By Maryssa Crews, Catalyst Strategic Solutions ALM Analyst
It’s a dark and stormy late afternoon…and you’ve just received the results of your interest rate risk model. You review them to discover you’re still low risk on all horizons. Whew! You sigh in relief as you wipe the sweat from your brow.
And then, suddenly, the phone rings.
You answer and an ominous voice echoes through, “Seven days…seven days until the examiners come!” Click. You aren’t worried; your risk is low! A week passes, and just as forewarned, the examiner arrives. You present your credit union’s IRR results, but the examiner doesn’t fully trust them!
How did this happen? Credit unions depend on IRR analyses to make vital balance sheet decisions. It is important to have confidence not only in the model itself, but also in the underlying assumptions that drive results.
How can that be achieved? Think of it as feeding the Asset Liability Management monster.
The Asset Liability Management (ALM) process is somewhat like a chimera: a monster made up of different parts. Modeling, reporting and decision making all comprise the monster, while assumptions are what you feed it. If your assumptions are outdated or unreasonable, the monster will spit out inaccurate results and may even show exposures that are opposite of actual risk.
Over the last year and a half, credit union obstacles have changed. Deposits surged and loan demand fell. As a result, assumptions, such as prepayments, pricing and deposit behavior, need to be reviewed and challenged. Do cash flow projections seem accurate? Are the projected dividend rates of shares realistic in each shock scenario?
Examiners review the assumptions applied in a model, as well as the development of those assumptions. Are the assumptions specific to the institution? Are they market benchmarks or best estimates from management? Conducting a non-maturity deposit analysis or prepayment study enables credit unions to apply assumptions that are unique to their institution. Assumptions should also be tested and stressed to defend them to the board, management and examiners.
Caution and reason can prevent catastrophe. Simply relying on past performance is dangerous. Feeding the monster assumptions based on recent history is like looking back at the monster chasing you while running straight into its trap ahead of you. Beta sensitivity testing and net interest income and prepayment shock back-testing are ways to ensure the assumptions applied to the model are producing accurate results. This testing may even uncover underlying risks if the assumptions differ more than expected.
As the economy and interest rates change, your assumptions must, too. Reasonable and rigorously tested assumptions will improve the accuracy and reliability of interest rate risk results. Feed your ALM monster well and the model will treat you, rather than trick you.
Interest rate risk management is an ever-evolving challenge. But it won’t be scary if you arm your credit union with the trusted insight and wide array of advanced ALM services available from Catalyst Strategic Solutions. Our experienced professionals stand ready to help. For more information, contact us today.