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Lecture Materials
ASSET/LIABILITY MANAGEMENT – YEAR 1
Dwight R. Larsen Vice President
United Bankers’ Bank Bloomington, Minnesota [email protected]
952-886-9525
August 5, 2016
1
Asset Liability Management -Year 1
(aka “The Nuts and Bolts of ALM”)
Graduate School of Banking
Madison, Wisconsin
Dwight R. Larsen
Today’s Outline
• Overview of the Section
• What is ALM?
• Why is ALM important?
• The “ALCO”
• Liquidity Risk and Management
2
Overview of the ALM Section
• Purpose? (see “Course Description”)
• Try and provide a basic understandingof the major ALM areas.
• Become “conversational” (not fluent)
• If not today, you may become involvedin ALM in the future!!! (POLL)
What is ALM?
3
A/L Management - Definition
• The process of planning, organizingand controlling asset and liabilityvolumes, mixes, maturities, rates, andyields with the objective of maximizingreturns and minimizing risk.
• Technically, encompasses all riskcategories (credit, IRR, liquidity,transaction, etc.)
What is ALM? (continued)
• Pre-session reading materials…?
• 1. “Active mgmt of the balance sheet”
– Setting rates, terms, maturities on loans
• And, making loans that get repaid!!!
– Setting rates, terms, maturities on deposits
– Determining what types of investment securities topurchase, given liquidity or income needs
– Ensuring adequate (but not too much) liquidity
– ENSURING ADEQUATE CAPITAL LEVELS!!!
4
What is ALM? (continued)
• 2. Understanding how changing marketinterest rates impact the bank’s netinterest income, net income, and capital.
What is ALM? (continued)
• Five main areas to be covered:
– Liquidity risk and management (today)
– Investment portfolio management (next Monday)
– Interest rate risk and management (today)
– Capital Planning & Management (next Monday)
– Funding (alternatives, options) (today, next week)
• Case Studies in ALM (next Monday)
Examples!!!
5
Liquidity RiskExample #1 – Cash Flows “Match Up”
Loan
• $100
• 8%
• 1 Year
CD
• $100
• 4%
• 1 Year
So…in this example, equal amounts of cash come to the bankand leave the bank at the same time; no liquidity risk!!!!
Liquidity RiskExample #2 – Cash Flows do not match up!
Loan
• $300
• 8%
• 1 Year
CD
• $100
• 4%
• 1 Year
In this more realistic example, the cash flows coming into the bankand going out of the bank do not match up…
6
Interest Rate RiskExample #1 – Repricing Risk is minimal
Loan
• $100
• 8%
• 1 Year
CD
• $100
• 4%
• 1 Year
In this example, the Loan and CD will each reprice in one year, whichshould allow the bank to maintain the spread (possibly higher or lower).
Interest Rate RiskExample #2 – Repricing does not match up
Loan
• $100
• Prime + 1%
• 1 Year
CD
• $100
• 4%
• 2 Years
In this example, the Loan (whose rate will vary over time) and CDreprice at different times, so, the spread could change over time!
7
Capital Planning& ALM?
14
8
Banking Business Model(“Balance Sheet”)
“Sources/Uses” of Funds “Sources/Uses” of Funds
AssetsCash & Due From Accts.Fed Funds SoldInvestmentsLoansReserve for Loan Losses
(contra asset)Other Real Estate Owned
(OREO – foreclosedproperty)
Premises and EquipmentOther Assets
AnyBank
LiabilitiesDDA (checking accts.)Savings AccountsMMDAsCDsBorrowed Funds*Other Liabilities
CapitalCommon StockSurplusUndivided Profits
*Borrowed funds include fed fundspurchased, brokered CDs, FHLB advances;also termed “other borrowed money”
“Typical” Income Statement
+Interest Income
-Interest Expense
Net Interest Income
-Provision for Loan Losses
+Non-interest income
-Non-interest expense
Pre-tax operating income
-Taxes (40%)
Net Income
$4,000,000
(1,500,000)
$2,500,000
(250,000)
400,000
(1,600,000)
$1,050,000
(420,000)
$ 630,000
As interest rateschange, net interestincome and netincome will beimpacted…
How much is thequestion!!!
9
Key Performance MeasuresROAA, ROAE, NIM
• ROAA = Return on Avg. Assets (Net Income/Avg. Assets)
(measures utilization of assets)
• ROAE = Return on Avg. Equity (Net Income/Avg. Equity)
** (is the optimal measure for shareholders) **
It is probably impossible to “maximize” all of theseperformance indicators at the same time!!!!!
• NIM = Net Interest Margin (Net Int. Inc./Avg. Earning Assets)
(measures spread & volume; net yield on earning assets)
All Roads Lead to Capital!
Remember!!!
10
Why is ALMImportant?
Recession Ended June ’09?The U.S.“Recovery” Will Be:
• “V” ?
• “U” ?
• “W” ?
• “L” (Japan in the 1990’s)?
• “Bath Tub” ????
11
Bank ROA’s – By Asset Size
Source: www.fdic.gov
Earnings are flattening…
*Through March 31, 2016
Bank NIM’s – By Asset Size
Source: www.fdic.gov
*Through March 31, 2016
NIM’s are getting squeezed!!!
12
Why is ALM Important?(Summary)
• Many smaller banks are struggling for moreearnings; trends in performance indicatorsare not entirely positive.
• Many business sectors not seeingmeaningful upticks/expansions.
• Situation results in banks taking onunwarranted risks that may impact earningsand capital for many years!
• Prudent ALM becomes very important!!!
“ALM” - KEY POINTS
• Earnings are maximized through properbalance sheet management (“A/Lmanagement”).
• Earnings drive shareholder value.
• Asset growth increases earnings (generally).
• Capital levels dictate asset growth.
• If earnings are retained on balance sheet,must grow over time or shareholder valuewill decline.
• A small increase in earnings has a largeimpact on shareholder value.
13
The ALCOAsset Liability Committee
“Driver” of ALM
ALM Roles of Different Groups
• Board of Directors – set targets, risk limits, etc.
• Senior management – day-to-day oversight andimplementing pricing guidelines
• Middle management – Implements pricing set byALCO, assists ALCO analysis, etc.
• Asset Liability Committee (ALCO) – establishespricing guidelines and makes liquidity decisions basedon analysis of performance, trends, competition, etc.
14
The “ALCO” - Purpose
• Function/purpose of ALCO?– Overall goal is to stabilize/increase profits
– Must make decisions regarding the pricingof loans and deposits, as well as fundingstrategies
– ALCO not just in place to reviewcompliance with various policy guidelines(IRR, Liquidity, etc.)
Time to visit the ALCO at First Dysfunctional Bank…
ALCO Members
• Should include individuals who have directinvolvement in pricing the bank’s earningassets and sources of funds
• Actual decision-making group should be small(<10 is best)
• Odd numbered decision-making committeeswork best (for voting reasons)
• Meet monthly or quarterly
15
The “ALCO”• Need to remain knowledgeable of the
major factors influencing ALM that arebeyond their control:– Interest rates, business cycles, accounting
changes, etc.
• Need to remain diligent and disciplinedon ALM issues they “can” control:– Pricing, terms of loans, deposits, etc.
– Forecasting liquidity needs/excesses, etc.
The ALCO Meeting & Process
Remember ever seeing this?
DATA(facts)
INFORMATION(answers to questions) DECISIONS!
Make sure the ALCO (or any committee) is reviewing information, not justa bunch of data. We can make better decisions with information.
16
The ALCO Meeting and Process(continued)
SO:
Data Information
Decisions!
Rates/Yield CurveFed Funds FuturesEcon. Trends *Employment *Demographics*
* national, regional, and local
Current Performance MeasuresIRR Models (NII, NI, NIM, etc.)Liquidity Models (short/excess)Actions of CompetitorsLoan/Credit IssuesCapital Issues
PRICING LOANS!PRICING DEPOSITS!BUY/SELL FUNDS!
ALCO MEMBERS “MUST”UNDERSTAND HOW
CHANGING INTEREST RATESIMPACT BANK EARNINGS!
17
Interest Rates 1980 – May 2016
Source: St. Louis Federal Reserve
Today’s Yield Curve is ?????
Source: U.S. Department of the Treasury
18
“ALCO” Meeting Information
• Has evolved; now covers more than traditionalinterest rate risk and liquidity issues
• Pricing and risk issues change over time;should you be reviewing different information?
• ALCO info depends on ALCO “focus”
“ALCO” Meeting Information(continued)
• Meeting Information “may” include:
– Current Yield Curve; very key information!!!
– Recap and trend of NIM, ROAA, ROAE,efficiency ratio, cap ratios, etc. includingcomparison to budgets and competition
– Trends on pricing of loans and deposits (i.e.avg yields, rates paid, and strategies forchanges)
– Earnings exposure to changes in rates (IRR)
19
“ALCO” Meeting Information(continued)
• Meeting Information “may” include:(continued)
– Projected sources/uses of funds (liquidity)
– Funding Capacity Recap
– New products and/or strategies
– Material loan/credit issues
– Earnings Credit Rate, Funds Trans. Pricing
– Capital Planning & Management
– Recap of compliance with policy guidelinesfor interest rate risk and liquidity!
“ALCO” Meeting Information(continued)
• Ask “What are we trying to accomplish?
• What are the key issues? What do we need toallow us to focus on these issues?
• Are we measuring and reporting risk positions withthe most appropriate and practical tools?
• Are we evaluating the risks and rewards ofstrategies to improve performance?
20
“Liquidity Management”Discussion Agenda
• Objectives, recap of historical liquiditymanagement, recent trends
• Liquidity Planning Techniques
– Internal Funding Analyses
– “Projected Sources & Uses of Funds”
• Funding Alternatives & Monitoring
Liquidity Management (Defined)
• Objective is to be able to obtain funds ata “reasonable” cost; can usually obtainfunds, but not at reasonable costs!!!!
• Better management of liquidity providesmore stability to the Bank’s NIM andyour blood pressure!
• Should be “forward-looking”
21
The “Costs” of Liquidity
• Unplanned, or last minute requests topurchase funds to meet loan demand,deposit run-off, etc. can be moreexpensive than you think.
• Carrying “too much” liquidity on thebalance sheet results in “costing” yourbank lost income!– Many banks tend to be countercyclical
investors (have cash when rates are low).
Two Types of LiquidityAsset Liquidity Liability(“Luxury”) Liquidity
• Fed Funds Sold
• Unpledged securities
• Saleable Loans
• Fed Funds Purchased
• Fed Discount Window
• Repo Agreements
• Borrowed Funds (FHLB)
• Rate Boards for CD’s
• Brokered Deposits
• Trust Preferred Sec’sPositives: Sales controlled bymgmt; not credit sensitive.
Negatives: Reduced profits.
Positives: Availability, flexibility
Negatives: Very credit sensitive,can be expensive.
22
LIQUIDITY TRENDS
• Generally, liquidity has been adequatesince 2000…
• TREND IS SHOWING THAT LIQUIDITYIS “GETTING TIGHTER” AT THISTIME….HOW DOES THAT IMPACTYOUR BANK?
0
100
200
300
400
500
600
700
800
900
1,000
1,100
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Mil
lio
ns
of
Do
lla
rs
UBB Agent Fed Funds Pool
A general “tracking” of liquidity trends since 2003
Fed Funds Sold to UBB by Community Banks (2003 – 2015 YTD)
23
Liquidity Management (Process)
• Is a “forward-looking” process
• Step 1 – Understand your bank’s generalliquidity trends.
• Step 2 - Estimate liquidity/funding needs(or excess) in future periods
• Step 3 - Determine/track alternatives
Internal Liquidity Analysis(Step 1 - Your Bank’s Liquidity Patterns)
• Certain banks have clear loan and depositcycles; what are your bank’s cycles???
• Use software for daily statements toobtain monthly average balances
• Use Call Report quarterly averages forloans, deposits, fed funds, investments
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Tracking Deposit Patterns
Step 2 - “Projected Sources andUses” Report
• Management of liquidity should beforward looking (not just a review ofliquidity ratios at previous quarter-end)
• Need to develop a “liquidity planningtool”
– Identify “Shortage” and “Excess”situations
25
Projected Sources/Uses of Funds(Where is “cash” coming from AND going to)
“Source of Funds” “Use of Funds” (“Needs”)
• Decrease in assets OR
increase in liabilities
– Liquid assets (Fed FundsSold)
– Loan payments/payouts
– Bond pymts/maturities
– New deposits
– Additional “borrowedfunds”
• Increase in assets OR
decrease in liabilities
– Funding loans
– Buying bonds
– Paying off depositors
– Paying off borrowedfunds
EXAMPLES EXAMPLES
Projected Sources/Uses of Funds
• Refer to handout– Generally is much easier to identify the
“uses” versus the “sources”
– Like most modeling, is not a finite number
– Purpose is to identify direction andmagnitude of the trend in liquidity
– Very helpful in setting up a “funding ladder”
26
First State BankAnalysis of Sources & Uses of Funds
Projection as of:
In 000's04/11/07 05/11/07 06/10/07 07/10/07 08/09/07 09/08/07
Anticipated Sources of Funds: 30 60 90 120 150 180
Estimated Monthly Loan Repayments 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000
Federal Home Bank Advances 5,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Investment Maturities / Calls 1,000,000 1,000,000 500,000 1,150,000 500,000 500,000
Federal Funds Purchased - Bank #1
Federal Funds Purchased - Bank #2
Federal Funds Purchased - Bank #3
National Brokered CD's 5,439,000 4,110,000 3,141,000
Local Market Deposits - Net Gain 5,000,000 500,000 500,000 500,000 500,000 500,000
Qwick Rate Brokered CD's
Public Fund CD's - Net Gain 5,000,000 5,000,000
Total Sources 18,000,000 14,939,000 18,110,000 12,791,000 9,000,000 14,000,000
March 12, 2007L
ow
De
gre
eo
fC
on
tro
lH
igh
Time Period
REFER TO HANDOUT!!!
First State BankAnalysis of Sources & Uses of Funds
Projection as of:
In 000's04/11/07 05/11/07 06/10/07 07/10/07 08/09/07 09/08/07
Anticipated Uses of Funds: 30 60 90 120 150 180
Investment Purchases 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Federal Home Bank Advances - Repay 5,000,000 500,000 500,000 1,000,000 500,000 500,000
Estimated Loan Funding 8,500,000 8,500,000 8,500,000 8,500,000 8,500,000 8,500,000
Public Fund CD's 419,000 36,000 4,111,000 512,000 4,819,000
Federal Funds Sold - Bank #1
Federal Funds Sold - Bank #2 2,000,000
Federal Funds Sold - Bank #3
Local Market Deposits - Net W/D 5,000,000
Qwick Rate Brokered CD's - Maturities
National Brokered CD's - Maturities 5,439,000 4,110,000 3,141,000
Total Uses 14,919,000 22,475,000 18,221,000 14,153,000 10,000,000 14,819,000
Sources Over Uses / <Deficit> 3,081,000 (7,536,000) (111,000) (1,362,000) (1,000,000) (819,000)
Current Position (4,330,000)
End of Period Cash Position (1,249,000) (8,785,000) (8,896,000) (10,258,000) (11,258,000) (12,077,000)
March 12, 2007
Low
Degre
eofC
ontr
ol
Hig
h
Time Period
REFER TO HANDOUT!!!
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Step 3 - “Funding Alternatives”
• Use of alternative sources of funding beengrowing for many years!
• Don’t forget to have policy guidelines, i.e. % oftotal deposits, capital, etc.
• Very helpful to develop a “tool” to aid inreviewing these alternatives. (see example)
• “Never pay more than you can borrow for…”
First State Bank
Alternative Funding Sources Worksheet
As of: July 10, 2006
Source: 3 6 9 12 18 24 30 36 48 60
Federal Home Loan Bank 5.640 5.760 5.720 5.680 5.660 5.690
Qwick Rate
average top 10 5.691 5.818 5.737 5.911 5.768 5.765 5.652 5.751 5.727 5.773
average top 25 5.584 5.745 5.681 5.831 5.731 5.738 5.615 5.703 5.666 5.706
average top 50 5.499 5.683 5.634 5.782 5.693 5.702 5.469 5.655 5.577 5.626
Broker #1 5.450 5.550 5.650 5.752 5.803 5.854 5.905
Broker #2 5.450 5.550 5.650 5.700 5.750 5.800 5.850 5.850 5.900
Broker #3 5.450 5.550 5.650 5.700 5.750 5.750 5.750 5.800 5.800 5.800
Local Markets (high offering) nearest term 4.630 5.260 5.410 5.440 5.250 5.560 5.500 5.500 5.500 5.500
7/10/2006
Average of Above 5.424 5.615 5.627 5.717 5.657 5.718 5.597 5.715 5.711 5.738
High of Above 5.691 5.818 5.737 5.911 5.768 5.800 5.750 5.850 5.854 5.905
Current Bank CD Rates 2.300 4.750 3.000 3.500 3.500 3.750 3.750 4.000 4.000
Termin MonthsREFER TO HANDOUT!!!
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Liquidity RegulatoryGuidance
• SR 03-15 – Interagency Advisory on PrimaryCredit & Effective Liquidity Managementhttp://www.federalreserve.gov/boarddocs/srletters/2003/sr0315.htm
• FIL-84-2008 – Liquidity Risk Managementhttp://www.fdic.gov/news/news/financial/2008/fil08084.html
• FIL-13-2010 – Funding and Liquidity RiskManagement
• http://www.fdic.gov/news/news/financial/2010/fil10013.html
“Sound” Liquidity Risk Mgmt.
(from FIL-13-2010)
• Importance of cash flow projections.
• Diversified funding sources.
• Stress Testing.
• Cushion of liquid assets.
• Well-developed contingency funding plan.
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Contingency Funding Plans
(from FIL-13-2010)
• All institutions should have formal CFP.
• The detail should be commensuratewith the complexity of the institution.
• Should identify stress events, fundingsources/uses, and mgmt processes.
A Final Comment on Liquidity
“GET LIQUIDITY WHEN THE MARKET WANTSTO GIVE IT TO YOU.”
Translation – Lock in funding during low rate environments!
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“ALM” - FINAL POINTS
• Earnings are maximized through properbalance sheet management (“Asset LiabilityManagement”).
• Earnings drive shareholder value.
• Asset growth increases earnings (generally).
• Capital drives asset growth.
• If earnings are retained on balance sheet,must grow over time or shareholder valuewill decline.
• A small increase in earnings has a largeimpact on shareholder value.
Bring your calculatorsfor “Case Studies”
Please completeclass evaluations!!!