Lecture Materials ASSET/LIABILITY MANAGEMENT YEAR 1

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1 Lecture Materials ASSET/LIABILITY MANAGEMENT YEAR 1 Dwight R. Larsen National Bank Examiner Office of the Comptroller of the Currency Minneapolis, Minnesota dwightrlarsen@hotmail.com August 4, 2017

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3 Asset Liability Management - Year 1 (aka The Nuts and Bolts of ALM ) Graduate School of Banking Madison, Wisconsin Dwight R. Larsen Today s Outline Overview of the Section What is ALM? Why is ALM important? The ALCO Liquidity Risk and Management 1

4 Overview of the ALM Section Purpose? (see Course Description ) Try and provide a basic understanding of the major ALM areas. Become conversational (not fluent) If not today, you may become involved in ALM in the future!!! (POLL) What is ALM? 2

5 A/L Management - Definition The process of planning, organizing and controlling asset and liability volumes, mixes, maturities, rates, and yields with the objective of maximizing returns and minimizing risk. Technically, encompasses all risk categories (credit, IRR, liquidity, transaction, etc.) What is ALM? (continued) Pre-session reading materials? 1. Active mgmt of the balance sheet Setting rates, terms, maturities on loans And, making loans that get repaid!!! Setting rates, terms, maturities on deposits Determining what types of investment securities to purchase, given liquidity or income needs Ensuring adequate (but not too much) liquidity ENSURING ADEQUATE CAPITAL LEVELS!!! 3

6 What is ALM? (continued) 2. Understanding how changing market interest rates impact the bank s net interest income, net income, and capital. What is ALM? (continued) Five main areas to be covered: Liquidity risk and management (today) Investment portfolio management (next Monday) Interest rate risk and management (today) Capital Planning & Management (next Monday) Funding (alternatives, options) (today, next week) Case Studies in ALM (next Monday) Examples!!! 4

7 Liquidity Risk Example #1 Cash Flows Match Up Loan $100 8% 1 Year CD $100 4% 1 Year So in this example, equal amounts of cash come to the bank and leave the bank at the same time; no liquidity risk!!!! Liquidity Risk Example #2 Cash Flows do not match up! Loan $300 8% 1 Year CD $100 4% 1 Year In this more realistic example, the cash flows coming into the bank and going out of the bank do not match up 5

8 Interest Rate Risk Example #1 Repricing Risk is minimal Loan $100 8% 1 Year CD $100 4% 1 Year In this example, the Loan and CD will each reprice in one year, which should allow the bank to maintain the spread (possibly higher or lower). Interest Rate Risk Example #2 Repricing does not match up Loan $100 Prime + 1% 1 Year CD $100 4% 2 Years In this example, the Loan (whose rate will vary over time) and CD reprice at different times, so, the spread could change over time! 6

9 Capital Planning & ALM? 14 7

10 Sources/Uses of Funds Banking Business Model ( Balance Sheet ) Sources/Uses of Funds Assets Cash & Due From Accts. Fed Funds Sold Investments Loans Reserve for Loan Losses (contra asset) Other Real Estate Owned (OREO foreclosed property) Premises and Equipment Other Assets AnyBank Liabilities DDA (checking accts.) Savings Accounts MMDAs CDs Borrowed Funds* Other Liabilities Capital Common Stock Surplus Undivided Profits *Borrowed funds include fed funds purchased, brokered CDs, FHLB advances; also termed other borrowed money Typical Income Statement +Interest Income -Interest Expense Net Interest Income -Provision for Loan Losses +Non-interest income -Non-interest expense Pre-tax operating income -Taxes (40%) Net Income $4,000,000 (1,500,000) $2,500,000 (250,000) 400,000 (1,600,000) $1,050,000 (420,000) $ 630,000 As interest rates change, net interest income and net income will be impacted How much is the question!!! 8

11 Key Performance Measures ROAA, ROAE, NIM ROAA = Return on Avg. Assets (Net Income/Avg. Assets) (measures utilization of assets) ROAE = Return on Avg. Equity (Net Income/Avg. Equity) ** (is the optimal measure for shareholders) ** NIM = Net Interest Margin (Net Int. Inc./Avg. Earning Assets) (measures spread & volume; net yield on earning assets) It is probably impossible to maximize all of these performance indicators at the same time!!!!! Remember!!! All Roads Lead to Capital! 9

12 Why is ALM Important? Bank ROA s By Asset Size 1.60% 1.40% 1.20% Earnings are flat 1.00% 0.80% 0.60% 0.40% *Through March 31, % 0.00% -0.20% >$1B $100MM - $1B < $100MM Source: 10

13 5.00% Bank NIM s By Asset Size 4.75% 4.50% 4.25% 4.00% NIM s are getting squeezed!!! 3.75% 3.50% 3.25% 3.00% 2.75% Through March 31, % >$1B $100MM - $1B < $100MM Source: Why is ALM Important? (Summary) Many smaller banks are struggling for more earnings; trends in performance indicators are not entirely positive. Many business sectors not seeing meaningful upticks/expansions. Situation results in banks taking on unwarranted risks that may impact earnings and capital for many years! Prudent ALM becomes very important!!! 11

14 ALM - KEY POINTS Earnings are maximized through proper balance sheet management ( A/L management ). Earnings drive shareholder value. Asset growth increases earnings (generally). Capital levels dictate asset growth. If earnings are retained on balance sheet, must grow over time or shareholder value will decline. A small increase in earnings has a large impact on shareholder value. The ALCO Asset Liability Committee Driver of ALM 12

15 ALM Roles of Different Groups Board of Directors set targets, risk limits, etc. Senior management day-to-day oversight and implementing pricing guidelines Middle management Implements pricing set by ALCO, assists ALCO analysis, etc. Asset Liability Committee (ALCO) establishes pricing guidelines and makes liquidity decisions based on analysis of performance, trends, competition, etc. The ALCO - Purpose Function/purpose of ALCO? Overall goal is to stabilize/increase profits Must make decisions regarding the pricing of loans and deposits, as well as funding strategies ALCO not just in place to review compliance with various policy guidelines (IRR, Liquidity, etc.) Time to visit the ALCO at First Dysfunctional Bank 13

16 ALCO Members Should include individuals who have direct involvement in pricing the bank s earning assets and sources of funds Actual decision-making group should be small (<10 is best) Odd numbered decision-making committees work best (for voting reasons) Meet monthly or quarterly The ALCO Need to remain knowledgeable of the major factors influencing ALM that are beyond their control: Interest rates, business cycles, accounting changes, etc. Need to remain diligent and disciplined on ALM issues they can control: Pricing, terms of loans, deposits, etc. Forecasting liquidity needs/excesses, etc. 14

17 The ALCO Meeting & Process Remember ever seeing this? DATA (facts) INFORMATION (answers to questions) DECISIONS! Make sure the ALCO (or any committee) is reviewing information, not just a bunch of data. We can make better decisions with information. The ALCO Meeting and Process (continued) SO: Data Rates/Yield Curve Fed Funds Futures Econ. Trends * Employment * Demographics* * national, regional, and local Information Current Performance Measures IRR Models (NII, NI, NIM, etc.) Liquidity Models (short/excess) Actions of Competitors Loan/Credit Issues Capital Issues Decisions! PRICING LOANS! PRICING DEPOSITS! BUY/SELL FUNDS! 15

18 ALCO MEMBERS MUST UNDERSTAND HOW CHANGING INTEREST RATES IMPACT BANK EARNINGS! Interest Rates 1980 June % 22.5% 20.0% 17.5% prime fed funds 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% Source: St. Louis Federal Reserve 16

19 Today s Yield Curve is????? 7% 6% 5% 4% 3% 2% 8/25/2000 7/17/2007 6/19/2017 1% 0% 3 mo 6 mo 2 year 5 year 10 year 30 year Source: U.S. Department of the Treasury ALCO Meeting Information Has evolved; now covers more than traditional interest rate risk and liquidity issues Pricing and risk issues change over time; should you be reviewing different information? ALCO info depends on ALCO focus 17

20 ALCO Meeting Information (continued) Meeting Information may include: Current Yield Curve; very key information!!! Recap and trend of NIM, ROAA, ROAE, efficiency ratio, cap ratios, etc. including comparison to budgets and competition Trends on pricing of loans and deposits (i.e. avg yields, rates paid, and strategies for changes) Earnings exposure to changes in rates (IRR) ALCO Meeting Information (continued) Meeting Information may include:(continued) Projected sources/uses of funds (liquidity) Funding Capacity Recap New products and/or strategies Material loan/credit issues Earnings Credit Rate, Funds Trans. Pricing Capital Planning & Management Recap of compliance with policy guidelines for interest rate risk and liquidity! 18

21 ALCO Meeting Information (continued) Ask What are we trying to accomplish? What are the key issues? What do we need to allow us to focus on these issues? Are we measuring and reporting risk positions with the most appropriate and practical tools? Are we evaluating the risks and rewards of strategies to improve performance? Liquidity Management Discussion Agenda Objectives, recap of historical liquidity management, recent trends Liquidity Planning Techniques Internal Funding Analyses Projected Sources & Uses of Funds Funding Alternatives & Monitoring 19

22 Liquidity Management (Defined) Objective is to be able to obtain funds at a reasonable cost; can usually obtain funds, but not at reasonable costs!!!! Better management of liquidity provides more stability to the Bank s NIM and your blood pressure! Should be forward-looking The Costs of Liquidity Unplanned, or last minute requests to purchase funds to meet loan demand, deposit run-off, etc. can be more expensive than you think. Carrying too much liquidity on the balance sheet results in costing your bank lost income! Many banks tend to be countercyclical investors (have cash when rates are low). 20

23 Two Types of Liquidity Asset Liquidity Liability( Luxury ) Liquidity Fed Funds Sold Unpledged securities Saleable Loans Positives: Sales controlled by mgmt; not credit sensitive. Negatives: Reduced profits. Fed Funds Purchased Fed Discount Window Repo Agreements Borrowed Funds (FHLB) Rate Boards for CD s Brokered Deposits Trust Preferred Sec s Positives: Availability, flexibility Negatives: Very credit sensitive, can be expensive. LIQUIDITY TRENDS Generally, liquidity has been adequate since 2000 TREND IS SHOWING THAT LIQUIDITY IS GETTING TIGHTER AT THIS TIME.HOW DOES THAT IMPACT YOUR BANK? 21

24 Millions of Dollars UBB Agent Fed Funds Pool Fed Funds Sold to UBB by Community Banks ( ) A general tracking of liquidity trends since ,100 1, Liquidity Management (Process) Is a forward-looking process Step 1 Understand your bank s general liquidity trends. Step 2 - Estimate liquidity/funding needs (or excess) in future periods Step 3 - Determine/track alternatives 22

25 Internal Liquidity Analysis (Step 1 - Your Bank s Liquidity Patterns) Certain banks have clear loan and deposit cycles; what are your bank s cycles??? Use software for daily statements to obtain monthly average balances Use Call Report quarterly averages for loans, deposits, fed funds, investments Tracking Deposit Patterns 23

26 Step 2 - Projected Sources and Uses Report Management of liquidity should be forward looking (not just a review of liquidity ratios at previous quarter-end) Need to develop a liquidity planning tool Identify Shortage and Excess situations Projected Sources/Uses of Funds (Where is cash coming from AND going to) Source of Funds Decrease in assets OR increase in liabilities EXAMPLES Liquid assets (Fed Funds Sold) Loan payments/payouts Bond pymts/maturities New deposits Additional borrowed funds Use of Funds ( Needs ) Increase in assets OR decrease in liabilities EXAMPLES Funding loans Buying bonds Paying off depositors Paying off borrowed funds 24

27 Projected Sources/Uses of Funds Refer to handout Generally is much easier to identify the uses versus the sources Like most modeling, is not a finite number Purpose is to identify direction and magnitude of the trend in liquidity Very helpful in setting up a funding ladder First State Bank Analysis of Sources & Uses of Funds Projection as of: March 12, 2007 In 000's Time Period 04/11/07 05/11/07 06/10/07 07/10/07 08/09/07 09/08/07 Anticipated Sources of Funds: Estimated Monthly Loan Repayments 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 Low Degree of Control High Federal Home Bank Advances 5,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Investment Maturities / Calls 1,000,000 1,000, ,000 1,150, , ,000 Federal Funds Purchased - Bank #1 Federal Funds Purchased - Bank #2 Federal Funds Purchased - Bank #3 REFER TO HANDOUT!!! National Brokered CD's 5,439,000 4,110,000 3,141,000 Local Market Deposits - Net Gain 5,000, , , , , ,000 Qwick Rate Brokered CD's Public Fund CD's - Net Gain 5,000,000 5,000,000 Total Sources 18,000,000 14,939,000 18,110,000 12,791,000 9,000,000 14,000,000 25

28 First State Bank Analysis of Sources & Uses of Funds Projection as of: March 12, 2007 In 000's Time Period 04/11/07 05/11/07 06/10/07 07/10/07 08/09/07 09/08/07 Anticipated Uses of Funds: Investment Purchases 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Low Degree of Control High Federal Home Bank Advances - Repay 5,000, , ,000 1,000, , ,000 Estimated Loan Funding 8,500,000 8,500,000 8,500,000 8,500,000 8,500,000 8,500,000 Public Fund CD's 419,000 36,000 4,111, ,000 4,819,000 Federal Funds Sold - Bank #1 Federal Funds Sold - Bank #2 2,000,000 Federal Funds Sold - Bank #3 Local Market Deposits - Net W/D 5,000,000 Qwick Rate Brokered CD's - Maturities REFER TO HANDOUT!!! National Brokered CD's - Maturities 5,439,000 4,110,000 3,141,000 Total Uses 14,919,000 22,475,000 18,221,000 14,153,000 10,000,000 14,819,000 Sources Over Uses / <Deficit> 3,081,000 (7,536,000) (111,000) (1,362,000) (1,000,000) (819,000) Current Position (4,330,000) End of Period Cash Position (1,249,000) (8,785,000) (8,896,000) (10,258,000) (11,258,000) (12,077,000) Step 3 - Funding Alternatives Use of alternative sources of funding been growing for many years! Don t forget to have policy guidelines, i.e. % of total deposits, capital, etc. Very helpful to develop a tool to aid in reviewing these alternatives. (see example) Never pay more than you can borrow for 26

29 First State Bank Alternative Funding Sources Worksheet As of: July 10, 2006 REFER TO HANDOUT!!! Term in Months Source: Federal Home Loan Bank Qwick Rate average top average top average top Broker # Broker # Broker # Local Markets (high offering) nearest term /10/2006 Average of Above High of Above Current Bank CD Rates Liquidity Regulatory Guidance SR Interagency Advisory on Primary Credit & Effective Liquidity Management FIL Liquidity Risk Management FIL Funding and Liquidity Risk Management 27

30 Sound Liquidity Risk Mgmt. (from FIL ) Importance of cash flow projections. Diversified funding sources. Stress Testing. Cushion of liquid assets. Well-developed contingency funding plan. Contingency Funding Plans (from FIL ) All institutions should have formal CFP. The detail should be commensurate with the complexity of the institution. Should identify stress events, funding sources/uses, and mgmt processes. 28

31 A Final Comment on Liquidity GET LIQUIDITY WHEN THE MARKET WANTS TO GIVE IT TO YOU. Translation Lock in funding during low rate environments! ALM - FINAL POINTS Earnings are maximized through proper balance sheet management ( Asset Liability Management ). Earnings drive shareholder value. Asset growth increases earnings (generally). Capital drives asset growth. If earnings are retained on balance sheet, must grow over time or shareholder value will decline. A small increase in earnings has a large impact on shareholder value. 29

32 Bring your calculators for Case Studies Please complete class evaluations!!! 30