By Brian Cox, CFA
Although banks may not consider the asset liability management (ALM) model to be a purpose-driven tool for driving profits or making strategic decisions, they should. An ALM model can help the asset-liability committee (ALCO) think more holistically about possible changes within its balance sheet. And it can provide data to help drive decisions, transforming the ALCO into a purpose-driven committee versus a regulatory requirement.
Here are a few examples of when and how you can use data from the ALM model to drive smart decision making:
Evaluation of derivative transactions
When a bank considers utilizing derivatives to help with its balance sheet strategy, the ALM model is one of the most valuable tools in its arsenal. To evaluate the effectiveness of employing a derivative strategy we need data to see how the derivative position behaves in different scenarios and how that behavior impacts the overall balance sheet of the institution. We can then use that data to see if the derivative position increases or decreases our overall risk position and achieves the desired goals.
To accomplish this analysis and generate the necessary data needed for the ALCO to make an informed decision, the institution needs to run simulations (i.e., “what-if” scenarios) in the ALM model. The ALM model provider should be able to assist in building the scenarios, running the simulations, ensuring accurate data and interpreting the output. Running simulations is the only way to see if the derivatives achieve the goal of the ALCO as was intended, so, as a best practice, one should be run before any derivative transaction is executed. This will ensure regulatory bodies do not criticize transactions.
If your institution does not have the ability to run “what-if” scenarios to evaluate a potential derivatives position, then you should not be considering derivatives.
Funding structure changes
ALCO’s frequently debate changing the funding structure of their institution when rates change or other market opportunities present themselves. All too often, however, these discussions are simply hypothetical and do not utilize actual data. Bringing data from the ALM model into these discussions is a great catalyst to drive actual decision making in the committee.
The ALM model is built for scenario analysis. When funding structure is on the agenda, run some “what-if” scenarios in the ALM model to project out the impacts to profits and risk exposures over the next 24 to 36 months. This information equips the ALCO with what it needs to make decisions.
Determining growth targets
When considering growth objectives for a financial institution, it is critical to know the impact potential growth targets (both in assets and liabilities) will have on capital, liquidity, margins and various other ratios. Conducting simulations will provide the necessary data relating to risks and rewards needed to allow the ALCO to make decisions on growth targets.
The ALM model will project out the impact on financial ratios as a result of meeting growth goals. This data will help bank management get in front of any issues that could negatively impact the institution as a direct result of growth. It removes the hypothetical discussions that often occur when hard data is not present and helps to facilitate action. It can also encourage management to begin making strategic decisions on how to position the bank to capitalize on certain growth opportunities.
By utilizing the ALM model to generate data for decision making, the ALCO can see how proposed changes will impact the overall institution. This will arm the committee and management with the hard data it needs to make decisions and get things done. The model puts the right information in front of the right people so that they can make the right decisions.
Provided by Detalus
Brian Cox, CFA is a Director and Portfolio Manager in the institutional group at Detalus Advisors, a financial services firm that focuses on balance sheet strategy and investment management for financial institutions.
Detalus Advisors, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein