Plansmith Blog

Financial institutions are not like other businesses. After all how many other businesses get a daily statement of condition? In what other business is the balance sheet also the product list? It must be remembered that a financial institution’s directors typically come from other industries. For these reasons, it is management’s responsibility to translate the business model, key operating ratios and banking language into terms familiar to directors to insure meaningful dialog.

It is always interesting to me to hear different people’s views of cash flow – from a personal perspective as well as a business perspective. I regularly ask people if they balance their personal checkbooks. Shockingly - to me, at least – I almost always hear "no". Most people feel comfortable checking an app or logging in online to view their balance periodically, scanning transactions for reasonableness rather than logging debits and credits in an old-fashioned check register. (Full disclosure time…I still use a check register for my personal accounts, so I’m biased here. I find it strangely comforting.) But most consumers feel they have a good handle on their cash flow without writing out the details. If they’re running short on cash they have back-up plans in mind - they can transfer money from another account, cut spending in the short term, ask relatives for a loan or cross their fingers, hold their breath and wait it out.

Interestingly, the response I usually hear from small businesses (outside of the banking industry) is that they do have a strong, more formal handle on their day to day cash needs. They keep a check register (albeit mostly electronically, for example in QuickBooks). They know how much cash they need to fund their regular business needs and they monitor their cash flow in detail. They know which customers they need to collect from up-front, and which ones are slow to pay. They have concrete back-up plans if cash runs tight – savings, lines of credit, which bills they can delay paying versus which payments are critical to be paid on time. They know where they’ve been and where they’re trending - positive cash flow is critical to staying in business, so cash flow is always top of mind. Otherwise they’re out of business (and hence not part of my survey.)

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.

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.