The ALCO Process: A View From the Regulatory Arena

Discussion Points Outline the responsibilities of an asset liability committee (ALCO). Discuss commonly observed ALCO best practices in community banks. Review areas of the ALCO policy and/or ALCO activities that could be enhanced. Discuss liquidity risk management. Review new IRR guidance. Discuss regulatory ALM modeling tips. Introduce upcoming guidance on credit risk analysis of investment securities.

Asset-Liability Committee (ALCO) Responsibilities ALCO Composition Senior management committee in a financial institution responsible for coordinating the institution's borrowing and lending strategy, and funds acquisition to meet profitability objectives as interest rates change. ALCO Responsibilities – Liquidity Risk Exposure The ALCO should actively monitor the institution’s liquidity profile and should have sufficiently broad representation across major institutional functions that can directly influence the institution’s liquidity risk profile (e.g., lending, investment securities, wholesale and retail funding). For example, the ALCO will have responsibility for setting limits on the arbitrage of short-term borrowing, while lending long-term instruments. Among the factors considered are liquidity risk, interest rate risk, operational risk and external events that may affect the bank's forecast and strategic balance-sheet allocations. ALCO Responsibilities – Interest Rate Risk Exposure The ALCO should ensure that the risk measurement system adequately identifies and quantifies risk exposure. Reporting  The ALCO will generally report to the board of directors and will also have regulatory reporting responsibilities. Reporting process should communicate accurate, timely, and relevant information about the level and sources of risk exposure. Summarizes the principals of sound liquidity risk management that the agencies have issued in the past Includes FIL 84-2008 “Liquidity Risk Management” Guidance re-emphasizes the importance of cash flow projections, diversified funding sources, stress testing, a cushion of liquid assets, and a formal well-developed contingency funding plan (CFP) as primary tools for measuring and managing liquidity risk

Asset-Liability Management Typically, asset-liability management (ALM) is associated with reporting a financial institution’s historical Gap, EVE, and net interest income sensitivity results. Ideally, ALM should involve an integrated process between interest rate risk, liquidity risk management, budgeting, and strategic planning that includes the entire bank; and develops future dynamic strategies that balance risk and profitability.

ALCO Best Practices Observed in Community Banks Although there is no official written guidance that outlines regulatory expectations of the ALCO, the following are ALCO best practices observed by examiners of community banks: Liquidity that is readily available, including the availability of collateral to be pledged. Credit lines accessible with material adverse change clauses readily accessible to determine circumstances that would disallow use of the lines. Limitations on particular types of deposits that can be accumulated, for example, municipal deposits. ALCO package that includes a 1-page summary covering all key model assumptions including any recent changes to the assumptions. Funding diversification guidelines. Establishing targets and composition mix of the investment portfolio. IRR and liquidity limits that require action vs. additional discussion (e.g., Red, Yellow, Green). ALCO packages that show level and trends vs. just showing the level specifically for risk limits. Cash flow coverage for runoff of collateralized deposits. Testing credit lines at least annually.

ALCO Best Practices Observed in Community Banks (con’d) Although there is no official written guidance that outlines regulatory expectations of the ALCO policy, the following are ALCO policy best practices observed by examiners of community banks: Has substance, structure and focus. Ties-in other policy parameters, e.g., Investment Policy guidelines and the impact on liquidity. Includes description of how key assumptions are determined, and the source documents used to make the assumptions. Includes minimum risk limits for maintaining liquid, unencumbered assets. Includes a definition of liquidity assets. Outlines expectations for independent review. Includes funding risk limits by maturity, e.g., limits on short-term, wholesale funding).

What can a well-run ALCO do even better? Provide clearer and more descriptive language in the ALCO minutes in regards to ALCO meetings. For example -- Who contributes to the discussion? What is actually said? Provide details on the status, risks, and results of previously implemented strategies. Conduct sensitivity testing of key assumptions. Further develop contingency planning. Back-testing.

Common Examination Criticisms of the ALCO Function and/or ALCO Policy Lack of detail on type of collateral available for pledging purposes. Ability to track borrowing capacity and availability of funding from various sources. Lack of policy limits for liquidity, or lack of meaningful policy limits. Inability of management to explain why certain limits were established. Base-case and stress scenarios are not adequately explained relative to the bank’s overall condition. Inadequate modeling of new products and/or new strategies prior to implementation. ALCO report package does not adequately explain the bank’s current balance sheet risk-return profile. Not considering current level of earnings and capital when assessing risk limits, e.g., a risk limit of 15% of net interest income could eliminate earnings. Not revisiting established risk limits periodically to determine continued relevance. Lack of documentation for key assumptions, e.g., deposit betas, prepayments. No sensitivity testing of key assumptions.

Liquidity Risk Management: Points of Emphasis Corporate Governance Risk Tolerances Liquidity Risk Measurement, Monitoring, and Reporting Stress Testing Collateral Position Monitoring Funding Diversification Contingency Funding Plans Liquid Asset Cushion FIL-37-2009 includes Holding Company – Liquidity Risk Management which is not in the Statement

Corporate Governance Understanding nature of risk Periodic reviews Lines of authority and responsibility Development and implementation of appropriate policies and risk measurement and monitoring systems

Risk Tolerances Unencumbered liquid asset reserves Identification of unstable and liquid asset coverage ratios Cash flow projections Funding concentrations

Liquidity Risk Measurement, Monitoring, and Reporting Cash flow projections Reasonable, appropriate, and well-documented assumptions Meaningful time horizons

Stress Testing Institution specific scenarios Market wide events Multiple time horizons Sources of potential liquidity strain Impact on cash flows, liquidity position, profitability, and solvency

Collateral Position Management Value of pledged assets relative to amount of security required Unencumbered assets available to be pledged

Funding Diversification Effective diversification in the types and tenor of sources Maintenance of market access Identification of alternative funding sources in a variety of scenarios

Contingency Funding Plans Identify Stress Events Assess Levels of Severity and Timing Assess Funding Sources and Needs Identify Potential Funding Sources Establish Liquidity Even Management Processes Establish a Monitoring Framework for Contingent Events

Contingency Funding Triggers Reputation Event Asset Quality Event Funding Event Economic Event Capital Event Regulator Event Liquidity Ratio Violation

Liquid Asset Cushion Availability of a cushion of liquid assets without legal, regulatory, or operational impediments Availability to be sold or pledged to obtain funds in a range of stress scenarios Inclusion of contractual and noncontractual cash flows

Advisory on Interest Rate Risk Management (January 6, 2010)

Interest Rate Risk Guidance FIL-52-96: Joint Interagency Policy Statement on Interest Rate Risk FIL-2-2010: Financial Institution Management of Interest Rate Risk Summarizes the principals of sound liquidity risk management that the agencies have issued in the past Includes FIL 84-2008 “Liquidity Risk Management” Guidance re-emphasizes the importance of cash flow projections, diversified funding sources, stress testing, a cushion of liquid assets, and a formal well-developed contingency funding plan (CFP) as primary tools for measuring and managing liquidity risk

Why did we issue the advisory? Address the importance of having robust processes for measuring and mitigating, as necessary, exposures to potential increases in interest rates. Emphasize the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls.

IRR Guidance: Major Areas of Concern Corporate Governance Understanding risk profile. Establishment, approval, and implementation of IRR management strategies, policies, procedures and risk tolerances. Integration of new strategies, products, and business into IRR system. Firm-wide risk management efforts. Measurement and Monitoring of IRR Fully understand underlying analytics, assumptions, and methodologies. Selection of appropriate time horizons.

IRR Guidance: Major Areas of Concern Stress Testing Instantaneous and significant changes in interest rate levels (e.g., up and down 300 and 400 basis points) across different tenors to reflect changing slopes and twists of the yield curve. Prolonged rate shocks. Changes in relationships in key rates and slope of yield curve. Assumptions Reasonableness of prepayments, NMD sensitivities and decay rates, and key rate drivers. Historical and forward analysis.

IRR Guidance: Major Areas of Concern Risk Mitigating Steps Identification of IRR exposures Discussions of risk and appropriate action steps given the scenario Internal Controls and Validation – Model Validation Independent review of the logical and conceptual soundness Reasonableness of assumptions Backtesting of assumptions Adequate follow-up procedures

General Theme All measurement involves error. As a result, there is a need to: Sensitivity Test – How wrong on average? Stress Test – How bad can it get? Back Test – How accurate were my forecasts?

Regulatory Tips: ALM Model Theory Identify the bank’s appetite for IRR in comparison to credit risk and other risk types. Ensure that IRR measurement guideline exposure limits are consistent with the bank’s IRR appetite. Consider a “risk management” rather than a “budget” perspective for IRR measurement. Consider running a no growth scenario if the bank budgets ≥ 10% asset growth.

Regulatory Tips: ALM Models & Assumptions Consider the following: moving beyond a simple gap model if significant optionality exists (almost always) use ALM models that capture long-term IRR exposure (extended simulations and/or EVE) Ensure that management understands and supports the bank’s most critical ALM modeling assumptions. Consider identifying all critical model assumptions in writing.

Regulatory Tips: Critical Model Inputs Assumptions that significantly impact model output: Starting balance sheet (chart of accounts) Scenarios & interest rates Growth & new business assumptions Prepayment assumptions Deposit Repricing and NMD assumptions

Regulatory Tips: Scenarios & Interest Rate Assumptions Consider at least a +/- 300bp rate change over one year (or more spontaneous) in the worst case scenario. While banks are not required to perform +/- 400bp rate shocks, the IRR Advisory allows examiners the latitude to determine that based upon the institution’s profile and current economic conditions, a +/- 400bp shock is necessary. For example, in a period of extremely low interest rates, +400bp shocks would likely provide helpful risk management insights into IRR exposures, and/or identify some weaknesses in the current balance sheet structure. Consider non-parallel rate scenarios where material optionality exists. Ensure that driver rate choices are reasonable and consistent with business-line pricing methodologies. Ensure that discount rates or discount curves in valuation models are reasonable and supported.

Regulatory Tips: Back-testing Assess model assumptions and results. For less complex institutions, may be largely narrative. Ensure directional consistency.

Upcoming FIL: Credit Risk Analysis of Investment Securities Purpose FDIC has become concerned that some financial institutions are not conducting adequate pre- and post-purchase credit analyses of debt securities. Over reliance on credit ratings and insufficient internal credit analyses have increased supervisory concerns. Supervisory Policy Re-emphasizes pre- and post-purchase guidance outlined in the Interagency 1998 Supervisory Policy Statement on Investment Securities. Ratings should be only one component of a comprehensive process for assessing credit risk. Management should complete its own credit analysis that evaluates the issuer financial condition, cash flow ability, and collateral performance. Due diligence review of the legal documents associated with debt securities includes management review of materials, such as, prospectuses/offering circulars, indentures, trustee reports, pooling and servicing agreements, and reps and warranty agreements. Use of third party credit reviews is acceptable if these reviews are current, transparent, independent and thorough.

Summary The ALM process should identify, measure, monitor and proactively manage funds management and IRR exposure. Examiners have identified community bank best practices for the ALCO and the ALCO policy. Recently issued supervisory guidance on funding/liquidity risk management and IRR provide further clarity on regulatory expectations of the ALCO. Also, upcoming guidance on credit risk analysis of investment securities emphasizes acceptable methods of analyzing the credit risk factors of a debt security pre- and post-purchase.

Questions?