Testing Critical ALM Assumptions
Fear is a great motivator. Even though most bankers are always interested in the ALCO process and the degree of IRR (Interest Rate Risk) contained in the current balance sheet and pricing strategy, at times they seem almost obsessed. This obsession usually comes shortly after receiving notice of the next exam date!
Keep a few things in mind. Most bankers are more prepared than they initially think because most have been participating in meaningful ALCO meetings for years now, and they understand the reporting and risk guidelines they are using.
But, also keep this in mind; regulators are not only interested in reviewing the critical assumptions used in your reporting system, they are also becoming more and more “obsessed” with “stressing” these assumptions, perhaps looking for a “breaking point” along the way. In fact, the lengthy low-rate environment we still “enjoy” has generated heightened “scrutiny” related to a couple of these “key” assumptions.
The first is the rate sensitivity of deposits (these measures of rate sensitivity are called Betas) and the second is the ability to maintain current balances of non-maturing accounts (referred to as “decay” or “retention” rates).
In retrospect, the regulators have been keenly interested in the above two phenomena for quite a long time. In fact, referring back to the last Supervisory Insights issued by the FDIC (Winter 2014), here is how they framed the process:
"The objective of sensitivity analysis is to isolate the impact a single assumption may have on the results of the IRR measurement system. This is accomplished by changing one assumption (e.g., increasing the decay rate or the beta factor by X percent) and re-running the analysis to compare results.)"
Rates have been so low for so long the conjecture is that it might be difficult to predict how depositors will react if, and when, rates increase. So, the calculated Betas (in the last five years) may turn out to be somewhat inaccurate because it is difficult to predict how aggressive depositors might react if they see higher rates offered down the street. And, the migration to Non Maturing deposits might suddenly reverse and head for the exit, or at least back to Time Deposits.
Please keep in mind that BancPath has included a series of reports in the addendum titled "Assumption Stress Tests". In these reports, we use six separate tests to gauge the impact of assumption changes (stresses).
In relation to the two assumptions discussed above we “stress” the betas and retentions assumptions to see what impact the changes have on Interest Expense (and thus Net Interest Income) and the Market Value of Equity
Currently Betas are calculated using the last 60 periods. But, as discussed above, these may be too low (who knows for sure) if rates zoom up. So, the Betas are stressed by increasing them to 125%(or to what extent desired by bank management) and a report is run to show the increased rate sensitivity (increased cost associated with the higher Betas) and the new risk profile. The impact of the increased betas varies across the board depending on current Betas, current balances, and the current liability mix.
The second test “stresses” the current “retention factor” of non-maturing deposits, including NIB DDA’s; Money Markets (MM); Savings, and NOW accounts in relation to Market Value of Equity (MVE). The test is simple because it reduces current retention factor expectations by 25% (25% is a default but the reduction is determined by the bank for each report run). So, for example, if MM accounts have a determined duration of four years, the “stressed” duration would become three years (4 X .75 = 3). This is critical because the duration used determines how far you move along the wholesale funding curve to determine the difference between current cost (retail) and replacement cost (wholesale). So, if rates increase and MM account balances disappear this test prepares management and the board for less value in these deposits, and ultimately less MVE.
If you spend the time to understand the key assumptions used in your reporting system, and then understand the results produced by stressing these assumptions, you will have a great start toward your exam preparation.
Call us at AMG (800.226.1923) if you want help sorting out the critical assumptions in your ALM reporting system.