Business Insights: Directors Play Critical Role in ALM Management

Bank Director interviewed Ryan Torjak, NBE, director of ALM Review and Regulatory Services at BNK Advisory Group, about the importance of directors understanding asset/liability management (ALM) as well as ensuring they provide management with the resources to develop a solid ALM foundation.

Why is it critical for directors to understand asset/liability management (ALM)?

In Jay Brew's and Ed Seifried's soon to be published book, The Art of Risk in Community Banks, they list the duties of a bank director. One of the duties is to assess risk, set risk parameters, monitor risk, and provide management with dynamic tools and models. As part of that duty, directors need to ensure they are providing management with the appropriate resources necessary to develop a solid ALM foundation. Good risk management platforms can peform dynamic modeling and should be suitable to the complexity of the institutions’ balance sheets. It is a critical piece of a bank's risk management platform.

Within ALM, there are two absolutely crucial components. First, management must have the necessary tools to perform risk management. Second, directors must have an understanding of what ALM represents, as well as what management is doing with the tools provided. Remember, ALM is a significant portion of your CAMELS rating.

What are some common misconceptions bank directors have when it comes to ALM?

The most common misconception is that banks just use ALM for compliance, and not for strategic direction. We've worked with countless banks that only run asset liability models or perform asset liability reporting for compliance purposes. While banks do have a regulatory compliance responsibility, we encourage institutions to take ALM a step forward strategically to further the bank's risk management capabilities. We love working with clients who take modeling seriously–those institutions that have strategically implemented their ALM modeling into budgeting, capital plans, etc., which help boards and management steer the bank. We have some clients who have heavily integrated it into their longer term strategic planning processes and this seems to work very well for them in terms of projecting profitability and value using various “what if” scenarios.

Another common misconception is the importance of economic capital and its various forms of measurement, which are becoming relevant with the onset of understanding the impact Basel II will have on the banking environment within the United States. A lot of directors don't have a firm understanding of economic capital and its various measurements, so they disregard it entirely. They focus on income and the various exposures to income, but more often than not they shy away from trying to understand the true value of their institution–that's the fundamental component of economic capital. When properly measured, economic capital gives you a firm understanding of what your institution is worth and is typically attributable to inherent value of your core deposit franchise.

What are the top three areas of focus when using a proactive approach to ALM?

The board needs to be comfortable that the models or tools it uses for ALM match the complexity of the institution's balance sheet, which is an area that involves executive management as well as directors–although the board usually relies on executive management for this understanding. The consideration usually centers around how much optionality the balance sheet contains. Depending on the observed level of complexity, directors should expect managers to periodically evaluate whether the bank's ALM model can actually show this level of complexity and therefore properly capture your sensitivity to market risk (interest rate risk).

The second is that directors have a responsibility to take the lead role in setting up a solid ALM policy framework. This involves creating policies, which are usually written by management, but need to be understood and approved by the board. Directors need to set risk limits for the various measurements provided in the ALM reports (risk measures for income, liquidity, and value), but most importantly, should be certain they understand these measures and limits.

Third, as part of the risk management framework, directors need to periodically evaluate executive management to make sure that management is providing an appropriate level of ALM risk reporting and information. In smaller institutions, that oversight usually comes in the form of internal audit reporting. However, it's a good idea for directors to periodically attend educational programs on these topics. That way when they come in and listen to their management team, they have a broader understanding of the topics and quality of information.

Why is it important for directors to focus on a proactive approach to risk management?

There will be a heightened amount of regulatory scrutiny on banking institutions, simply because we've had such a huge change in the yield curve. We have been experiencing a flat treasury curve for quite some time, but the front end of the curve has jumped up incredibly over the last 24 months. This has created margin compression in most institutions. So where will we go from here? Good question. More importantly, is your model capable of real life simulations, such as a flat yield curve? If not, it is certainly something to consider as a better practice!

We have no idea where we're going from here and a good, dynamic asset liability tool can come into play in terms of paying for itself. When the model is set up properly, is capturing enough data, has the key assumptions that are required, and is appropriate for the bank's balance sheet, you can run simulations of what may happen in the future. And as mentioned, it is an effective way to plan strategically. Because of the environment we're in and the unknown factor moving forward, management and directors should be thinking about the accuracy and capability of the bank's ALM model.

How does value proposition play a role in your firm's approach to ALM, and what are the benefits of taking a proactive approach?

Number one, being reactive generally costs shareholders or stakeholders money. When we have individuals call us for help, it's generally because they entered into a transaction without being able to properly assess the various risks of the transaction, or they did not have the capability to perform any type of dynamic modeling (stress test, what ifs, etc.).

If I'm a director, I want to be able to sleep at night knowing that I've given management the appropriate tools to show me which way I should be driving the bank. And the directors are certainly the people who are driving the bank. You don't look through your rear-view mirror to drive, you look through the windshield. That's exactly the way directors should be thinking about ALM. A powerful tool, while expensive, will generally pay for itself by helping you avoid mistakes. It will allow you to perform “what if” simulations. Examples would be what if we decide to buy another institution, what does that do to our balance sheet, what if we want to enter into a new product offering, and how will this impact the balance sheet?

There are so many different working parts in banking. It is very dynamic, and good models allow you to forecast what will happen to your institution if you take a given action and how the decision will play out through various interest rate scenarios. If you're reactive, meaning you don't take these steps ahead of time, it can end up costing you earnings and value, and garnering regulatory scrutiny. Don't get me wrong. There are a lot of managers who do well with the old back of an envelope analysis, but when the transaction works against you, it is usually very costly to the pocketbook. Unfortunately, the pocketbook belongs to the shareholders and/or stakeholders who have elected you to oversee their institution.

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