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Flawed Decision Making The non-decision lets just debate the rate outlook Wishful thinking the problem will go away
Delayed decision making lets have another committee meeting before we act
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
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
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
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.
Characteristics of Ineffective AL Committees (2) 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.
Characteristics of Ineffective AL Committees (3) 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 offbalance sheet positions that are managed in Treasury.
Risk management decisions are made in response to the present situation and short-term objectives. Longer term strategic considerations are given little or no thought.
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Characteristics of Ineffective AL Committees (4) 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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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 about most 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 dependent variables).
ALCO Functions and Responsibilities 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 of directors
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ALCO Functions and Responsibilities 5. Regularly review analysis of the banks exposure to adverse consequences from rate changes. Even though the projected exposure may be within policy limits, the ALCO may decide that actions should be undertaken to change this exposure. In addition to responses to changes in rate expectations, ALCO may want to change the banks IRR exposure because other changes, such as poor earnings, make it appropriate to temporarily reduce the banks exposure to rate risk. 6. Regularly review analysis of the banks exposure to liquidity risk under defined stress scenarios. Identify potential vulnerabilities and respond as appropriate.
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ALCO Functions and Responsibilities 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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ALCO Functions and Responsibilities 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, the minutes should identify: When the meeting was held Who attended Major topics discussed Specific decisions made
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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, procedural problems, 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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10:30-10:40 Competitive Situation 6. 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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10:40-11:10 Current Risk Assessment 8. Current rate risk exposure and projection measures (model reports of EVE and EAR for a range of possible future interest rates). 9. Current rate outlook/forecast.
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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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COMMENT
Goals: Provide background Reinforce connection between ALCO decisions and banks financial performance Ensure that prior ALCO decisions were implemented (oversight) Enables the ALCO to compare with limits
NEEDED INPUT
History (e.g., past 12 months) of banks IRR exposure and of rate movements Performance of margin, net interest income, economic value, etc.
2. 3.
Steps: Select base case scenario, highlighting expectations vis--vis types of rate change Determine analysts confidence in base case Articulate and document logic Expressed in same terms as exposures are measured (including as a percentage of limit) This usually takes the form of on-balance sheet and/or off-balance sheet actions to alter the banks risk exposure profile Output: decision summary Economic and market data
4.
Decide on IRR positions. Determine basic implementation strategy and delegate implementation
responsibility.
5.
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Good ALCO reporting has four characteristics: It must include all of the information that decision makers need. It must clearly call attention to the most important issues. It must be timely. It must be actionable.
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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 also contain 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. Interagency Policy Statement on Funding and Liquidity Risk
Management, Paragraph 20, March 2010 25
Credit Reports ALCO Reports Operating Loss Reports Financial Reports Performance Reports Audits Etc
Appropriate aggregation
Appropriate disaggregation currencies Clarity for non-specialists
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An executive summary is a big help for busy managers. 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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Up 300 bp
Up 200 bp
Up 100 bp
Down 100 bp
Down 200 bp
Down 300 bp
Business strategy 1: Business strategy 2: Business strategy 3: Base case strategy: Business strategy 4: Business strategy 5: Business strategy 6:
Source: BancWare ALM 5
5.41%
3.76%
2.17%
0.0%
-2.44 %
-5.14%
-7.97%
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100 50 0 -50 -100 -150 rates rise -200 Q0 Q1 Q2 Q3 Q4 Q5 Q6 no change rates fall
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45
Net Interest Income
40 35
Rising
Current
30 25 20 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q
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Declining
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%
-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%
-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%
-7.46%
-14.02%
-20.24%
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No Change in Rates
Down 200 Basis Points Scenario Percentage Change 0.03% 0.08% 0.33% 0.59% 0.71% 0.83% 0.95% 1.10% 1.50% 1.91% 2.07% 3.54%
Economic Value Fed Funds Sold Personal Loans Floating US Treasuries Treasury US Treasuries Fixed Commercial Loans - Floating CDs LT 100k Personal Loans - Fixed Commercial LOC Agencies CDs GT 100k Municipals Savings Accounts 8,936 5,070 17,239 17,080 111,440 71,252 24,774 61,924 21,225 193,918 9,167 19,193
Economic Value 8,939 5,074 17,295 17,181 112,235 71,842 25,009 62,602 21,544 197,620 9,357 19,872
Change 3 4 56 100 795 590 235 678 319 3,703 190 679
NOW Accounts
ARMs Money Market Accounts Lines of Credit Commercial Loans Fixed Mortgages MBS
33,537
79,150 74,620 25,007 97,334 23,507 23,012
34,723
82,242 77,840 26,161 107,325 29,302 28,842
1,186
3,092 3,220 1,153 9,991 5,794 5,830
3.54%
3.91% 4.32% 4.61% 10.26% 24.65% 25.33%
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Asset Sensitive
80
x
low confidence or no direction
recommended target
Liability Sensitive
-20
-80
prior 12 months
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2. The policy communicates managements intentions and rules to everyone involved in the process
3. Establishes specific objectives and responsibilities 4. Establishes priorities for goals
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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.
Policy Perspectives
Strategic risk management how much liquidity risk, measurement and management conditions, etc. Tactical risk management what to do about liquidity risk in todays bank and market conditions.
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2. A more important reason to have a policy is that it communicates managements intentions and rules to everyone involved in the process. If you dont know where you are going, any road will take you there. 3. The policy establishes specific objectives and responsibilities. Creating the policy forces managers and directors to identify their objectives and to assign responsibilities. 4. The policy establishes priorities for goals..
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The IRR policy should address which methods the bank uses to measure and monitor rate risk, How is interest rate risk defined (earnings or value).
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Consistent with risk appetite. (Managing to risk neutral or positioning?) Appropriate given the banks risk management expertise?
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Source: Answer to Question 7, Interagency Advisory on Interest Rate Risk Management Frequently Asked Questions, January 12, 2012, pages 5 and 6.
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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 management and the board
Frequency of required reports from the ALCO
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The rate risk management policy must specify and describe required reports. An accurate, informative, and timely management reporting system is essential for both monitoring and managing rate risk exposure.
The policy should identify what position or department is responsible for preparing reports.
The policy should stipulate the frequency of reporting.
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Interest Rate Risk Major hedging strategies and risk management actions, such as the use of derivatives, should be authorized by the policy. 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 for using 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.
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Last but not least, some independent report of compliance with the IRR policy is a good idea. The policy might, for example, require the audit department to make an annual review and report of compliance with policy provisions.
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Eleven Elements of An Effective IRR Policy 7. Measures to Test the Accuracy of Data, Assumptions, and Calculations Used in the Rate Risk Measurement Process Data reconcilement Date testing (exception trapping) and scrubbing Assumption validation/backtesting Model audits
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Eleven Elements of An Effective IRR Policy 8. Measures to Test the Accuracy of Estimated or Projected Exposure to Changes in Prevailing Interest Rates It is also important to establish procedures for periodic comparisons of forecasted rate sensitivity with actual changes in the banks income or EVE after subsequent rate changes. The term backtesting mainly refers to this type of output verification. EVE backtesting is limited to outputs for which there is a corresponding, observable market price.
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Eleven Elements of An Effective IRR Policy 9. Measures to Test the Effectiveness of Rate Risk Management Activities
IRR management activities do not always accomplish what we expect. The bestintentioned- and implemented plans do not always produce the desired results. While measuring and managing IRR is imperfect at best, bank managers should have some procedures to follow so that the effectiveness of their rate risk measurement and management can be monitored and adjusted as necessary. The procedures themselves do not belong in the policy. However, the policy should at least establish the requirement for such follow-up and testing. 53
Eleven Elements of An Effective IRR Policy 10. Regulatory Compliance A general policy declaration to the effect that the bank will comply with all applicable laws and regulations never hurts, but a broad statement to that effect is clearly not sufficient by itself. Regulators usually expect to see some specific requirements included in ALM or IRR policies.
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Eleven Elements of An Effective IRR Policy 11. Policy Coordination For all banks, an IRR policy paragraph should address how policy will be coordinated with policies for lending/credit, investments, liquidity, strategic planning, and capital. One way to coordinate these would be to have proposed changes in any one policy made subject to a review process that includes individuals responsible for enforcing the other policies.
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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 of implementation Audit the integrity of the risk measurement and risk reporting process
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2.
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Internal Controls The regulators expect institutions to have an adequate system of internal controls to ensure the integrity of all elements 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. These controls 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.
Testing data
Testing assumptions Testing output Testing for compliance with limits, policy constraints and regulatory requirements. Testing internal controls for key vulnerabilities such as assumption modifications.
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Essential Non-Audit Oversight Tasks 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 of implementation.
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Review Q&A
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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.
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