10 Practices Credit Unions Need for Successful ALM
10 Practices Credit Unions Need for Successful ALM
ALM Framework Refresher for Credit Unions
By definition, a credit union is a financial institution that accepts deposits (liabilities) which it pays interest on and offers loans or makes investments (assets) for which it receives interest. As such, without a strategy to manage those assets and liabilities, a credit union will risk profitability (impacting its operational flexibility as a non-profit) and at worse cause the institution to seek external assistance or fail.
In order to mitigate those risks, a credit union should have a comprehensive asset liability management (ALM) framework to manage its assets and liabilities, considering factors such as interest rate risk, credit risk, liquidity risk, and capital adequacy.
What Is Asset Liability Management?
ALM is the process of managing assets and liabilities in a manner to mitigate risk to an enterprise, with a clear understanding of how that management affects net interest margin (NIM) and the economic value of equity (EVE).
A comprehensive ALM framework provides guidance and governs processes implemented as part of the framework. This should be approved by the board of directors, and it requires documentation, testing, and third-party verification.
A variety of best practices will help to ensure that a credit union’s ALM framework is in proper order.
Regularly Review and Update ALM Components
ALM components should be periodically reviewed and updated as needed to reflect changes in the market, the credit union’s risk profile, the regulatory environment, and the credit union’s customer base. These key components include measuring and monitoring risk, interest rate management, credit risk management, liquidity management, and capital planning.
Robust Risk Measurement & Monitoring
A credit union should have robust risk measurement and monitoring processes in place to identify and assess risks on an ongoing basis. This may involve using various analytical tools such as stress testing, scenario analysis, and sensitivity analyses to evaluate the potential impact of various risk factors on the balance sheet. Some of the key metrics used in quantifying the risk of the ALM strategy are NIM, EVE, and duration gap (DGAP).
Most institutions have a variety of methods to measure liability risk. Items to incorporate into the strategy should include:
- Monitoring and forecasting daily cash activity while focusing on areas that contribute an out-sized risk to the forecast, such as large depositors, balances above the National Credit Union Administration limit, and open lines of credit
- Identifying risky clients and the likelihood of capital flight
- Focusing on retaining high-balance clients through strategies like private banking services, premium credit cards, complimentary safety boxes, and concierge services for wires, foreign exchange, or large withdrawals
- Focusing marketing on retaining and attracting high-net-worth accounts through traditional channels such as branch managers and digital channels with “white glove” service
- Establishing tested plans to rapidly onboard new clients, and this can include Know Your Customer and Anti-Money Laundering checks
Interest Rate Management and Hedging
A credit union should have quality interest rate management and hedge with an understanding of interest rate changes and their potential impact on future cash flows.
The firm should have a plan for managing its exposure to interest rate risk, including strategies for managing the maturity and repricing of its assets and liabilities. This includes:
- Evaluating interest rate risk by quantifying NIM, EVE, DGAP, and income sensitivity to interest rates
- Being mindful of negative convexity in the investment portfolio and how to quantify and hedge appropriately
- Evaluating hedging and its effectiveness
- Periodically reviewing interest rate risk modeling and assumptions
- Being efficient with the use of interest rate caps, payer swaptions, puttable bonds, and make-whole callable bonds
Liquidity Management, Monitoring, and Stress Testing
A credit union should have a plan for managing liquidity levels and ensuring that it can meet its funding obligations under normal and stressed market conditions. This involves maintaining adequate levels of liquid assets, developing contingency funding plans, and monitoring market conditions to identify potential liquidity risks.
Forecasting daily needs and stress testing those assumptions
Managing liquidity starts with forecasting the daily needs of the credit union followed by stressing those assumptions to see how they affect the forecast. Assumptions should be reasonable, appropriate, reviewed, documented, and approved by management.
For example, credit unions should conduct periodic tests to ascertain if internal systems are robust enough to handle inflows and outflows at an amount close to 25% of their deposit base.
Informing Future Projects With an Economic Outlook
The credit union as an institution should have an economic outlook that informs all projections, such as budgeting or allowance. Stakeholders such as auditors and examiners will look for an outlook narrative and may also look for a forecast of economic variables such as unemployment or gross domestic product as well (depending on asset size of your institution).
Growth rates used in budgeting and capital planning should be tied back to this outlook and forecast, and policy and procedures should be written around the outlook’s source (vendor-purchased versus internally generated) and its frequency of update. For the new CECL allowance standard, expect auditors to check that all senior management are aligned on the outlook and that decisions regarding economic estimates have evidence of discussion and approval in committee minutes.
Forecasting and testing provide the basis for setting adequate levels of liquid assets and developing contingency funding plans. The forecasts should be stressed under varying scenarios and durations, such as changes in interest rates, changes in the yield curve and scenarios such as a global financial crisis, the end of the zero interest rate policy, a taper tantrum, stagflation, inflation, and bank runs.
Note that liquidity can be measured differently; for example, asset-based liquidity measures whether liquidity from high-quality liquid assets can cover daily operational needs such as deposit withdrawals and loan originations. The liquid assets should be assigned liquidity tiers and marked with whether they are free of legal and regulatory impediments. Additionally, such assets should be able to be operationally available to meet liquidity needs.
Monitoring market conditions should help identify potential events that could lead to liquidity issues and instability in the deposit base. The speed at which communication and news travels and the ease of moving funds has shortened the time credit unions have to react, so that speed must be incorporated into updates of a forecasting model.
Credit Risk Management
A credit union should have a plan for managing its exposure to credit risk, including policies and procedures for assessing and monitoring the creditworthiness of its borrowers and counterparties.
Part of managing credit risk requires a consistency in the underwriting process and proper reviews of exceptions when they occur. Those exceptions should be well documented as part of the credit risk assessment and loan approval process. Examples of counterparty risk management metrics commonly include:
- CAMELS (capital adequacy, asset quality, management quality, earnings, liquidity, sensitivity to the market) analysis for significant counterparty risks
- CECL (current expected credit losses) allowance calculations performed quarterly for loans and securities
- Credit stress testing, often annually for scenarios where probability of default may increase suddenly for portfolio segments
- Formal loan review that occurs regularly for large exposures (i.e., large commercial real estate lending) and random sampling for most consumer lending
While tracking these metrics may traditionally be handled by a credit committee rather than an asset liability committee (ALCO), credit unions should always keep asset quality in mind for ALM. For example, risky counterparties may constrain liquidity in the event of a seizure or bankruptcy. New CECL allowances will impact NIM, and therefore future pricing and product mix for loans.
Capturing data is equally important, as it feeds in the analytics and modeling for the underwriting process. Credit risk management should be seen as an area where there can be continuous process refinement to improve credit management and operational efficiency.
Additionally, counterparty risk can be monitored with a credit default swap, government reporting, and public filings. Monitoring market conditions can also help identify potential events that could lead to liquidity issues and instability in the deposit base.
Establishing a Liquidity Policy and Contingency Funding Plan
The results and measures from all the forecasts should provide inputs for a credit union’s liquidity policy and contingency funding plan that is adopted and approved by the board.
The liquidity policy should govern daily and operating cash needs as well as establish plans for meeting forecasted liquidity shortfalls and unforeseen contingencies.
In contrast, the contingency funding plan should include policies and procedures, projection reports, and action plans designed to ensure sources of liquidity are sufficient under contingent events.
Some of the largest failures in the banking system can be attributed to operational failures. In order to mitigate operational risk, credit unions should have adequate internal controls that can identify and address potential issues before they lead to losses. This includes the following:
- Employees who are adequately trained and equipped to identify operational risk and take appropriate action along clearly structured reporting lines
- Robust systems and processes in data management, risk assessment tools, and reporting that are used to identify, measure, and manage operational risk
A credit union should have a clear plan for managing its capital levels and ensuring that it adequately meets regulatory requirements. Aside from incorporating the forecasting of expected cash flows and liquidity needs, capital planning also involves developing stress scenarios and contingency plans to ensure that the credit union can maintain adequate capital levels under adverse market conditions. Regular assessment of regulatory requirements and comparison of existing new and alternative funding sources should also be considered as part of the process.
Governance and Controls
A credit union should have strong governance and controls in place to ensure that its balance sheet management practices are effective and aligned with its overall risk management strategy. This may involve establishing clear roles and responsibilities and reporting lines, implementing robust risk management processes, and conducting regular audits and reviews of its balance sheet management practices.
A credit union should have a plan for communication for events such as rapid moves in interest rates and unfavorable press. Statements for media and for regulatory body distribution should be prepared and updated, and there should be an outline for statements to be delivered to customers under such events (as well as a plan for the exact communication method).
The Proper ALM Framework
A robust ALM framework will allow a credit union to manage assets and liabilities successfully in a wide variety of economic and regulatory environments. For credit unions working to develop a comprehensive ALM strategy, third parties can quickly assist in developing a framework that is comparable to your peers and that reflects updated issues that are in focus by regulators and auditors.