Auditing Asset-Liability Management (ALM) Functions

Transcription

1 Auditing Asset-Liability Management (ALM) Functions Presentation to ACUIA Region 6 October 7 9, 2015 Presented by: Harvey L. Johnson, CPA, CGMA Partner

2 Session Outline Economic Environment & Credit Union Balance Sheet Structure Understanding ALM o Interest Rate Risk Defined Measurement of Interest Rate Risk o Income Simulation o Net Economic Value Analysis Auditing ALM

3 Resources

4 Resources Federal Deposit Insurance Corporation (FDIC) Advisory Letter on IRR Management (January 2010) Federal Deposit Insurance Corporation (FDIC) Interagency Advisory on IRR Management FAQ (January 2012) Federal Reserve Bank (FRB) Interagency Guidance on Funding and Liquidity Risk (March 2010 Vol. 75, No. 54) FDIC: Interest Rate Risk Series on YouTube NCUA IRR (2014) NCUA Guidelines InterestRateRiskProg.pdf

5 Overview

6 IRR Why Such A Big Deal? One of the NCUA s top concerns Key threat to financial stability o Given the current environment, there is potential for rapid rate changes to occur o If rates do change rapidly it will stress earnings, potentially close credit unions who are unprepared. o Huge impact on members! Less purchasing power, available cash flow, o Expect increases in foreclosures, TDRs, modified loans, and nonaccrual loans

7 Top Economic Concerns How will the economy and markets respond to rising interest rates? How fast will they risk? How long? Inflation.it s coming! How will members be able to handle the combination of rising interest rates and inflation? What happens to IRR if (when) the stock market bubble bursts? Bond market is going to be hit much harder than stock market when rates rise.

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12 What Is INTEREST RATE RISK? Threat that a change in market interest rates may: Reduce net interest income o Adversely affect the economic values of financial assets and liabilities Impair capital, elevating the risk of insolvency Impair liquidity

13 Interest Rate Risk Why Is It Important? The majority of our assets and liabilities are financial instruments We buy and sell money: o Income We sell loans and receive interest o Expense We buy shares and pay a dividend Financial Performance is therefore affected by future economic circumstances

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15 Sources of Interest Rate Risk Repricing Risk Basis Risk Yield Curve Risk Option Risk

16 Repricing Risk Repricing risk is the risk resulting when assets and liabilities have different average maturities or repricing dates Earnings change when there is a change in the level of rates

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18 Basis Risk This is the risk from unequal movements in interest rates on a credit union s assets and liabilities with the same maturity or repricing.

19 Basis Risk Example Balance Sheet Year 1 Year 2 1CMT 1% Year 3 1CMT 1.5% Rate Income/ Expense Rate Income/ Expense Rate Income/ Expense $5M 1 YR ARM 4.25% $212, % $262, % $187,500 $5M 1 Year Certificate Net Interest Income 1.50% $75, % $100, % $62, % $137, % $162, % $125,000

20 Yield Curve Risk Risk of short term rates changing by more or less than the change in long term rates Rule of Thumb o Short term rates are often more volatile than intermediate and long term rates

21 Yield Curve Risk

22 Causes of Option Risk Option Risk arises whenever credit union products give customer the right, but not the obligation, to alter the quantity or the timing of cash flows

23 Examples of Option Risk Contractual Options o Call/Put options in securities o Interest rate caps, floors Ambiguous Options o Loan prepayments/payoffs o Revolving balance accounts, credit cards, lines of credit o Withdrawal of shares o Implicit rate caps and floors

24 Measurement Systems

25 NCUA Measurement Systems Management should utilize the results of the credit union s IRR measurement systems in making operational decisions such as changing balance sheet structure, funding, pricing strategies, and business planning.

26 Interest Rate Risk Measurement Tools GAP Analysis Income Simulation o Measurement of short term risk o Earnings Perspective Net Economic Value Analysis o Measurement of long term risk o Value Perspective

27 GAP Analysis Simplest, easiest to understand Identifies repricing mismatches within various time buckets o Models static balance sheet o Eliminates growth distortion o Captures only repricing risk o Uses basic data inputs and simple assumptions o Dynamic Model uses baseline assumptions

28 Income Simulation Modeling Income simulation models project future net interest income and how it changes as interest rates move The amount that it changes from current market rates to higher and lower market rates determines the level of risk

29 Income Simulation Static and Dynamic Modeling o Static = current, no growth projected o Dynamic = repricing, option, basis risk o More data inputs and assumptions = greater risk of uncertainty, inaccuracy o Scenarios should be severe, yet plausible (worst case) o Minimum of two year time frame

30 Income Simulation (000 s) Rates Down 100 Flat Rates Rates Up Interest Income $2,900 $3,000 $3,100 Interest Expense $940 $1,300 $1,620 = Net Interest Income $1,960 $1,700 $1,480 $ Change from Flat $260 $ 220 % Change from Flat 15.3% 12.9% Policy Limit 20% 20%

31 Net Economic Value (NEV) Models Measurement of the future (long term) earnings potential of today s balance sheet Risk is measured by the change in value of the credit union s assets and liabilities due to interest rate movements and the impact these changes have on the capital position

32 EVE or NEV Long term IRR valuation model Longer term analysis Models static balance sheet using NPV, no growth Capture multiple types of IRR Data assumptions are significant Difficult to accurately predict and subject to multiple assumptions, so focus is on EVE volatility, % change from base case

33 Net Economic Value Formula + The value today (present value) of future amounts the credit union will receive, such as loan principal and interest payments, and investment principal and interest. The value today (present value) of future amounts the credit union will pay for its funds, such as deposit principal and interest payments. = Net Economic Value

34 Value Changes With Interest Rates Amount: $1,000 Coupon: 6% Life: 5 years Payments: Annual Period Cash Flow 5% 6% 7% , Total 1, , , % Change 4.33% 4.10%

35 Price Sensitivity Assets Liabilities

36 Price Sensitivity & Maturity For a Given Rate Change: o Shorter Maturities Have Smaller Value Changes o Longer Maturities Have Larger Value Changes

37 NEV Impact of Changes in Interest Rates Change in Interest Rates Increase /Decrease in PV Asset Decrease Liability Decrease Impact on NEV Unfavorable Favorable Asset Increase Liability Increase Favorable Unfavorable

38 Net Economic Value (000 s) Rates Down 100 Flat Rates Rates Up PV Assets $148,500 $146,400 $139,600 PV Liabilities $125,000 $123,400 $119,200 = Net Economic Value $23,500 $23,000 $20,400 $ Change from Flat $500 $(2,600) % Change from Flat 2.1% (11.3)% Policy Limit 25% 25% NEV Ratio 15.8% 15.7% 14.6% Policy Limit 6.0% 6.0% 6.0%

39 Prospective IRR Considerations Pricing is critical in managing risk when rates begin to increase especially share pricing Managing levels of loan vs. share growth Potential changes in share mix to more rate sensitive funds and/or share attrition Impact of changing yield curve

40 Assumptions Rate changes Prepayment estimates Uncertain Maturities o Deposit assumptions (run off, decay, etc.) Assumptions should be clearly documented and periodically reviewed. o Key assumptions should be communicated to the ALCO and the Board

41 Modeling Considerations Non parallel Rate Shocks/Rate ramps Dynamic Balance Sheet Change in Deposit Composition Share Attrition Stress Assumptions o Non Maturity Shares o Prepayments

42 Measurement Systems Downloads from loan/deposit systems External feed for investment portfolio Integration with the general ledger Mapping of GL to IRR system o Key! If mapped wrong, data will cause errors o Aggregated data: break down of portfolio (fixed rate vs. variable, terms, etc.)

43 NCUA Components of IRR Measurement Models Chart of Accounts Credit unions with significant holdings of adjustablerate mortgages should differentiate balances by periodic and lifetime caps and floors, the reset frequency, and the rate index used for rate resets. Similarly, credit unions with significant holdings of fixed rate mortgages should differentiate at least by original term, e.g., 30 or 15 year, and coupon level to reflect differences in prepayment behaviors.

44 NCUA Requirements

45 NCUA Requirements 12 CFR Part 741 o Requires FICUs to develop and adopt a written policy on interest rate risk management and a program to effectively implement that policy. Who does the rule apply to? o Effects FICUs with assets > $50 million o Only 45% of FICUs but 96% of FICU assets

46 NCUA Requirements All FICUs are required to have an IRR policy and program which should incorporate the following five elements into their IRR program: 1. Board approved IRR policy. 2. Oversight by the board of directors and implementation by management.

47 NCUA - Board Oversight The Board of directors is responsible for oversight of their credit union and for approving policy, major strategies, and prudent limits regarding IRR. The Board should annually assess if the IRR program sufficiently identifies, measures, monitors, and controls the IRR exposure of the credit union.

48 NCUA Management Responsibilities Management should: o Develop and maintain adequate IRR measurement systems; o Evaluate and understand IRR risk exposures; o Establish an appropriate system of internal controls (e.g. separation between the risk taker and IRR measurement staff); o Allocate sufficient resources for an effective IRR program. For example, a complex credit union with an elevated IRR risk profile will likely necessitate a greater allocation of resources and focus on IRR exposures;

49 NCUA Requirements 3. Risk measurement systems assessing the IRR sensitivity of earnings and/or asset and liability values. 4. Internal controls to monitor adherence to IRR limits. 5. Decision making that is informed and guided by IRR measures.

50 Risk Mitigation and Limits

51 Risk Limits & Mitigation Effective risk limits should permit management to: o Control IRR exposure o Initiate discussions about risk o Take appropriate action as identified in IRR policies and procedures Risk limits should be re evaluated for reasonableness Management should develop effective risk mitigation strategies when exposure approaches or exceeds risk limits

52 Risk Controls & Limits Policies and procedures Authority and responsibility Risk limits (concentrations on types of assets and liabilities, rate floors, etc.) Risk mitigation

53 Risk Limits Earnings & Capital Based Earnings (NII and NI) Loan to deposit mix Concentrations in assets and liabilities Graduated risk limits

54 NCUA Policy Limit Examples Examples of limits are as follows: o GAP: less than 10% change in any given period, or cumulatively over 12 months. o Income Simulation: net interest income after shock change less than 20% over any 12 month period. o Asset Valuation: after shock change in book value of net worth less than 50%, or after shock net worth of 4% or greater. o Net Economic Value: after shock change in net economic value less than 25%, or after shock net economic value of 6% or greater. NCUA emphasizes these are only for illustrative purposes, and management should establish its own limits that are reasonably supported.

55 Monitoring & Reporting Management & Board Reporting Assess Reports Risk Limits Compliance

56 Identify & Measure Model selection Data inputs Assumptions* Documentation*

57 Risk Limits and Mitigation Strategies Risk tolerance and profile o Consider complexity, earnings and capital o Change with risk profile and conditions o Ensure action plans are devised in appropriate

58 Mitigation Strategies Asset sales and purchases Product mix and structure alterations Strategic growth and initiatives Hedging (swaps, options, floors, caps, etc.)

59 Reporting Evaluate trends and IRR exposure Evaluate compliance with policies and limits Evaluate key assumptions Evaluate various stress scenarios, including those involving breakdowns of key assumptions and parameters

60 Interest Rate Risk Red Flags Noncompliance with risk limits No risk limits Frequent exceptions to the interest rate risk policy Significant changes in the level and trends of interest rate risk exposure Reports are not provided by management that identify and quantify the level of interest rate risk

61 Internal Controls

62 Internal Control Structure System to Ensure Integrity of IRR Management Process Adequate Corporate Governance Policy Guidance Management and Measurement Systems Internal Control System

63 Internal Control System Enforces roles, responsibilities and lines of authority Segregation of duties Adequacy of System Inputs & Measurement Systems o Data inputs and assumptions are accurate and complete prior to running simulations, reports, etc. Policy Compliance Independent Review and Validation o Test integrity of system and models used Corrective Action Procedures

64 Auditing ALM

65 Objective of ALM Review Review the Credit Union s IRR and ALM functions to ensure sound risk management practices are in place to measure, monitor, and control funding and liquidity risk.

66 Specific Objectives of an ALM/IRR Review The objectives of an internal review of ALM/IRR are to determine that: The quality of the risk management process and level of interest rate exposure are part of the Credit Union's IRR profile. Management has identified and quantified the level of IRR assumed by the Credit Union. Credit Union officers and employees are operating in conformance with established IRR management guidelines. Corrective actions are taken when either the Credit Union's processes to identify and manage IRR exposures or the level of capital to support its risk are deemed inadequate. The Credit Union has adequate corporate governance, including active involvement by the board of directors and management in liquidityrisk management.

67 Specific Objectives of an ALM/IRR Review The Credit Union has identified strategies, policies, procedures, and limits for controlling interest rate and liquidity risk. The Credit Union has employed adequate systems and processes for measuring, monitoring, and reporting interest rate and liquidity risk. There are comprehensive contingency funding plans (CFPs) for addressing potential adverse liquidity events and meeting emergency cash flow need. There are appropriate internal controls for liquidity risk management. These objectives are accomplished through physical inspection of detailed records, inquiry of management and other Credit Union personnel, review of minutes of the asset liability committee (ALCO), observation and inspection of the third party software utilized, and a review of the Credit Union's system of internal controls.

68 ALM / IRR Not a one size fits all, nature and complexity of institution determines how robust your ALM function needs to be.

69 Areas to Review Corporate Governance & Risk Management Policies & Procedures Contingency Funding Plans Internal Controls

70 IRR Audit Process 1. Adequacy of internal control system 2. Compliance with internal control system 3. Adequacy of measurement systems 4. Accuracy of data inputs

71 IRR Audit Process 5. Adequacy of assumptions 6. Validation of calculations 7. Backtesting 8. Annual report to the Board

72 CFP

73 CFP A compilation of policies, procedures, and action plans for responding to contingent liquidity events. The objectives of the CFP are: o to provide a plan for responding to a liquidity crisis o identify contingent liquidity sources that the institution can use under adverse liquidity circumstances o describe steps that should be taken to ensure that the institution s sources of liquidity are sufficient to fund operations

74 CFP Testing/Consideration Determine the Credit Union has a CFP Determine whether the CFP has identified levels of liquidity events Determine whether the CFP has identified strategies to implement during liquidity events Determine whether the Credit Union has tested lines and other sources of liquidity credit

75 Questions and Answers Please use the chat pane to submit your questions.

76 Mark Your Calendars Three Part Webinar Series On IRR/ALM Part Two Developing Appropriate Assumptions For Your Credit Union November 4, 2015 Watch your Inbox for your invitation.

77 Contact Please Contact: Harvey Johnson, CPA, CGMA Partner Leader, Credit Union Services Team PBMares, LLP 150 Boush Street, Suite 400 Norfolk, VA Phone: (757) or (757)

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