Pub. 4 2015 Issue 3

April 2015 27 l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s EFFECTIVE INTEREST RATE RISK MANAGEMENT REVIEWING THE ROLES OF ALCO AND DIRECTORS T HE FDIC WINTER SUPERVISORY INSIGHTS publication details in-depth the responsibilities of Management and Directors in an Asset Liability (A/L) process which results in effective management of the bank. We traditionally have viewed these reports and similar publications from the Federal Reserve and OCC, as meaningful blueprints for what future examination cycles could focus on. In this article, we focus on Board and Asset Liability Committee (ALCO) responsibilities outlined by the FDIC and recently published interest rate risk metrics by the OCC. Earnings Pressure and the Rate Forecast Backdrop The stubbornly slow economic recovery was difficult to diagnose early after the recession ended in 2009. The corresponding prolonged period of very low interest rates has confounded economic forecasters for the last five years. For example, according to the Blue Chip Financial Forecast in July 2009, expectations for the Fed Funds rate two years out (2011) was a whopping 3.26%. Contrast that with Fed Fund Futures currently trading around 1.25% - 1.75% in 2017. This misdiagnosis early on in the recovery had the effect of tamping down the willingness of many banks to extend 3-5 year fixed rate loans or add long term assets to the investment portfolio – both common practices today. On the liability side, depositors too have been unwilling to tie up funds beyond 12 months resulting in ballooning non-maturity deposit balances across the industry. Persistently low rates and a slow growing economy have led to an era of incremental lengthening of assets, loosening of lending standards and short-term retail deposits. Directors’ Responsibilities With this backdrop, consider the oversight responsibilities the FDIC outlines for Bank Directors. According to the FDIC, “The usefulness of an IRR measurement system depends on the reasonableness of the assumptions that are used as inputs” and that the board of directors should complete a periodic review of the key assumptions used in the modeling process. This review is aligned with the ultimate responsibility the board has for the degree of interest rate risk taken by the institution. Active director involvement is cited by the FDIC as an important component in the ALCO process at well-rated institutions. Participating in discussions pertaining to policy exceptions and key determinants of changing risk profiles are noted in addition to discussing pricing strategies and product mix with management in the ALCO meeting. On an annual basis the board is responsible for assessment of the third party review of the ALCO process. In short, it seems involvement beyond cursory review of the current rate risk position and rate environments is the responsibility of an effective Board. Asset Liability Committee Responsibilities The ALCO Committee has both oversight and strategic responsibility. At the most basic level, ALCO needs to review and approve the assumptions feeding the asset liability model and understand the interest rate risk position of the institution. In most cases this should occur quarterly but could be more frequent in times of quickly moving market rates, emerging competitive pressures or new product introductions. ALCO should identify ways to mitigate risk and quantify the impact of proposed strategies on interest rate risk, capital and projected earnings. Upon review, it falls on ALCO to approve the strategies for management to implement and review going forward. Finally, ALCO has the responsibility to complete an independent model validation and consider implementing any recommended changes. Growing regulatory attention on non-maturing deposit balances places the responsibility on Banks to develop and maintain pricing change betas and decay rates for these deposits. Modeling potential migrating behavior of these balances going forward should be analyzed by ALCO by completing change in deposit mix simulations to determine potential liquidity and earnings implications. In the end, the A/L process is a key tool to manage interest rate risk, an item the FDIC calls “one of the most important jobs of a banker.” The process can be burdensome yet it’s incumbent upon us as bankers to use this process not only for regulatory compliance but also as the means to drive stable long-term earnings of our institutions. The BOK Financial - Financial Institutions Group provides third party asset liability reviews, modeling, consulting, decay rate studies, and investment portfolio strategy. Reach us at 866.440.6515 or www.boscinc.com/services. © 2015 BOSC, Inc. Securities offered by BOSC, Inc., member FINRA/SIPC. Asset liability modeling, CD underwriting, portfolio accounting and safekeep- ing services are provided by BOKF, NA, an affiliate of BOSC, Inc. Investments and insurance are not insured by the FDIC; are not deposits or other obliga- tions of, and are not guaranteed by, any bank or bank affiliate. The content in this document is for informational and educational purposes only and does not constitute legal, tax or investment advice. Always consult with a qualified financial professional, accountant or lawyer for legal, tax and investment advice.