Assets And Liabilty Management

Asset Liability Management 101 Presented by Shirley Austin Director, Consulting Services

Our Goal as Credit Unions?

Maximize Member Value Reasonable Loan Rates Competitive Share Rates Convenient and Efficient Service

But how do we do it?

EFFECTIVE ASSET LIABILITY MANAGEMENT EQUALS MAXIMUM MEMBER VALUE

ALM History Date

Event

State of ALM

Pre- 1960s

Good Ole Days

Asset Management and Portfolio Matching

1961

Non-Reg Q CDs

Advent of Liability Management

1975

Stagflation

Birth of Gap Analysis

1982

PCs

Advent of Simulations

1984

Value Recognition

Duration Analysis

1988

Options Proliferation

Prepayment Models

Now

Complexity and Rope

Risk Management

Inherent Risks

Credit Risk Liquidity Risk Market Risk Operations Risk Legal Risk Interest Rate Risk

Interest Rate Risk

The risk that changes in current interest rates can adversely affect: Assets Liabilities Capital Income Expense In other words… the entire balance sheet

Components of Interest Rate Risk (IRR)

Repricing Risk Basis Risk Yield Curve Risk Option Risk

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.

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.

Basis Risk Example Year 1

 MEMBER CERT

 ARM LOAN  Loan Rate = 1 yr CMT plus 200 bps  Resets Annually  Initial Rate 1 yr CMT Spread Rate

1.25% 2.00% 3.25%

 1 Year Maturity  Renewable Annually at Prevailing Rate  Initial Rate 1.40%

SPREAD = 185 BP

Basis Risk Example Year 2 Rates Increase 100 BP  ARM Loan

 Member Cert

 Rate 1 YR CMT Spread Rate

 Rate 2.25% 2.00% 4.25%

SPREAD = 200 BP

2.25%

Basis Risk Example Year 3 Rates Decrease 125 BP  ARM Loan

 Member Cert

 Rate 1 YR CMT Spread Rate

 Rate 1.00% 2.00% 3.00%

SPREAD = 175 BP

1.25%

Yield Curve Risk

Risk of short-term rates changing by more or less than the change in longterm rates. Rule of Thumb Short term rates are often more volatile than intermediate and long-term rates.

Option Risk

Risk that rate changes prompt changes in the amount or maturity of instruments. Often referred to as “embedded options.” Cashflows/Prepayments Variable Interest Rates Call Features

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.

Balance Sheet

LOANS  Types Consumer Mortgage Credit Card Share Secured Home Equity  Embedded Options Variable Rate Caps and Floors Prepayments

Balance Sheet

INVESTMENTS  Types Certificates of Deposit Overnight Funds Money Markets Governments/Agencies Mortgage Backed Securities  Embedded Options Variable or Adjustable Rate Callable Caps/Floors Prepayments

Balance Sheet

SHARES  Types Regular Shares Share Drafts Club Accounts Share Certificates Money Markets  Options Variable Rate Early Withdrawals/Cashflows

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

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, and time, and Gap management involves the management of all three.

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 interestbearing instrument that can be repriced to a market rate in a given time frame.

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 given time 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.

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 remain relatively consistent across interest rate cycles.

Typical Gap Report

Total Assets: $10,000 1 mo

3 mos

6 mos

12 mos

12+ mos

Total

RSAs

$500

$500

$2,000

$2,500

$3,500

$9,000

RSLs

$1,500

$2,000

$2,000

$2,000

$500

$8,000

$(1,000)

$(1,500)

0

$500

$3,000

$1,000

Cumulative Gap $(1,000)

$(2,500)

$(2,500)

$(2,000)

$1,000

(25)%

(25)%

(20)%

10%

Gap % of Assets

(10)%

Gap Analysis

Upside  Conceptually 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)

Gap Analysis

Downside  Doesn’t quantify risk  Assumes asset and liability characteristics are symmetrical Static 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

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

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.

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 simulation testing even if they’re using gap analysis.

Income Simulation

Characteristics of NII modeling  Quantifies 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 the results.

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 related products or “complex” investments, the model should be able to incorporate the instruments’ characteristics - “embedded options.”

The Lingo (Part One)

Embedded Options  Characteristics 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.

Embedded Options

Examples Call 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 mortgagebacked products).

Embedded Options

Rule of Thumb Unless properly managed, call and prepayment options will be exercised at the worst possible time for the owner of the instrument.

Income Simulation

Static – Used to measure interest rate risk. Dynamic – Used to manage the credit union’s balance sheet and earnings.

Income Simulation

Static model  Use 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 nonmaturing deposits.

Income Simulation

Dynamic model  What-if Best case Worst case Most likely Strategic analysis  Strategic risk mitigation  Budgeting and forecasting

Income Simulation Here are the NII risk categories (Static models) Low Percent decline in NII over a projected 12-month horizon Percent decline in NI over a projected 12-month horizon

<20% <40%

Moderate 20 to 30% 40 to 75%

High >30% >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)

The Lingo (Part One-and-a-half)

Rate Shock An immediate, sustained, parallel shift in the yield curve.

Rate Shock 18% 16% 14% 12% 10% 8%

Base

6% 4% 2% 0% ON

1 Yr

3 Yrs

5 Yrs

10 Yrs

30 Yrs

Rate Shock 18%

Up 300

16% 14% 12% 10% 8%

Base

6% 4% 2% 0% ON

1 Yr

3 Yrs

5 Yrs

10 Yrs

30 Yrs

Rate Shock 18%

Up 300

16% 14% 12% 10% 8%

Base Down 300

6% 4% 2% 0% ON

1 Yr

3 Yrs

5 Yrs

10 Yrs

30 Yrs

Income Simulation

Upside  Conceptually simple  Easy to explain to board members  Quantifies risk in terms of earnings and future capital accumulation  Static modeling requires little, if any, subjective assumptions  Simple modeling can be relatively inexpensive and uncomplicated

Income Simulation

Downside  Short-term: the full risks presented by longer-term instruments could remain hidden.  Dynamic modeling requires increased subjective assumptions.

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.

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)

NCUA’S IRR REVIEW

 Step 1: ALM Policies Review  Step 2: Integration of ALM into Strategic Planning  Step 3: Quality of ALCO Oversight  Step 4: Internal Controls, Staff  Step 5: Assessment of IRR Measurement Tools

SUMMARY

 ALM is an Ever Evolving Process.  The steps and complexity of the ALM program should fit the needs of the credit union.  Board and Senior Management commitment and involvement is critical to success.  ALCO does not reside in a vacuum- should provide policy guidance.

Thank you

Consulting Department  Shirley Austin- Director, Consulting Services  (800) 342-0203, extension 6811  [email protected]

 Ben Mauldin- SVP, Risk Management and Consulting Services  (866) 661-6848  [email protected]