RMA presents a series of articles designed to help community and super-community banks get a foothold in their management of market risk

Part V: practical issues today the role of ALCO in risk/reward: RMA presents a series of articles designed to help community and super-community banks get a foothold in their management of market risk

Jim Clarke

CAMELS ratings include four risk components managed by different departments within each bank. The overall monitoring, however, should fall to one committee. Oversight of interest rate risk generally falls to the bank’s Asset/Liability Committee. The final article in this series, therefore, will address the ALCO process.

Market risk normally comes in one of three varieties–interest rate risk, currency risk, or equity risk. This series, developed with community banks in mind, has focused on the first of the three, interest rate risk, whose oversight generally falls to a banks’ Asset/Liability Committee, or ALCO.

The role of the ALCO is to manage the balance sheet to achieve an optimal balance between risk and reward. The ALCO needs to ensure that the bank has adequate funding for earning assets (liquidity management) and insulation from the movement of market interest rates (interest rate risk management). An ALCO should also keep the board informed as to the bank’s total risk profile.

Community banks are periodically examined by their primary regulator and the FDIC. An examination usually concludes with an exit interview with the board, at which time CAMELS ratings are reviewed. Board members should never be surprised at the ratings if the ALCO is performing its quarterly duty of reporting the bank’s risk profile.

Banks use different formats for the ALCO. Some banks have a board ALCO along with a management ALCO. A management ALCO, which is the type discussed in this article, will surely include the CEO, CFO, the investment officer, and probably the controller. Effective committees should also include representatives from the loan department and retail banking.

An ALCO will make decisions that affect lenders. There are interest rate environments, such as that of 1999-2000, where it may be prudent to slow down loan origination due to a flat yield curve and a relatively high cost of funding loans. And an ALCO will often make decisions affecting deposit pricing–for example, deciding to lower the interest rate on deposits, which may cause an outflow of customers. This may be acceptable from a financial point of view, but the head of retail should be present to voice a different point of view. Accordingly, a good ALCO process requires an honest exchange among senior managers, not simply a monologue by the CFO.

A productive ALCO meeting results from a focused agenda–such as the one recommended in Figure 1.

Figure 1

ALCO Committee Sample Agenda

1. Macroeconomy–national & local business cycle.

2. Interest Rate Environment–current & forecasts.

3. Cash Flow Pro Forma,

4. Liquidity Position.

5. Interest Rate Risk Exposure.

6. Loan & Deposit Activity.

7. Decisions.

Agenda item #1. Regional and money center banks generally have their economist open the meeting by discussing the business cycle and how it relates to the bank’s market area, emphasizing how the cycle will influence the bank’s loan decisions and credit quality. Community banks do not have a professional economist, but there are other resources. A bank’s controller is a good candidate to play the role of the economist. A good data source is the FDIC Web site, which includes a “state profile.” In due course, the FDIC will likely disaggregate its profile to a more local subset. Many other data resources are on the Internet, including Web sites of the regional Federal Reserve Bank. Table 1 suggests a framework for reviewing the economy, using data from August 2003.

Agenda item #2. Business cycle data is important to ALCO decisions, but interest rate information is critical Current interest rate data is readily available on the Internet and from the broker]dealers with whom the bank works. However, ALCO decision making involves the future, so interest rate forecasts are important. Although interest rate forecasting is not an exact science, the committee needs a point of reference. The best approach may be for the bank to look for consensus on the movement of interest rates, as seen in Table 2. In 2003 it was relatively easy to reach consensus, as most indicators pointed to a rising-rate environment.

Agenda items #3 and #4. Excess liquidity has concerned community banks over the past two years and must be addressed in the ALCO process, beginning with a forecasted cash flow analysis as shown in Table 3. This table presents a conceptual approach to cash flow–individual banks may extend beyond this simplified presentation. The important distinction is in isolating non-discretionary sources and uses of cash. For most banks, amortization and prepayment of loans (sources of cash), and loan commitments (uses of cash) are the most important items. A comprehensive analysis of cash flow goes a long way toward determining the bank’s liquidity position. Using a cash flow pro forma to gain a solid handle on liquidity, the committee can address interest rate risk and begin to think about the deployment of cash or the funding of assets.

Agenda item #5. The next piece of information crucial for the committee is a report on the bank’s interest rate risk position. Table 4 shows the GAP report for a sample bank. GAP is a traditional approach that many community banks rely on to conceptualize their interest rate risk exposure. The most important piece of information in Table 4 is the bank’s cumulative GAP over the one-year time horizon. Table 4 shows a positive GAR indicating that the bank is asset sensitive and will benefit from a rising-rate environment.

“Fable 5 shows the exposure of the bank’s net interest income to a change in market interest rates. This is a simulation that recalculates key income statement ratios in declining-rate and rising-rate environments, allowing the committee to decide what is acceptable and whether it may want to reposition the bank’s balance sheet.

From a regulatory point of view, Table 6 probably represents the most important agenda item. This table shows the sensitivity of the balance sheet; in particular, it shows the sensitivity of the economic value of the bank’s equity (EVE). The sensitivity of EVE based on the simulation results in Table 6 can then be compared to the limits the board established in the bank’s interest rate risk policy.

Decision Time

The committee is now ready to make decisions about the deployment of cash and the funding of assets. The two broad decisions to be made are shown in Figure 2.

Figure 2

Decisions

Deployment of Cash

Make Loans

Buy Investments

Repay Maturing Deposits

Repay Borrowing (FHLB Advances)

Funding Assets

Sell Loans

Sell Investments

Borrow Money (FHLB Advances)

Increase Deposits

The committee meeting started with an economic analysis. This information on the business cycle should be valuable in determining the potential for deploying cash for loan origination. The interest rate forecast should give the committee a sense of the future direction of interest rates. Coupling an interest rate forecast with the bank’s interest rate risk exposure should allow the committee to consider the optimal duration of assets and liabilities and make decisions that will change balance sheet duration.

Symmetry in Knowledge

The ALCO process should not be a random affair. A logical agenda can ultimately lead to good decision making that is consistent with the economic environment and the bank’s current balance sheet. This process works best if all members of the committee are familiar with the basic concepts of asset/liability management. A problem at many banks is the asymmetry in knowledge between the financial and nonfinancial managers.

It is the job of the CEO and CFO to close this gap. All senior managers who serve on the ALCO should be educated in the basic language of asset/liability management, and the CFO must ensure that all decisions are presented showing what-if scenarios. This is critically important when embedded options are involved in the decision.

Managing a bank’s balance sheet, while complicated, ultimately reveals the trade-off between risk and reward. This trade-off ought to result in an optimal balance sheet for each bank based on its preference for risk.

This five-part series has attempted to educate bank managers in the complexity of balance sheet management. RMA is currently developing a two-day, course on market risk that will place much of what has been discussed in this series in an educational framework. This course should be beneficial in bringing all senior managers up to speed on asset/liability management.

Market Risk: The Series

Part 1: July/August 2003 “A Historically Low Rate Environment”

Part 2: September 2003 “To Know Market Risk is to Know Duration & Convexity”

Part 3: October 2003 “Current State of Interest Rate Risk Management”

Part 4: November 2003 “Modeling IRR: The Devil Is in the Assumptions”

Part 5: February 2004 “The Role of ALCO in Risk/Reward”

If you are missing any of these articles, Search under “Online Products” at www.rmahq.org.

Table 1

Economic Outlook [right arrow] Business Cycle

Real GDP Real growth in GDP is forecast at 3%

to 4%. Economy will gradually expand.

Nominal GDP Nominal GDP growth will be 4% to 6%

given continued moderate inflation.

Consumer Confidence This is a critical leading indicator. It

rose 4 points in the August survey to

81.3%. Consumers have been more

positive in the past two months.

Leading Indicators The leading indicators were down in

2002, but show a strong upward trend

since July 2003.

Unemployment Remains in the 5.8-6% range. Should

decline as economy strengthens.

Inflation Remains low–2.2% annualized. Two

factors to watch–energy and dollar.

Equity Markets Positive signs in the past nine months.

Some good profit reports and the scandals

of 2001 & 2002 are subsiding.

Uncertainties [right arrow] Washington factor–deficits

& Iraq.

Table 2

Interest Rates & Monetary Policy

Indicator Direction

Implied Forward Rates 1-year Treasury = 1.25%

What does the current 2-year Treasury = 1.80%

yield curve tell us 2-yr. = 1-yr. + 1-yr. exp./2 = 2.45%

about the future 1- Market expects rates to rise!

year Treasury forward

rate?

LIBOR Swap Yield Curve Similar to the cash yield curve.

Strong positive slope-signaling

expected rise in rates.

45-Year Low [right arrow] Short term–1.00%

Rates will eventually [right arrow] Intermediate–term-5-year 3.5%

regress to the mean. [right arrow] Long-term–10-year 4.6%

Economic Outlook Everything points to a rise in interest

rates over the next 18 months.

As economy strengthens, the probability

will increase.

Fed Watch [right arrow] Rates decreased 475 basis

points in 2001.

[right arrow] Rates decreased 50 basis points

in 2002.

[right arrow] Decrease of 25 basis points

in 2003.

Consensus Most economists believe rates will

increase-consensus is building for

3rd to 4th quarter of 2004.

Table 3

Cash Flow Analysis

Sources Uses

Nondiscretionary Loan Commitments

* Loan amortization.

* Loan prepayment.

* Maturing investments.

* Callable investments.

FHLB Advances Investment Decisions

Deposit Decisions Loan Decisions

Table 4

GAP Report

(000) <3 mo. 3-6 mo. 6-12 mo. 1-3 yrs.

Rate-Sensitive Assets $207,714 $33,833 $60,702 $121,165

Rate-Sensitive Liabilities 201,370 29,849 33,962 81,447

Cumulative GAP 6,345 10,329 37,068 76,786

As a % of Assets 1.1% 1.7% 6.2% 12.9%

Table 5

NII at Risk

-50 -25 Base +100 +200 +300

EA Yield 5.13% 5.18% 5.23% 5.42% 5.61% 5.78%

Liability Cost 2.17% 2.21% 2.25% 2.39% 2.54% 2.69%

Net Interest

Margin 3.48% 3.50% 3.51% 3.55% 3.58% 3.61%

ROAA 1.21% 1.22% 1.23% 1.26% 1.28% 1.29%

ROAE 12.30% 12.38% 12.48% 12.77% 13.01% 13.15%

Table 6

Economic Value Sensitivity Analysis

-50 -25 Base +100 +200 +300

% Change in

Assets 0.5% 0.2% -1.5% -3.0% -4.4%

% Change in

Liability 0.6% 0.3% -1.1% -1.8% -2.5%

EVE -1.0% -0.6% -3.4% -10.6% 16.8%

EVE Estimate 10.92% 10.99% 11.08% 10.87% 10.21% 9.65%

Well-capitalized 6.00% 6.00% 6.00% 6.00% 6.00% 6.00%

Contact Clarke at JJClarke2@aol.com.

Jim Clarke, Ph.D., is founder and president of Clarke Consulting, Villanova, Pennsylvania. He is currently working with RMA to develop materials for a course on market risk.

COPYRIGHT 2004 The Risk Management Association

COPYRIGHT 2005 Gale Group