28 Hoosier Banker November 2015 DIRECTORS / SENIOR MANAGEMENT Strategic Modeling for High Performance: Asset/Liability Management The successful performance of a community bank ultimately depends on proper understanding and management of interest rate risk. Sometimes, however, bank management is too complacent about modeling changes in interest rates and the resulting impact on earnings. Many institutions have more complexity embedded in their balance sheets than they realize, and they may not be getting the best information on which to base decisions. In the battle for net interest margin, it pays to have a sound decision-making process that includes a robust asset/ liability model with strong support from the provider. We know deposit rates, loan rates and bond yields rise and fall About the Author Jeffrey F. Caughron is chief operating officer/ managing director of The Baker Group. He has been working in banking, investments and interest rate risk management since 1985, and currently serves as a market analyst and portfolio strategist. His trading experience includes several years on the Treasury desk for an international bank on Wall Street, with subsequent positions trading mortgage-backed securities and other taxable fixed-income products for regional broker/ dealers. Caughron has published numerous articles on risk management topics and is quoted frequently in the financial press. A graduate of the University of Oklahoma, Caughron has served on the faculty of several banking schools and has done consulting work for foreign banks. The author can be reached at 800-937-2257, email: jcaughron@GoBaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider. with market conditions and general interest rate trends. However the story doesn’t end there. We have to remember it is the relationship between short and long rates, or the shape of the yield curve, that ultimately dictates earnings performance. Borrowing costs are driven by interest rates in the short end of the maturity spectrum, while the bank’s asset yields (rates on loans and bonds) are priced off of the longer end. When the difference between short and long rates is minimal (a flat yield curve), bank margins are compressed. On the other hand, during times when the yield curve is steep, margin widens and earnings improve, given the appropriate time lag. The trick is to identify and project what the yield curve is doing to our cost of funds and asset yields today and in the future. Remember, too, the complication of yield curve twists is added to the uncertainty of cash flows from all sorts of optionality. The number of variables needed to model interest rate risk is often enough to drive management crazy. In order to get it all right, we simply need the proper tools, including an ALM system that incorporates the essential assumptions that must be modeled. Any basic model must simulate the impact of re-pricing volumes of assets and liabilities into new reinvestment rates or costs. To do it right, we also must incorporate time lags and repricing sensitivities of the various types of balance sheet items. Further, we must have the ability to model changes in the shape of the yield curve, along with growth and sector diversification strategies. The model must have back-testing capabilities for users, and the vendor should provide proof of validation by an outside auditor. The best way to view a bank is as a single system made up of various constituent parts. These component parts include, but are not limited to, funding sources, loan structures and investments. A good asset/ liability model will piece together the mechanics of this system, so that the bottom-line effect of interactions among the different parts can be clearly seen and reported.
RkJQdWJsaXNoZXIy MTg3NDExNQ==