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Overcoming uncertainty over rising rates

How to prepare ALCO for fresh challenges

Overcoming uncertainty over rising rates

By Mike Guglielmo, Darling Consulting Group

Clearly examiners are becoming increasingly concerned about rising rates and the degree to which financial institutions are prepared. Some of the latest insights came from a recently published FDIC Financial Institution Letter (FIL 46-2013) entitled “Managing Market Risk in a Challenging Interest Rate Environment.” 

While the concepts and suggestions highlighted were not new, the specific points emphasized, combined with our direct and indirect experiences with clients and examiners this year, indicate that traditional “check-the-box” risk management practices are no longer going to suffice.

There’s more to the FIL than wanting to narrow the gap between the 2010 guidance and current risk management practices. Examiners’ concern over asset extension and growth in non-maturity deposits over the past few years has taken center stage.

The recent steepening of the yield curve has resulted in some notable changes in unrealized securities gains/losses and has triggered some early signs of retail deposit change.

Bottom line: A more advanced risk assessment process that includes well-informed behavioral assumptions; sensitivity and stress-testing analysis; and risk-mitigation/“what-if” simulations is needed in order to transform “unknown” risks into “known” risks.

Once risks are known, institutions can then inform their risk appetite and establish the appropriate level of control and oversight.

Here is some points for consideration as your bank’s management and board look towards 2014:

Broader risk measurement activities

Institutions need to adopt a broadened holistic approach when measuring and managing risk and utilize several techniques when performing their risk assessments.

In addition, there are inherent strengths and weaknesses associated with the various measures we employ and risk managers need to know how to reconcile and explain differences in results when they are in conflict (i.e. EVE simulations that depict exposure to rising rates vs. NII simulation results that show no such risk).

For institutions that exhibit exposure to rising rates, additional measures that can more fully inform stakeholders and serve as a foundation for “early warning” should be added to the mix. This could include investment portfolio sensitivity testing results and ongoing deposit migration analysis, combined with liquidity assessments that demonstrate the ability to withstand the impacts of potential stress events.

As institutions expand their measurement processes, it is important for results to be presented in an informative way so that stakeholders can understand the current risks clearly and in a concise format. This is becoming more challenging as the number of measures is increasing along with the accompanying risk limits or triggers.

Asset-liability management committees and boards can quickly become overwhelmed with too much analysis and can fall into a state of indecision. Increased use of dashboards that start at a high level and drill down into specific risk areas is a sensible way institutions can manage and improve communication of risks but success will a function of report design and education.

Increased risk understanding and awareness

Management and directors need to have a greater understanding of risk beyond traditional static measures and need to express their understanding of the interplay between interest rate risk, liquidity, credit, capital, and related operational risks.

Holistic modeling techniques need to become part of the ongoing risk assessment process. These approaches must be bolstered with more formalized assumption development—such as historical customer behavioral studies—along with simulations based on alternative assumptions and risk mitigation strategies. These must highlight potential vulnerabilities and how they can be overcome.

True, regulatory guidance has been repeatedly promoting this notion over the past few years. However, many organizations continue to rely on point-in-time measures or ratios. They fail to adopt ways to evaluate risk on a more forward-looking basis.

While many institutions have expanded their interest rate risk simulation activities, many have stopped short of simulating alternative assumption sensitivity scenarios or stress scenarios. Or they fail to discuss the results of these simulations in the context of the interrelated risks.

Institutions need to recognize that arriving at a baseline risk profile is just the first step in understanding risk. By expanding analyses to include the impact of alternative assumptions (i.e. accelerated deposit runoff or more aggressive deposit rate increases) decision makers can assess the potential impact of an adverse event; evaluate the cost/benefit of preemptive action; and, if necessary, proactively formulate a strategic response.

With broader use and reliance on simulation models to assess risk, a greater level of importance must be placed on your organization’s data and assumption management process. The impetus to perform historical / statistical studies should go beyond regulatory compliance – having insight into past experience will not only confirm if assumptions currently applied are relevant and representative of past experience, but will also strengthen your stakeholders’ understanding of the key risk contributors and lead to more strategic insight.

Enhanced governance and oversight

We find that many institutions need to revisit their current policies, early warning measures, and risk limits to ensure their operating philosophies and risk appetite are still being accurately represented and effectively articulated.

In addition, directives relative to management’s risk measurement, monitoring, communication, and decision making processes need to be revisited and in many cases need to more clearly defined.

Organizations are being strongly persuaded to increase board involvement in the risk assessment and decision-making processes. That’s no easy task. Many are struggling to find ways to increase their board’s involvement while striking a balance between effective oversight and inappropriate micromanagement.

In general, a steady diet of ongoing education needs to be part of the risk management evolution. As board members learn more from the exposure each period, increased awareness and understanding will follow.

This process can be accelerated. You can do so through the development of more substantive policy statements, which include explanations relative to the risk assessment process. Among these: the various measures employed, why specific measures are utilized (or not utilized) and their respective strengths and weaknesses; the assumption management process; the role of sensitivity and stress-testing; and how management utilizes “what-if” strategy simulation to evaluate the risk/return tradeoffs of decisions.

Where this effort will take your bank

Institutions that have already invested the time and energy into enhancing their risk measurement and management processes with more holistic risk assessments, formal assumption studies, sensitivity and stress-testing analysis, and strategy/“what-if” simulations are not concerned about rising rates.

They already know how earnings, liquidity, and capital will be affected and what management will need to do to mitigate or offset the impacts. They are already prepared and have transformed the fear of uncertainty into strategic opportunity.

The greatest risk today is to do nothing and expect examiners to prescribe what should be done.

Managing uncertainty in today’s environment is not about regulatory compliance.

It is about competitive survival.

About author Mike Guglielmo

Guglielmo is managing director at Darling Consulting Group. With over 20 years in asset liability management, he provides both technical and strategic consulting to a diverse group of financial institutions in the U.S. and abroad. Prior to joining DCG in 1992, he managed the asset liability management and strategic planning process for a large regional bank in the northeast. 

ALCO Beat

ALCO Beat articles featured exclusively on ABABJ.com are written by the asset-liability management experts at Darling Consulting Group. Individual authors' credentials appear with their articles. DCG's consultants have served the banking industry for more than 30 years. You can read more about the firm's history here.

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