“some”banksinthepast,butwhyithappenedand

– howareYOUpreparedtodealwithchangesinmarketconditions!

• Notethatthosewith30‐40%exposuresawamuchsmallerdeclineinmargin,andwhat’smissingisthediscussionontheoverallLEVELofmargin…

© 2017

Performance of FI’s from 2004 w > 30% LT Assets

2015Y 2014Y 2013Y 2012Y 2011Y 2010Y 2009Y 2008Y 2007Y 2006Y 2005Y 2004YNII\AA 3.25 3.26 3.24 3.33 3.45 3.47 3.46 3.44 3.39 3.47 3.61 3.60Int Inc\AA 3.70 3.75 3.80 4.05 4.41 4.72 5.13 5.70 6.16 5.88 5.39 5.09Int Exp\AA 0.45 0.48 0.56 0.73 0.96 1.25 1.67 2.27 2.77 2.40 1.79 1.49

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

Average Performance of Banks < $1 billion and LT Assets (04) > 30%

39

Changes from 2004-2006• Change in Int Exp +91 bp• Change in Int Inc +79 bp

© 2017

RISK VS. RISK AND RISK VS. RETURN

Measuring ALCO Risks

40

© 2017 41

Home Community Bank ExampleHistorically low financial performance• ROA @ breakeven or loss since 2007• Strong capital levels sustained through recession• Little or no asset growth• Predominate loans

• VR CRE with rates floors • High levels of investments to total assets

• Interest rate risk reports say they will make more $$$ if rates rise

• But it doesn’t say if they will make ENOUGH $$$ if they don’t!

• Would you like no or low earnings with little volatility or higher earnings with managed volatility?

© 2017

Home Community Bank2015 results show

• improvement in ROE\ROA• Decline in capital ratio (increase in eq. multiplier below)• What did they do?

43

© 2017

Home Community BankGrowth Rates

• Loans\EA up from 53% to 64% past 4 years

• 2013 year loans grew faster than assets

• 2014 Assets grew faster than loans

• Relate this to the bank’s capital ratio performance

44

© 2017

Home Community BankEarnings components

• Net Int Margin\EA up from 2.71% to 2.94% (up 23 bp or 8.5%)

• What might be the cause?

45

© 2017

Home Community BankEarnings components

• Non-Int Margin\EA up unchanged or slightly worse• -2.26% to -2.37%

• Increase is not due to more fees or expense cuts

46

© 2017

Home Community ResultsTrends show increased performance

• identified as main cause the increase in loan\earning asset levels

• What questions does this raise about the future of the bank’s earnings if rates change?

• What happened to “liquidity” in this case”• Are we at all concerned about potential for credit losses in

the new loans?

47

© 2017 48

Traditional Income @ RiskUsing Immediate Rate Shocks, Sample Bank appears fine• All rates move together, immediately• Effect of floors is lost

Traditional Rate Shock Analysis says no earnings at riskWhen subjected to a different rate projection, that moves gradually and non-parallel…

© 2017 49

Traditional Income @ Risk• Under planned growth (Dynamic) little risk in high rates

-0.69%, but slightly more in +2% immediate -1.37% • Under static plan (no growth or change in mix), risks don’t

change in the gradual rate moves (GI) but more severe in the I&P moves.• How does the BPA trend information help us here?• Does this bank look to have an interest rate risk problem?

© 2017 50

Traditional Income @ RiskYr. 2 shows that in the GI High rate increase, margin IMPROVES +2.28%, but in immediate shock of +2% it declines -3.76%

• Which one do we use to manage our bank?

Note again the impact of the planned growth vs. the static values.

• Static results less positive and more negative• The impact of the growth and mix changes planned by management

© 2017 51

Short or Long Term Horizon• Unanswered question: Is the bank making

enough money for capital and risk needs• Income at risk (IAR) measures are short term

looks at risks to capital formation• Value at risk (EVE) measures look at structural

concerns on capital needs from balance sheet mix

• EVE levels can be changed over time• IAR risks are “stress events” on capital

• Base capital component on IAR analysis • Use EVE to select strategy when either IRR measure is

OUT of compliance

© 2017

Home Community Current EVECurrent EVE levels show strong levels of EVE in all shocked scenarios

However, the % change in the EVE ratio is significant.

Most ALM policies limit the % change in EVE. Max change averages -35%

• Home outside their limit for % change

What does this imply?

52

© 2017

EVE CluesStrong “book” capital provides the cushion for volatility• As bank grows, how far will the

“cushion” erode– Capital growth vs asset growth

Longer term assets in loan or investment portfolio• As rates increase, values

decrease on long-term, fixed rate assets

• Strategy options include– Shorter term and variable rate

loans– Sell LT investments and reinvest

short• What is the trade-off for each?

Short term, more volatile funding costs• As rates risk, the cost of funds

rises so no “value” from having fixed rate funding to match to the assets

• What assumptions are made for non-maturity deposits?

• Strategy options include– Lengthen liability maturities

• Incent consumers to longer term products

• Initiate new Non-maturity Account to lag market rates

• Use longer term borrowings• Reduce overall size by running off

maturing balances

53

© 2017 55

Lengthen BorrowingsBank Liability Maturities:• Large amount of maturing borrowings in next 5 months. • In the fast shock scenarios, replacement costs rise quickly while

asset values decline causing a negative impact on EVE• Income will be OK as long as new loans continue at higher rates

Option being considered:• Purchase longer term advances now, and allowing the others to

roll off at maturity– Inflate Assets, lower Capital/Assets and ROA temporarily–Save Interest Expense

© 2017 56

Lengthen Borrowing ResultsEVE Results• Purchase of 5 & 7 year borrowings increases Pre-shock EVE

by nearly 2%• Post shock EVE less sensitive with longer liabilities in shorter

assets• Sensitivity improves to within policy range

Income results• Baseline margin declines by 3% of original value to buy

protection– Base margin was 2.98% in Base rate forecast, – dropped 11 bp or 3% to 2.89%

• Allows the bank to make some additional long term loans with better asset yields while managing additional EVE risk.

© 2017

Concept of Risk vs. ReturnThe Right ALCO Question? • Which performance line would

you choose? • Who answers this question at

your bank?• How do they decide the

answer• Gut or intuition• Scenario analysis

• What other issues should we think about?

• Associated credit risk• Bank expertise?• Competition• Etc.

57

© 2017 58

Taking This to Year 3Banksim• Community bank competition• Allocates resources based on real-world pricing and growth

actions that your team is willing to take• Remember: ROE = ROA * Leverage• Remember: What are the drivers of ROA?• Remember: What are potential market risks to different

ALCO risk areas that you need to protect or insure against– How much capital is enough or too much

lecture materials asset/liability management – year 2 · pdf filelecture materials...

Documents