20 SEPTEMBER / OCTOBER 2022 Asset Pricing and ALM Strategy DIRECTORS / SENIOR MANAGEMENT Andrew Okolski Senior Financial Strategist The Baker Group andyo@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. After navigating the 2008 housing crisis and the 2020 pandemic, banks now face the most feared economic monster of all – inflation. The Consumer Price Index year-over-year jumped 8.6% in May, backed by broad price increases across many sectors. This is well above the Fed’s normal target of 2% and increases the chances of more severe economic headwinds. If the Fed aggressively fights inflation through higher rates and balance sheet reduction, it will add significant downward pressure on consumers and the overall economy. If it is not aggressive enough, inflation can remain elevated for a longer period of time, also adding significant downward pressure. While everyone had hoped for a breather coming into 2022, instead we find ourselves in an equally challenging situation in which asset pricing and asset/ liability management (ALM) strategy are of utmost importance. For most of the past couple of years, it was income and capital pressures that kept many up at night. The good news is that today’s higher yields offer quick relief in those categories. Unfortunately, we now have some new pressures coming in the form of falling asset market values. While every institution is unique, the function of managing interest rate risk (specifically market risk) can almost always be improved through the inclusion of economic value of equity (EVE) and income simulation results. Doing so is key when discussing overall asset pricing, along with the difference between ALM results and executed strategy. It’s important to note that the rate of change in asset/ liability management is as important as the overall amount of change. This is why asset pricing becomes so important in this type of volatile interest rate environment. The faster interest rates rise, the greater the negative impact, particularly on economic value of equity. Mainly this is because quick rate movements leave depository institutions little time to react and adjust their asset yields. We can only add higher-yielding investments and write higher-yielding loans so fast. Often this means that the first few quarters during a rising rate trend can magnify and even potentially overstate our interest rate risk (IRR) as measured through EVE. So, what can we do to combat this? Part of the answer is that we need to quicken the pace of asset repricing on our balance sheets. This is by no means an easy task, but it is necessary and should be a top priority. Increased loan demand is a welcome sight, especially after what we have experienced the past two years. The tricky part is that those new loans need to be at or above current market levels to begin softening our EVE risk. It doesn’t help our IRR position to be adding loans at 2021 levels. The market currently expects fed funds to reach 2.5% to 3% by the end of this year, and short investments (without credit risk) can easily earn 3% yield or more. All of these factors must now be taken into account when discussing and adjusting asset pricing strategies. This is one of the reasons that including ALM results in every strategic decision is critical. It greatly shortens our reaction time and reduces how far off the path we can find ourselves in volatile environments. The year 2022, and likely 2023, will require more frequent asset/ liability and strategic planning sessions. At the same time, we need to ensure that the decisions we make in those meetings are in line with the assumptions we use in our ALM documents. Otherwise, we are basing our strategic movements on outdated directions. For example, what if our ALM assumes that new
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