ALM MODELING ASSUMPTIONS:
GETTING IT RIGHT MATTERS!
Monday, June 17, 2013
3:30 PM – 4:45 PM
Presented by:
Michael Guglielmo
Managing Director
Darling Consulting Group
260 Merrimac Street
Newburyport, MA 01950
P: (978) 463-0400
E: [email protected]
www.fmsinc.org | 800-ASK-4FMS
Session Description
With continued uncertainty and elevated regulatory expectations,
model-risk management has taken on a whole new level of
importance and at the heart of it all is your ALM model
assumptions. Having defensible assumptions and knowing the
impact of being wrong is critical to ensuring your ALCO making
the most informed decisions. This session will explore practical
methods to develop, support, document and stress-test the most
critical key assumptions that go into your ALM model (most notably
loan prepayments, core deposit pricing and deposit decay rates).
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Key Take Aways
• This is NOT about regulatory compliance
– Business challenges demand it!
• Effective assumption development will drive strategic
thinking and decision-making
• Sensitivity / stress-testing is critical to process
• Consistency across risk measurement process is
expected
• Management and Board understanding is important
– don’t ignore it!
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What we’ll discuss
• Importance of good assumptions
• Key assumptions
– Descriptions
– Impact
– Sources
– Verification methods
• Role of ALCO and the Board
• Q&A
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An Effective ALM Modeling
Process Should…
• Assess the financial risk position
– Short-term / long-term
• Provide understanding of key drivers and contributors
of potential risk
–
–
–
–
Events or circumstances
Impact of product / funding pricing and mix
optionality / customer behavior
Impact of key assumptions
• Facilitate strategic decision-making
– Simulation of “what-if” strategies
– Alternative business paths / stress-testing scenarios
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Why Are Assumptions More
Critical Than Ever?
• Increased balance sheet and business
complexity
• More risks
• Greater competitive pressure
• Less margin for error
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…But Assumptions Impact More Than
Just Interest Rate Risk Management
• Financial disclosures
• Financial forecasting / budgeting
• Profitability measurement
• Liquidity risk management
• Capital and strategic planning
• Stress-testing
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Consequences of Being
Wrong Are More Profound
• Financial
–
–
–
–
–
Ineffective ALCO
Lost revenue opportunities
Bad decisions / poor financial performance
Restatements
Credit downgrades
• Regulatory
– Criticism
– Corrective action (i.e. MOU, C&D)
• Legal
– SOX compliance, etc.
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ALM Software Providers Are
Trying To Meet The Changing
Needs…
• Increased capabilities / flexibility
• Integration with third party tools and
analytics
• Success varied
• Blessing and curse
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…And So Are Some Outsource
Solutions
• Need to know what you have control over
– Many providers restrict control/flexibility
• Vendor choice important
– Choose carefully / ask questions
• Important: don’t abdicate your responsibility
• …and there are no “industry standards”
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How Do We Know if We Have
The Right Assumptions?
• Truth is…there is no such thing!!!
• Assumptions by their very nature will be
wrong
• Important to a) recognize this and b)
develop an ongoing development and
review process
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Elements of an Effective Assumptions
Development and Support Process
• Ongoing historically-based studies and
analyses
– Quantitative AND qualitative
• Establishment of sensitivity / stress-testing
framework
• Self validation
– Back-testing (actual vs. forecast)
• Independent review
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Begin by Understanding
Where You Have Been
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Establishing Sensitivity /
Stress-Testing Framework
• Evaluate alternative assumption scenarios
– Deposit pricing and sensitivity betas
– Behavioral assumptions
• Deposit retention
• Loan and investment prepayments
– Product pricing, growth / mix changes
– Alternative rates / yield curves
• Compare results to base-case model
– NII simulations
– Economic valuations
– Liquidity forecasts
• Perform with regularity
• Document and discuss results at ALCO
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Why Is Stress Testing
Important?
• Identify key strengths and vulnerabilities of balance
sheet
– Identifies key assumptions that have greatest impact
– Quantifies the relative impact of the assumptions
• Emphasizes that results not absolute
• Profound impact on strategy discussions and decisions
A better informed ALCO will be
more confident and proactive!
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“Self Validation”
Back Testing (Defined)
• Means different things to different people
– Practitioners
– Examiners
– Auditors
– “Quants”
• Simple working definition:
“Using historical data to
validate whether a model
has predictive validity”
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Back Testing Framework
•
Starts with historical data tracking
–
–
–
–
•
Use of historical activity to support internal discussions
–
–
–
–
•
Prepayment activity
Deposit retention
Offering rates, deposit rates, spreads
Balance sheet growth (changes)
Comparisons of actual activity versus previous assumptions used
Involvement of Lines of Business (LOB) managers
Formal documentation and approval process is ideal
Some organizations will simulate impact of newly proposed assumptions
Enhanced back-testing activities
–
–
–
–
Re-processing previous models using actual inputs
Regression/correlation studies
Behavioral studies
Attribution analysis
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Self Validation
(Back testing)
QUARTERLY LOOKBACK SUMMARY
Name
• Compare prior projections vs. actual
results (rolling 90-day look back
works well)
• Review major variances by portfolio /
product (drill down as necessary)
• Reconcile within x% of NII
• Monitor historical trends in variances
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Actual
Income
Forecasted
Income
Variance
$
%
Volume
Rate
Mix
Assets
Investments
Agency
Corporate
Muni
Short Term
Stock
Treasury
Loans
Residential
Commercial RE
C&I
Agriculture
Installments
Other
4,258
712
374
26
254
17
21
19
3,546
1,926
895
315
9
362
40
4,124
813
350
27
398
0
18
20
3,311
1,739
848
320
8
355
41
133
3.1%
(101) -14.2%
24
6.4%
(1) -2.3%
(143) -56.4%
17
99.0%
3
13.4%
(1) -3.9%
235
6.6%
187
9.7%
47
5.2%
(5) -1.7%
1
7.9%
7
1.8%
(1) -3.1%
114
42
21
(0)
(21)
14
0
(0)
72
32
34
1
0
(4)
9
(3)
(144)
2
(1)
(120)
3
3
(1)
141
160
(12)
(7)
0
11
(11)
22
1
0
0
(3)
(0)
0
0
21
(5)
25
1
(0)
0
1
Liabilities
Deposits
Non-Maturity
Time (CD)
Borrowings
FHLB
Repo
Short Term
1,134
1,033
326
706
102
65
35
2
1,145
1,048
333
714
97
62
32
3
(10) -0.9%
(15) -1.5%
(7) -2.1%
(8) -1.2%
5
4.9%
3
5.1%
3
7.7%
(1) -67.2%
12
10
17
(8)
3
0
3
(0)
(16)
(19)
(18)
(1)
2
3
(0)
(1)
(6)
(6)
(6)
0
(0)
0
(0)
0
NII
3,123
2,980
143
4.6%
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What Are the Key
Assumptions?
• Behavioral
– Prepayment (investment and loans)
– Deposit retention/decay and sensitivity
• Financial / Strategic
– Investment portfolio structure, level and mix
– New loan and deposit composition and pricing
– Wholesale funding game plan
• Economic
– Rate scenarios
– Time horizon
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But There Are Other
Important Assumptions Too…
• Data handling
– Aggregation methodology
– Problem / missing data management
• Other modeling methodologies
– Optionality parameters (call/put logic)
– Valuation techniques
– Credit/default risk
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The Three Most Critical
(ALM) Assumptions:
1. Deposit sensitivity / lives
2. Prepayment / refinancing
3. Replacement / new volume
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Deposit Assumptions
•
Description
– Rate changes applied to deposits in various rate scenarios
– Decay/retention rates used to project lives of non-maturity
deposits
– Estimates of core (non-rate driven) balances
•
Severity Rating
Impact: moderate to severe
– Have greatest impact on results
– Most difficult to get “right”
•
Assumption sources
– Historical deposit studies
– Review and discussion with business managers
– Discussions and formal approval within ALCO
•
Verification methods
– Deposit studies
– Back-testing
– Independent review
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Impact of Decay and Pricing
on Valuation Measures
Shorter Average Lives
Change in Post-Shock Ratio (Basis points)
200
100
Results with No
Non-Maturity Deposit Value Impact
0
-100
-200
-300
Change in Post-Shock Ratio (Basis points)
200
-400
100
-500
0
-100
0
100
200
300
Longer Average Lives
-200
Change in Post-Shock Ratio (Basis points)
-300
200
-400
-500
-100
100
-100
0
100
200
0
300
-100
-200
-300
-400
-500
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-100
0
100
200
300
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Impact of Pricing Sensitivity and
Non-Core Funding Volatility
Before
After
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Developing Deposit Assumptions
• “Core deposit study”
–
–
–
–
–
Internal or externally performed
Many different flavors
Higher cost <> more accurate results
Can provide meaningful information…but
Will not provide answers with any certainty
• Analyzing historical activity can tell you a lot
– Balances, rates, # of accounts, open/closed activity
– Provides perspective – can serve as reference point
• Should relate quantitative results with qualitative experience
– No single right answer - range of possible outcomes
– Too many influencing factors
– Data can be misleading or skewed by events, product or technology
changes, etc.
• Periodically apply “optimistic” and “pessimistic” alternatives
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Prepayment Assumptions
•
Description
– Curtailment or early payoffs applied to loans and investments
•
Impact: low to moderate
Severity Rating
– Can impact level of projected earnings/value
– Risk profile can be altered as well
•
Assumption sources
–
–
–
–
•
Historical prepayment tracking/studies
Vendor-supplied models (residential)
Secondary market sources (residential, some installment)
Review and discussion with business managers
Verification Methods
–
–
–
–
Back-testing
Activity tracking
Third party sources
Independent review
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Impact of Prepayment
Assumptions
Alternative Prepayments (-200bp)
$70,000
$65,000
Monthly NET INTEREST INCOME ($000)
Year 2
Year 1
$60,000
$55,000
$50,000
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6
2005
2006
2007
200BP
Alt
Prepay
BASE
200
BP
$0
Year 1:
Year 2:
$446,557
$291,379
$613,041
$562,148
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$480,888
$331,414
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Replacement Assumptions
•
Description
– Rates and characteristics applied to cash flow replacement and
growth
•
Severity Rating
Impact: low to moderate (occasionally severe)
– Greatest impact is generally on level of projected earnings
– Risk profile can be altered as well
– Severity can depend upon type of scenarios (shocks vs. ramps)
•
Assumption sources
– Historical activity tracking
– Review and discussion with business
managers
•
Verification Method
– Activity tracking
– Back-testing (actual vs. forecast)
– Independent review
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Impact of Replacement
Assumptions
Before
After
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Data Handling Issues
•
Description
– Assumptions made relative to handling data
Severity Rating
•
Impact: low to moderate
•
Examples
– Aggregation of dissimilar products
– Inaccurate contractual cashflow and repricing
– Ineffective option handling (i.e. calls, puts, caps, floors)
– Misapplied prepayment parameters
– Problem data resolution
– Bad or missing data is “scrubbed” into the data prior to import
•
Verification Methods
– Independent review
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The Role of ALCO and
The Board
• ALCO/Senior Management
– Responsible for the development and support of
assumptions
– Create appropriate level of processes and controls
– Discuss, modify, and approve assumptions regularly
• Board
– Delegates oversight to ALCO
BUT
– Needs to understand key assumptions and trends!
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ALCO Best Practices for
Assumption Management
• Document and explain key modeling assumptions
in ALCO package
• Discuss at each meeting
• Solicit input from business lines
• Periodically run alternatives
– Sensitivity / stress tests
– Inform and educate
Start simple!!!
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So What Does This
All Mean?
• Institutions need to pay closer attention to the
assumptions used in the ALM process
• Develop better means to substantiate, verify,
test, and communicate
• Increase ALCO and Board awareness and
involvement
• Make sensitivity and stress-testing a
functional priority
- 33 -
www.fmsinc.org | 800-ASK-4FMS
Key Take Aways
• This is NOT about regulatory compliance
– Business challenges demand it!
• Effective assumption development will drive strategic
thinking and decision-making
• Sensitivity / stress-testing is critical to process
• Consistency across risk measurement process is
expected
• Management and Board understanding is important
– don’t ignore it!
- 34 -
www.fmsinc.org | 800-ASK-4FMS
ALM MODELING ASSUMPTIONS:
GETTING IT RIGHT MATTERS!
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www.fmsinc.org | 800-ASK-4FMS
Michael R. Guglielmo
[email protected]
(978) 463-0400
With over 25 years of experience in asset/liability
management, Michael provides technical and strategic
risk management consulting to a diverse group of
financial institutions in the U.S. and abroad. Michael is
also a frequent author and top-rated speaker on a
variety of balance sheet and financial risk management
topics.
Prior to joining DCG, Michael managed the ALM and
strategic planning process for a regional bank in the
northeast.
He is a graduate of Fairfield University with a degree in
economics.
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www.fmsinc.org | 800-ASK-4FMS
About DCG
•
Independent balance sheet/risk management consultancy
•
Serving the industry for three decades
•
Substantive and highly dedicated staff (80+ employees)
•
More than 500 clients served annually
•
Highly regarded speakers, authors, and educators:
– Numerous professional and industry associations
– Resource for examiners
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DCG’s Services
•
ALM model outsourcing and balance sheet advisory services
•
Individual project-based services:
– Model validation & process review
– Liquidity review (including contingency planning)
– Core deposit & loan prepayment studies
– ALCO performance reviews
– Capital planning / stress-testing
•
Education
– Workshops for management and board of directors
– ALM model workshops
– Annual balance sheet management conference
– Examiner training
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DCG Resources Available
•
White Papers
– ALM & ALCO
– Liquidity Risk Management
– ALM Modeling & Audits
– ALCO Performance
•
E-Mail Newsletters (Complimentary)
– ALM Insights
– DCG Bulletin
•
DCG Website – DarlingConsulting.com
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About DCG
•
•
DCG provides balance sheet management solutions for banks, thrifts and
credit unions across the United States. Our 80+ person professional team
offers a unique and comprehensive approach to balance sheet management
that incorporates specialized tools, educational programs, and unbiased
advice for institutions between $20 million and $200 billion in assets. Working
in partnership with senior management and boards of directors, we produce
significant, quantifiable results for hundreds of financial institutions throughout
the country.
DCG’s menu of products and services include:
– Timely and informative educational programs for executives and
professional associations
– Customized and pro-active advisory and consulting services in the areas
of balance sheet management, investments and financial and strategic
planning
– Cost-effective outsourcing of the risk management and modeling process
– Comprehensive model and assumption validation services in support of
regulatory model risk management (OCC 2011-12 / SR 11-7) compliance
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About DCG (continued)
•
Find out more about balance sheet management by visiting our website
DarlingConsulting.com
– DCG WEB SITE Articles on bank profit and risk management



Gateway to additional banking industry information/research
Register for the annual balance sheet management conference
Upcoming educational events around the country
– ALM Insights & DCG Bulletin – DCG’s complimentary e-newsletters that
address a variety of topical balance sheet and risk management issues
– To register:



Visit us: DarlingConsulting.com
E-mail us: [email protected]
Call us: 978-463-0400
- 41 -
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