The art of ALM


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The art of ALM

  1. 1. THE ART OF ALM Good judgment is every bit as important as quantitative risk measurement in getting a good picture of your CU's financial standing. Asset/liability management can be defined as a process of evaluating balance sheet risk, making prudent decisions, and executing actions to control your credit union's risk and to reach its financial goals. It is an integral part of your credit union's financial management process and, as such, affects the entire scope of your operation, including lending, marketing, product pricing, investment analysis, cash management, internal controls and data processing. One may think that since risks are to be measured, ALM is a science. For example, if rates rise by 100 basis points, your ALM model calculation shows that net income would fall by 10 percent and net economic value would fall by 5 percent. By shifting the CU's balance sheet to an asset-sensitive composition, the net interest income would now rise by, say, 10 percent and the net economic value would fall, say, just by 2 percent, well within your board policy guidelines. Good job, isn't it? Actually, it depends! To use an analogy, you are seeing the "numbers" in your report as if seeing a swan swimming gracefully on the water's surface. However, under the surface of the water, the swan is paddling very hard. To come up with meaningful numbers, human decisions are needed to deal with various complicating factors. This is the art of ALM. HANDLING THE GRAY AREAS Indeed, there are many gray areas in ALM. Some balance sheet account information is difficult to quantify. The contractual maturity (or ex-ante maturity-the maturity term that your CU initially agreed with your members) may be very different from the behavioral maturity (or ex-post maturity-when your members actually repay the loans or withdraw the shares). Below are four complicating factors. 1. Mortgage prepayments. Complication exists in mortgages and mortgage-backed securities due to the cash-flow uncertainty arising from prepayments. In times of falling
  2. 2. rates, people tend to prepay and refinance fixed-rate mortgages. In times of rising rates, prepayments tend to slow down. Nevertheless, prepayments still occur due to family relocation or changes in borrowers' circumstances. How would you account for such prepayment patterns? There is no specific answer. One point is clear though; you should not only rely on the contractual maturity. You need to estimate the behavioral maturity and cash flow. Below are some estimation methods, but which method to choose is an art and is subject to your choice and discretion. CPR = 1 - (1 - SMM)^sup 12^ For example, if the SMM is 1 percent, then the CPR is 1-(1-0.01)12 or 11.36 percent. For small SMM values, a reasonable approximation can be taken as: CPR = 12 x SMM. (c) Office of Thrift Supervision prepayment coefficients: The OTS has provided a CPR national average showing the prepayment coefficients and CPR percentage formula based on the types and ages of conventional 30-year fixed-rate mortgages; FHA/VA 30-year FRMs; 15-year FRMs; ballooned FRMs; and adjustable-rate mortgages. The OTS prepayment coefficients for different types of mortgages are available every quarter from OTS's Web site ( (New, moderately seasoned and well- seasoned mortgages are defined as mortgages of age up to 30 months, between 30 months and 10 years, and over 10 years respectively.) The coefficients can be used to calculate the prepayment amount and hence the cash flow affecting ALM risk measurement. (d) Public securities association: This method assumes that the prepayment rate increases linearly over the first 30 months and then levels off at a constant CPR. For example, for mortgages of age less than 30 months, the prepayment rate rises by 0.2 percent a month. For mortgages with age of at least 30 months, with a PSA index of 100 percent, the CPR is 6 percent. With a PSA index of 200 percent, the CPR is 12 percent and so on. (e) Internally developed method: You can track your members' historical prepayment pattern by loan types, by coupon rate and by seasoning. New mortgages are less likely to be prepaid than mortgages staying on the book for some time. Over time, develop prepayment assumptions to put into your ALM model. Unfortunately, the data only shows the historical
  3. 3. pattern. We do not have a crystal ball to see the future nor to repeat the experiments to get the same results. What prepayment method should you choose? The OTS and PSA prepayment rates may be very different from your members' behavior. Actual prepayment rates depend on your CU's unique situation. If your members are young with high mobility, the prepayment rates would tend to be higher than if you have many older members. Given the characteristics of your members and community location, a good approach to deciding is to develop your own internal estimated prepayment rates over time with comparison to the other methods. However, if you have an insignificant mortgage portfolio or you are a small credit union without resources or expertise, using the vendor model or external estimation could be a short cut as long as the actual observed prepayment rates do not differ significantly. Keep tracking and improving! 2. Assets and liabilities with embedded options. Apart from mortgages, many credit unions have embedded options in their balance sheets. On the assets side, you may hold callable agencies, bonds or collateralized mortgage obligations to earn a higher yield. You may have loans or ARMs with interest rate caps or floors. On the liabilities side, you may have convertible Federal Home Loan Bank advances so as to take advantage of the initial lower funding cost. For some sophisticated credit unions, you may have complex instruments with coupon formulas related to more than one index. If you have these structured items, the behavioural cash flow stream could differ widely, depending on the external interest rate environment. For example, in a falling-rate environment, the average weighted term to maturity of CMOs would fall due to prepayments. In a rising rate environment, the FHLB advances may be converted from fixed rate to floating rate. Make sure you take these embedded options into consideration. Run what-if models with the appropriate interest-rate ceilings or floors, prepayment or convertibility options as rates change. Set up your ALM models to realistically reflect your interest rate risks associated with these instruments. Here the "art" part of ALM is that you have no control over when the embedded options would be exercised. What you can do is to make the most reasonable assumptions in light of the available information.
  4. 4. KEEPING IT COLORFUL 3. Non-matured deposits or members' shares. Another complicated balance sheet item is non-matured shares. The challenge for ALM is how to measure this risk and what strategy is to be adopted. Non-matured shares, such as regular shares, share drafts and money market accounts, have no maturity specification. Unlike fixed rate share certificates, which have a specified dividend rate for a specific maturity, balances in these accounts can be withdrawn on demand. The uncertain timing of the cash flow makes appropriate treatment of these accounts hard to determine. Not only are the amount and maturities uncertain, the dividend rates paid are at your credit union's discretion. If your credit union is facing strong competition and your member shares are very rate sensitive, you may need to price your non matured shares aggressively, commensurate with the rise in external market rates. However, if your member shares are not particularly rate sensitive, you may not have to increase the dividend rates as much or you might delay the rate increase. Your members may value your excellent service quality, your convenient locations and your relationship more than a few dividend basis points. You may also choose to explore other strategies, such as offering a tiered rate to keep the more rate sensitive accounts. see, the change is the same-a rise in rates, but the decision and actions can be very different depending on what strategies you are going to choose. Wise human decisions are made with good information. To better understand your members' behavior under various rate conditions, it is important to conduct a core deposit analysis to quantify your members' behavior for assumptions to be placed into your ALM model. This demonstrates the beauty of merging art and science in ALM. Indeed, NCUA issued a letter of guidance to credit unions in 2003 on sound practices for evaluating non- maturing shares, superseding its recommendations in 2002. In essence, NCUA does not define what method of measuring NMS should be used. Credit unions are to make their choices depending on individual circumstances. As principles for best practice, credit unions have to take necessary steps to measure, monitor and control interest rate and liquidity risks as economic conditions and interest rates change.
  5. 5. Some credit unions may choose to assume NMS behavior with longer maturities when measuring their liquidity risk. Some may choose to have less rate-sensitive pricing when projecting their net interest income or using discounted value instead of book value for NEV calculation. For these credit unions, NCUA requires a documented assessment of their members' behavior, market conditions and future needs. Companies like McGuire Performance Solutions ( can assist with this type of analysis. The choice of treatment of these NMS affects net income and reported NEV. If you treat the NMS as non-rate sensitive deposits with long-term behavioral maturity, you can use them to finance longer-term assets with higher yield, thereby improving your bottom line and meeting your members' needs for loans. Also, a higher NEV would be shown. However, your choice has to be justified and prudent. If not, you would expose your credit union to unfavorable liquidity and interest rate risks. 4. Interest-rate risk analysis method. Apart from the above complicating input assumptions, the next challenge is: What calculation methods are you going to use? Should you use parallel or proportional rate shocks? Should you use immediate rate shocks or rate ramps? Any rate-change time delay? A parallel rate shock assumes that changes in the offering rates are in parallel to the change in driver rate. A proportional rate shock assumes that changes in offering rates are proportional to the driver rate. For example, the prime rate (driver rate) is 5 percent. Deposit rate is 2 percent and loan rate is 8 percent. In parallel shock, when prime rate is up by 100 basis points from 5 percent to 6 percent, deposit rate would become 3 percent (= 2 percent 1 percent) and loan rate would become 9 percent (= 8 percent 1 percent) in the model calculation. In proportional shock, deposit rate would only become 2.4 percent (= 2 percent/5 percent multiplied by 6 percent) and loan rate would become 9.6 percent (= 8 percent/5 percent multiplied by 6 percent) in the calculation.
  6. 6. CHOOSING YOUR TECHNIQUE Which method to use is a matter of judgment. Regulators usually need to see the risk exposure in an immediate parallel shock of plus or minus 300 basis points as a prudent soundness measure. However, to evaluate a realistic outcome, you may like to also use rate ramps and proportional shocks for internal ALM purposes. It is not adequate to look at the numbers shown on the interest rate risk reports. You must look beyond the numbers to understand the impact human behavior can have on the risk position of your credit union-today and in the future. For example, suppose your projected report shows that in an up 300 basis point rate shock, the ROA dropped from 1.20 percent to 0.8 percent and NEV fell by 4 percent. One reason might be that you are experiencing a re-pricing mismatch because your credit union has a large fixed-rate mortgage portfolio with re-pricing terms much longer than your members' shares. In this case, to improve your ROA and protect your credit union as rates rise, you may choose to lengthen your member shares maturity and finance long-term mortgages with long-term liabilities (e.g. using FHLB advances to match the fund flows). Alternatively, you may choose to sell some of the mortgages to the secondary market while retaining the servicing rights for the fee income. However, if the reason for the decrease in ROA was due to embedded options in your balance sheet, your decision would be different. For example, if the drop in ROA is due to the higher interest rates associated with the conversion of the wholesale borrowings to floating-rate liabilities, a more appropriate solution would be to match them with variable-rate assets or to reduce the convertible liabilities. An example is that a credit union has a HGHLB convertible advance on the liability side of its balance sheet. The interest rate was originally fixed, but there was an option that the FHLB can choose to change the advance (a form of wholesale borrowing) from fixed rate to floating rate. When interest rates rise, it is likely that the FHLB would exercise this option and the CU would be subject to a risk of higher interest cost.
  7. 7. It is also important to ensure that reasonable, well-documented assumptions have been included in your NEV analysis. For instance, accelerated prepayments shorten cash flow maturity, improving portfolio value and overall NEV. Similarly, if your member non-maturity shares are non-rate sensitive, with very low decay rates, your NEV would increase by treating them with a longer-than-immediate term to maturity. The key is to understand the reasons behind the numbers. Keep the assumptions as realistic and as sensible as possible and take appropriate actions to correct any deviation from your strategic plan and ALM policy limits. Proactive credit union managers need to carefully think about how their goals can be achieved and how to optimize the benefits of using the results generated. After all, the ALM model is a tool. Its success depends critically on the users and decision makers. A sound ALM process involves much more than an interest rate risk measurement system. Effective ALM operation requires human decision to make various choices in the input assumptions, processing methods, output interpretation and corrective actions. ALM is more than just quantitative analysis of the rate shocks reports or modeling calculation. This, to some extent, explains why in the risk-focused examination process of the NCUA, examiners evaluate a CU not only on its performance figures but also, very importantly, its management's ability to identify, measure, monitor and control risk. In a nutshell, ALM is both an art and a science. It entails the beauty of an integrated view with the aim to achieve the goals of the credit union while striking a balance with its risk containment hinged upon human decisions. BY HAZEL W. LEE, CFA Hazel W. Lee, CFA, is director of strategic research and analysis at Profitstar lnc (, a CUES Financial Suppliers Forum member providing ALM and profitability models as well as financial management solutions, and a Jack Henry Company. Reach Lee at Copyright Credit Union Executives Society Dec 2005