Interest Rate Risk Management: The Importance of the ALCO Process

In this edition of Taylor Advisors’ eBrief, we would like to touch on a subject that has seemed to receive an ever increasing amount of attention from regulators and bank management alike: interest rate risk (IRR).  In the most recent inter-agency guidance, regulators provided several recommendations relating to risk management tools (more extreme shocks and longer measurement horizons) and the appropriateness of policies and procedures to deal with IRR.  In this newsletter, we will show how the Asset/Liability Committee (ALCO) can be management’s cornerstone for managing interest rate risk and the overall balance sheet process.

The Asset Liability Committee

In name, all banks have an Asset/Liability Committee, or ALCO process.  In practice, however, the ALCO process at many banks is not utilized to its full potential, as some banks use it mainly to satisfy regulators.  The goal, though, is for the ALCO process to facilitate a discussion among management and the board that addresses potential risks and strategic opportunities relating to the entire balance sheet.  In this way, effective interest rate risk management begins with increasing the effectiveness of the ALCO process.

What are some ways in which banks can improve their ALCO process?  One of the best practices is to make sure that a major portion of each ALCO meeting is devoted to developing strategies to manage risk while maintaining profitability based on the current balance sheet position.  Some of the key areas of the balance sheet that should be addressed include earning asset mix, liquidity management, deposit pricing, wholesale funding, the investment portfolio, capital, tax minimization, and interest rate risk.

During ALCO meetings, specific strategies should be discussed, formulated and then documented in the minutes.  The objectives of the different strategies would revolve around profit improvement and/or risk management. This may require some adjustment on the part of management, but using this time to plan and strategize for the future will be well spent.

The Asset/Liability Committee should also be responsible for creating policies that specify risk tolerance limits as well as how the bank plans to stay within those limits. Sometimes, compliance tools/worksheets need to be created and/or enhanced to monitor and document board approved limits.  Whenever ALCO sets limits or goals such as these, remember to make sure that the goals are quantifiable.  For example, a goal to simply reduce earnings sensitivity to rising rates is not very useful and may even be counterproductive.  Instead, the following questions would need to be answered to provide more focus and direction:

• What is our maximum acceptable earnings sensitivity?
• What individuals/departments are responsible for achieving this goal?
• What is our timeframe for accomplishing this goal?

Forecasting and Measuring Interest Rate Risk

For your planning and strategizing to be meaningful, it is necessary for the ALCO to consider a number of variables affecting the bank’s risk profile.  The main one, obviously, is interest rates.  By now, most, if not all banks are simulating rate shocks of +/- 400 basis points to see the effect on earnings.  A good practice in addition to this is simulating non-parallel rate shifts (e.g., the short end of the yield curve rising faster than the long end) to see the effect on earnings in a variety of scenarios.

Other variables to focus on include such things as loan prepayment speeds, betas/decay rates for deposit accounts (NOW and MMDA), and pricing spreads.  Any assumptions that are made relating to these variables need to be reviewed at the ALCO meetings to see if changes in the rate environment or the balance sheet call for adjusting the assumptions.  For example, a period of rising interest rates normally results in tighter loan pricing spreads.  Having assumptions that are reasonable and up to date will help ensure that interest rate risk is measurable, and thus manageable.

Benefits of an Effective ALCO Process

The benefits of an effective ALCO process are far reaching.  First of all, as was described above, it allows banks to better understand and measure risks, which, in turn, enables them to better manage them and plan for the future.  All of this helps lead the bank towards finding an appropriate strategy based on its unique circumstances, and ultimately should help stabilize and/or improve earnings.  Bank analysts have said for years there is a correlation between higher performing banks and institutions that have effective and productive asset-liability management.  For example, squeezing an additional 10 basis points of net interest margin on earning assets of $100 million is $100,000 pre-tax.  That is the benefit just for one year!

Aside from all of this is that it shows regulators that management is going the extra mile to be prepared for any situation.  Regulators these days are being especially critical of lax or deficient Asset/Liability policies and procedures.  The ability to discuss, quantify, evaluate, and document the various components of the balance sheet management process will demonstrate to examiners that the bank is going well beyond what is required.

Conclusion:  The goal of the ALCO is to bring accountability and a proactive focus to the balance sheet management process while promoting responsible governance and oversight.  A forward-looking approach to evaluating different strategies and how their risk/reward trade-offs would affect the bank’s interest rate risk profile and profitability is essential, both internally for the bank, and externally for the regulators.