Directors reviewing their bank’s asset/liability management policy in the wake of recent bank failures should avoid merely reacting to the latest crisis.
Managing the balance sheet has come under a microscope since a run on deposits brought down Silicon Valley Bank, the banking subsidiary of SVB Financial Group, and Signature Bank, leading regulators to close the two large institutions. While most community banks do not have the same deposit concentrations that caused these banks to fail, bank boards should ask their own questions about their organization’s asset/liability strategies.
A bank’s asset/liability management policy spells out how it will manage a mismatch between its assets and liabilities that could arise from changing interest rates or liquidity requirements. It essentially provides the bank with guidelines for managing interest rate risk and liquidity risk, and it should be reviewed by the board on an annual basis.
“With both Silicon Valley Bank and Signature Bank, you had business models that were totally different from a regular bank, whether it’s a community bank, or a regional or even a super regional, the composition of their asset portfolios, the composition of their funding sources, were really different,” says Frank “Rusty” Conner, a partner at the law firm Covington & Burling. “Anytime you have a semi-crisis or crisis like we’ve had, you’re going to reassess things.”
Conner identifies three key flaws at play today that mirror the savings and loan crisis of the 1980s and 90s: an over-concentration in certain assets, a mismatch between the maturities of assets and liabilities, and waiting too long to recognize losses.
Those are all lessons that directors should consider when they revisit their bank’s asset/liability management policies and programs, he says.“Is there any vulnerability in our policies that relates to concentration or mismatch, or failing to address losses early?”
In order to do that, directors need to understand their bank’s policies well enough to ask intelligent and challenging questions of the bank’s management. The board may or may not have that particular subject matter expertise on its risk, audit or asset/liability committee, or in general, says Brian Nappi, a managing director with Crowe LLP.
“I don’t think there’s a deficiency in policies per se,” he adds. “It’s the execution.”
Nappi recommends that boards seek to “connect the dots” between their company’s business strategy and how that could fare in a changing interest rate environment.
Conner raises a similar point, questioning why some banks had so much money invested in government securities when the Federal Reserve was telegraphing its intent to eventually raise interest rates.
“That whole issue just looks so clear in hindsight now, and maybe that’s unfair,” he says. “But why is it that we didn’t anticipate that, and are we in a better position today to anticipate similar types of developments in the future?”
Boards could consider bringing in an outside expert to review the asset/liability management policy, says Brandon Koeser, a senior analyst with RSM US. A fresh set of eyes, such as an accounting firm, consultant or even a law firm, can help the board understand if its framework is generally in line with other institutions of its size and whether it’s keeping pace with changes in the broader economy.
“You also want to think about the [asset/liability management] program itself, separate from the policy, and how often you’re actually going through and reviewing to make sure that it’s keeping pace with change,” Koeser adds.
Steps to Take: Revisiting the Asset/Liability Management Policy
- Establish and understand risk limits.
- Consider how to handle policy exceptions.
- Define executive authority for interest rate risk management.
- Outline reports the board needs to monitor interest rate risk.
- Establish the frequency for receiving those reports.
- Evaluate liquidity risk exposure to adverse scenarios.
- Understand key assumptions in liquidity stress testing models.
- Review guidelines around the composition of assets and liabilities.
- Monitor investment activities and performance of securities.
- Review contingency funding plans.
Directors should also ask management about any liquidity stress testing the bank may be engaging in. Do directors fully understand the key assumptions in the bank’s stress testing models, and do they grasp how those key assumptions could change potential outcomes?
And if executives tell the board that the bank’s balance sheet can withstand a 30% run off of deposits in a short period of time, directors shouldn’t be satisfied with that answer, says Matt Pieniazek, CEO of Darling Consulting Group, a firm that specializes in asset/liability management. The board should press management to understand exactly how bad losses would need to be to break the bank.
“Directors don’t know enough to ask the question sometimes. They’re afraid to show their stress testing breaking the bank,” he says. “They need to have the opposite mindset. You need to understand exactly what it would take to break the bank. What would it take to create a liquidity crisis? How bad would it have to get?”
Sometimes policies tend to be too rigid or not descriptive enough, adds Pieniazek.
“The purpose of policies is not to put straighBtjackets around people,” he says. “If you have to look to policies for guidance, you want to make sure that they have an appropriate amount of flexibility and not too much unnecessary restrictiveness.”
Many banks’ policy limits concerning the use of wholesale funding — such as Federal Home Loan Bank advances and brokered deposits — are too strict and unnecessarily constrained, Pieniazek says. “A lot of them will have limits, but they’re inadequate or the limits are not sufficient, both individually and in the aggregate.”
An example of this might be a policy that stipulates the bank can tap FHLB funding for up to 25% of its assets and the Federal Reserve discount window for up to 15% but restricts the bank from going above 35% in the aggregate.
Along those lines, directors should make sure management can identify all qualifying collateral the bank might use to borrow from the Federal Reserve or FHLB, taking into account collateral that may have been pledged elsewhere. And directors should revisit any overly rigid policies that could tie executives’ arms in a liquidity crunch. A policy stipulating that a bank will sell securities first may prove too inflexible if it means having to sell those securities at a loss, for instance.
A board will also want to understand whether its asset/liability management plan considers the life cycle of a possible bank run. In that kind of scenario, how much would the bank depend upon selling assets in order to meet those liquidity needs? And what’s the plan if some of its securities are underwater when that happens?
While the most recent banking crisis doesn’t necessarily mean bank boards need to overhaul their asset/liability management policies, they should at least review those policies with some key questions and lessons in mind.
“If your regulator comes in, and they see dust on the cover of the ALM policy,” says Koeser, “and they see that the liquidity stress test or scenario analysis aren’t appropriately incorporating shocks or stressors, it could be a difficult conversation to have with your regulator on why there weren’t changes.”
Bank Director’s Board Structure Guidelines include a resource focused on ALCO Committee Structure. The Online Training Series includes units on managing interest rate risk and model validation. For more about stress testing to incorporate liquidity, read “Bank Failures Reveal Stress Testing Gaps.”