Making Asset Liability Management Work for You

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1 Making Asset Liability Management Work for You By Denny DeGroote, Manager Asset Liability Management Solutions for TMG After working with credit unions for more than 20 years, I have observed a number of credit unions that do not have a strategic Asset Liability Management (ALM) process in place. For some, they developed a policy several years ago that still guides them. Some are caught between the way it used to be done and an updated process that lacks for any number of reasons. However, there are those that I have worked with that have successfully leveraged the ALM process and are using it as a guiding hand in the strategic growth of the credit union. The question you should ask yourself is whether you have a good strategy in place that will be a guide for your future.

2 What s the difference between an okay ALM strategy and a better one? There are a couple of differences that you need to consider. 1. The first is whether you treat it as a requirement or an important business strategy. ALM is something credit unions must do at a minimum level to please examiners. If this is required, then why not gain additional benefit by using the results of the process to help make strategic decisions. Credit unions that are successfully using ALM strategies are committed to leveraging this process to maximize their potential for growth. 2. The second difference is a third party consultant. As growing credit unions use the ALM process to their advantage, they ve gotten help. Consultants can provide an effective ALM program that would include regular forecasting, typically quarterly, and regular and consistent measurement of interest rate risk. To achieve this, someone has to be committed to making sure the analysis gets done. A good investment is an outside consultant that is paid to get it done, and they also offer an objective view on the data. There is no question that credit union resources are stretched thin, even with an increasing number of technology solutions. And, while technology is supposed to create efficiencies, in many cases it has added responsibilities to already burdened staff. That s another reason why hiring an ALM consultant could be the right solution for your credit union. So what goes into an effective ALM strategy? First of all, we need to look at ALM and what it is. Then we ll look at how and why a third-party brings value to the process. THE BASICS At its root, ALM is nothing more than managing your assets and your liabilities so that you produce a spread that is sufficient to cover the cost of doing business and capital contributions consistently. At its root, ALM is nothing more than managing your assets and your liabilities so that you produce a spread (the difference between income from earning assets and outgo from cost of funds = Gross Spread) that is sufficient to cover the cost of doing business (net cost of operations) and capital contributions (reserve transfers) consistently. As the market has become more competitive and consumers have diversified their financial relationships, the Gross Spread is becoming less sufficient. That means you need to manage your balance sheet more closely and determine where additional revenue may be generated. This is obviously easier said than done. Your pricing structure is likely more complex than it has ever been. You most likely have a variety of loan, deposit and investment products that have differing and longer

3 maturities. It s tough to manage it all, but a consistent, stable spread is not impossible if you are regularly and honestly (not unrealistically optimistic) reviewing your balance sheet. This equates to pricing individual products as the market demands. You don t want to lump products into general categories and make adjustments to all, when just one or two will be effective. As you work to keep the Gross Spread consistent, ideally you would strive for a net Return on Assets (ROA) of one percent. While one percent isn t a requirement, it is a reasonable goal that most financial institutions set as a benchmark. If the one percent ROA is surprising to you, think about the last time you really looked at your ALM process. ALM becomes more complex as you grow your assets and add new products and services. To assume your ALM strategy of five or 10 years ago is still effective; you re putting your credit union at a distinct disadvantage. There are a significant number of credit unions who are prudent in their financial management, but certainly not strategic. ALM becomes more complex as you grow your assets and add new products and services. Combine this with an economy that is extremely sensitive and your balance sheet does not produce as it once did. Let s boil it down to this: not too long ago, a successful credit union planned for a 12 percent return on loans and six percent cost of funds. This created a spread of six percent. It was a guaranteed business plan. Boy, life was good. MAXIMIZING YOUR GROSS SPREAD It s no longer that simple. There is little to no margin for error. ALM has become critical to maximizing your Gross Spread. This means more and different pricing strategies for the various products that you offer. What if the market rates change up or down? What will that do to your cash flows? What does that mean for the liquidity requirements you have to meet loan demand and deposit withdrawals? These are questions you have to answer to manage a consistent Gross Spread. The best way to do this is through your ALM process. Consider the first three months of The markets have been exceptionally volatile, which at one point has impacted rates more than 200 basis points. Were you ready to weather such a swing? Or did you have to scramble and adjust on the fly? We ve become accustomed to working in a volatile market, and in doing so created a sense of complacency. It s the idea that we are still here, we are still serving our members, and maybe

4 we aren t growing as fast as we could, but we are surviving. An ongoing ALM strategy helps create a roadmap that says if x happens, then we should do y. An effective ALM plan might start with a two-year forecast. To make the forecast realistic, examine the growth targets assigned to each loan and deposit product, and your pricing assumptions for each product category. Also incorporated into the forecast should be decay and prepay data, as well as driver rate projections, which would portray how the credit union would react internally to external interest rate movement. These would be considered imbedded assumptions. When all of these are in place, the forecast should be a fairly accurate picture of your balance sheet and the corresponding income production. If you like what you see, then great. Now you need to make darn sure you do what ever it takes to make it materialize. This means everyone from your board of directors to individual members of your staff must understand their role. If you don t like what you see, and are coming up short of your goals, you still have time to consider what needs to be done now to fix the shortfall. Go back and decide whether the assumptions are reasonable. Ask what actions can be taken to move the growth target. It s easier and less stressful to deal with this on the front-end then to wait until after the fact. Once the forecast is complete, you ll want to consider the what-ifs, particularly rate shock income simulations. This could be a range from zero to 500 basis points movement either way. These simulations help you measure the exposure you have to interest rate movement and correspondingly to earnings forfeiture you might experience. In addition, consider running a Net Economic Value (NEV) report to project potential capital value in different rate environments. This report measures your equity exposure. Another common report is a Cash Flow report. This provides an accurate look at the cash flow activity within your balance sheet and the amount of liquidity you will have through the measurement period. This will give you a good sense of the money available for your funding needs. Since you don t want to borrow unnecessarily, this report can anticipate your liquidity needs. And, now it s time to start over for the next quarter analysis. What? You don t have time? Probably not, because most credit unions don t have the resource to commit to consistent ALM analysis, which is why successful credit unions partner with outside resources. They help to manage the process.

5 THIRD PARTY VENDORS/SOFTWARE Since your spreadsheet software is probably not the right tool for a strategic ALM process, no matter how proficient your spreadsheet skills are, and time is at a premium, you need the right tools to execute well. There are a variety of solutions available in a wide range of prices from software to consultants with proprietary programs, and everything in between. You can also elect to outsource the entire process. An ALM consulting service will prepare the reports for you (with your assumption input), analyze the reports and propose solutions. Other benefits of choosing a consulting practice versus a simple software solution may also include: BENEFITS OF CHOOSING A CONSULTING PRACTICE. Objective analysis.. Strategic planning assistance.. Education and training support.. Policy assistance. Whatever solution you choose, make sure it benefits your long-term goals. THE BOTTOM LINE Answer this question, how does your bottom line look? In today s competitive marketplace, you will continue to work with small margins and deal with ever-changing factors such as competition, product mix, marketing, rates, etc. The advantage to a strong ALM program is that it will help you make the right decisions that could mean the difference between average strategy and great strategy. Denny DeGroote manages TMG s ALM solution (using Farin and Associates SAM software) as well as provides strategic planning services to credit unions throughout the country. He can be reached at dennyd@themembersgroup.com or ABOUT TMG (The Members Group): TMG is a financial services organization dedicated to providing innovative customized solutions to credit unions across the country. TMG s core products include credit, debit, ATM and prepaid solutions, as well as online reporting, item processing, ACH, ALM and printing services. TMG is owned by the Iowa Credit Union League. For more information, visit