ALM Basics Understanding Your ALM Reports Presented By: Jeff Fransen ALM Analyst Southwest Corporate

1
ALM Basics Understanding Your ALM
ReportsPresented ByJeff FransenA/LM
AnalystSouthwest Corporate Investment
ServicesPlano, TXMarch 24, 2009
2
Overview

• Asset/Liability Management (A/LM) Defined
• Objectives and Purpose of A/LM
• Risk Fundamentals
• Methods Used to Assess Interest Rate Risk
• Interpreting and tracking Interest Rate Risk

3
Asset/Liability Management (A/LM)

• The process of structuring assets (loan and
  investment products, rates, terms, etc.) and
  liabilities (share products, rates, terms, etc.)
  to maintain sufficient future positive earnings
  and capital strength.

Source NCUA Examiners Guide
4
Objectives of Asset/Liability Management

• Capital Adequacy
• Maintain adequate levels of capital such that
  solvency is not threatened by significant and
  prolonged changes in the level of interest rates
• Earnings Stability
• Ensure that net interest income is sufficient and
  stable to cover operating expenses, loan
  charge-offs, investment losses, and other
  non-operating losses over all phases of the
  interest rate cycle
• Liquidity Management
• Maintain sufficient liquid assets to meet normal
  and seasonal patterns in loan and share flows
• Ability to sell an investment without incurring
  significant costs and/or penalties

4
5
Purpose of A/LM

• To establish an A/LM program to reasonably
• Identify,
• Measure,
• Monitor,
• Report,
• and Control
• Interest Rate Risk.

6
Risk Fundamentals

• Interest Rate Risk
• The risk that changes in prevailing interest
  rates will adversely affect assets, liabilities,
  capital, income, and/or expense at different
  times or in different amounts

7
Risk Fundamentals (cont.)

• Types of Interest Rate Risk
• Mismatch Risk
• Imbalance of maturity structure between Assets
  Liabilities
• Commonly associated with funding long-term fixed
  rate assets with short-term deposits and non-term
  shares
• Reinvestment Risk
• Risk of reinvesting principal and interest at
  lower interest rates
• Embedded Option Risk
• The risk that arises from a characteristic of an
  asset or liability that can alter the term or
  cash flow structure
• Commonly associated with prepayment and call
  options

7
8
Risk Fundamentals (cont.)

• Types of Interest Rate Risk
• Price Risk
• Risk that a change in interest rates will
  adversely impact the valuation of assets
• Commonly associated with Available For Sale
  investments
• Mark to Market and AFS Adjustments

8
9
Methods Used to Assess Interest Rate Risk

• Gap Ratio Analysis
• Income Simulation
• Net Economic Value (NEV)
• The method should identify, measure, and monitor
  interest rate risk. Risk limits should be
  quantified.

10
Gap Ratio

• Short-term risk measurement
• Identifies maturity and repricing mismatches
  between assets and liabilities
• Proxy for change in the gross spread over the Gap
  time horizon
• Used for credit unions with non-complex balance
  sheets
• Complex Credit Union
• Complex investments
• Embedded options
• Remaining maturities in excess of three years
• Long-term real estate loans

11
Gap as an A/LM Tool

• Rate Sensitive Gap (RSGAP)
• Rate Sensitive Assets Rate Sensitive
  Liabilities
• Rate Sensitive Assets Assets maturing/repricing
  within Gap time horizon
• Rate Sensitive Liabilities Liabilities
  maturing/repricing within Gap time horizon
• RSGAP Ratio
• Rate Sensitive Gap / Total Assets

12
Understanding Gap

• Positive Gap Asset Sensitive
• Rising interest rates improve net interest
  income, falling rates reduce net interest income
• Negative Gap Liability Sensitive
• Rising rates reduce net interest income, falling
  rates improve net interest income

13
Gap Report
14
Gap Report

• Step 1 Identify Gap Ratio
• Step 2 Determine if Asset or Liability
  Sensitive
• Step 3 Identify Key Drivers within Assets and
  Liabilities
• Step 4 Understand how the ratio is being
  impacted
• Conclusion Mismatch risk between repricing
  assets and repricing liabilities.
• Large CD balance implying half of the credit
  unions CDs will be repricing in the next 6 months.

15
Gap Report
16
Gap Report

• Step 1 Identify Gap Ratio
• Step 2 Determine if Asset or Liability
  Sensitive
• Step 3 Identify Key Drivers within Assets and
  Liabilities
• Step 4 Understand how the ratio is being
  impacted
• Conclusion favorable Gap ratio for a falling
  rate environment.
• NTS repricing at faster rate, driving higher
  negative ratio.
• Callable investments will be called

17
Gap Ratio Analysis Summary

• Short Term risk measure
• Focuses on maturity and repricing mismatches
  between assets and liabilities
• Works as a rough proxy for a change in the gross
  spread over the near term
• Remember
• Ratios asset sensitive
• Good for rising rates
• -Ratios Liability sensitive
• Good for falling rates

18
Income Simulation

• Intermediate-term risk measurement
• Simulates impact of rate changes on net interest
  income and net income
• Used for credit unions with complex balance sheets

19
Income Simulation

• Positive Change in NII
• NII increases over the stated time period given
  all assumptions.
• Negative Change in NII
• NII Decreases over the stated time period given
  all assumptions.

20
Income Simulation Report
21
Income Simulation Report

• Step 1 identify rate scenarios
• Step 2 observe risk in each scenario
• Step 3 identify drivers of risk
• Large changes (volatility) in interest income or
  expense
• What is driving the volatility of interest income
  and expense

22
Income Simulation Report

• Step 3 Identify drivers of risk
• Large changes (volatility) in interest income or
  expense
• What is driving the volatility of interest income
  and expense

23
Income Simulation Report

• Conclusion
• Interest income and volatility (risk) is
  generated from real estate portfolio
• Due in large part to total balance relative to
  total assets
• Interest expense volatility (risk) is generate by
  the term deposits due to short average maturities
  in CD portfolio, they will reprice quickly and
  increase interest expenses

24
Income Simulation Report (2)
25
Income Simulation Report (2)

• Step 1 identify rate scenarios
• Step 2 observe risk in each scenario
• Step 3 identify drivers of risk
• Large changes (volatility) in interest income or
  expense
• What is driving the volatility of interest income
  and expense

26
Income Simulation Report (2)

• Step 3 Identify drivers of risk
• Large changes (volatility) in interest income or
  expense
• What is driving the volatility of interest income
  and expense

27
Income Simulation Report (2)

• Conclusion
• Largest risk exposure to assets comes from
  vehicle loans portfolio
• Due to short average maturities in CD portfolio,
  they will reprice quickly and increase interest
  expenses
• Though NTS balance grew, risk from NTS increased
  marginally

28
NII Simulation Analysis Summary

• Intermediate term risk measure
• Projects income and expenses to identify earnings
  volatility
• Easily illustrates the impact of changing
  interest rates on NII and NI
• Remember
• change NII is increasing
• - change NII is decreasing

29
Net Economic Value (NEV)

• Long-term risk measurement
• Measures the value of equity at a point in time
  by discounting interest income and interest
  expense over the life of the existing balance
  sheet
• Net Present Value (NPV) of projected Net Interest
  Income (NII) stream
• Employed by credit unions with complex balance
  sheets

29
30
Net Economic Value (NEV)

• Calculated as the market value of assets less the
  market value of liabilities Non-earning assets
  liabilities are held at book value
• Market Value of Assets (MVA)
• Net present value of all interest earning assets
• Market Value of Liabilities (MVL)
• Net present value of all cost bearing liabilities
• Net Economic Value of Equity (NEV)
• NEV MVA - MVL

30
31
Net Economic Value (NEV)

• Risk is determined by measuring the volatility of
  NEV in the various rate shock scenarios
• Higher percentage changes in the value of equity
  imply increased levels of risk
• Positive change in NEV
• Suggests that the value of equity should increase
  over the life of the balance sheet implies a
  positive relationship between gross spread and
  market interest rates
• Negative change in NEV
• Suggests that the value of equity should decrease
  over the life of the balance sheet implies a
  negative relationship between gross spread and
  market interest rates

31
32
Net Economic Value
33
Net Economic Value

• Step 1 Identify rate scenarios
• Step 2 Observe Risk over scenarios to determine
  risk exposure
• Step 3 Identify risk drivers (suggestions)
• Look at total change in NEV
• Determine if asset or liability valuation is
  driving total NEV change
• See if asset valuation or liability valuation is
  more volatile
• Determine accounts w/in assets or liabilities
  driving the overall valuation

34
Net Economic Value

• Step 3 Identify risk drivers
• Determine if asset or liability valuation is
  driving total NEV change
• Determine accounts w/in assets or liabilities
  driving the overall valuation

35
Net Economic Value

• Conclusion
• Overall Risk is driven by asset side of the
  balance sheet
• Due to R/E portfolio, MBS Inv,
• While borrowings are the most volatile of
  liabilities, the NTS and term deposits are
  driving the liability valuation
• This is due to the rate sensitivity factors of
  NTS as well as the fairly short maturities of
  term CDs

36
Net Economic Value (2)
37
Net Economic Value (2)

• Step 1 Identify rate scenarios
• Step 2 Observe Risk over scenarios to determine
  risk exposure
• Step 3 Identify risk drivers (suggestions)
• Look at total change in NEV
• Determine if asset or liability valuation is
  driving total NEV change
• See if asset valuation or liability valuation is
  more volatile
• Determine accounts w/in assets or liabilities
  driving the overall valuation

38
Net Economic Value (2)

• Step 3 Identify risk drivers
• Determine if asset or liability valuation is
  driving total NEV change
• Determine accounts w/in assets or liabilities
  driving the overall valuation

39
Net Economic Value (2)

• Conclusion
• Overall Risk is driven by assets, though risk has
  been significantly reduced
• Risk still driven by Real Estate and MBS Inv
• Risk has decreased on liability side due to
  decrease in borrowings, volatility still being
  driven by NTS and Term CDs.
• Changing NTS repricing sensitivities would change
  liability volatility

40
Net Economic Value Analysis Summary

• Long-term Risk Measure
• Focuses on the change in the market value of
  equity
• Illustrates the impact of changing interest rates
  on the value of future cash flow
• Remember
• change increasing market value and gross
  spread
• - change decreasing market value and gross
  spread

41
Summary

• A/LM is an effective tool in identifying,
  measuring, monitoring, and reporting interest
  rate risk.
• Credit Unions face many different types of
  interest rate risk
• The most common methods of measuring and
  reporting risk are
• Gap, Income Simulation, Net Economic Value
• To truly understand these reports, credit unions
  need to have a process to decompose and identify
  sources and drivers of risk

42
Questions?
43
Contact Information

• Questions
• Jeff Fransen, A/LM Analyst
• [phone] extension 7874
• fransenj_at_swcorp.org
• Mark DeBree, Manager of A/LM
• [phone] extension 7873
• debreem_at_swcorp.org
• For Information on obtaining SCIS A/LM Services
• [phone]