assets and liabilty management

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Asset LiabilityManagement 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

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



Inherent Risks

Credit Risk

Liquidity Risk

Market Risk

Operations Risk

Legal RiskInterest Rate Risk



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



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

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




ARM Loan

Rate1 YR CMT 2.25%

Spread 2.00%

Rate 4.25%

Member Cert

Rate2.25%

Rates Increase 100 BP

SPREAD = 200 BP




ARM Loan

Rate1 YR CMT 1.00%

Spread 2.00%

Rate 3.00%

Member Cert

Rate1.25%

Rates Decrease 125 BP

SPREAD = 175 BP



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.



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



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

MortgageCredit 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 RateCallable

Caps/Floors

Prepayments



Balance Sheet

SHARES Types

Regular SharesShare 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, andtime, 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 interest-bearing 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 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.



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.



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%



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)



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



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 simulationtesting even if they’re using gap analysis.



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.



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.”



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.



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).



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.



Income Simulation

Static – Used to measure interest rate risk.

Dynamic – Used to manage the credit union’sbalance sheet and earnings.



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.



Income Simulation

Dynamic modelWhat-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 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)



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

Rate Shock

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



Rate Shock

Base

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

ON 1 Yr 3 Yrs 5 Yrs 10 Yrs 30 Yrs



Base

Up 300

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%


Rate Shock



Base

Up 300

Down 300

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%


Rate Shock



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



Income Simulation

DownsideShort-term: the full risks presented by longer-term

instruments could remain hidden.

Dynamic modeling requires increased subjectiveassumptions.



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

PlanningStep 3: Quality of ALCO Oversight

Step 4: Internal Controls, Staff

Step 5: Assessment of IRR MeasurementTools



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.



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]

mailto:[email protected]

mailto:[email protected]

assets and liabilty management

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