3 minutes
Solidify day-to-day efforts so you can focus on the link to strategy.
Strengthening a credit union’s asset/liability management process enhances the information it delivers to credit union staffers, which is very valuable in today’s data-driven operating environment.
Effective ALM requires sound modeling techniques and reporting. Enhanced modeling and reporting can help quantify risk more effectively and lead to improvements in business decision-making and capital allocation. Many credit unions are seeing the value of enhanced risk reporting, providing an enterprise-level view of the financials in addition to maintaining regulatory and other requirements. This information allows the financial team to communicate more effectively with the board of directors and executive management as well as the credit union’s examiners.
CFOs should regularly assess analytics and financial reporting processes, asking questions like:
- Are our processes appropriate to generate the data we need for strategic decision making?
- Does our process effectively measure interest rate risk, liquidity and capital adequacy?
- Do we have a sufficient liquidity policy? Is it limiting, or does it allow for growth
In addition, following these five practices can help ensure a strong ALM process:
1. Make smart ALM software decisions. Having software and architecture that can support the complexity of the balance sheet is needed to run modeling. The model must be able to adequately quantify the risks on the balance sheet. At ALM First Financial Advisors, we see as imperative such modern techniques as stochastic-based modeling, which allows for statistical analysis of a random probability distribution or pattern that may not be predicted precisely, and single/multi-factor interest rate modeling.
2. Acknowledge the difference between the income and fair value reports. Net interest income simulations help assess short-term risk to income. They are great for assessing income volatility but may miss longer-termed interest rate positions beyond the simulation horizon. Fair value reports are more comprehensive, as all cash flows are encompassed. They are also beneficial for assessing duration gaps and mismatches that can be detrimental in volatile rate environments.
3. Use validations to search for weaknesses. Many institutions regard model validation as a regulatory exercise—just another box to check off on the examiner’s checklist. But along with testing current assumptions and procedures, validations provide an opportunity to gather cross-departmental input to evaluate the overall integrity of a credit union’s risk modeling.
4. Understand various roles related to ALM. While the CFO holds primary responsibility for ALM activities, the board of directors and management have key accountabilities. For example, the board must determine the credit union’s overall direction and approve risk-tolerance levels, as well as review and approve policies. Directors also have a fiduciary duty to be able to read and interpret financial statements, understand the components of interest rate risk and annually assess the effectiveness of the IRR program.
Once the board approves the credit union’s ALM policy and plan, it’s up to management to carry it out. This involves developing and maintaining the IRR measurement system, including the procedures and assumptions necessary for modeling, evaluating risk exposure and cultivating staff expertise. Management also is responsible for providing clear, timely reports to the board.
5. Do your homework before engaging an ALM advisory firm. Before selecting a provider, ask: What is the level of skill and experience of the advisory firm's staff? How is the advisory firm compensated (e.g., transaction-based or fee-based)? What’s the difference and why does it matter? Does the firm provide holistic advice regarding the overall balance sheet? Does the firm have access to capital markets? What’s the upshot? How does this impact the CU? How knowledgeable is the firm’s staff on regulatory issues? How satisfied are its existing clients, and what kind of feedback have they received from examiners?
The financial industry has undergone substantial changes in the past 10 years. Technology has made conducting sophisticated modeling easier, while increased competition and compliance pressures have demanded significant increases in knowledge levels and the resources expended. Meeting these demands requires a thorough analysis of current ALM practices and a willingness to make necessary improvements. Your credit union will benefit from the insights gained from more effective processes and, with less time spent on the basics, you’ll have more time for planning strategy.
Alec Hollis, CFA, is director/ALM Strategy Group for ALM First Financial Advisors, Dallas.
