20 Hoosier Banker March 2016 For a number of years, bank regulators have focused on the adequacy and soundness of asset liability committee (ALCO) processes used by banks to manage interestrate risk exposures. With respect to the reporting system or model that is used for A/L analysis, there are certain key points that are generally considered, including: • Does the model possess sophistication and complexity that is appropriate for the institution? • Are assumptions back tested regularly? • Is data input accurate and current? • Are model assumptions reasonable and updated? • Has the model itself been tested and validated by an outside auditor? Two of these, back testing and model validation, are especially noteworthy. These are entirely different processes, but equally important to the overall integrity of any modeling process and the resulting usefulness of the reports. It is important to understand the distinction between them. The starting point for any good A/L model will be accurate input of key balance sheet information such as balances, yields, reinvestment rates, and the contractual re-pricing or maturity schedules. These are the known data entry characteristics. From there we must build into the model a variety of assumptions in order to account for those factors we cannot know of in advance. These include time lags, sensitivities or betas, behavior of non-maturity deposits and prepayment speeds, among others. Asset/liability modeling therefore involves the input of certain known characteristics, combined with certain unknown behaviors, that must be assumed. Gauging the reasonableness of these behavioral assumptions is important to assessing the overall integrity of the system. Back testing is helpful in this regard. What Is Back Testing? Back testing is the process of reviewing the projections of an A/L model after the fact and comparing those projections against actual performance. The results of a back test help answer questions such as: 1. Were projections different from actual bank performance? DIRECTORS / SENIOR MANAGEMENT Back Testing and Validation of A/L Reporting Systems 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. Chris Wilson, is vice president and financial strategist of The Baker Group, which he joined in 2002. The author can be reached at 800-937-2257, email: cwilson@ gobaker.com. About the Authors 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 The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider.
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