By Walt Williams
Nthe beginning of three decades has passed since the last time interest rates rose as fast as 2022, meaning many of today’s banks have spent their entire careers in a calmer rate environment. That lack of experience can prove a hindrance when managing rate risk, but not a crippling one. Proper modeling and a back-to-basics approach to asset liability management can help.
Raj Mehra worked for JPMorgan Chase in 1994, when the Federal Reserve nearly doubled interest rates to 6 percent a year. “We’ve obviously been here before,” said Mehra, who is now EVP and CFO at Freedom Bank of Virginia. “Not everyone might remember that, and everyone will have a different playbook for how to deal with it.”
Freedom Bank’s playbook has benefited from previous decisions such as interest rate swaps made early in the pandemic when rates were low. Other institutions have also looked ahead and developed their own sets of play calls, although those strategies are only as good as the modeling used to produce them.
“I hope everyone [ALM] practitioners run a variety of scenarios to be able to tease out the risk that may be present on their balance sheet for various sets of interest rate outcomes,” said Dan Schwartz, director, corporate treasury, at Discover Financial Services.
Real world modeling
The better a bank understands the behavioral tendencies of its deposit base, the better it will be able to control its cost of funds as the Fed continues to move rates skyward, said Darnell Canada, managing director at Darling Consulting Group. And that data must reflect what is happening in the real world.
“The inputs and assumptions that go into these models should change because the environment has changed,” Canada said. “Normally, that doesn’t happen in the small window of time that we see. Normally, the Fed doesn’t move this quickly.
“That’s one of the main messages we’re trying to get across to people: it can be dangerous to make the assumption that my balance sheet is going to behave the same as it did in the last one or two or three rate cycles because the current cycle doesn’t look like the last two cycles.”
Robert Perry, principal at ALM and investment strategy firm ALM First, has similar advice: “It’s important to make sure that your asset modeling and pricing is live: that it’s up to date with market rates and you don’t like. from getting behind the eight ball and misprice assets. If you’re writing a car loan right now not far north of where the Treasury rate is, and you leverage that asset and put it on your balance sheet, you’re not going to be properly compensated for that asset.”
Focus on the basics
Modeling is one thing, but Susan Sharbel, senior advisor at Abrigo, whose ABA supports loan loss accounting solutions, takes a back-to-basics approach in a recent paper on five ALM best practices. He admits nothing earth-shattering, but it’s good practice no matter the rate environment. But some require different thinking, such as his first proposal, which starts the ALM process with an updated capital plan.
“Usually [capital planning]seen through a regulatory lens: regulators demand it, so we have to do it,” says Sharbel. “But actually capital is also your buffer. It is something that you can take advantage of to grow the institution to be more profitable. It is very important to have a solid plan so that when you do your stress test, you can see the impact on your capital.”
An “expansive” scenario analysis stress test is his second recommendation. Again, assessing risk is something banks must do, but many are not good at, at least in Sharbel’s mind. Just as people who own motorcycles want to buy the most expensive helmet they can afford for maximum protection, “institutions really should invest in the most robust model they can afford,” he said.
His third recommendation is to ensure reasonable assumptions in ALM models: Use institution-specific data whenever possible. Use account-level data and custom account charts as ALM best practices. Fourth on the list is using a measurement system that captures all short-term and long-term risks. “A lot of the time a lot of institutions capture risk in what we call silos,” he said. “So this is your credit risk. This is your interest rate risk. This is your liquidity risk. This is the risk of your choice. They count individually, right? But that’s not how it happens in banks. It happens simultaneously. … It’s a lot more productive to look at everything, you know, because everything influences each other.”
Finally, Sharbel recommends annual ALM model validation. Like capital planning and stress testing, validation is something institutions already require, but that doesn’t mean they shouldn’t do the bare minimum, Sharbel said. High confidence in the ALM model leads to better business decisions and “we are in a time where decision-making is paramount.”