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To understand the ALCO Process, we must first understand how it came to be. The first session of our 6-part series provides the logic for the ALCO Process and includes a sample ALCO Policy. In this session we will also explain why we feel a single consolidated policy is the appropriate tool for the upcoming era.
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The ALCO Process
Is Your Board on Board For The New Environment?
KPN Consulting
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Why ALCO Now?
Pricing Model Today:
You Must Defend Efficient Pricing!
KPN Consulting 2
Source 6 Months 1 Year 2 YearsBrokered .40% .60% 1.15%
CDARS .38% - .49% .50% - .61% .97% – 1.22%
FHLBA .27% .35% .90%
The ALCO Process
• Some History First ….
• Commercial Banks that made Prime-Based loans supported by demand accounts had little need for sophistication.
• Also, our Investment Strategy was mostly about Short Term Deposits and Treasury Bonds.
• In those days, Credit Risk was all that mattered.• But, that all changed as competition for loans and profits
forced us into other arenas.
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The ALCO Process
Residential Mortgages Typically Fixed Rates for 3-5 years
Commercial “Mini-Perms”Commercial Real Estate Loans (Typically Owner-Occupied) With 5-15 Year Rates
Mortgage Backed Securities Fixed Rates with Additional Issue of Maturity
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New Areas for Growth & Profitability
The ALCO Process
• Residential Mortgages: though we would prefer to have rates float, borrowers are normally desirous of fixed rates.
• Given the credit history of mortgages (Not Sub-Prime!!), we are attracted to this loan product. Also, the dollar size of these loans makes them almost like a traditional commercial mortgage.
• So, we enter this space with a need for some longer than normal rate sets.
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The ALCO Process
• This is where the ALCO Process comes into play …
• Our funding sources continue to be short term in nature.
– And this leads to an Interest Rate Risk problem.
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Demand AccountsMoney Market Accounts
Savings AccountsCertificates of Deposit
The ALCO Process
• These kinds of issues really began in the late 1980’s and this is when the issue of Interest Rate Risk at the Community Bank level became important.
• Many of us started our ALCO process with a policy on Interest Rate Risk and that is often one of several “ALCO-Related” policies.
• Other ALCO-related risks came out of this era.
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The ALCO Process
• For instance, many of us use to invest in very “Vanilla” Investment Instruments – Fed Funds Sold, Treasury Notes and Bonds, Other Bank’s Deposits .
• But, again in the 1980’s, we could not find enough yield in these instruments and we began investing In longer term Agency Bonds and Agency Mortgage-Backed Securities.
• This created another ALCO-Related Risk to consider and newer, more sophisticated Investment Policies began to appear.
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The ALCO Process
• As was true with Interest Rate Risk, we created an Investment Policy often as a separate document but very much a part of the ALCO process.
• This pattern continued as new funding options entered our business – this created not only a need for a Funds Management Policy, but we also witnessed a change In how we managed Liquidity Risk.
• And more, sometimes separate policies, were created.
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The ALCO Process
• Where does that leave us today?
• Many of us have several ALCO-related policies and some are beginning to consolidate these various documents into a single ALCO policy.
• Hopefully, this will create a more understandable situation as it relates to both Directors and examiners as a single policy makes it simpler to tie together each of the various components.
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The ALM Process
• The ALCO must pursue many goals…
Four Key Goals
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Maximize Net Earnings
Grow the Institution’s Equity
Maximize Stability in Earnings and Equity
Manage and Control Risk
Management Role
• Ensure that the Board’s attitude toward risk is reflected in the operations of the Institution …
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Develop Policies / Procedures
Create Lines of Authority
Develop Risk Tolerances
Develop Measurement Tools
Monitor Risk for Board
Ensure Internal Controls
The Board Role
• One of the most important functions of the Board in the ALCO process is to set the tone for an Institution’s risk approach.
• This approach can be seen in many of the limits set within an ALCO policy.
• Boards must understand that this role is crucial and must understand how those limits influence Growth/Earnings.
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The ALCO Policy
KEY ALCO COMPONENTSInterest Rate Risk Management
Profit Spread Management
Capital Management
Liquidity Risk Management
Funds Management
Investment Risk Management
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Interest Rate Risk
• For Many Bankers, Interest Rate Risk (IRR) Management Is The Most Difficult Concept Imbedded In the ALCO Process.
• Likely, This is True Because Much of this Is Truly an “Art” as opposed to a “Science”.
• And, Much of this “Art” Has Evolved During the Past Ten Years.
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Interest Rate Risk
• Today, The Secondary Market Which Was Created With Fannie Mae’s Appearance in the1930’s Handles Much of the IRR in the Residential Mortgage Business.
• However, Other Kinds of Longer Term Assets Have Come On To Our Balance Sheets and This Is Where We Find Our IRR Today.
• Our 4th Session Will Dig Into This Risk.
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Profit Spread Management
• This Tends To Be Where Most Of Us Spend Most of Our Time …
• Prime-Based Lending Typically Provides a Good Map But With This Crisis, Bankers Have Created Relief By The Use of Loan Floors.
• Though We All Know The Potential Problem Coming With Those Floors, We Have Been Helped Greatly With Them During Most of This Crisis.
• We have Also Been Helped Greatly With Falling Rates and Most of Us Are Witnessing an Unprecedented Cost of Funds Today.
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Profit Spread Management
• This is Also The Most Tactical of our ALCO Issues Requiring Daily Attention to Loan and Investment Yields and Deposit Rates …
• And, Is Also Where We Often See Paralysis – Staying In Fed Funds, Going Long on Liabilities, etc.
• Note of Caution – No Decision is a Decision!
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Profit Spread Management
• This is also Where Boards and Management Can Sometimes Get Confused over Roles …
• Our Belief is that Much of this Issue Belongs in the Tactical Arena and with Management …
• The Review of this Issue Tends to Occur on a Monthly Basis With the Board Review of the Operating Performance of the Institution …
• This is Where the Board Should Focus ….
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Capital Management
• Managing Your Capital to Levels Supported By The Regulators is The Goal Here …
• We Use Three Concepts of Capital in the Banking Industry:
• Leverage Ratio: Shareholders Equity / Assets• Tier 1 Ratio: SE + LLR /Assets • Total Risk Based Capital: Tier 2 Equity / Risk
Based Assets
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Capital Management
• A Bank Should Set Its Capital Levels Based on Regulator Definition of Either Well or Adequately Capitalized:
We Will Look at this Issue in More Detail in our Final Session
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More Risk Adequately Capitalized 4.00% , 5.00%, 8.00%
Less Risk Well Capitalized 5.00% , 6.00% , 10.00%
Liquidity Risk
• Essentially, The Risk of a Bank Running Out of Money!
• Bank’s Can Have Asset-Based Liquidity and Liability-Based Liquidity:
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Asset-Based1. Fed Funds Sold2. Deposits3. Securities Portfolio
Liability-Based1. Access to FHLB Advances2. Brokered Deposits3. Fed Funds
Liquidity Risk
• Like So Many Banking Topics, Liquidity Risk Has Been An Evolving Issue…
• No Doubt, This Evolution Began With The FIRREA Legislation Which Opened The Door To The FHLB System To Commercial Banks.
• But, The Increasing Popularity of Brokered Deposits Coupled With the Various Forms of Retail Concepts Has Also Had a Major Impact.
• We Believe That This Has Been A Difficult Path For our Regulatory Arena and We Will Pursue This Topic Later.
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Funds Management
• This is Another Topic We Will Explore In Detail …• This is Also One of Two Topics That Federal
Regulators Have Addressed in the Past Year.• And For Many Bankers, This is Also An Area That Has
Created Stress With Consent Orders.
• Should Efficient Funding Tools Be Taken Away When They Are Most Needed?
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2004 2005 2006 2007 2008 2009
Deposits $6,585 $7,141 $7,825 $8,546 $9,037 $9,227
Mutual Funds $8,107 $8,906 $10,414 $12,039 $9,601 $11,121
Total Wholesale Funding
$1,907 $2,077 $2,160 $2,464 $2,673 $1,852
Total Assets $10,106 $10,877 $11,860 $13,039 $13,853 $13,134
Wholesale Funding /
Total Assets18.9% 19.1% 18.2% 19.7% 19.3% 14.1%
Role of Wholesale Funding12/31/04 – 12/31/09
Bank Thrift Industry Data
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Investment Risk
Two Main Objectives With This Issue:
Liquidity
Yield
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Investment Risk
• Liquidity – Asset-Based Liquidity Refers To Assets That You Maintain That Can Be Sold or Pledged in Order To Raise Funding.
• In Order To Be Quickly Saleable, You Must Ensure That Investments Held for This Purpose Have Unquestioned Liquidity and Can Be Sold Into A Market With Depth.
• During This Past Crisis, Many of Us Learned What Depth in a Market Means.
• And, For Many This Has Led To a More Conservative Investment Strategy.
• We Will Focus on this Issue in our 5th Session.
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The ALCO
• Typically, An Institution May Have One or Two ALCO’s – one for Management and one for the Board …
• This Is What We Do at our de novo Bank, However, our Suggestion is to Have One ALCO With Two Activities …
• Management – Focus on Tactical Issues
• Board – Focus on Strategic Issues
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The ALCO
• But, Whatever You Do …
• Involve One or More Outside Directors in the ALCO Process!
• Be Ready For That Day an Examiner Asks for an ALCO Meeting – with your Board ALCO person!
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An ALCO Policy
Sample Policy
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ALCO
• Summary …
• The ALCO Process is One Of Your Key Issues.• The Board Must Be Familiar With The Policy.• The Board Must Set Risk Tolerances Through
Policy Limits.• The Board Must See Monitoring of These Limits on
a Regular Basis.
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