By Terry Treadwell, CPA
In previous installments we have reviewed a framework for an effective asset/liability management policy and structured a best-practice asset/liability committee (ALCO).
Today we take up the practical aspects of ALM modeling and how it can become a more integral tool in your credit union's decision-making process—the ultimate goal being no big balance sheet surprises at your credit union as interest rates change. Even when the fed funds rate drops 75 basis points in a day like it did earlier this week.
Though it sounds mundane, all ALM discussions need to start with a simple definition of interest-rate risk:
Interest-rate risk is the risk that rates will move in a direction that will create a loss in future credit union earnings and economic value.
These rate movements may cause an unanticipated decrease in interest income or an increase in interest expense and further impact the underlying economic value of a credit union's assets and liabilities. For this reason, IRR measurement processes measure both earnings at risk as well as economic value at risk.
The Importance of Measurement
Anticipating future earnings impacts due to rate movements is critical for all credit unions. Sound management of IRR provides the ability to maintain safety, soundness and profitability for the long term. Measurement processes using strategic modeling will quantify this risk and help your ALCO focus on better managing and anticipating net interest margin and bottom line results.
By utilizing an IRR measurement model, current balance sheet, income/expense, and yield/cost of funds information is used to project changes in each asset and liability for a future period of time, typically one year periods tracked by month. The re-pricing frequency of the assets and liabilities is often analyzed, providing the basis for what we all know as "gap analysis." Gap analysis, however, falls short because it lacks earnings impact information. For this reason, simulation modeling is more useful, because earnings can be estimated in various interest rate and balance sheet environments.
A key strategic modeling objective is to help you answer these questions:
1. If market rates stay the same for the next 12 months, what will your credit union's balance sheet, net interest margin and net income components look like 3, 6, 12 and 24 months from now?
2. What is the "worst-case" interest-rate scenario and how will this scenario impact future credit union margins, earnings and balance sheet?
Once these questions are answered, there shouldn't be any big surprises at your credit union as interest rates change. You have the ability to manage potential future performance risks for your credit union.
You Can't Model What You Don't Analyze
To accurately model, you must be able to answer a number of questions:
Is your credit union growing assets and is that growth profitable? Conversely, has growth been a struggle, or do you need to shrink your assets in order to improve your capital situation? What is your ideal capital level to maintain?
What percentage of your total assets do you target to hold as loans vs. investments? What about your deposit mix—what percentage are you willing to acquire as "non-core" deposits by paying top-of-the-market rates?
Do you analyze the components of your net interest margin and its change every month? If so, is it rising? falling? steady?
To help answer these questions, start by analyzing loan pricing and mix. Review recent closed loan activity, as well as your pipeline, to realistically gauge demand for loan product, rates and structures. Consider the turns in the housing market, competitive pricing pressures, and credit concerns, and how these will impact your future volumes and pricing. Understand your loan payment trends, both contractual and prepayments. Don't forget to consider adjustable-rate loan repricing behavior and projected future repricing.
Next consider deposits. How is the mix and pricing changing as interest rates have fallen? Are you measuring deposits that are both leaving and coming in? Are you monitoring how deposit pricing tracks both your competitors and external market alternatives? Do you understand which deposits are "core": those that will stay regardless of your pricing structure?
Using Modeling to Understand the Big Picture
Effective ALM goes well beyond behavior of net interest margins in alternative interest-rate environments. It depends most on how strategically focused your credit union is and requires an educated board and senior management team. With this understanding of credit union balance sheet and earnings dynamics, your modeling also becomes the conduit for testing key strategies related to:
- desired vs. current capital and liquidity levels;
- desired vs. current performance ratio measurements;
- the feasibility of new product offers and
- non-interest income competitive strategies.
Unfortunately, many credit union executives are still pulling numbers out of the hat. Product pricing is being determined based on what Old Joe's Community Bank next door is offering. The future will be bleak for credit unions not willing to model and measure.
By using an IRR modeling process, while continually re-evaluating underlying assumptions, your ALCO can formulate strategies that assure a reasonable return on assets and minimize risks related to future interest rate movements. Your ALM modeling reports can now become the framework for a working strategic business plan.
Stop worrying and start modeling!
Terry Treadwell is an associate of Stogniew and Associates, providing internal audit and consulting services to credit unions and community banks. She has over 15 years experience in ALM and can be reached via e-mail or at 727.787.7400.
Read the first two posts in this series, "ALM: A Working Framework" and "The Best-Practice ALCO."
Read more on ALM in this Credit Union Management magazine archive.
