What is a Dynamic ALCO

Transcription

1 Managing a Dynamic ALCO Managing Earnings, Value and Liquidity Risks in your Decision Making Process Presented By: David Koch President & CEO dkoch@farin.com (608) What is a Dynamic ALCO Dynamic refers to the plans and assumptions used to measure risks We aren t a static or No Change business, so why measure it? No regulations exist requiring static but has evolved over time given our approach to managing ALCO We have been complying with requirements, not ACTIVELY using ALCO to Manage Dynamic Requires You To Do More! More Discussion More Accountability More Integration of Plans with Actions that Change as Environment Changes This is NOT a course in how to appease regulators! 2 1

2 Definition: Asset/Liability Management asset/liability management is the processes of acquiring and deploying funds to maximize the earnings, and value of the institution, while controlling financial risks. Key Issues: Set Direction to Meet Capital Plan Goals for Earnings, Growth and Capital Measure All Financial Risks to Plan Measure Risk based on Return! 3 Traditional ALCO Process ALCO Measures looked at various risks in silos little interaction was assumed between each risk area and each area had its own policy. Walls separate the results from one area versus the others. Earnings at Risk Value at Risk Liquidity Risk Credit Risk 4 2

3 There s no such thing as a free lunch Governments never learn. Only people learn. - Milton Friedman No Risk, No Return Interest Rate Risk Credit Risk Liquidity Risk Regulatory Risk You Make Your Money Managing Risk! What Risks you manage, you control Managing to the Peer makes you AVERAGE! Who do you make your money for? 5 Busy Regulators January 2010: Interagency Guidance on Interest Rate Risk Management April 2010: Initial Interagency guidance on Capital & Liquidity Risk March 15, 2011: OTS Letter to CEO s on Capital Management Warning shot for increased capital planning and risk management processes April 4 th 2011: Supervisory Guidance on Model Risk Management January 6 th 2012: Interagency Advisory on Interest Rate Risk Follow up to 2010 Feb 2 nd 2012 NCUA 12-CU-05 Interest Rate Risk Requirements April 5 th 2012: Interagency Guidance on Liquidity Risk May 14th 2012 FFIEC Statement on Liquidity & Capital Stress Testing for Community FIs Don t Forget Dodd-Frank! 6 3

4 Managing Concurrent Risks Excerpt from the January 2010 FFIEC Interest Rate Risk Advisory Policies and Procedures Institutions are expected to have comprehensive policies and procedures governing all aspects of their IRR management process. Such policies and procedures should ensure the IRR implications of significant new strategies, products and businesses are integrated into IRR management process. Policies and procedures also should document and provide for controls over permissible hedging strategies and hedging instruments. Institutions should ensure the assessment of IRR is appropriately incorporated in firm-wide risk management efforts so that the interrelationships between IRR and other risks are understood. 7 Interrelated Risks Credit Risk Liquidity Risk Interest Rate Risk ALCO and Board must recognize that efforts to control one risk have impact on other risks Reducing liquidity levels raises interest rate risk levels and may increase credit risks Reducing interest rate risk levels may increase liquidity and LOWER earnings So, what s the real driver for managing ALCO risks? 8 4

5 Capital Is King Since the economic crisis of 2009, financial institutions have been urged to increase capital levels Examination Reports Regulatory Guidance New Proposed Capital regulations Increasing Capital results in less leverage Deleveraging is saying more capital! Remember Financial Institutions Manage ROE ROE = ROA * LEVERAGE Leverage = Assets / Capital More capital = Less Leverage = Less Equity Growth or Shareholder return! In order to grow assets (capital) more, must increase earnings in a commodity based industry! What does that spell for your strategic plan? 9 Interrelated Risk An Example Today many institutions are faced with the following situation: High liquidity levels earning little to no income in the investment portfolio Low loan demand, at least in products that the institution favors Low interest rates that appear to be here for a while Recovering from past credit risk mistakes, costing income to over fund the ALLL Regulatory environment that is risk adverse Low ROEs What is ALCO s goal in the next few years? 10 5

6 Interrelated Risks An Example Potential solutions and impacts: Decrease liquidity by buying investments with longer maturities and higher yield Increase earnings now and for the next few years Lose liquidity (and possibly capital) in coming years when rates rise and value of security falls Decrease liquidity by shrinking the institution Lower deposit rate even more (if you can) and drive off funding from low relationship accounts. Problem with fixed costs against a smaller denominator. May not fix ROA. Increase loans by holding longer term, fixed rate loans Increase the earnings at risk volatility as rates rise, these loans won t reprice Perception of high risks with this activity in eyes of management, board and regulators Remember the song by The FIXX One thing leads to another yeah yeah. 11 Setting ALCO Straight First, ALCO is keeper of how ALL risk management functions impact the institution Second, Risk Management is about trade-offs between risk and desired return. Why do we take risk anyway? Starts with having a desired return, but where does that come from? It s built from your Capital Plan! Or if you prefer, your Budget 12 6

7 Why is a Capital Plan Important Business strategies need to be developed and applied in the context of a business plan or strategy. We are dealing with Asset quality issues affecting earnings and capital accumulation in many shops. The probability of increased capital standards. High liquidity levels that are decreasing spreads Maturing loans and investments going back out at lower rates. Deposit costs at near 0% levels Your capital plan feeds: Core funding growth goals Non-Regulatory core funding goals Goals for overall level of investments Goals for business plan or strategy we will be evaluating and stress testing 13 Effective Capital Planning Process Horizon 3 to 5 Year Horizon Step 1 Long-Range Financial Goals Reconcile earnings, capitalization, & growth Equalize LT growth - core, loans, & assets. Should Include Setting Balance sheet mix Loans, investments, NE assets Core deposits, Borrowing Levels, other Liabilities, capital Step 2 Set Annual Goals Lead to achieving financial goals Provide framework for drilling down in greater detail Step 3 Build the Business Plan Using you re A/L & Planning model Attempt to hit annual goals set in Step 2 Step 4 Build Core Funding Strategy Board involved in setting Steps 1 & 2. Management and ALCO have to determine how Step 3 works and if goals are achievable. What comes out of 1 & 2 are prioritized goals that determine HOW ALCO should set the course for achievement 14 7

8 ROA Required to Maintain Capital Ratio Step 1: Set Strategic Financial Goals That Work! Growth Scenario Beginning Assets Total Capital Capital Ratio Annual Asset Growth Assets After Growth e ota Capital to Maintain Ratio Additional Capital Needed Average Assets ROA 1 $ 100,000 $ 8, % 0.00% $ 100,000 $ 8,500 $ - $ 100, % 2 $ 100,000 $ 8, % 5.00% $ 105,000 $ 8,925 $ 425 $ 102, % 3 $ 100,000 $ 8, % 10.00% $ 110,000 $ 9,350 $ 850 $ 105, % 4 $ 100,000 $ 8, % 15.00% $ 115,000 $ 9,775 $ 1,275 $ 107, % 5 $ 100,000 $ 8, % 20.00% $ 120,000 $ 10,200 $ 1,700 $ 110, % 6 $ 100,000 $ 8, % 25.00% $ 125,000 $ 10,625 $ 2,125 $ 112, % Growth Scenario Beginning Assets Total Capital Long Term Capital Ratio Annual Asset Growth Assets After Growth e ota Capital to Maintain Ratio Additional Capital Needed Average Assets ROA 1 $ 100,000 $ 8, % 0.00% $ 100,000 $ 9,500 $ 1,000 $ 100, % 2 $ 100,000 $ 8, % 5.00% $ 105,000 $ 9,975 $ 1,475 $ 102, % 3 $ 100,000 $ 8, % 10.00% $ 110,000 $ 10,450 $ 1,950 $ 105, % 4 $ 100,000 $ 8, % 15.00% $ 115,000 $ 10,925 $ 2,425 $ 107, % 5 $ 100,000 $ 8, % 20.00% $ 120,000 $ 11,400 $ 2,900 $ 110, % 6 $ 100,000 $ 8, % 25.00% $ 125,000 $ 11,875 $ 3,375 $ 112, % 15 Managing Growth and Capital Step 2: Set Annual Goals to Reach Strategic Financial Goals Scenario 1: Increase Capital & Grow at 10% Year Beginning Assets Total Capital Beginning Capital Ratio Targeted Capital Ratio Annual Asset Growth Assets After Growth Capital to Achieve Ratio Additional Capital Needed Average Assets Net Income Current $ 100,000 $ 8, % 8.50% 10.00% $ 110,000 $ 9,350 $ 850 $ 105, % Year 2 $ 110,000 $ 9, % 8.75% 10.00% $ 121,000 $ 10,588 $ 1,238 $ 115, % Year 3 $ 121,000 $ 10, % 9.00% 10.00% $ 133,100 $ 11,979 $ 1,392 $ 127, % Year 4 $ 133,100 $ 11, % 9.25% 10.00% $ 146,410 $ 13,543 $ 1,564 $ 139, % Year 5 $ 146,410 $ 13, % 9.50% 10.00% $ 161,051 $ 15,300 $ 1,757 $ 153, % Scenario 2: Increase Capital and slow asset growth Year Beginning Assets Total Capital Beginning Capital Ratio Targeted Capital Ratio Annual Asset Growth Assets After Growth Capital to Achieve Ratio Additional Capital Needed Average Assets Net Income Current $ 100,000 $ 8, % 8.50% 0.00% $ 100,000 $ 8,500 $ - $ 100, % Year 2 $ 100,000 $ 8, % 8.75% 2.50% $ 102,500 $ 8,969 $ 469 $ 101, % Year 3 $ 102,500 $ 8, % 9.00% 5.00% $ 107,625 $ 9,686 $ 718 $ 105, % Year 4 $ 107,625 $ 9, % 9.25% 7.50% $ 115,697 $ 10,702 $ 1,016 $ 111, % Year 5 $ 115,697 $ 10, % 9.50% 10.00% $ 127,267 $ 12,090 $ 1,388 $ 121, % 16 8

9 ROA Targets 12% ROE Will raising industry capital targets bring capital into the industry or drive it out? 17 Capital Goal Setting Concept Start with minimum regulatory capital requirements Add a buffer that provides a cushion so that stresses don t cause capital failure Issues Stress Tests What are reasonable and appropriate stress tests for Community FI s Issues Capital & Buffer Where are capital requirements headed? How should the buffer be determined Qualitatively? Quantitatively? Our Take on the Buffer Concept Based on Credit, Liquidity and Interest Rate Risk in your shop, how much MORE capital is required to maintain Core Minimums AFTER the adverse event. This is an ALCO measurement process. 18 9

10 Capital Requirements Core Consensus is 7-8% Field examiner behavior Will banks and CUs be the same? CUs currently have 1% higher core capital minimum CUs do not currently have risk based requirement Risk Based Consensus is it will increase from 10% to 12% Binding constraint on many banks Large percentage of assets at 100% risk weight Major new proposal out for comment now that significantly impacts risk based and core capital in the future. 19 Capital Goal Setting Step 2: Move from Macro View (Step 1) to Annual Goals Set Year by Year goals for Capital/Asset Growth Earnings Dividend Payout Establish a Priority for goals Does Capital win over earnings or growth? Is it time now to grow and let capital drop for a while? Board establishes priority and risk limits Step 3: ALCO and Management takes the results and determines viability and required actions necessary to hit annual goals Using ALM modeling what are the required changes to meet the overall plans May involve more risks but can be measured against established limits 20 10

11 ALCO s Primary Responsibilities Manage the level of Net Interest Income/Net Income Management of Balance Sheet Structure Loan/Investment & Deposit/Borrowing Mix Growth rates Controlled through Loan & Deposit Pricing Investment Portfolio Management Earnings impact Liquidity Needs Wholesale Funding Capital Utilization Risk Measurement and Management Interest Rate Risk Liquidity Risk Credit Risk Regulatory Risk So with a set of prioritized goals established, ALCO can now determine how best to meet these goals and what risks are inherent in hitting the targets. 21 ALCO Goal Develop measurement systems that: Project the future earnings of the institution over a short horizon (2-3 years) Test the performance of earnings in a variety of interest rate scenarios Develop strategies to minimize undesirable risks or manage risks taken Develop Processes that Maximize financial performance under all foreseeable economic conditions 22 11

12 Interest Rate Risk Management MANAGING RISK 23 What Is Interest Rate Risk? Interest Rate Risk is the risk that an institution s earnings AND market value will change as market interest rate change. Measures the amount of change in earnings or value under different rates. The earnings at risk portion measures short-term changes to the income statement. The market value at risk element measures long-term risks to earnings and relative value of assets & liabilities. Both measures indicate the impact on earnings capacity only difference is the horizon evaluated

13 Interest Rate Risk Redefined Income Portion of Definition Reinvestment risk is the risk that as one instrument matures and is replaced with another, the funds being reinvested will carry a different interest rate than the funds in the original instrument. Example - a customer s $10, day CD yielding 6% is about to mature. Tomorrow we ll pay her $10,150 P&I. If we wish to continue to fund the asset supported by the CD, we ll have to replace the $10,000. In order to do so we ll have to pay prevailing market rates, which might mean something other than 6%. At that point the $10,000 reprices. Our cost of funds may rise or fall. Reinvestment risk is not a problem as long as it s occurring at approximately the same speed on both assets and liabilities. 25 What Causes Interest Rate Risk? Four Reasons Why or When Financial Instruments Are Rate Sensitive Maturity Example: 90 day CD with P&I due at maturity Amortization Example: 30 year fixed rate mortgage reprices gradually as the principal and interest payments are received. Prepayment Example: 11% fixed rate mortgage with market rates of 8%. It reprices when owner refinances to obtain a better rate. Contractual repricing terms on arm or variable rate loan Example: 30 year ARM with annual resets. Interest Rate Risk is Caused by Changes in Actual vs. Expected Cash Flow 26 13

14 Historical Rate Comparison Current concern is that rates may move as they did in IRR Measurement Techniques Picking the Right Tool to match the job Gap Analysis Measures dollar volume difference between rate sensitive (repricing) assets and liabilities Considered an INEFFECTIVE TOOL for measuring real earnings at risk. We will NOT cover this. Income Simulation Projects reinvestment and repricing of cash flows in different rate scenarios to estimate effect on net interest income and net income Measures impact of interest rate changes on earnings 28 14

15 Income Simulation MODELING RISK 29 Definition Static Income Simulation Projecting financial statements assumes a constant balance sheet. No change in level or mix. Measure effect of rate changes on income by running multiple rate environments. Income at risk = Projected changes in income in the different rate environments Policy limits set to minimize rate change effect one key metric used in measuring return Example Drop in Net Interest Income should not be more than 15% of base level if rates move against institution

16 Static Income Simulation Today Typically 1-3 Years Horizon Usually run against Gradual and/or Immediate & Permanent Rate movements Current Balance Sheet and Forecast Balance Sheet are the Same Income is a flow that occurs over time. To test income at risk you must run a forecast. In static income at risk the balance sheet composition is held constant throughout the forecast. 31 Dynamic Income Simulation Definition Projection of institution s financial statements based on a set of assumptions. Total Assets may change Loan/Investment & deposits/borrowings levels change Consistent with Budgeting and Liquidity management Measure effect of rate changes on income by measuring multiple rate forecasts. Income at risk is measured by fluctuations in income measurement under the different rate environments 32 16

17 MB&T Static IAR Analysis Non-parallel rate changes Immediate & Parallel rate shocks 33 Fallacies of Static IAR With Static we are testing the IRR in the existing Balance Sheet Not really, The fact that we are replacing cash flows means we are forecasting a dynamic position that simply has no change in mix from current levels. Use of forecasted data clouds the output How is a plan that does not represent what we are actually implementing help me in making decisions? Management can manipulate assumptions and change the look of the risk Isn t that easily validated by doing regular back tests ensure actions are consistent with plans? 34 17

18 Dynamic Income Simulation Advantages Model used for dynamic income at risk analysis can be used for multiple purposes. Budgeting Strategic Planning Interest Rate Risk Analysis Liquidity Risk Measures most important management issue: short and medium term earnings the effect of rate changes performance ROA, ROE, EPS, etc. Disadvantages Cost of software People costs for skills to manage Data and Time Intensive Ideally your plan should be incorporated into model. 35 MB&T Dynamic IAR Analysis Non-parallel rate changes Immediate & Parallel rate shocks 36 18

19 Static vs. Dynamic Comparison 1 Yr. Net Interest GI Base GI High Margin % Dynamic 3.172% 3.374% 3.258% 3.433% Static 3.076% 3.232% 3.126% 3.213% Volatility in Net Int. Inc. from Flat Rates GI Base GI High Dynamic 3.662% % 6.528% % Static 3.643% 9.017% 5.371% 8.413% Dynamic results show higher volatility (positive) but higher total earnings as well. 37 Implementing Dynamic ALCO Focus on Production, not Income. Focus on How Results are Generated not just the results Must prove that you manage the forecasts : Be able to demonstrate accurate projections Document variances, causes and impacts on performance Prove timely actions are taken and projections are rerun showing new performance levels 38 19

20 The time has come to do more in ALCO FFIEC IRR ADVISORY 39 Joint Agency Policy on IRR First Adopted in 1996 Added the S component to CAMEL Rating Developed Qualitative Assessment process for Examination No Uniform Supervisory Measure Major Components Board & Senior Management Oversight Roles Risk Management Processes Controls & Limits Identification & Measurement Monitoring & Reporting Internal Audit & Review 40 20

21 Joint Agency Policy Statement 5 Areas of Risk To Model 1. Repricing Risk: Impact of mismatch of repricing timing or amount on earnings/capital 2. Basis Risk: How different balance sheet components respond to market rate movements due to driver response Example: Libor vs. Prime movements 3. Yield Curve Risk: Recognition that Yield Curves do not move the same amounts for all maturities (nonparallel movements) 4. Price Risk: Changes in market values of financial instruments and the impact on the market value of capital. 5. Option Risk: Changes to cash flows resulting from rate movements FFIEC IRR Guidance A IRR Regulatory Guidance Issued December 2009 Restatement of 1996 Joint Agency Policy Statement on Interest Rate Risk FIL Joint Agency Policy Statement: Interest Rate Risk 3 Major Issues: Effective Policies & Governance Effective Measurements Meaningful & Adequate Reporting 42 21

22 2010 FFIEC IRR Guidance What to Measure To obtain Well Managed rating, must measure both earnings & economic value at risk Must extend simulation of Income at Risk to minimum of 2 years. If you are using dynamic balance sheet modeling, you must also run a static balance sheet. Why? Minimize Assumption Risk Must be able to prove your model is effective at measuring real risks 43 Managing Internal Assumptions KEYS TO BUILDING A VALID MODEL 44 22

23 Assumptions in Modeling Internal Assumptions: Those inputs that ALCO can control Offering rates Growth & mix projections External Assumptions: Assumptions that influence results that are outside of ALCO control Future interest rate levels Loan prepayment speeds 45 ALCO Model Keys Models depend on accurate assumptions Most critical of all assumptions is the speed of cash flows coming due and repricing - CONTROLLABLE More asset flows, faster the response to rate movements Recent years have seen regulatory pressure to Validate models Model Validation is designed to ensure proper flows, management assumptions, and market assumptions Ideally, ALCO and Budget processes would share assumptions and monthly variances validate projected flows vs. actual Can be used to directly impact earnings and production expectations 46 23

24 Production Based ALCO Interest Rate Risk Levels are linked directly to the speed of flows More asset flows, faster the response to rate movements Model Validation is a process designed to ensure proper flow and management assumptions, but If ALCO and Budgets are to meet, then the projected flows directly impact earnings and production expectations 47 Production Based ALCO Example: Community Bank with 100 million loan portfolio Current Interest Rate Risk shows Asset Sensitive More assets reprice than liabilities Budget is to maintain loan levels How much volume does the loan department have to produce to stay even? New loans must equal the amount or renewing, maturing and loan repayments Using the modeling as a production guide helps keep ALCO accurate and loan department on plan 48 24

25 Production Based ALCO ALM Model Projected Runoff by quarter Q1 Q2 Q3 Q4 Review of cash flows acts as a validation step for reasonableness each ALCO meeting Normal run-off for this bank is $1.6 million/month 1 st Qtr showing nearly $2 million/month Data issues! Similar report showing planned originations, including renewals, helps set targets and drive discussion of Products (Fixed/Variable, Balloon/Full Amortizing, etc) Rates (Need to integrate good pricing model) Strategy (Liquidity needs, deployment of excess funds) 49 Common Issues in ALCO Models Bad input data skews projected cash flow/repricing information Begin monitoring cash flows behind Income at Risk results Explain and document all discussions of variance and production (minutes) Deposit repricing rates versus expected or past performance don t match Little time spent assessing What-if or real world plans 50 25

26 Data Integrity Issues Core system data is assumed to be valid when discussing source data for modeling What is the value of integrated data is the underlying data is wrong? Core Data is FULL of problems Bad Maturity Dates No Balloon data Bad repricing information Loans coded as fixed actually have repricing data No margin on repricing data Bad data leads to inaccurate results Institutions should run monthly data validation reports from model to identify problems 51 Deposit Assumptions in IRR Model Major source of margin concern centers on deposit rate movements in rising rates. Following analysis tracked actual rates to historical through last rising rates Comparison of margin performance to projection 52 26

27 Model Assumptions: Deposit Rates Account Flat Rates Pricing Rule Rising 3% Rates over 12 months Shock +2% Immediate Savings 0.05% Move by 50% of rate change NOW 0.05% Move by 50% of rate change MMDA 0.25% Move by 75% of rate change Rewards 1.13% Move by 50% of rate change 1.55% at end of 1 yr 1.55% at end of 1 yr 2.5% at end of 1 yr 2.98% at end of 1 yr 1.05% in 1 month 1.05% in 1 month 1.75% in 1 month 2.48% in 1 month 53 Sample Bank NMD Rates MMDA rates reached a cap in last rate rise Checking rates mirrored MMDA and new Rewards Account introduced as cost control Measure Savings rates are on life support 54 27

28 Rate Comparison Actual to Forecast Actual Real Changes Actual % change Savings 0.00% 0% NOW 2.5% 58% MMDA 2.0% 48% Rewards?????? Projected Projected % Change Savings 50% NOW 50% MMDA 75% Rewards 50% Areas of pricing concern: Savings significantly different real response than projected MMDA Moderately overstated NOW reasonable but how does the addition of Rewards account change response this time? Need to rethink deposit rate changes in model then rerun risk to determine true sensitivity 55 Modeling Risks Using the Same Driver for All Rates with Beta factors can cause major skew in output

29 What Rate Projections Do I Use? EXTERNAL RATE FORECASTS 57 What Rate Projections Should I Use? Most ALCO s focus on rate shocks Little Probability Misstate earnings levels Some use rate ramps No bearing to real rate movements When rates change impacts performance Often one index used to control all offering rates simplify the model Ignores Basis Risk Budgets built on single rate forecast off track when Fed moves Assuming 100% probability 58 29

30 FFIEC IRR Guidance What Interest Rates To Measure? Traditional measures have been shocks +/- 100, 200, & 300 basis points Not enough stress, implied a 400 bp test Rate movements must be both severe and plausible Must recognize current cycle and possibility for scenario Should consider changes in slope, & twists in curve Who defines plausible? Are parallel shocks plausible? 59 Top Reasons to Eliminate Shocks Interest Rate Shocks are Not Realistic Going back in time, we don t find any time period where the curve moves across all rates up/down by the same amount FFIEC Indicated in 1996 that Yield Curve Risk was real and should be measured. They did NOT say Shocks were the answer Shocks Mask the Impact of Option Risks Consider a bank with Variable CRE loans on 5% floors priced at Prime +0.5% (3.75% today). Shocking rates up 2% would cause these loans to reprice IMMEDIATELY off the floor rate. What s that do to the Net Interest Margin Calculation? 60 30

31 Top Reasons to Eliminate Shocks Shocks Lose the Impact of Basis Risk When all rates move the same, then Basis risk is missed completely FFIEC Indicated in 1996 that Basis Risk was real and should be measured. No regulation exists from ANY REGULATOR requiring the use of shocks in the ALCO process But it is expected to be included and without good control, will be used to reign in unwanted risks. The real truth is shocks were used to test the impact on market value for securities. It was a bogey on long term risk. Never meant for true risk analysis just carried over lacking any other option 61 Historical Rate Comparison 62 31

32 Cost of Shock Analysis 1 Year NII Comparisons 3.71% of Assets How much is this insurance costing me if I use Shocks over real rate forecasts? 3.31% of Assets 63 Cost of Shock Analysis 2 Year NII Comparison What does this say over 2 years the ALCO should be doing? 64 32

33 ALCO Decisions Now we have a better understanding of how to measure Income at Risk and What to Avoid How do we describe what we find? Asset Sensitive: More assets reprice than liabilities If rates increase Income should increase If rates decrease Income should decline Liability Sensitive: More liabilities reprice than assets If rates decrease Income should increase If rates increase Income should drop Is it possible to have a neutral position where rate changes don t impact the earnings at all? Option risks make this nearly impossible for retail financial institutions More on Option risks next session 65 Measuring Income at Risk Bottom Line: If you have been running Static Balance sheets for Income at Risk Begin to run Dynamic in addition to Static Validate the Projected Cash Flows on the model Back Test to prove your assumptions on growth are reasonable and reliable If you are running Dynamic Balance Sheets Validate cash flows and ensure production in the model squares with department targets (i.e. Loan Production) Document variances and adjustments to assumptions Must be measuring Non-parallel rate movements Must be measuring at least 2 years into the future 66 33

34 Value at Risk Analysis Next Session What is it, why do we do it and how do we use it for decision making Liquidity Risk Analysis An introduction to Liquidity Risk Measures 67 34