Effective Asset/Liability Management: A View from the Top *
by Doug Gray, Managing Examiner, Federal Reserve Bank of Kansas City
"With growing cash balances and ever-declining interest rates over the past several years, the banking industry’s net interest margins have trended downward, exhibiting some volatility."1 While this quotation could certainly come from any banking publication today, the statement is actually from a paper published in 2005 that discusses balance-sheet management at community banks. Today, community banks are encountering some of the same challenges they faced nearly a decade ago: sizable cash balances, low interest rates, and reduced loan demand. The words of radio news broadcaster Paul Harvey seem appropriate: "In times like these, it helps to recall that there have always been times like these." However, simply acknowledging that these challenges have persisted does not help institutions respond to them. Rather, each community bank should have its board of directors’ and its senior management’s "view from the top" to effectively lead it through these challenging asset/liability management (ALM) times.
In general, ALM refers to efforts by a bank’s board and senior management team to carefully balance the bank’s current and long-term potential earnings with the need to maintain adequate liquidity and appropriate interest rate risk (IRR) exposures. Each bank has a distinct strategy, customer base, product selection, funding distribution, asset mix, and risk profile. These differences require that assessments of risk exposures and risk management practices be customized to each bank’s specific risks and activities and not take a one-size-fits-all approach.
Regulatory Assessment of Asset/Liability Risk Management
Regulators assess risks and risk management activities in four broad categories, reflected in the figure below. This article will discuss two of these key aspects as they relate to ALM: 1) board and senior management oversight, and 2) policies, procedures, and risk limits.
Board OversightIn 1995, the Federal Reserve Board issued risk management guidance that emphasized that each bank’s board is ultimately responsible for the bank’s condition and performance.2 Interagency guidance and policy statements issued since that time have reinforced the principle that although bank directors can delegate certain activities, they retain ultimate responsibility.
Effective oversight requires the board of directors to rely on sound ALM. Because ALM is complex, some bank directors might find overseeing interest rate and liquidity risks challenging. Senior management typically provides the board with information derived from IRR or liquidity models that contain general assumptions and produce output reports. Much of this information is driven by very detailed "behind-the-scenes" model inputs and assumptions. As a result, the directors’ review is generally limited to monitoring exposures through key model output reports and measures but with little knowledge of the assumptions behind or limitations of those measures. While being able to quantify and monitor risk positions is important for sound oversight of balance-sheet exposures, effective board oversight requires more than simply evaluating model outputs; it also requires a broad perspective on all business lines and products, strategic goals, and risk management.
Board oversight should include:
- Understanding Risks. Through policies, reporting mechanisms, and discussions at board meetings, bank directors should demonstrate that they clearly understand the risks inherent in the institution’s ongoing activities. Directors should also question senior management about risks and risk management costs presented by new activities and deliberate about the risk/reward trade-offs.
- Providing Appropriate Guidance. The board sets the tone and communicates the risk tolerance for the organization. Risk tolerance, including quantitative risk limits and definitions of permissible and impermissible activities, should be communicated so that the board, senior management, and other bank personnel clearly understand the bank’s risk thresholds and approach to managing the effects of balance-sheet exposures on capital and earnings. This is most frequently accomplished by establishing appropriate policies and risk limits, which is discussed in greater detail later in this article.
- Monitoring Exposures. Once the risks inherent in the institution’s activities are recognized and guidance is provided to staff, directors should require that senior management report risk exposures on a timely basis. In community banks with low IRR or liquidity risks, the board should review risk reports at least quarterly. However, in community banks with high IRR or liquidity risks, the board, or a designated committee, should review risk reports more frequently.
Board reports should also be meaningful to the directors in their risk oversight role. For example, many IRR models have been developed to provide detailed quantitative data. However, some of this information is more meaningful to the senior managers evaluating daily activities than to the directors overseeing institutional risks and setting strategic direction. To be useful, board ALM reports should be timely, accurate, and appropriately detailed and should clearly note any noncompliance with bank policies. While directors should understand, at a high level, the assumptions made and any weaknesses in the models used to produce the reports, they do not need a detailed understanding of all the nuances or model mechanics. Too much or too little information, along with the wrong kind of information, can hamper the board’s ability to effectively steer the institution through the sea of IRR and liquidity risks.
- Making Personnel Decisions and Delegating. Many community bank directors are specialists in fields outside of banking and likely lack a background in ALM issues and other risk areas. However, most community bank boards recruit key managers who possess the expertise necessary to effectively administer risk management activities. Bank directors also have the opportunity to allocate time and funding to train and develop individuals who need enhanced knowledge in balance-sheet risk management commensurate with the bank’s risk exposure. Once key personnel are identified and developed, the board may confidently delegate daily risk oversight to these capable managers.
Senior Management Activities
In many cases, the board delegates routine oversight of balance-sheet risks to a committee of senior managers known as the Asset and Liability Management (ALM) Committee or the Asset and Liability Committee (ALCO). A community bank’s ALCO often assesses earnings, establishes loan and deposit strategies and pricing, monitors detailed IRR exposures, and evaluates liquidity risk exposures and contingency funding needs. Given the broad array of activities the ALCO conducts, representation should include senior managers from the bank’s lending, investment, deposit-gathering, and accounting functions.3 The ALCO should make regular reports to the full board, so appropriate oversight by the board can be carried out.
Senior management activities should include:
- Implementing ALM Policies. The primary responsibility of senior management when carrying out ALM activities is to ensure that policy and risk guidance established by the board is appropriately implemented. ALM policies should provide the blueprint for ALCO and other bank personnel to follow when identifying, measuring, and controlling IRR and liquidity risks. In addition to communicating appropriate risk tolerances, policies should direct management to develop or acquire risk measurement tools that provide ongoing quantitative reporting of the relevant risk exposures.
- Developing Risk Monitoring and Reporting Tools. Many community banks use a battery of tools to oversee ALM risks depending on the complexity of their balance sheet. IRR is often monitored using vendor models to identify and measure risk exposures under various rate scenarios. Liquidity risk is typically identified, measured, and monitored through spreadsheets that compute existing balance-sheet liquidity positions, forward-looking source and use projections, and adverse scenario effects. The key consideration for any management team in determining what measurement tool to use is ensuring that the tool can quantify the institution’s specific risk exposures. For example, a small bank located in a rural community with nearly 50 percent of its total assets invested in callable bonds should not be relying on a simple maturity gap, since the complexity of the balance sheet would demand a more sophisticated tool regardless of asset size. It is imperative that management implement appropriate tools to adequately measure the risk in the balance sheet.
- Reporting Risk Exposures to the Board. Reports provided to senior management and the board should evaluate the institution’s compliance with established risk limits. Regardless of asset complexity, funding characteristics, or the risk measurement mechanism used, the board relies on management’s ability to properly identify the risk in the bank. For example, many community banks establish net interest income change limits for various interest rate change scenarios in their IRR management policies. In these banks, management would be expected to quantify and report to the board the level of and trend in net interest change percentages for those scenarios specified in the bank’s policy. Directors should receive sufficient information to understand the bank’s existing interest rate and liquidity risk profiles relative to established limits and the potential impact of strategic and tactical decisions on those exposures.
- Attracting and Developing Personnel. It is also critical that a bank’s staff maintain adequate depth and expertise for carrying out risk measurement and mitigation activities. Risk oversight is dependent on having the proper personnel to understand the balance sheet’s complexity and properly develop an ALM oversight program capable of ensuring that risks stay within the boundaries set by board policies. Hiring and developing appropriate staff can be particularly challenging for rapidly growing community banks or those with increasing product complexity. Typically, these banks are either acquiring other institutions or implementing new business lines. In these situations, the bank can avoid pitfalls by ensuring that the appropriate staffing infrastructure is in place to identify, measure, and report interest rate and liquidity risks from new activities prior to commencement. This requires that senior management exercise appropriate due diligence and risk analysis to determine how the new activities (for example, a new mortgage origination program) or products (for example, a new CD) could affect the bank’s overall IRR profile. The results of these analyses should be presented to the board prior to implementing the new activity. This exercise, in turn, will allow senior management to propose and the board to adopt changes to policy and establish risk limits related to the new activities.
The responsibilities of the board of directors and senior management are summarized in the figure below.
Policies, Procedures, and Risk Limits
One of the most effective tools the board and senior management can provide to their staff is a sound policy directive for the bank’s various activities and risk exposures. Through sound policies, the board communicates to frontline and senior personnel its expectations with respect to risk tolerance, desirable and undesirable activities, internal control and audit, and risk measurement. Typically, directors develop ALM policies that consolidate the board’s expectations for interest rate and liquidity risk exposures and oversight. When examiners evaluate ALM policies, they are looking to see that the following issues are appropriately addressed:
- The policy should state the bank’s objectives for ALM and provide a well-articulated strategy for managing the risks associated with balance-sheet accounts. This would typically include the board’s view regarding trade-offs between earnings and interest rate and liquidity risk exposures.
- Another critical element of any ALM policy is appropriate aggregate risk limits for interest rate and liquidity risk exposures. Traditionally, community bank ALM policies would establish maturity/repricing gap risk limits to address IRR exposures and one or two liquidity ratio metrics (e.g., loans-to-deposits or noncore funding dependence ratios) for liquidity risk exposures. With the proliferation of callable bonds, mortgage-backed securities, Internet and brokered CDs, correspondent bank and Federal Home Loan Bank borrowings, and financial derivatives, many community banks have implemented more robust, forward-looking risk measurement techniques.
While many community banks have implemented better risk measurement tools, risk limits are not always established. For example, regulatory guidance suggests that sound risk limits for IRR exposures should address the risk in relation to earnings and capital exposures – usually framed in terms of limits to net interest income, net income, and/or the economic value of equity change percentages for specific interest rate shock scenarios.4 Regulatory guidance has also pointed to the need for forward-looking analysis for sound liquidity risk management. Often, this takes the form of sources/uses projections. A sound policy would establish risk parameters in the form of minimum forward-looking cash flow coverage ratios. These risk limits should be clearly stated, should meaningfully address the bank’s activities, and should effectively communicate the board’s risk tolerance. Risk limits should also be periodically reevaluated in light of the institution’s other risk exposures (e.g., credit, operational, reputational) and any new products or business activities.
- The policy should provide clear lines of authority, responsibility, and accountability regarding risk management activities. It should include addressing situations where the institution falls outside of its established risk parameters, defining who is responsible for implementing strategic and tactical activities, establishing and maintaining risk measurement systems, and identifying risks that may arise from new products or activities. In many community banks, these responsibilities fall to one or a few individuals. The board should be aware of any concentration in responsibility or authority and ensure that adequate controls are in place to mitigate any resulting risks. An effective control might include, for example, independent reviews of these activities by someone who understands the risk management activities and potential problems that could arise.
- The policy should also clearly delineate the types of activities that an institution may conduct. This might include the types of financial instruments or activities that are permissible for either the banking book or risk mitigation (that is, hedging) activities. When managing liquidity risks, the policy should indicate what types of funding are acceptable and to what degree these sources should be used. For example, some community banks have incorporated the use of Internet or brokered deposits to augment local deposit volumes. For such institutions, the ALM policy should discuss how Internet or brokered deposits might be appropriately used and the extent to which the board considers these deposits acceptable. While nontraditional funding may change the bank’s inherent liquidity risk profile, sound controls over the volume and type of inherently riskier funding sources may help to mitigate risks.
While the use of financial derivatives by community banks to hedge certain interest rate risks remains relatively modest, especially at the smallest banks, the use of derivatives has nevertheless become somewhat more prevalent in community banks in the past several years. Any community bank using financial derivatives to hedge exposures should have personnel with sufficient knowledge and expertise to ensure that the bank’s risk exposure is not elevated by these activities. Before the bank engages in the use of financial derivatives, bank policies should address the appropriate use of these instruments, including a discussion of permissible derivative activities, an independent review of derivatives and the effectiveness of hedging activities, and appropriate accounting policies. Management should ensure that, prior to using financial derivatives, they understand the economics of the instruments, the potential risks from improper use, and accounting requirements for hedging activities.
Leading ALM Risk Management Practices
Many community banks have developed structures and policies to enable the board and senior management to effectively oversee balance-sheet risk exposures. However, examiners continue to identify opportunities to improve oversight of these risks. Occasionally, those opportunities rest with the board’s knowledge of IRR and liquidity concepts. While community bank directors are not expected to be subject matter experts, board members should have a certain level of foundational understanding to effectively carry out their fiduciary responsibilities. To ensure that the board has sufficient understanding of balance-sheet risk management concepts, some banks have benefitted from external resources for educating directors.5 Other banks have included on their board at least one outside director who possesses a sound understanding of balance-sheet management concepts. Together, these approaches have been effective in improving boards’ abilities to oversee balance-sheet risk exposures.
Another leading practice is to identify risks and update policies before implementing new products or activities.6 In many cases, community bankers have responded to the challenge of meeting desired earnings targets by implementing new business lines or investing in new categories of assets. In some instances, while the board and senior management may have held cursory discussions regarding the characteristics of these assets or business lines, they nevertheless failed to conduct a thorough due diligence evaluation of risks, including interest rate and liquidity risks. In some cases, the bank commenced an activity or invested significant funds in a particular asset only to later learn that additional processes, resources, and personnel were needed to effectively manage the risks arising from these activities or assets. Thus, the potential boost to earnings initially expected from these strategies was consumed by unexpected risks and additional post-implementation expenses related to risk management.
The community banking landscape has changed significantly in the past decade, and these changes have required heightened attention to ALM risk management strategies and processes. These changes, which include more products with embedded options, have required directors and senior managers to acquire enhanced knowledge about interest rate and liquidity risks to both manage traditional ALM risks and keep up with new ways of doing business. Changes have also reinforced the need for directors and senior managers to reevaluate and communicate guidance and risk tolerances to bank personnel. By ensuring that a sound oversight structure based on strong communication of risk tolerance is in place, directors can effectively steer the bank through challenging banking conditions whenever they occur.
- * This is the second in a series of three articles on asset/liability management. Please see the first article "Interest Rate Risk Management at Community Banks" in the Third Quarter 2012 issue of Community Banking Connections.
1 Todd Taylor and Sasha Antskaitis, "Balance Sheet Management for Community Banks," Bank Accounting & Finance (December-January 2005), p. 29.
- 2 See Supervision and Regulation (SR) Letter 95-51, "Rating the Adequacy of Risk Management Processes and Internal Controls at State Member Banks and Bank Holding Companies," available at www.federalreserve.gov/boarddocs/srletters/1995/sr9551.htm.
- 3 Often, outside directors are also included as ALCO members to ensure that an appropriate degree of independence is maintained in the oversight of balance-sheet risk decisions.
- 4 Interest rate shock scenarios often take the form of assumed instantaneous shifts – either up or down – in all interest rates affecting a bank’s assets and liabilities. Regulatory guidance indicates that these shocks should be significant (i.e., 300/400 basis points or more), and limits should be established for significant and meaningful shocks. See SR Letter 10-1, "Interagency Advisory on Interest Rate Risk," available at www.federalreserve.gov/boarddocs/srletters/2010/sr1001.htm.
- 5 External resources for educating directors can include consultant training and ALCO support, external training seminars, and online training modules. The Federal Reserve System has developed a resource for bank directors that can be accessed at www.bankdirectorsdesktop.org.
- 6 For more information on new product or service considerations, please refer to the article "Considerations When Introducing a New Product or Service at a Community Bank" in this issue.