Interest-Rate Risk: What Goes Down Must Come Up?

July 23, 2010
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In-house vs. outsourced

Whether ALM is performed in-house or is outsourced, credit unions should ensure they satisfy the key elements addressed previously.

Credit unions that outsource the ALM function should consider whether the provider offers the ability to discuss the analysis in depth to ensure full understanding of risk exposures. If not, where can a credit union acquire that knowledge?

Likewise, for credit unions that perform ALM internally, do they have the staff available to accurately decompose and understand the risk analysis?

When evaluating risk reports, keep these factors in mind:

  • Be aware of the assumptions that drive risk analysis. Very important! Be familiar with and understand the assumptions used in the model, such as non-term share repricing, prepayments, etc.
  • Make realistic assumptions. Ensure that assumptions made in the risk identification and measurement process are reasonable and reflect courses of action the credit union is likely to take.
  • Identify and understand key risk exposures and drivers.
  • Comprehend the products under consideration before adding them to the balance sheet.
  • Diversify cash flows, collateral, and credit quality on the asset side of the balance sheet.
  • Recall the risk/return trade-off. In order to improve earnings, risks must be taken and managed. Remember, high returns come with high risk.
  • Evaluate all products on a risk/return basis; never evaluate products solely upon return.

Whichever method a credit union chooses, the key point to absorb from the regulatory advisories is that credit union managers must understand the ALM process and modeling their credit union uses.

Finally, be aware of all the risks inherent on the credit union’s balance sheet and understand how and why the components of risk arise and how they can be managed.

While measuring and managing interest-rate risk may not make credit union managers’ list of favorite hobbies, it can help shield credit unions from excessive risk exposures.

The textbook definition of ALM is, “The process of structuring assets and liabilities so earnings stability and capital adequacy is not materially affected by prolonged change in the level of interest rates.”

This means credit unions should use their knowledge of ALM and their ALM reports to manage the overall balance sheet composition to ensure that earnings and the subsequent capital contributions aren’t severely impacted by changes in interest rates. What has come down likely will go up.

While the Federal Reserve has indicated it doesn’t intend to raise interest rates for an “extended” period, economists predict that when it does happen, the upward trend could be rapid. Credit union managers would benefit from understanding ALM capabilities and how ALM can be used to manage interest-rate risk.

Mark DeBree manages the ALM Services group for Southwest Corporate Investment Services, which provides interest rate risk analysis, model validations and core deposit analysis for client credit unions. Contact him at 800-442-5763.

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