Why ALM Practices Should Go Beyond Compliance & into Strategic Planning

Over the last two years, I have often found myself mystified while reviewing the Asset Liability Management (ALM) practices of my community banking clients. When I ask for liquidity forecasts, many times I get a blank stare. At best I may receive a forecast for an upcoming week — with nothing beyond that timeframe.

While cutting my "ALM teeth" in the thrift industry in the mid-'80s, accurate ALM modeling meant survival in many cases. Fast-forwarding to today, I find most community banks light years behind where my thrift was 25 years ago! Interest-rate risk measurements are usually bare-bones and prepared to comply with minimums required to pass regulatory muster. And, although ALCO meetings are held, the information reviewed tends to bog down in product details rather than focus on strategic balance sheet and earnings management.

Frankly, I'm puzzled by this state of ALM in banks, especially in light of the current economic environment, and I want to help CUs avoid the trap that many of these banks seem to have fallen into. This background might help.

In May 1996, a Joint Policy Statement on Interest Rate Risk (IRR) management was issued by the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC providing guidance to examiners and bankers on sound practices for managing interest rate risk.

In 1999, NCUA issued guidance on ALM, and in a November 2000 letter explained new examination procedures related to IRR. In general, these regulators provide broad guidance for IRR Management related to these areas:

  • Oversight responsibility of board and senior management.
  • Establish risk controls, limits, policies and procedures.
  • Establish an appropriate system for measuring, monitoring and reporting.
  • Establish an effective risk management and internal control audit environment.
Many early interpretations of these guidelines focused on "validation audits" of the ALM software itself. And, while the mathematical integrity of a model is certainly important, it is not an audit expenditure often considered as adding member-value. In fact most of the major providers of ALM models (Sendero, Profitstar, Plansmith, etc.) today have annual "validation audits" verifying the mathematical integrity of the model itself. At a minimum, your model vendor should provide support that such an audit is being conducted on an annual basis. If this has not been done, detail model testing will need to be performed to make sure the model is correctly performing mathematical calculations.

In addition to ALM-software validation audits, many CU executives are opting to have an independent review of their ALM modeling processes to provide substantive ideas and recommendations for improving overall balance sheet decision-making processes. These reviews are normally conducted by qualified ALM auditors through discussions with credit union personnel responsible for modeling and an analysis of all applicable information. Your auditor should evaluate:

  • Interest rate risk measurement based on business complexity.
  • Data sources for investments, loans, deposits, borrowings, off-balance sheet derivatives, interest rate scenarios, prepayments, embedded options, product pricing assumptions and forecasts.
  • Modeling assumptions and methodologies, including liquidity considerations.
  • Review of valuation (EVE) and IRR volatility under alternative interest rate scenarios.
  • Forecast vs. actual results (and back-testing procedures).
  • Internal controls, process documentation and staffing adequacy.
Executives at best practice CU reach beyond having an IRR audit simply to satisfy regulators that they are compliant with their IRR Management and ALM processes. Rather, their extended ALM framework is the basis for strategy development. Their boards understand the value added by a functional ALCO. These credit union executives want their ALM auditor to provide a more detailed evaluation of measurement techniques, such as those used for liquidity, interest rate risk, capital and earnings management and investments.

IRR and ALM-related policies language goes beyond the standard boilerplate. Policies are now written to align with the credit union board's and management's operating philosophy - providing the flexibility needed to make prudent and proactive decisions. This involves requesting your auditor provide you with suggestions on strengthening related policies based on what is observed as working for other financial institution clients.

ALCO meetings are not limited to recapping the month's financial performance and compliance measures; they now now focus on developing strategy, establishing specific goals and plans, setting prices, evaluating risk and creating action plans. ALCO members receive the necessary information required to make critical strategic decisions. Your ALM auditor should be able to review your ALCO reporting package and help you most effectively report your CU's current risk profile.

I will be happy to send you an ALM-policy framework you can use to refine your own policies.

Terry Treadwell is a CPA providing internal audit services to CUs. She can be reached at ttreadwe@tampabay.rr.com or 813-920-1226.

Where to Go for Guidance

Review examiner guides used for evaluating a credit union's IRR practices.

A checklist of IRR review procedures.