Mar 13 2014

Asset-Liability Management: Theory, Practice, Implementation, and the Role of Judgment

Evaluating interest rate risk (IRR) will remain a chief priority for credit union executives, especially when enforcing an effective asset-liability management (ALM) policy. Credit unions should identify pressing IRR issues and implement solutions that will allow them to withstand volatility related to periods of rapidly rising interest rates

John Brick
Brick & Associates, Inc.
Report Number 325

Executive Summary

When the S&L industry ran into jackknifing interest rates in the late 1970s and early 1980s, its fixed-rate mortgage- heavy balance sheet was ill pre-pared. You know how that story ends.

Coming out of a different recession, credit unions are in a much better structural position to weather the coming rise in interest rates, with only 25% of assets hitched to long-term mortgages, and a much healthier mix of checking, savings, and money market products funding those assets. But regulators have learned their lesson, and individual institutions’ directors and managers are responsible for ALM by understanding and modeling their own IRR. As products proliferate, portfolios grow, and examiners watch, credit unions need to know their risks and set sound policies.

What is the Research about?

Different perspectives and risk tolerances between credit union practitioners and credit union examiners mean that both groups take different approaches to analysis and policy. Generally speaking, examiners seek practices that minimize IRR as much as possible and may ask for analysis and policies that credit unions consider unrealistic. Credit unions seek to understand and mitigate IRR but do not always agree with the demands imposed by examiners. This research seeks to balance the priorities of both by placing ALM in historical perspective and outlining the variables that dictate its current practice.

The full report provides a comprehensive review and operational insights for both financial professionals and the directors who oversee them. In recent years, the author’s firm prepared a number of separate papers focusing on specific aspects of the ALM process. This report is both a compilation and an extension of those earlier efforts in a cohesive framework.

What are the credit union implications?

After reaching record levels in the early 1980s, interest rates then entered a prolonged stretch of declining rates spanning over three decades. There were relatively short periods when short-term rates increased 200 to well over 500 basis points (bps). However, with the exception of those occurring in the early 1980s, these increases were not sustained. The resulting income pressure due to the high levels of IRR was short-lived, and relief was quickly forthcoming as rates declined. Thus, credit unions did not feel the full and potentially devastating effects of these episodes. This means that despite a much better understanding of IRR and more powerful analytical tools, financial institutions have not been tested in a prolonged period of rapidly rising interest rates that have been sustained at a high level.

Three near-term possibilities will test credit unions’ collective IRR: (1) a return to a more “normal” level of interest rates when the Fed ends its ultra-low interest rate policy, (2) a stronger economy and lower levels of unemployment and underemployment, and (3) increased inflation or inflationary expectations.

Other important considerations from the report:

  • Net economic value (NEV) and income simulation. Using these approaches in tandem is healthy. A shocked NEV provides a single, all- inclusive statistic that captures complex relationships, including durations and embedded options. Income simulation over a three- to five-year period allows managers to forecast the effect of rate shocks while understanding the interplay of other factors, like operating expenses, loss provisions, and non-interest income.
  • Non-maturity deposits (NMDs). One of the shortcomings of NEV analysis is that it depends heavily on assumptions for valuing NMDs, which are subject to immediate withdrawal but which, in aggregate, act like long-term deposits. NMDs may provide a degree of protection against rising rates, but credit unions should understand the historical behavior of their own NMDs and fully understand the assumptions embedded in any ALM analysis of those deposits.
  • Systemic risk. Changes in regulations and balance sheet structures mean that the credit union system of 2014 is far less risky than the S&Ls of the 1980s. In the unlikely event that interest rates rise quickly to double digits, many individual credit unions would suffer, but the damage is unlikely to match the full rout suffered by S&Ls in the 1980s.

The key takeaway is the need for effective IRR management and build-ing in a margin of safety in the ALM modeling process. To paraphrase a long- standing caveat in the investment community, past performance (in managing IRR) is not a guarantee of future performance.