Plansmith Blog

Lately I’ve talked to a lot of bankers who are actually looking forward to the inevitable rise in market interest rates. They believe that their institution’s net interest margin and profit will increase because that’s what their rate risk analysis is telling them.

There is an architecture design concept that says, "form follows function." Once the ALCO has determined what it must do, it must inventory the resources at hand as well as those necessary to make it successful. Among these resources are the men and women within your company whose abilities and perspective will contribute to achieving the goal. It is safe to assume that the general purpose of the ALCO is to control the behavior of the net interest margin by understanding and controlling the factors that affect margin.

Now that you have clarified your purpose , we can discuss using the right tools.

While "No pain, no gain" may be an effective strategy for muscle building, it is counter-productive in margin management. There are institutions that have an entire staff devoted to running asset-liability management systems only to finish in time for the ALCO meeting, only to begin all over again.

Just because we can use a computer does not make it useful. We are continually amazed by supposedly sophisticated systems that can require several hours to produce a single scenario. These models discourage creativity and thoughtful analysis. Models should shorten the time and data requirements for use otherwise; no one will want to use them.

Planning models are learning tools not predictors. The more scenarios investigated the more we learn about the behavior of our margin and our organization. Speed of operation is not just a convenience, but it encourages learning and allows us to sharpen our strategies. More importantly, speed allows continuity of thought when developing an idea. We get immediate feedback. A model must be efficient to be effective. We can take a good model right into your ALCO meeting and simulate new ideas on the fly.

Asset-liability management complexity increases inversely to the volume of data. Effective modeling systems actually generate their own input based on our assumptions using relationships. Prepayments, for example, should automatically adjust by the system for every change in the rate environment. Growth and seasonal distribution of new balances should automatically adjust as rates rise or fall to reflect customer behavior or competition. Models should reduce data entry, save time and give results that are more thorough.

When we speak of a models speed, it applies to more than just the computations. Speed, when communicating concepts are even more important to the strategy development. Graphics are the best way to transmit the issues and solutions quickly and clearly. These are not just time series graphs but rather behavioral graphs that become models to use to forecast and explain behavior. Behavior graphics lead naturally to action plans.

For example, behavioral analyses using multiple rate shock simulations allow us to describe a completed asset-liability management analysis into a quick and complete display or description of yield and margin behavior. Through graphs, we see both description of the problem and the solution simultaneously. No other format provides this prospective. Using these powerful tools, we turn complexities into simplicity.

At the risk of branded a heretic, let me say that the solution to margin management is not to be found in the accounting systems. Regardless of the linkages between general ledger, accounts payable, fixed assets, investments, loans, deposits and your asset-liability management system, the answer is not there. The data in your accounting system is the history. Bankers are often so rooted in their general ledger, that they mistakenly believe that they must pull data directly from the mainframe or they cannot do and effective job. Although that is comforting, asset-liability management and the ALCO must deal with the future, not the past.

Check back for the final part of this series, "Why ALCOs Fail: Staffing the ALCO" .

The Asset Liability Committee, ALCO, is often best characterized as observers of the margin rather than controllers of margin behavior. Why, after all the meetings, sophisticated computer software, consultants and regulatory pressure, do ALCOs fail management? Because unlike a financial institution failure, it continues to function, it simply just does not make a difference. There is motion with no progress.

As providers of community bank and credit union planning software and consulting services for over 40 years, it is our mission to help our clients make the entire planning and management process both efficient and effective. To that end, we conduct ongoing research into the challenge of building an effective ALCO.

We have been able to identify three reasons for ALCO failure:

1) Unclear purpose

2) Wrong tools

3) Wrong people

In the first part of this series, we will be addressing the issue of having an unclear purpose.

Clarity of Purpose

To quote Alice in Wonderland’s Cheshire Cat "if you don’t know where you are going, then any road will take you there." Does your community bank's ALCO have a destination or goal? While developing the goal, the first controversy we usually meet is whether the ALCO is limited to margin issues, or should it deal with decisions related to the entire institution? As we talk to bankers, we find that many ALCO meetings become loan meetings; others complain that they become embroiled in complex investment products. The largest segment of ALCO’s review their gap reports, discuss data inaccuracies, and review rates then adjourn.

The first step toward creating an effective ALCO is to define its goals and objectives. Why are we here? What is our purpose? How will we know we are truly effective? What is asset-liability management anyway? How do we do this job? Who should be on this committee? What resources do we have available to us?

Once the strategic issues are resolved, other questions should be considered. What is the best margin we can achieve in this environment? Most institutions would gladly take a 5% margin, but it is probably impossible in their market, in this environment. Other considerations include calculating the required margin. There is a minimum margin that can be computed by adding capital formation requirement, dividends, net overhead, loan losses and taxes, i.e., all those cash flows the margin must support. These considerations help us quantify the goals and even suggest strategies to reduce the pressure on the margin and establish realistic margin goals.

In addition to a strategic plan, the ALCO need an ALCO policy to serve as a guide as the ALCO moves forward. Most recently developed ALCO policies include measurement of risk using simulation results and margin minimum and maximums, or possibly allowable margin changes under multiple rate scenarios, high, low and most likely.

Finally, an ALCO action plan should be the product of the meeting. Always conclude your ALCO meetings with specific set of actions to be executed by designated individuals operating within a specific timetable. Even if everything is going according to plan and the committee elects to do nothing, that is an action plan and should be noted in the minutes. With this simple discipline, you will reap substantial rewards for your efforts.

Check back for parts two and three of this series, "Why ALCOs Fail: The Wrong Tools" and "Why ALCOs Fail: Staffing the ALCO" .

The road to profitability begins with a very simple concept. An asset is acquired at a certain value X and it is sold at a value Y where Y is greater than X and the difference between the two gets you going. This is a concept that is very simple indeed. But this post isn’t a narrative about the arithmetic involved in generating profits; rather it is a discussion that begins with examining the nature of the assets being bought and sold, which is money.

Non-financial businesses ranging from the humble lemonade stand to the behemoth WalMart are easy to understand. The assets being transacted are, for the most part, quite tangible. It is easy to understand that something is manufactured, it is delivered to a retail place of business, it is stored in a warehouse as a portion of inventory, it is displayed on a shelf and it is ultimately purchased by people like you and me to put in a bag to take home. The equivalent chain of distribution can be identified in banking but there is one big difference that makes it all the more complicated. It is the fact that the product, being money in its many different forms, is not something you see, feel, taste, hear, or smell in any direct way.

If you are a parent, you use "what if" scenarios every day with your child. What if you get lost? What if you saved your allowance rather than spend it? What if your friends ask you to…? What if you study for that test? What if a stranger offers you a ride?

Wow - what a fantastic trip to the 2014 ICBA in Honolulu this past March. It was a long way to travel but given this year’s weather, a little time in the sun mixed with one of my favorite conventions could not have come at a better time.

I would like to extend a sincere thank you to all of our clients and prospective clients that stopped by the Plansmith booth and took a few minutes to talk with me and my colleague, Ron Trice. In an era of endless emails, conference calls and web presentations it is always nice to put a face to a name and shake hands with all of you. If you didn’t come by the booth but happened to see the two tall guys in the loudest most obnoxious Hawaiian shirts ever - yes, that was us.

Tell me about your business. What is your organization like today? How did it get there? How is it managed? Where do you see it going and how are you planning to get there? What obstacles are in your way? Tell me about your business.

When I ask this of a financial institution, I usually receive balance sheets and risk reports. Most people immediately think ‘numbers’ when you mention planning. I challenge you to think differently, think communication. Tell me about your business.

Tom Parsons and I had the pleasure of attending the CUNA Government Affairs Conference in our nation’s capital. It was a great opportunity show support for our many credit union clients as well as learning more about the many challenges they face.

Opening night featured a performance by singer Eddie Money, which literally had the Washington Convention Center "shaking to the beat of the night". Day two presented a strong stream of visitors to the many exhibitor booths spread out around the convention center floor. It was great to finally put a few client faces to the many voices that we speak to regularly. We met a number of new credit unions that were interested in our solutions for managing risk and active planning. It was fun being able to run our Financial Compass model for these individuals, right there on the convention floor. Some really seemed impressed by our ability to quickly provide a two and three year rolling forecast for their organization. Impressive perhaps, but after all, "the future is ours to see".

Last week we covered the first half of the OCC letter requesting information from client banks on their interest rate risk (IRR) model. Along with the letter, you may have run across some forms to be filled in with results from your model. This post and the accompanying webinar are meant to clarify the letter and terminology. Separately, but related, we have produced a video and guide for completing the OCC EV IRR Data Form for Financial Compass Clients (to be released soon).