True or False

A budget is a once a year process for an institution.

True: A budget is a process typically done once a year to establish targets/goals of measure to be used as guidelines throughout the year.

Budgeting and Planning are synonymous.

False: A budget is a point in time measurement; whereas a plan is a living, breathing, moving idea composed of volumes and rates.

Interest Rate Risk is only useful to regulators.

False:  If used dynamically, interest rate risk should be a valuable analysis to your business.

Let’s discuss.

As much as a Budget is needed for creating solid benchmarks, a plan can only be effective if it is actively monitored and adjusted as needed. A plan represents your best attempt today at reaching budget targets. A plan allows you the ability to anticipate change based on what you have learned, from what has actually occurred.

A plan needs to be agile. Planning is a verb. A plan is living and breathing in that it houses relationships. Simply put, it stores the necessary information on the flow of funds in and out of the institution. It’s extremely hard to predict margin without planning what is coming in and going out of your balance sheet. For example, let’s say you want to grow Certificate of Deposits to align better with your longer term asset commitments. Which CDs, what term, new money or existing, shifted perhaps from non-maturity deposits?  These questions are best answered by first looking into your maturity data.

Budgets without maturities tell only half a story. 

A simple Gap report is a good place to start for an overall view what is expected to mature or reprice based on business you have already done. A gap can give you an idea of what you should have available and poses this question: are you planning on keeping things as is, directing balances into other products, or might you lose them all together?

But what about the budget? Didn’t you already define where the bank would grow? Where is that taken into account? Where can you see those numbers?

Well, if you are not using a system that records maturity data and predicts future maturity flows, this would be impossible. If you are, then you’re in luck. You have access to whole world of dynamic data.The dynamic gap report, for example, is produced from your current history. Your planned forecast will combine what is currently on your books and what is planned to be available, assuming the plan is executed.

Now you’ll need to look at rates. Again, not just the current yields and costs, but where you believe rates are headed now, not way back when the budget was originally formed.

Now you are ready to test ideas. Call them what-ifs or alternative scenarios (yes, these are synonymous) you have enough information to make adjustments to your plan. Through the act of planning, you are defining volume growth, term and rate estimates for your future, and--this is important--before you commit to them in real life!

Planning allows you to measure the impact of your idea(s) against life as you now know it, against other ideas, to determine if it still aligns with your original budget benchmarks. This doesn’t need to be complicated or time consuming, it just has to be investigated.

What is the purpose of using IRR as part of your planning process? Plenty. You simply must use it in a more dynamic manner. Let’s discover Future Shock.

Future Shock

The problems with regulatory Interest Rate Risk Shock measurements are pretty obvious: they’re static. Static shocks tell you what you already know, as it is based on today’s balance sheet. It measures only what you have on your books today as if you will keep things exactly where they are, then applies dramatic rate changes to the dollars available to reprice. In many cases the most it can show is vulnerability in an extreme rate change. This information may guide you to review your rate projections or the fact that you may need to review your spreads associated with rising and falling rates. But why would I just change rates or rate spreads? Isn’t that mixing a forecast (rates) with a static measure (balances)?  Why, yes it is!  So, why not combine the ease of a shock report with dynamic balance sheet changes?  Great idea, that’s what we call a Future Shock.

Future shock is as simple as moving the report date request from today to a future period. Your model will apply all future activity to that point in time. So, if you're making Commercial RE Loans for the next 6 months, it will capture the amortization of those loans, the rate those loans are projected to be made at, and combine the forecasted maturity to the actual maturity. Now you are measuring Future Risk.

Future Shock tells you the whole picture. Given where you are today, and the predictions of where you believe you will be in the future, apply extreme changes to the rate environment that may expose any risk to margin.

But I Outsource IRR...

Why do people shy away from IRR? It’s too complicated. There are too many unknowns.  No one uses it. No one understands it. And I agree, to a point.

Too many times clients believe it’s too difficult or they build in so much complexity they find it difficult to support and to explain to others, not to mention examiners. My advice to all of you is to lighten up!

I’m not saying don’t do your homework, but keep the results simple. Don’t let detail stifle creativity. You don’t have to take my word for it either. Try a test for yourself. Take one of your largest accounts and build as much detail as you can think of into the offering rate pricing betas, the prepayment tables in varying rate conditions.

Most likely there will be no significant difference. Now, of course, there will be those circumstances that this will not always be the case, and that’s true. This brings us back full circle to the importance of planning.

Want to brush up on your budgeting prowess? Check out our recent webinar, "5 Things to Consider this Budgeting Season."