FDIC presentation on Asset Liability Management Process 4-11

ALCO Responsibilities – Liquidity Risk Exposure • The ALCO should actively monitor the institution’s liquidity profile and should have sufficiently broad representation across major ins

The ALCO Process:

A View From the Regulatory Arena

• Review areas of the ALCO policy and/or ALCO

activities that could be enhanced

• Discuss liquidity risk management

• Review new IRR guidance

• Discuss regulatory ALM modeling tips

• Introduce upcoming guidance on credit risk

analysis of investment securities

Asset-Liability Committee (ALCO)

Responsibilities

ALCO Composition

• Senior management committee in a financial institution responsible for coordinating the institution's borrowing and lending strategy, and funds acquisition to meet profitability objectives as interest rates change.

ALCO Responsibilities – Liquidity Risk Exposure

• The ALCO should actively monitor the institution’s liquidity profile and should have

sufficiently broad representation across major institutional functions that can directly influence the institution’s liquidity risk profile (e.g., lending, investment securities,

wholesale and retail funding).

• For example, the ALCO will have responsibility for setting limits on the arbitrage of

short-term borrowing, while lending long-term instruments Among the factors

considered are liquidity risk, interest rate risk, operational risk and external events that may affect the bank's forecast and strategic balance-sheet allocations.

ALCO Responsibilities – Interest Rate Risk Exposure

• The ALCO should ensure that the risk measurement system adequately identifies and quantifies risk exposure.

Reporting

• The ALCO will generally report to the board of directors and will also have regulatory reporting responsibilities Reporting process should communicate accurate, timely, and relevant information about the level and sources of risk exposure.

Asset-Liability Management

• Typically, asset-liability management

(ALM) is associated with reporting a

financial institution’s historical Gap, EVE,

and net interest income sensitivity results.

• Ideally, ALM should involve an integrated process between interest rate risk, liquidity risk management, budgeting, and strategic planning that includes the entire bank; and develops future dynamic strategies that

balance risk and profitability

ALCO Best Practices Observed in Community Banks

• Although there is no official written guidance that outlines regulatory

expectations of the ALCO , the following are ALCO best practices observed

by examiners of community banks:

o Liquidity that is readily available, including the availability of collateral to be pledged.

o Credit lines accessible with material adverse change clauses readily

accessible to determine circumstances that would disallow use of the lines.

o Limitations on particular types of deposits that can be accumulated, for example, municipal deposits.

o ALCO package that includes a 1-page summary covering all key model

assumptions including any recent changes to the assumptions.

o Funding diversification guidelines.

o Establishing targets and composition mix of the investment portfolio.

o IRR and liquidity limits that require action vs additional discussion (e.g., Red, Yellow, Green).

o ALCO packages that show level and trends vs just showing the level

specifically for risk limits.

o Cash flow coverage for runoff of collateralized deposits.

o Testing credit lines at least annually.

ALCO Best Practices Observed in Community Banks (con’d)

• Although there is no official written guidance that outlines regulatory expectations of the ALCO policy , the following are ALCO policy best practices observed by examiners of

community banks:

o Has substance, structure and focus.

o Ties-in other policy parameters, e.g., Investment Policy

guidelines and the impact on liquidity.

o Includes description of how key assumptions are

determined, and the source documents used to make the assumptions.

o Includes minimum risk limits for maintaining liquid,

unencumbered assets.

o Includes a definition of liquidity assets.

o Outlines expectations for independent review.

o Includes funding risk limits by maturity, e.g., limits on

short-What can a well-run ALCO do even better?

• Provide clearer and more descriptive language in the ALCO minutes in regards to ALCO meetings For example

o Who contributes to the discussion?

o What is actually said?

• Provide details on the status, risks, and results of previously implemented strategies

• Conduct sensitivity testing of key assumptions

• Further develop contingency planning

• Back-testing

Common Examination Criticisms of the ALCO Function and/or ALCO Policy

• Lack of detail on type of collateral available for pledging purposes.

• Ability to track borrowing capacity and availability of funding from various

sources.

• Lack of policy limits for liquidity, or lack of meaningful policy limits.

• Inability of management to explain why certain limits were established.

• Base-case and stress scenarios are not adequately explained relative to the

bank’s overall condition.

• Inadequate modeling of new products and/or new strategies prior to

• Lack of documentation for key assumptions, e.g., deposit betas, prepayments.

• No sensitivity testing of key assumptions.

Liquidity Risk Management:

• Contingency Funding Plans

• Liquid Asset Cushion

Corporate Governance

• Understanding nature of risk

• Periodic reviews

• Lines of authority and responsibility

• Development and implementation of

appropriate policies and risk measurement and monitoring systems

Risk Tolerances

• Unencumbered liquid asset reserves

• Identification of unstable and liquid asset coverage ratios

• Cash flow projections

• Funding concentrations

Liquidity Risk Measurement, Monitoring,

and Reporting

• Cash flow projections

• Reasonable, appropriate, and

well-documented assumptions

• Meaningful time horizons

Stress Testing

• Institution specific scenarios

• Market wide events

• Multiple time horizons

• Sources of potential liquidity strain

• Impact on cash flows, liquidity position,

profitability, and solvency

Collateral Position Management

• Value of pledged assets relative to amount

of security required

• Unencumbered assets available to be

pledged

Funding Diversification

• Effective diversification in the types and

tenor of sources

• Maintenance of market access

• Identification of alternative funding

sources in a variety of scenarios

Contingency Funding Plans

• Identify Stress Events

• Assess Levels of Severity and Timing

• Assess Funding Sources and Needs

• Identify Potential Funding Sources

• Establish Liquidity Even Management

Processes

• Establish a Monitoring Framework for

Contingent Events

Contingency Funding Triggers

Liquid Asset Cushion

• Availability of a cushion of liquid assets

without legal, regulatory, or operational

impediments

• Availability to be sold or pledged to obtain funds in a range of stress scenarios

• Inclusion of contractual and

noncontractual cash flows

Advisory on Interest Rate Risk

Management (January 6, 2010)

Interest Rate Risk Guidance

• FIL-52-96: Joint Interagency Policy

Statement on Interest Rate Risk

• FIL-2-2010: Financial Institution

Management of Interest Rate Risk

Why did we issue the advisory?

• Address the importance of having robust

processes for measuring and mitigating, as

necessary, exposures to potential increases in

interest rates

• Emphasize the importance of effective corporate governance, policies and procedures, risk

measuring and monitoring systems, stress

testing, and internal controls

IRR Guidance:

Major Areas of Concern

• Corporate Governance

 Understanding risk profile.

 Establishment, approval, and implementation of IRR management strategies, policies, procedures and risk tolerances.

 Integration of new strategies, products, and business into IRR system.

 Firm-wide risk management efforts.

• Measurement and Monitoring of IRR

 Fully understand underlying analytics, assumptions, and methodologies.

 Selection of appropriate time horizons.

 Prolonged rate shocks.

 Changes in relationships in key rates and slope of yield curve.

IRR Guidance:

Major Areas of Concern

• Risk Mitigating Steps

 Identification of IRR exposures

 Discussions of risk and appropriate action steps given the scenario

• Internal Controls and Validation – Model

General Theme

All measurement involves error As a result, there is a need to:

• Sensitivity Test – How wrong on average?

• Stress Test – How bad can it get?

• Back Test – How accurate were my forecasts?

Regulatory Tips: ALM Model Theory

• Identify the bank’s appetite for IRR in

comparison to credit risk and other risk types

• Ensure that IRR measurement guideline

exposure limits are consistent with the bank’s

IRR appetite

• Consider a “risk management” rather than a

“budget” perspective for IRR measurement

• Consider running a no growth scenario if the

bank budgets ≥ 10% asset growth

Regulatory Tips: ALM Models & Assumptions

• Consider the following:

 moving beyond a simple gap model if significant

optionality exists (almost always)

 use ALM models that capture long-term IRR exposure (extended simulations and/or EVE)

• Ensure that management understands and

supports the bank’s most critical ALM modeling assumptions

• Consider identifying all critical model

assumptions in writing

Regulatory Tips: Critical Model Inputs

Assumptions that significantly impact model

output:

 Starting balance sheet (chart of accounts)

 Scenarios & interest rates

 Growth & new business assumptions

 Prepayment assumptions

 Deposit Repricing and NMD assumptions

Regulatory Tips:

Scenarios & Interest Rate Assumptions

• Consider at least a +/- 300bp rate change over one year (or more spontaneous) in the worst case scenario

• While banks are not required to perform +/- 400bp rate shocks, the IRR Advisory allows examiners the latitude to determine that based upon the institution’s profile and current economic conditions, a +/- 400bp shock is necessary.

 For example, in a period of extremely low interest rates, +400bp shocks would likely provide helpful risk management insights into IRR

exposures, and/or identify some weaknesses in the current balance

Regulatory Tips: Back-testing

• Assess model assumptions and results.

• For less complex institutions, may be

largely narrative.

• Ensure directional consistency.

 Over reliance on credit ratings and insufficient internal credit analyses have increased supervisory concerns.

• Supervisory Policy

 Re-emphasizes pre- and post-purchase guidance outlined in the

Interagency 1998 Supervisory Policy Statement on Investment

 Due diligence review of the legal documents associated with debt

securities includes management review of materials, such as,

prospectuses/offering circulars, indentures, trustee reports, pooling and servicing agreements, and reps and warranty agreements.

• The ALM process should identify, measure,

monitor and proactively manage funds

management and IRR exposure

• Examiners have identified community bank best practices for the ALCO and the ALCO policy

• Recently issued supervisory guidance on funding/liquidity risk management and IRR provide

further clarity on regulatory expectations of the ALCO

• Also, upcoming guidance on credit risk analysis

of investment securities emphasizes acceptable methods of analyzing the credit risk factors of a debt security pre- and post-purchase

Questions?