By Walt Williams
NOTfirst three decades have passed since interest rates last rose as rapidly as 2022, meaning many bankers today have spent their entire careers in a much calmer rate environment . This lack of experience can prove to be a hindrance to interest rate risk management, but not prohibitive. Proper modeling and a back-to-basics approach to asset-liability management could help.
Raj Mehra was working for JPMorgan Chase in 1994 when the Federal Reserve nearly doubled interest rates to 6% in one year. “We’ve definitely been here before,” says Mehra, who is now EVP and CFO at Freedom Bank of Virginia. “Not everyone may remember it, and everyone will have a different playbook for how to deal with it.”
The Freedom Bank playbook benefited from past decisions such as interest rate swaps carried out at the start of the pandemic when rates were low. Other institutions have also looked to the future and developed their own sets of play calls, although these strategies are only as solid as the modeling used to produce them.
“Let’s hope that everyone [ALM] practitioners run various scenarios to be able to disentangle the risks that may be on their balance sheets for a diverse set of interest rate outcomes,” says Dan Schwartz, director, corporate treasury, at Discover Financial Services.
Real world modeling
The better a bank understands behavioral trends in its deposit base, the better it will be able to control its funding costs as the Fed continues to skyrocket rates, says Darnell Canada, managing director of Darling Consulting Group. And that data should reflect what’s happening in the real world.
“The inputs and assumptions that go into these models are expected to change as the environment changes,” says Canada. “Typically, that doesn’t happen in the small window of time that we’ve seen. Typically, the Fed doesn’t act that quickly.
“That’s one of the key messages we’re trying to get across to people: it can be dangerous to assume that my balance sheet is going to behave the same way it has over the past one, two or three last rate cycles because the current cycle is nothing like the last two cycles.
Robert Perry, director of ALM and investment strategy firm ALM First, has similar advice: “It’s important to make sure your asset modeling and pricing is live: that it’s day with market rates and you get behind the eight ball and misprice the assets. put on your balance sheet, you are not being properly compensated for that asset.
Focus on the basics
Modeling is one thing, but Susan Sharbel, senior consultant at Abrigo, which the ABA endorses for loan loss accounting solutions, takes a back-to-basics approach in a recent article on five ALM best practices. She acknowledges that none are earth-shattering, but they are good practice regardless of the pricing environment. But some call for a different mindset, like his first recommendation, which is to start the ALM process with an updated capital plan.
“Typically [capital planning]is viewed through a regulatory lens: regulators require it, so we have to do it,” says Sharbel. “But really capital is also your buffer. This is something you can leverage to grow the institution to become more profitable. It is very important to have a solid plan so that when you do your stress tests you can see what the effects are on your capital.
Stress testing “expansive” scenario analysis is his second recommendation. Again, assessing risk is something banks already have to do, but many aren’t good at it, at least in Sharbel’s mind. Just as motorcycle owners want to buy the most expensive helmet they can afford for maximum protection, “institutions should really invest in the most rugged model they can afford,” she says.
His third recommendation is to ensure reasonable assumptions in the ALM model: Use institution-specific data whenever possible. Use account-level data and a custom chart of accounts as an ALM best practice. The fourth on the list uses a measurement system that captures all short-term and long-term risk. “Often many institutions capture risk in what we call silos,” she says. “So here is your credit risk. Here is your interest rate risk. Here is your liquidity risk. Here is your option risk. They are calculated individually, right? But that’s not how it’s done in the bank. They all happen at once. … It’s much more productive to watch everything, you know, because they all influence each other.
Finally, Sharbel recommends an annual validation of the ALM model. Like capital planning and stress testing, validation is something institutions already require, but that doesn’t mean they shouldn’t do the bare minimum, says Sharbel. High confidence in an ALM model leads to better business decisions, and “we’re in an age where decision-making is everything.”