alco for a bank

7/28/2019 ALCO for a bank

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Asset/Liability Management Certification

Training Program

Day 4 Session 2

Presented by:

Leonard Matz

February 7-10, 2012

www.sheshunoff.com


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Topics for This Session

2

1. Making ALCO effective.

2. Best practice IRR reporting.

3. Contents of a best practice IRR policy.

4. Oversight, internal controls and audit.

5. Review Q&A


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Making ALCO Effective

3


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4

Flawed Decision Making

The non-decisionlets just debate the rateoutlook

Wishful thinking the problem will go away

Delayed decision makinglets have anothercommittee meeting before we act


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Asset / Liability Committee (ALCO)

Two reasons why a committee is at the center of rate risk management:

1. Many of the risk management issues requires the CEOs and CFOs

attention and also have strategic ramifications

2. Typically the CEO and the CFO lack day to day familiarity with all f the bank

activities impacting the risks

ALCOs mission should include:

1. To be responsible for setting interest rate risk limits, developing interest rate

risk strategies, and making sure that the bank stays within these limits

2. Setting investment portfolio strategy is another responsibility that often falls

under the ALCO umbrella

3. Liquidity management

5


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ALCO Membership

Membership should include senior managers from each major lending,

investment, deposit, and funding area in the bank.

The following bank functions should be represented on ALCO:

Chief Executive Officer

President

Chief Financial Officer

Treasurer

Senior Investment Officer

Asset/Liability Manager

Senior Credit Officer

Senior Branch Officer

Senior marketing Officer

6


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7

Poor Delegation of Risk Management Authority

Confusion among managers as to which person or which

department is responsible for aspects of risk measurement,management, or oversight.

Lack of an owner responsible for all aspects of risk positions.

Policy restrictions that focus on actions rather than on risks.

Ambiguous delegation of authority. For example, insufficientdistinction between responsibility for final approval,responsibility for review, and responsibility for activemeasures.

Delegation of responsibility without authority.

Delegation of responsibilities to one or more committeeswithout making the committee chairman or some other officerresponsible.

Duplicative, redundant, or overlapping delegations ofauthority.


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8

Characteristics of Ineffective AL Committees (1)

The chief executive officer does not attend

meetings.

ALCO members are unsure of what the ALCO is

required to accomplish.

ALCO members are uncomfortable with the validity

of the risk information presented.

The agenda is cluttered with review items, leaving

insufficient time for decisions and providing a lot of

excuses to avoid making decisions.


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Risk reports provided to committee members are

too voluminous, complex, or late to support

informed decision making.

Too much time is spent discussing the current

interest rate and economic outlook instead of

alternative management decisions.

ALCO discussions are dominated by the individuals

directly responsible for monitoring IRR exposure.


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10


Risk management decisions are not implemented.

The results of previous decisions are not measured.

The only managed portion of the banks IRR and

liquidity risk is the risk in assets, liabilities, or off-

balance sheet positions that are managed inTreasury.

Risk management decisions are made in response

to the present situation and short-term objectives.

Longer term strategic considerations are given littleor no thought.


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11


Management of the banks liquidity position is

inconsistent with policy guidelines adopted by the

ALCO.

The profitability and riskiness of key loan and

deposit products are not monitored by the ALCO.

New loan and deposit products or new variations of

existing loan and deposit products are introduced

without ALCO discussions about their risk

characteristics.


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12

ALCO Functions and Responsibilities

1. Select IRR and liquidity measurement systems and

methodologies.

2. Select the rate risk variables that the bank believes

best describe the rate risk.

The ALCO has to choose whether it is concerned aboutmost likely rate changes or other potential rate changes

and how those potential rate changes will be selected.

The ALCO must also choose whether it is concerned with

changes in projected net income, projected economic

value of equity, etc. (selection of the dependentvariables).

3. Select liquidity scenarios and stress levels.


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13


4. Establish specific limits on the acceptable level of

risk on a consolidated basis and recommend those

limits to the board for its approval and for

incorporation into the policy. In addition, the ALCO

may establish less-official limits that are more

restrictive than limits established in the policy.(More restrictive limits may be established when

circumstances require a temporary change.) From

time to time, the ALCO may want to recommend

changes in limits established by the board ofdirectors


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5. Regularly review analysis of the banks exposure to

adverse consequences from rate changes. Eventhough the projected exposure may be within policylimits, the ALCO may decide that actions should beundertaken to change this exposure. In addition toresponses to changes in rate expectations, ALCO

may want to change the banks IRR exposurebecause other changes, such as poor earnings, makeit appropriate to temporarily reduce the banksexposure to rate risk.

6. Regularly review analysis of the banks exposure toliquidity risk under defined stress scenarios. Identifypotential vulnerabilities and respond as appropriate.


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7. Review reports indicating whether previous ALCO

decisions were implemented, the extent to which

previous ALCO decisions resulted in the intended

changes to the banks IRR exposure, and whether IRR

exposure limits have been exceeded.


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8. The ALCO must also keep minutes of all meetings. This

rule should hold for informal meetings as well as formal

meetings. Also, outside auditors and bank examiners

usually review ALCO minutes, and they expect to see a

complete record. ALCO minutes do not have to be

lengthy or unusually detailed. At a minimum, theminutes should identify:

When the meeting was held

Who attended

Major topics discussed

Specific decisions made


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17

Sample ALCO Agenda

10:00-10:15 Status Reports

1. Minutes of prior meeting.2. Review of implementation status of decisions

from prior meeting.

3. Review of any policy violations, proceduralproblems, etc.

10:15-10:30 Review of Historical Information

4. Review of the trend in rate risk exposure levels.5. Review of the trend in related information, such

as liquidity and capital ratios.


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Sample ALCO Agenda

10:30-10:40 Competitive Situation6. Review of relevant competitive information,

such as deposit rates.

7.Analysis of current loan and deposit strategies,planned promotions, securitizations in process,

and other planned changes.


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Sample ALCO Agenda

10:40-11:10 Current Risk Assessment

8. Current rate risk exposure and projection measures(model reports of EVE andEAR for a range of possible future interest rates).

9. Current rate outlook/forecast.

10.Confidence level in current rate outlook.

11.Comparison of current rate risk exposure to board-

approved limits and to ALCOsmost recent target.


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Sample ALCO Agenda

11:40-11:50 Related Issues

16. The impact of the current and targeted rate risk

exposure on the banks capacity to

meet its budget.

17. The adequacy of current liquidity.

18. The impact of the current and target rate risk

exposure on liquidity risk levels.

11:50-12:00 Open Discussion

12:00 Noon Adjourn


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Five Steps for Sound Decision Making

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AGENDA ITEM COMMENT NEEDED INPUT

Review IRRperformance history.

Goals: Provide background Reinforce connectionbetween ALCO decisionsand banks financial

performance Ensure that prior ALCOdecisions were implemented

(oversight)

History (e.g., past 12 months)of banks IRR exposure and

of rate movements Performance of margin, netinterest income, economicvalue, etc.

Review current IRR

exposures.

Enables the ALCO tocompare with limits

Exposure reports (exposuresvs. limits)

Determine rate outlook. Steps: Select base case scenario,highlighting expectations

vis--vis types of rate

change Determine analystsconfidence in base case Articulate and documentlogic

Economic and market data

Decide on IRR

positions.

Expressed in same terms asexposures are measured(including as a percentage of

limit)

Output: decision summary

Determine basic

implementation

strategy and delegate

implementationresponsibility.

This usually takes the formof on-balance sheet and/or

off-balance sheet actions to

alter the banks riskexposure profile

Source: Adapted from a table developed by J. Kimball Hobbs.


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Best Practice IRR

Reporting

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Best Practice ALCO Reports

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Good ALCO reporting has fourcharacteristics:

It must include all of the

information that decision makersneed.

It must clearly call attention to the

most important issues.

It must be timely.

It must be actionable.


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What do Risk Managers Need to See?

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Compliance with Risk Exposure Limits.

Non-limit policy violations.

Current exposures.

History. Information that relates current risk

exposures to exposures in prior time periods and to

prior risk management decisions provides both

context and continuity.

Support for new decisions. The package should alsocontain economic data or forecasts to help guide

ALCO members.


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US Interagency Requirements

Reportable items may include but are not limited to:

cash flow gaps,

cash flow projections,

asset and funding concentrations,

critical assumptions used in cash flow projections,

key early warning or risk indicators,

funding availability,

status of contingent funding sources, or collateral usage,

the use of and availability of government support, such as lending

and guarantee programs, and implications on liquidity positions,particularly since these programs are generally temporary or

reserved as a source for contingent funding.

Format revised.

25

Interagency Policy Statement on Funding and Liquidity Risk

Management, Paragraph 20, March 2010


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Management Reports

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Multiple levels of details

Focus on key metrics

Appropriate aggregation

Appropriate disaggregation currencies

Clarity for non-specialists

Flexible content special situations and topicsreviewed infrequently

Flexible frequency for scenarios


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Advice for ALCO Packages

28

An executive summary is a big help for busymanagers.

Report formats should be uncluttered, emphasizing

graphs and simple tables.

Use color to highlight key information.

Use the same description each time you prepare a

package, and show the history for each major

exposure as a line graph.

Try to keep supporting detail in appendices.


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More Focused ALCO Reporting and Risk Dashboards

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Percentage Point Variance


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Percentage Point Variance

Under Various Rate Scenarios

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EARNINGS AT RISK

Rising Interest Rate ScenarioFlat Rat

Scenario Declining Interest Rate Scenario

Up 300 bp Up 200 bp Up 100 bp No change Down 100 bp Down 200 bp Down 300 bp

Business

strategy 1:5.41%

Business

strategy 2:

3.76%

Business

strategy 3:2.17%

Base case

strategy:0.0%

Business

strategy 4:-2.44 %

Business

strategy 5:-5.14%

Business

strategy 6:-7.97%

Source: BancWare ALM 5

Comparisons of Risk Limits


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and Measured Exposures

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-200

-150

-100

-50

0

50

100

150

200

Q0 Q1 Q2 Q3 Q4 Q5 Q6

NetInterestIn

come

rates rise no change rates fall

Trend in Net Income:


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Trend in Net Income:

Actual Plus Four Projected Scenarios

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20

25

30

35

40

45

50

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

NetInterestIncome

Actual

Declining

Rising

Budget

Current

Forecast

Sample Output of Economic Value


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Sample Output of Economic Value

Simulation Model Interest Rate Scenario(in thousands of dollars)

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Down 300 bp Down 200 bp Down 100 bp Base Case Up 100 bp Up 200 bp Up 300 bp

PV of Assets 606,537 589,107 574,333 560,866 548,097 536,172 524,713

Percent Change 8.14% 5.04% 2.40% 0 -2.28% -4.40% -6.45%

PV of Liabilities 491,109 484,877 478,866 472,727 466,530 460,391 454,413

Percent Change 3.89% 2.57% 1.30% 0 -1.31% -2.61% -3.87%

PV of Equity 115,429 104,230 95,467 88,140 81,567 75,781 70,300

Percent Change 30.96% 18.26% 8.31% 0 -7.46% -14.02% -20.24%

Source: BancWare ALM 5



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and Measured Exposures

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-35%

-30%-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

-300 -200 -100 Base

Case

100 200 300

Policy Limit

- all months

% Value at Risk

June 200X% Value at Risk

September 200X

% Value at Risk

March 200X


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Products Ranked by Economic Value Sensitivity(for a 200-basis point decrease in rates scenario)

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No Change in Rates Down 200 Basis Points Scenario

Economic Value Economic Value Change PercentageChange

Fed Funds Sold 8,936 8,939 3 0.03%

Personal Loans Floating 5,070 5,074 4 0.08%

US Treasuries Treasury 17,239 17,295 56 0.33%

US Treasuries Fixed 17,080 17,181 100 0.59%

Commercial Loans - Floating 111,440 112,235 795 0.71%

CDs LT 100k 71,252 71,842 590 0.83%

Personal Loans - Fixed 24,774 25,009 235 0.95%

Commercial LOC 61,924 62,602 678 1.10%

Agencies 21,225 21,544 319 1.50%

CDs GT 100k 193,918 197,620 3,703 1.91%

Municipals 9,167 9,357 190 2.07%

Savings Accounts 19,193 19,872 679 3.54%

NOW Accounts 33,537 34,723 1,186 3.54%

ARMs 79,150 82,242 3,092 3.91%

Money Market Accounts 74,620 77,840 3,220 4.32%

Lines of Credit 25,007 26,161 1,153 4.61%

Commercial Loans Fixed 97,334 107,325 9,991 10.26%

Mortgages 23,507 29,302 5,794 24.65%

MBS 23,012 28,842 5,830 25.33%


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Just Because We Can, Doesnt Mean We Should

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24

moderate confidence -- rates up

moderate confidence -- rates down

low confidence

or no direction

high confidence -- rates down

AssetSensitive

LiabilitySensitive

% of limit

high confidence -- rates up

12-month history of position-taking, expressed as % of limit

IRR Position History

(% of Limit)

prior 12 months

100

80

20

-20

0

-80

-100

x

recommended

target

Sample ALCO Report

Improving Rate Risk Disclosure: Bank of Americas Are More


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Improving Rate Risk Disclosure: Bank of America s Are More

Realistic

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Contents of a Best

Practice IRR Policy

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Five Good Reasons to Have A Formal, Written Policy

1. Bank examiners require it2. The policy communicates managements intentions and rules to

everyone involved in the process

3. Establishes specific objectives and responsibilities

4. Establishes priorities for goals

5. Helps establish goal congruence and coordination throughout the

bank

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General Qualities for Effective Policies

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Policy provisions should be specific enough to achieve the banks

goals.

The policy should not include excessive detail. Confine most details

to either policy appendices or procedures manuals.

The best policy provisions provide clear, focused, and practical

guidance.

Policies should delegate responsibility for developing procedures or

assumptions rather than dictating the procedures or assumptions.

The best policies are customized to the financial institutions

resources, markets and strategies.

The best policies are living documents.

Policies must reflect constraints resulting from legal entity structure,

regulations and international activities.


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Policy Perspectives

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Strategic risk management how muchliquidity risk, measurement and managementconditions, etc.

Tactical risk management what to do about

liquidity risk in todays bank and marketconditions.


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Rate Risk Policy Scope and Content.

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Why Do We Need a Formal IRR Policy?

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1. Bank regulators require it. Necessary but notsufficient.

2. A more important reason to have a policy is that itcommunicates managements intentions and rules toeveryone involved in the process. If you dont knowwhere you are going, any road will take you there.

3. The policy establishes specific objectives andresponsibilities. Creating the policy forces managersand directors to identify their objectives and to assign

responsibilities.

4. The policy establishes priorities for goals..

Eleven Elements of An


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Eleven Elements of An

Effective IRR Policy

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1. Frequency and Method for Monitoring Interest Rate Risk

Exposure

The IRR policy should address which methodsthe bank uses to measure and monitor rate risk,

How is interest rate risk defined (earnings or

value).

What target of rate risk exposure is the bankaiming to manage?

What time frame(s) or time horizon(s)?

How often is rate risk measured?

Eleven Elements of


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Eleven Elements of

An Effective IRR Policy

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2. Rate Risk Exposure Limits Consistent with risk appetite. (Managing

to risk neutral or positioning?)

Appropriate given the banks risk

management expertise? Consistent with path to the exit.

Li it f St T t ( t h k ) M d t


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Limits for Stress Tests (rate shocks) are Mandatory

46

Management should establish limits, triggers, or thresholds for stress

scenarios in order to compare risk measurement results with theinstitutions risk tolerance. Typically, institutions establish a set of

stress scenarios as part of the regular IRR assessment process. Long-

standing supervisory guidance provides that an appropriate limit

system should permit management to control IRR exposures, initiate

discussion about opportunities and risk, and monitor actual risk takingagainst predetermined risk tolerances. Risk measurements and limits

generally focus on the level of volatility on earnings and capital.

Source:Answer to Question 7, Interagency Advisory on Interest Rate

Risk Management Frequently Asked Questions, January 12, 2012, pages

5 and 6.

Eleven Elements of


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Eleven Elements of


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3. Clear Identification of Authority/Responsibility

The policy should clearly identify the authority andresponsibility for specific elements of rate risk managementand oversight. Individuals and committees responsible formaking rate risk management decisions should be identified.

IRR policies typically include many specific requirements forthe creation and operation of an ALCO. A sample list of IRRpolicy specifications for an ALCO includes:

ALCO membership

ALCO duties and responsibilities

How often the ALCO should meet

Decision-making authority of the ALCO

Form of reports from the ALCO to senior managementand the board

Frequency of required reports from the ALCO

Eleven Elements of


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e e e e ts o


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4. Reporting

The rate risk management policy must specifyand describe required reports. An accurate,informative, and timely management reportingsystem is essential for both monitoring and

managing rate risk exposure.

The policy should identify what position ordepartment is responsible for preparing reports.

The policy should stipulate the frequency ofreporting.

Eleven Elements of


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5. Acceptable and Unacceptable Courses of Action for ManagingInterest Rate Risk

Major hedging strategies and risk management actions,such as the use of derivatives, should be authorized by thepolicy.

The IRR policy should define:

When capital markets hedging is permitted.

How much capital markets hedging is permitted. What hedging instruments are acceptable.

Hedge limits by instrument.

What department or area in the bank is responsible forusing capital markets hedge instruments.

What hedging strategies are acceptable. How hedging activities will be reported, to whom they

must be reported, and how often they must be reported.

What controls will be required.

Eleven Elements of


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6. Measures to Take to Monitor Compliance with the IRR Policy

Regular reports of compliance with all policy provisions,especially limits are necessary.

The policy should identify:

who prepares compliance reports,

who receives compliance reports and how often is compliance reported.

Last but not least, some independent report of compliancewith the IRR policy is a good idea. The policy might, forexample, require the audit department to make an annual

review and report of compliance with policy provisions.

Eleven Elements of


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7. Measures to Test the Accuracy of Data,Assumptions, and Calculations Used in the RateRisk Measurement Process

Data reconcilement

Date testing (exception trapping) and scrubbing Assumption validation/backtesting

Model audits

Eleven Elements of


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8. Measures to Test the Accuracy of Estimated orProjected Exposure to Changes in PrevailingInterest Rates

It is also important to establish procedures forperiodic comparisons of forecasted rate

sensitivity with actual changes in the banksincome or EVE after subsequent rate changes.The term backtesting mainly refers to this typeof output verification. EVE backtesting is limitedto outputs for which there is a corresponding,

observable market price.

Eleven Elements of


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9. Measures to Test the Effectiveness of Rate Risk

Management Activities

IRR management activities do not alwaysaccomplish what we expect. The best-intentioned- and implemented plans do not

always produce the desired results. Whilemeasuring and managing IRR is imperfect atbest, bank managers should have someprocedures to follow so that the effectivenessof their rate risk measurement and

management can be monitored and adjustedas necessary. The procedures themselves donot belong in the policy. However, the policyshould at least establish the requirement forsuch follow-up and testing.

Eleven Elements of


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10. Regulatory Compliance

A general policy declaration to the effect that thebank will comply with all applicable laws andregulations never hurts, but a broad statement tothat effect is clearly not sufficient by itself.

Regulators usually expect to see some specificrequirements included in ALM or IRR policies.

Eleven Elements of


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11. Policy Coordination

For all banks, an IRR policy paragraph shouldaddress how policy will be coordinated withpolicies for lending/credit, investments, liquidity,strategic planning, and capital. One way to

coordinate these would be to have proposedchanges in any one policy made subject to areview process that includes individualsresponsible for enforcing the other policies.


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Oversight, Internal

Controls and Audit

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IRR Oversight Elements


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IRR Oversight Elements

Monitor compliance with policy limits and approved procedures Review the impact of previous changes in interest rates to

evaluate the accuracy of previous measurements of rate risk

exposure

Monitor implementation of previous risk management decisions

to determine the quality, timeliness and completeness ofimplementation

Audit the integrity of the risk measurement and risk reporting

process

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IRR Oversight Procedures and Controls


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IRR Oversight Procedures and Controls

1. Financial Institutions should develop procedures requiring: Appropriate methods for quantifying assumptions

Documentation of how assumptions were quantified, when it was done and who

did the work

Test of critical assumptions

Documentation of assumptions reviews

Controls for assumptions changes

Controls for assumption changes are particularly important

2. Controls for compliance with policies and risk management

procedures Periodic reviews to validate that bank enforces its IRR policy

Whether exceptions to policies or procedures receive the prompt attention

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Internal Controls


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Internal Controls

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The regulators expect institutions to have an adequate

system of internal controls to ensure the integrity of allelements of their IRR management process, including the

adequacy of corporate governance, compliance with policies

and procedures, and the comprehensiveness of IRR

measurement and management information systems. Thesecontrols should be an integral part of the institutions overall

system of internal controls and should promote effective and

efficient operations, reliable financial and regulatory

reporting, and compliance with relevant laws, regulations,

and institution policies.

FFIEC Advisory On Interest Rate Risk, page 8.

Requirements for Audit


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Requirements for Audit

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Focus on risks not reconcilements

Training

Testing data

Testing assumptions

Testing output

Testing for compliance with limits, policy constraints and

regulatory requirements.

Testing internal controls for key vulnerabilities such asassumption modifications.

Controls for Assumptions


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Controls for Assumptions

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Appropriate methods for quantifying assumptions.

Documentation of how assumptions were quantified, whenthe work was done and who did the work.

Tests of critical assumptions (sensitivity tests and/or backtests).

Documentation of assumptions reviews both periodicreviews and reviews following changes in bank activities ormarket conditions.

Controls for assumption changes.

Controls for assumption changes are particularly important.Internal and external auditors should review changes andcontrol procedures for changes. All changes should beundertaken for valid risk management reasons and not toavoid violating a risk exposure limit.

Essential Non-Audit Oversight Tasks


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Essential Non-Audit Oversight Tasks

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Review the impact of previous changes in interest

rates to evaluate the accuracy of previousmeasurements of rate risk exposure.

Monitor implementation of previous risk managementdecisions to determine the quality, timeliness, and

completeness of implementation.

IT Resources A Critical Risk Management Requirement


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IT Resources A Critical Risk Management Requirement

63

Supervisors have observed that an inability to

aggregate risk data in an accurate, timely, orcomprehensive manner can undermine the

overall value of internal risk reporting. For

example, whereas most firms focus on

establishing a management information

reporting framework to meet operational

requirements, internal risk reporting standardsdo not articulate the type of critical reporting

that would be required in a crisis or the speed

at which these reports would have to be

produced. We believe that in order to meet the

needs of the business line and risk

management staffs, firms should establishstandards, cutoff times, and schedules for

internal risk reports.

Source: SSG, Observations on Developments in Risk Appetite Frameworks and IT Infrastructure,

December 23, 2010, page 2 and page 12.


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Review Q&A

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Do you have a question that you would like


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y q y

answered during the Q&A session?

Simply follow the instructions below.

To ask a question, please press *1 on your

touchtone phone.

If you are using a speaker phone, please lift the

receiverand then press *1.

If you would like to withdraw your question, press

*1.

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Copyright Notice


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Copyright Notice

Portions of this presentation are copyrighted by Sheshunoff

Information Services, Inc. The remainder is copyrighted by Leonard

Matz.

No part may be reproduced in any form or incorporated in any

information retrieval system without prior written permission from

the copyright owner.

alco for a bank

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