Understanding "new norm" in balance sheet risk management

While time has certainly flown by for me, I am acutely aware that time has slowed to a crawl for too many bankers who have been examined recently. Unfortunately, comments my firm continues to hear around the country from CEOs, CFOs, and board members with freshly minted reports of examination in their hands remind me of a quote from Benjamin Franklin:

“By failing to prepare you are preparing to fail.”

The word “fail” here communicates the very real prospect for “consequences” associated with the failure to adequately comply with the 2010 guidance on interest rate risk and liquidity risk management.

Let there be no confusion: The rules have changed and the bar raised to new heights. Exam results continue to demonstrate the unwavering regulatory expectation that the bar be readily cleared.

Never have regulators delved into the depths of every aspect of bank balance sheet risk management processes as they are now. They are rolling up their sleeves, digging into everything. This includes data integrity, assumption development, model accuracy/validation, stress testing, risk limits, ALCO reporting, strategy development, board reporting, and policies. They are asking tough questions in order to assess the adequacy of bank interest rate risk and liquidity risk management activities.

There is a “new norm” in balance sheet risk management.

This article highlights the importance of being prepared; provides some steps banks can take to better prepare for their next exam; and presents a brief overview of some potential regulatory “coming attractions” impacting ALCO.

Importance of being prepared

It is impossible to over-prepare for your next exam. The consequences of inadequate preparation are too severe. And the “rules of engagement” being applied throughout the regulatory community can be quite inconsistent, placing a big premium on being prepared for the unexpected.

If asked a tough question, especially if in the middle of an overall challenging exam, how comfortable would it be to respond, “Can I get back to you tomorrow?”  Or, if told that you have to do something as “required” by regulatory guidance, are you sure you know what is truly required? Have you put yourself in the appropriate position to “push back,” if necessary? 

Many banks are currently investing valuable time and money doing things stipulated in their last exam that not only are not required by regulatory guidance, but also have little, if any, utility. The vast majority of those banks are the ones inadequately prepared, and therefore, were not in the best of positions to do anything to head off such unfortunate outcomes.

Getting ready for the next exam

Take control of the balance sheet risk management components of your next exam. It has been done quite successfully by numerous banks whose ALCO-related rigor and discipline enabled them to “get out in front” of their regulators by:

• Being honest with themselves, thereby enabling their banks to shore up risk management processes in advance of trouble, and exams.

• Putting themselves in the regulators’ shoes, thinking out what they want to see.

• Playing devil’s advocate by anticipating “the tough questions.”

• Documenting, documenting, documenting.

These banks have become successful implementing an ALCO process that encompasses the key risk management activities noted above: data, assumptions, validation, reporting, stress testing, strategy development, and policies.

How comfortable would your bank be in inviting regulators to sit in on your next ALCO meeting? I know numerous banks with a well-functioning and dynamic ALCO process that “insist” regulators attend their meeting when on-site for their exam.

Why? Because it is a home run!

Preparing for the next exam

While it is impractical to provide within this article a “how to” checklist for guaranteeing that you are appropriately prepared for your next exam, the following provides an overview of some of the more important elements to consider.

1. Interest rate risk

Clearly, instrument-level data (vs. aggregate data) is far superior for measuring interest- rate sensitivity. It is especially true for balance sheets with significant embedded options, such as interest-rate caps and floors on loans.

The person who controls the assumptions, controls the results. A rigorous approach to assumption development is critical. It is important that management responsible for each area of the balance sheet (e.g. retail deposits, commercial lending, residential lending, investments, etc.) be engaged in this process to ensure that product and pricing assumptions in the bank’s simulation model reflect current activity and expectations. This involvement also needs to be documented.

The old adage “garbage in, garbage out” applies in bank interest risk modeling. I continue to be surprised by the amount of “garbage” seen.

It is not that difficult to validate the accuracy of your model.

Make sure you back-test the results of your ALCO model by comparing to actual results and documenting an analysis of meaningful variances. Technically, every bank is required by regulation to validate their model/process annually by an independent party (either internal or external).

Underperforming ALCOs frequently suffer from reporting packages that miss the mark. A common shortcoming we observe are packages that are inundated with unnecessary detail that skews valuable ALCO time to focusing on the past, as opposed to the future (where are we headed and what are we going to do).

Another limitation relates to ALCO packages that look pretty with color, charts, and graphs, but fall far short in painting a clear picture of the bank’s risk position. While it looks great, it is not very helpful in facilitating a meaningful discussion. What’s missing is a breadth and depth of scenarios analyzed and how those results are presented.

Concerns by the regulatory community regarding an appropriate understanding by banks of their interest rate risk position are embodied in the interagency guidance discussion on stress testing. Make sure your interest-rate-risk model includes the following:

• Simulation horizons that reflect at least 5 years.

• Scenarios that include at least a 400 basis point increase in rates.

• Scenarios that examine non-parallel yield curve shifts (e.g. flattening as rates rise).

• At least one interest rate shock scenario in the 300-400 basis point range.

• Economic Value of Equity (EVE) analysis.

My firm believes that rate ramp scenarios (vs. rate shocks) are far superior in helping bank management and their boards understand how rate changes are likely to flow through their earnings, and thus better facilitate strategy development. Notwithstanding, many regulators are demanding that banks prepare shock analyses. For whatever it’s worth, the scenarios we currently run for the approximately 300 bank models we prepare quarterly are as follows:

• -100 bp (actually a flattening of the curve)

• +200 bp rate ramp over 1 year

• +400 bp rate ramp over 2 years

• +500 bp with substantial yield curve flattening over 2 years

• +300 bp instantaneous parallel shock

Under the heading of stress testing also falls testing the sensitivity of key assumptions. Some of the more notable ones are prepayment sensitivity; deposit decay/migration; and price sensitivity of non-maturity deposits. As with any analytical exercise, banks need to avoid running so many different scenarios that one creates “analysis paralysis.”

Remember, the purpose of ALCO is simple: strategy development. At the end of the day the real purpose of risk management software is not to build a model. Rather, it is to facilitate decision-making. Do not underestimate the importance of this distinction.

The best ALCOs understand this quite clearly. And so now does the regulatory community, as evidenced in their guidance that put the industry on notice that they will be examining how risk measurement and analysis is utilized to make decisions.

2. Liquidity risk

Liquidity risk management could warrant a separate article of its own. While the bar has been raised on interest rate risk management, it has rocketed skyward for liquidity risk management. This applies to both operating and contingency liquidity management.

Liquidity risk management depends heavily on individual bank circumstances. Here are the elements of liquidity risk management that you should ensure are adequately addressed within your bank:

• Quantification of both on- and off-balance sheet liquidity with policy minimums.

• Documentation of discussions regarding loan and deposit growth for near-term (e.g. next 90 days) and longer-term (e.g. 9-12 month outlook) horizons, including implications of resulting cash shortfalls or excesses.

• Contingency liquidity policy that sounds more like a procedures manual than a typical policy might read.

• Contingency liquidity plan that includes:

• A risk monitor report that incorporates ratios, trends, and situations considered to be potential early warning indicators for a liquidity challenge or crisis.

• Cash flow projections out at least 1 year (preferably 2 years) reflecting net cash positions, including assumptions for deposit rollovers, loan renewals/activity, investment activity, and wholesale funding rollovers.

• Quantification of funding capacity from unencumbered securities and various policy approved wholesale funding sources available for contingencies.

• Descriptions and modeling of a series of increasingly stressful financial situations and the potential impact on customer behavior (e.g. deposit withdrawals/non-renewals, credit line draws, etc.) and availability of credit facilities (e.g. fed funds lines, Federal Home Loan Banks, brokered deposits, Fed, etc.) in order to quantify the potential degree and timing of liquidity problems.

• Pre-emptive strategies that the bank will implement in response to the triggering of early warning indicators, as well as to avoid/mitigate liquidity stresses reflected in the stress-testing exercises;

• Quarterly updates of contingency plan (more frequent if currently operating with liquidity stress).

• Board reporting of contingency planning activities, related stress testing results, and required actions, if any.

What’s on the regulatory radar?

The “new norm” is still a work in process for the regulatory community. Certainly, there are other risk-management-related issues on the regulatory radar screen.

1. Municipal securities. The fiscal wellbeing of municipalities and the potential for credit quality issues within the municipal bond market has been featured in headlines recently.

Banks with municipal bonds should ensure that they prepare an analysis of their municipal portfolio, and report their assessment to the pertinent committees. True, bank municipal portfolios consist primarily of small individual bonds, relative to legal lending limits and bank capital. However, the current environment warrants a confirmation of your bank’s municipal bond strategy, and the establishment of portfolio limits relative to capital.

2. On-balance-sheet liquidity. Given events of the last two years, there is a strong current preference among regulators for on-balance-sheet liquidity. In a number of cases we have seen this manifest itself in a bank’s being told it must maintain a minimum level of cash equivalents and/or unencumbered marketable securities on their balance sheets.  This requirement is generally expressed as a percentage of assets.

Since the ranges imposed have varied greatly, with some circumstantial, I am intentionally excluding any reference to specific metrics. (I don’t want to alarm you too much). Suffice it to say that there is a reasonable probability that the current regulatory sentiment, combined with elements of Basel III, will result in banks having to allocate a larger component of their capital in support of on-balance-sheet liquidity that is carried in the form of investment securities.

3. Shifts to the regulatory capital calculation. Bankers know of the increased focus on tangible equity, as well as talk at the Financial Accounting Standards Board regarding the elimination of the HTM (Held To Maturity) designation for securities. Now, there is some grapevine buzz that the regulatory community is considering the inclusion of tax- adjusted unrealized gains/losses on securities in the regulatory capital calculation.

Substantial ramifications for bank investment portfolio strategy are in the offing, should this occur.

In fact, let’s hope this is a bad rumor. It seems difficult to imagine why Washington would change the rules in a manner that would have the following effects: 

1. Lowering bank capital, thereby limiting growth capacity (ability to lend) at precisely the time our country would be looking to the banking system to support economic activity.

2. Reducing bank earnings, as they shorten the duration of bank investment portfolios to minimize the impact of the first point.

3. Removing a meaningful tool for interest-rate-risk management tool from banks that are asset sensitive (e.g. extend duration of investment portfolio at higher rate levels to protect against the negative impact of declining rates).

Adjusting to the “new norm”

The days when bankers took interest rate risk and liquidity risk management for granted—and did only what was deemed sufficient to keep the regulatory monkey off their backs—are over.

The best-prepared banks tend to focus their ALCO energies on strategy-related discussions. By emphasizing strategy development, these banks recognize the importance of succinct and clear presentation of the bank’s risk position and related risk drivers. This in turn drives the need for ensuring that risk measurement and modeling is sufficiently robust and based upon a disciplined approach to data gathering, assumption development, and validation. There is a mindset that permeates the organization that makes a real difference. It all begins with establishing the appropriate focus.

The point here is that your bank cannot become complacent with its ALCO process. The banking industry is in a state of flux, and bank risk management processes must be nimble—and constantly looking around the corner for oncoming traffic.

About the author

Matthew Pieniazek is the president of Darling Consulting Group (DCG), working nationwide with financial institutions in the areas of asset liability management, capital management, strategic planning, and mergers and acquisitions. In addition to assisting in the development of solutions for earnings enhancement and risk mitigation, he is active in helping institutions manage through the rigors of the current economic and regulatory environments.