29 Hoosier Banker October 2016 behavior of cash flows to a variety of influences. Here the bank must make assumptions about future events. For the risk measurement system to be reliable, these assumptions must be reasonable given the characteristics of the bank and its balance sheet. The Office of the Comptroller of the Currency identifies some common problems with regard to development of assumptions in the risk measurement process, including: • Failing to address potential risk exposures over a sufficiently wide range of interest-rate movements to identify vulnerabilities and stress points; • Failing to adequately modify or vary assumptions for products with embedded options to be consistent with individual rate scenarios; • Basing assumptions solely on past customer behavior and performance, without considering how the bank’s competitive market and customer base may change in the future; • Failing to periodically reassess the reasonableness and accuracy of assumptions. We should add to this list the failure to model non-parallel changes in the yield curve, since some instruments have cash flows that are driven by changes in short-term rates, while others are sensitive to changes in the long end. In any case, it is imperative to have a comprehensive set of reasonable assumptions built into any model projecting scenario cash flow dynamics. Once we have meaningful cash flow projections, we can simulate with more precision the effect on earnings of different interest-rate environments. This is more valuable than, for example, a call report-based system, which must rely on broad categories and average balances, rather than actual dollars of reinvesting and/or repricing cash flows. Again, banks with very simple balance sheets may not need the highest degree of precision, but they will Chicago Indianapolis St.Louis Milwaukee 201 NORTH ILLINOIS STREET, SUITE 1400 CAPITAL CENTER, SOUTH TOWER INDIANAPOLIS, INDIANA 46204-4212 T: 317.464.4100 • F: 317.464.4101 • SALAWUS.COM Locally Sourced, Handpicked Lawyers Growing in Indiana to meet your company’s legal needs A FULL SERVICE business law firm with a simple promise – PUT YOU FIRST LARRY TOMLIN | STEPHEN STITLE | JOHN TANSELLE | DEBRA MASTRIAN ANDREW PODGORNY | MARTHA LEHMAN | MARK WENZEL want to assess the adequacy of their systems in any case. Conclusion There are many considerations involved in the modeling of a bank’s interest-rate risk and liquidity exposures. The regulatory authorities have told us in no uncertain terms that bank management must be vigilant in its efforts to define, measure and manage those exposures. In order to do this properly, we must look at the behavior of cash flows. The swirl of repricing balances and changing interest rates creates a good deal of uncertainty with respect to future earnings, unless there is some meaningful way to model those dynamics. For banks that seek to upgrade and optimize their IRR processes, a good start is to review and assess the adequacy of their asset/liability reporting systems, particularly with respect to the ebbs and flows of liquidity. t
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