Perspectives

September 18, 2017
Managing Mortgage Pipeline Risk
By Robert Perry, Principal – ALM and Investment Strategy, ALM First Financial Advisors, LLC

Residential mortgage banking is a sizable and important market segment, and many institutions operate originate-and-sell models, in which mortgage production is sold to investors (e.g., Fannie Mae or Freddie Mac). Loans locked with borrowers but yet to be originated-and-sold represent the entity’s “mortgage pipeline.”

Managing this pipeline is critical in today’s market and calls for skilled management to keep risk under control while ensuring profitability. The hedging process can often seem confusing – even daunting – to some because it involves complex computations and the use of sophisticated models to manage risk and determine pricing. When done correctly, however, hedging strategies protect lenders from the unpredictability of interest rate movements and other financial risks, thus improving risk-adjusted returns and long-term business viability.

Managing the pipeline for secondary sale
When a mortgage lender locks with a borrower and the loan enters the mortgage pipeline, an open interest rate exposure is created. If interest rates change significantly, the price of the loan will change significantly as well. Additionally, the borrower is free to choose another lender without penalty. When a particular lock fails to originate, it is known as a “fallout” or “hard fallout”. This is where good pipeline management becomes essential; understanding your fallout is critical to understanding your market exposure.

Common strategies for managing pipeline market risk include using forward-sale commitments and hedging using capital market instruments.

Forward-sale commitment
Forward-sale commitments are direct commitments to sell to the investor at some point in the future; commonly, this includes GSE investors, such as Fannie Mae. Forward-sale commitments can be made on a “mandatory” or “best-efforts” basis for future delivery of the loan. A “mandatory” commitment requires the originator to deliver a set dollar amount of mortgage loans at a certain price by a specific date; if the originator does not deliver, the agent charges a “pair-off” fee.

A “best efforts” commitment hedges fallout risk by not charging a pair-off fee assessment if the loan fails to close; however, this comes at a cost, as the price will be less favorable.



Hedging with capital market instruments
Hedging the pipeline can also be accomplished through the use of capital markets instruments, most frequently using the TBA, or “To Be Announced”, mortgage-backed securities market. Larger, more sophisticated lenders tend to use this vehicle due to efficiency, flexibility gains and the ability to employ warehousing strategies to boost interest income – all leading to higher returns.

A successful hedging program includes three key steps:

1. Maintain models and accurate data
Because hedging decisions are made based on data, data quality is paramount to the hedging process. Ensuring accurate and timely data is of utmost importance, and often involves disciplined and rigorous databasing and IT architecture. Automation and integration of the LOS, servicing platform and financial modeling software are important to foster efficiency and to reduce the possibility of human error.

2. Estimate fallout
Understanding fallout, as discussed, is imperative to the hedging process, and can contribute significantly to hedge tracking error. Factors impacting fallout include interest rate movements, product type, pipeline stage, borrower characteristics and origination channels.

3. Compute the hedge dollar amount
To determine the dollar amount that needs to be hedged, the risk manager must measure the market risk exposure associated with the mortgage assets, after adjusting for the expected fallout impact. Also depending on the institution’s circumstances, the mortgage servicing rights (MSR) asset volatility could also be important to model. Because the firm has a long position in mortgages, the firm should initiate a hedge by selling short the appropriate amount of TBA MBS.

A well-planned mortgage pipeline management program reduces the risk of the pipeline’s price volatility. Eliminating all risk would mean a perfect score, even if the hedge position resulted in a loss. Adjustments to the hedging process should reflect post-process evaluations of the accuracy of predictions, such as the back-testing of hedge ratios.

While internal hedging can bring cost savings, ultimately a hedge strategy is only as good as its execution. Thus, partnering with firms that are experienced in analysis and capital markets is often a prudent approach.



Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Robert Perry, Principal – ALM and Investment Strategy, ALM First Financial Advisors, LLC
Robert Perry is a Principal at ALM First Financial Advisors. He is responsible for the ALM and Investment Strategy Groups, which includes development of asset liability and investment portfolio themes, as well as strategic focus for financial institution client portfolios primarily invested in the high credit quality sectors. He also is instrumental in balance sheet hedging strategy development.



September 10, 2017
FMS Quick Poll: ALCO Composition
By Financial Managers Society

Who gets invited to the party?

Our latest Quick Poll on who gets a seat at the table in the asset-liability committee meetings of FMS institutions was inspired by a question initially posed by a member on FMS Connect: who is on your ALCO? Among the 185 responses (147 from banks and 38 from credit unions, representing a cross-section of asset sizes), we of course found a heavy emphasis on the usual suspects – CEO, CFO, senior loan officer, etc. – but a number of less common attendees as well, including a representative from HR at one institution and an ALM model analyst at another.

The options provided in our multiple-choice question were fairly straightforward, but their uniform ALCO participation wasn’t necessarily so (Figure I). While President/CEO (97%) and CFO (96%) checked in as near-unanimous selections, an ALCO invitation wasn’t nearly as much of a sure thing for senior retail officers (59%) or controllers (43%), and CIOs found themselves on the outside looking in more often than not (20%).



One of the driving forces behind the original query posted to Connect was the notion of Board members attending ALCO meetings, and the response in our Quick Poll was decidedly mixed on the topic. Just over half of respondents (54%) noted that a director or other Board representative was regularly present for ALCO meetings. However, some poll participants clarified this position in the “other” category, where several respondents, for instance, noted that their full Board is on board for ALCO.

A number of common choices helped round out the rest of the write-in candidates in the “other” category of our poll, with the chief operating officer, chief risk officer, chief credit officer, treasurer and heads of marketing all receiving multiple votes (Figure II). Some of the other one-off ALCO participants offered in this section included branch managers, risk management officers, financial analysts and VPs of finance, deposits and service delivery.



In addition to asking poll participants who comes to ALCO meetings, we also wanted to know how often those meetings take place (Figure III). While quarterly (50%) and monthly (42%) were the most popular intervals, a number of other write-in scheduling options were proffered, ranging from bimonthly to twice a quarter – as well as four respondents who favor weekly ALCO meetings.

Thanks again to everyone who participated in our latest FMS Quick Poll. If you didn’t have a chance to complete the poll, be sure to weigh in with your views on social media or on FMS Connect!

FMS Quick Poll




AUGUST 16, 2017
Building an Optimal Investment Portfolio
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Bank investment portfolios are an increasingly important part of balance sheet management. As portfolios have grown by 5.9% over the past year, according to the FDIC, they also produce a larger share of earnings. However, regulatory challenges and the low interest rate environment have pushed some into lopsided positions, such as high concentrations of agency notes and collateralized mortgage obligations (CMOs), with those institutions dealing with what are now sub-optimal portfolio allocations.

These investment portfolios show heightened risk exposures, whether through maturity extension, early call features or declining levels of income – less palatable sources of risk in an industry currently focused on improving earnings. In order to boost long-term performance while mitigating risk, investment officers should keep an eye on the following key areas.

Target Duration
Investment policy statements describe the framework by which the institution manages its portfolio. One goal is to enhance profitability within the overall asset/liability management objectives, while a second aim is to establish a process for implementing specific measures to manage sensitivity to interest rate changes.

Accordingly, management should establish a target level of duration that reflects the institution’s asset/liability position, income requirements and risk tolerance. Academic studies consistently show that longer-duration portfolios provide higher levels of income. At the same time, highly-leveraged institutions need liquidity to fund loans, and this may reduce the desired level of price sensitivity, causing the investment officer to “shorten-up.”

Maintaining duration, moreover, is an essential factor in preserving margin and maximizing net interest income. As portfolios age, duration can decline unless cash flows are reinvested back out on the curve; this “opportunity cost” limits earnings potential. Similarly, portfolios comprised exclusively of mortgage securities can extend if prepayments lag initial projections, creating unexpected interest rate risk. Investment officers should closely monitor their portfolios and take steps to ensure target durations are preserved to protect net interest income.

Diversification
Many portfolios become heavily weighted toward certain “comfortable” sectors. The returns fixed-income investors receive are determined by various factors, such as volatility of rates, credit and yield curve slope. An emphasis on callable agencies, for example, implies a reliance on returns from taking extension risk or prepayment risk.

With an expected drop in market rates, this institution will receive unwanted funds which must be reinvested at lower yields. Conversely, calls slow down in a rising-rate environment, providing less cash to put to work at better yields or to fund loans. A diversified portfolio (more call-protected assets, in this case) would keep cash flow fluctuations to a minimum, leading to improved portfolio performance.

Cash Flow
It is recommended that the treasury group prepare cash flow projections in a base case, as well as several alternate scenarios. An institution exposed to mortgage security prepayments, for example, can act in advance to protect against a decline in income in a falling-rate environment by either pre-investing or realigning the portfolio. The cash flow projections provide the information necessary to understand the position and evaluate suitable strategies, with the ultimate goal of establishing an optimal cash flow profile.

Bond Ladder
A laddered portfolio consists of securities that mature in successive years, starting in the short term and extending out to five years or longer. Assembling a stable basket of cash flows avoids locking in all one’s funds at “low” yields, while enabling the investor to pick up some additional income.

The benefit of a ladder is that as rates move higher, bonds coming due in the near term can provide funds for reinvestment when the alternatives may be more attractive. Depending on the institution’s preference and individual situation, the principal can be put to work at the desired maturity. If current yields are higher than the bonds rolling off, the institution is able to increase overall returns, boosting portfolio performance.

Fixed vs. Floating
Many investment officers wonder about the optimal strategy for deploying assets – whether to put on longer-term fixed-rate investments that pay a higher coupon or add floating-rate instruments that would benefit if rates rise. The investment officer might be considering two options: a five-year fixed-rate note yielding 2.4% or a similar term floating-rate bond priced at 90-Day LIBOR (1.3%) plus 50 basis points, for a current yield of 1.8%.

If the market forecast is correct, then the yield for the floating-rate bond will increase 25 basis points in September 2018 and a similar amount the following year – bringing the yield to 2.3% at September 2019. By contrast, the institution will have received a constant 2.4% for the fixed-rate option. Assuming a $1 million investment, the fixed-rate bond provides interest income of $72,000 over the three-year time horizon, compared with $65,250 for the “floater.” Even as the yield curve has flattened, fixed-rate assets may still provide higher levels of current income than floating-rate alternatives in the intermediate term.

Best Execution
In light of recent advances in technology, regulatory agencies such as FINRA have reiterated their commitment to ensuring best execution as a key investor protection requirement. FINRA stated in a November 2015 regulatory notice, for example, that the market for fixed-income securities has evolved significantly and transaction prices for most securities are widely available to market participants.

Broker/dealer transaction costs can vary greatly based on the scope of the transaction and access to the most liquid dealers. For example, the Bid-Ask Spread Index from MarketAxess shows that block trades on actively traded corporate bonds currently have a 3-basis-point bid-ask spread, and “odd lots” trade at 7 basis points. Individual transactions often trade at higher spreads, indicating that investors may be “leaving money on the table.” A more diligent approach toward trading efficiencies could help support the bottom line.

Municipal Bonds
Banks have boosted their holdings of municipal bonds steadily over the past decade, according to Federal Reserve statistics. Industry reports generally show that institutions holding larger percentages of municipal bonds tend to be the high performers, and banks holding at least 30% of their investment portfolios in munis are typically found in the first quartile for investment yield.

A primary benefit of municipal bonds is the long period of call protection. Bank treasurers may be relatively certain they’ll hold on to the initial yield for seven to ten years, regardless of interest rate movements. With considerable optionality on most bank balance sheets, municipals provide much-needed predictable cash flow. In addition, the municipal curve remains steep, providing some price protection for a rising-rate environment.

The Bottom Line
Taking some of these steps may enable management to build more efficient investment portfolios that generate higher levels of income over time. Building predictable cash flow characteristics provides the flexibility to manage the portfolio effectively within the context of the balance sheet, while also leading to stable returns.

Of course, the institution should consider its asset-liability position when making these decisions. Investment officers should also continue to maintain robust risk management practices, keeping interest rate risk exposure at reasonable levels.



Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.
Robert B. Segal is the founder and CEO of Atlantic Capital Strategies, Inc., and has over 35 years of experience in the banking industry, having worked in several community banks with roles in mortgage banking, sales and trading and asset-liability management. Bob is also currently a Director-at-Large on the FMS Board of Directors.




AUGUST 8, 2017
Understanding Requirements for Model Validations
By James Jarrett, Director, Baker Tilly Virchow Krause, LLP

With the use of models becoming more frequent among financial institutions, federal examiners are pressuring institutions to perform validations on all of the models being utilized. The common models being used include Bank Secrecy Act/Anti-Money Laundering, Interest Rate Risk/Asset Liability Management and Allowance for Loan and Lease Loss (ALLL).

Management and individuals involved in modelling at financial institutions need to understand the applicable regulatory requirements per current bulletins, key elements to review for each type of model validation – including frequency of completion – and best practices for reporting the results.

REGULATORY REQUIREMENTS

The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Bank (FRB) have all issued specific guidance on the use of business models. The items below provide some history for regulatory guidance on model validations:
Track movement of loans by segment
to identify trends in portfolio growth
Institutions can review growth patterns of the loan portfolio by looking at their segments and by reviewing their balances. If a specific segment has grown significantly, the institution can begin to identify and document the reasons for changes in loan demand and supply.

Model Risk Management
The use of a model does not reduce risk to zero. Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Model risk can lead to financial loss, poor business and strategic decision-making or damage to an institution’s reputation. Model risk should be managed like all other risks and be part of the annual risk assessment process.

Regulatory guidance outlines a principle for managing model risk called “effective challenge,” which is defined as critical analysis by objective, informed parties who can identify model limitations and assumptions and produce appropriate changes.

In its basic form, a model consists of three components:

Each of these three components should be included as part of the model validation process to help ensure there are no areas of weakness that would increase the overall model risk.

Model Risk Management Framework
An effective model risk management framework should include:

■ Disciplined and knowledgeable development that is well documented and conceptually sound
■ Controls to ensure proper implementation
■ Processes to ensure correct and appropriate use
■ Effective validation processes
■ Strong governance, policies and controls
■ Use of vendor and other third-party models should be incorporated into the model risk management framework

These points outline that the use of a model begins prior to implementation, a documentation roadmap is essential and the process does not end with implementation. Additionally, the last bullet point states that even third-party models are subject to the other bullet points.

There are three key elements to model risk management:


MODEL VALIDATION
Model validation is specifically detailed in the regulatory guidance – it is the set of processes and activities intended to verify models are performing as expected. Additionally, model validations identify potential limitations and assumptions and require the need to determine the impact. Model validations should be completed by staff with the appropriate knowledge and experience of the model subject matter.

The three components (input, process and reporting) should be subject to validation. This applies to in-house developed models, as well as those purchased from a vendor. The amount of testing required will depend on how the model is used and the amount of control the institution has within the model. In some models (e.g., Interest Rate Risk), the institution may supply the third-party vendor the input information and assumptions to be input into the model. In these cases, the institution does not have direct access to the model calculations and scenarios. In comparison, a BSA/AML model and an ALLL model are usually purchased software that is implemented on the institution’s information technology domain. The institution will have direct access to the software, including the ability to edit assumptions and alerts and to tailor the model to its products, services and operations.

Model validations should be completed by staff independent of those responsible for implementation, development and use. While staff completing the validation should have the knowledge, skills and expertise needed for that subject area, the concept of knowledge does not mean from an information technology standpoint. The person completing the validation should have knowledge of the purpose of the model. For example, when validating a BSA/AML model, the person completing the validation should have sufficient knowledge of the requirements of BSA/AML to be able to review transaction detail, alerts and suspicious activity.

It is always best to complete the model validation in a test environment. This would eliminate the potential negative impact on “actual” customer information in the event there are issues. Additionally, model validation is not a “one and done” process. The regulatory guidance states “Banks should conduct a periodic review – at least annually, but more frequently if warranted.” As these model validations are normally done by a third party, this is an additional annual cost institutions must consider.

Components of a Model Validation
Conceptual design
Evaluate the logic and design of the model.

The model was designed in a way to achieve a certain objective; now the question is: Is the model designed in a way to do exactly that? Is there anything missing? Are all risks that the institution is exposed to taken into consideration? Does it include all products and services? Documentation is key in this component and ensuring the proper group is involved.

System validation
Validate the system to ensure that it is properly designed to perform.

After ensuring that the conceptual design is adequate in mitigating risks, the system itself should be tested to ensure that it reflects the same. For example, testing the output and effectiveness of the generated alerts to drive further tuning of the thresholds and scenarios. In many cases, institutions should run the model parallel to the existing process for several months to validate the results. During the validation process, this parallel testing should be reviewed.

During system validation, it is essential to ensure systems, products, services and transactions are considered and flow to the model. For example, the implementation of the BSA/AML model would need to ensure all products, services, systems are considered. Not all products (e.g., Trust) are contained on the core processing system. The model validation should verify that all systems are properly mapped to the model software.

Data validation
Validate that accurate and complete information is captured by a system to execute the model.

A system can be designed and implemented to achieve its objective, but end up failing badly due to data integrity issues. If the input data is not reliable, the output would not be in a position to give any value. This part will require identifying source systems and transaction codes, ensuring accurate data feeds. This piece of the validation is critical as the results of the data drive the results of the model and the reporting. During this phase of the validation, information is traced from the originating system to the model to verify all of the key data is captured. This would include any assumptions within the model. The basic concept here is “garbage in, garbage out.”

Process validation
This phase includes an evaluation of controls, the reconciliation of source data systems with model inputs, and the usefulness and accuracy of model outputs and reporting.

During this phase, it is verified that everything from the core system (source data) was captured by the model. For an IRR model, this involves a review of the data sent to a third party and the output reports compiled by the third party to ensure the information is part of the model.

Model Risk and Deficiencies
Several factors can influence the outcome of the validation and whether it performs as it should. The most common issues affecting the effectiveness and accuracy of the models include: ■ Exclusion of customers, products and services

■ System data is inaccurate, incomplete or irrelevant to the model purpose or design
■ Data mapping errors/irregularities, file load errors
■ Design of rules and/or configurations inconsistent with regulatory expectations and the institution’s risk exposures
■ Logic errors which produce inaccurate output
■ Lack of change management and/or adaptation to changes in organization activities that affect model performance
■ Lack of resources and expertise to effectively manage model risk management activities
■ Unclear lines of authority or accountability

REPORTING THE RESULTS
While a model validation is not technically an audit, a formal report should be written or issued if a third party has been contracted to complete a model validation. The reports should be issued to management responsible for the model. Additionally, consider presenting the report to the audit committee or board of directors of the institution. The information can help inform them on various components of the institution’s operations and strategies.

The following items should be included in the report:

■ The scope of the model validation
■ The date the validation was completed
■ Which regulatory compliance requirements the validation was conducted under (e.g., OCC, FRB or FDIC)
■ Detailed procedures completed during the validations
■ Detailed recommendations for improvements and corrective action to be taken by management
■ An overall rating (e.g., satisfactory, needs improvement, unsatisfactory) as to the effectiveness of the model

During the next regulatory review, the report and workpaper documentation should be provided to the examiners.

For those institutions that are subject to validation requirements, following the rules and timing requirements are a must, but all financial institutions using models within their organization would be wise to validate. As organizations understand the validation process more thoroughly, there are organizational and strategic opportunities to be gained.



Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

James Jarrett, Director, Baker Tilly Virchow Krause, LLP
James Jarrett is a director in the corporate governance and risk management group of Baker Tilly Virchow Krause, LLP and has more than 25 years of audit, accounting, and regulatory compliance experience in the financial services industry




June 27, 2017
Creating Funding Stability During Uncertain Times 
By D. James Lutter and Todd A. Terrazas, PMA Financial Network

The days of cheap funding appear to be winding down. Since 2008, financial institutions have been able to access and maintain stable deposit balances. Due to risk aversion among the general public, deposits across all institution sizes have witnessed significant growth with relative ease.

Accessible funding has been a great benefit to financial institutions. However, with most economists and Wall Street professionals believing the economy to be in the latter stages of a bull cycle, it is important for institutions to document and understand how each source will react in various stress situations. Understanding funding sources and how they will react to different markets can help lead to a proper liquidity balance.

Identify and Define Funding Sources
There are a variety of funding options available to financial institutions, and it is important to incorporate those that fit within your strategic plan. In doing so, you can identify what gaps exist within your current funding sources by answering a few basis questions:

- Are deposits in-footprint or out-of-footprint?
- Are deposits operating or non-operating?
- Are deposits commercial, retail or institutional?
- What are your noncore funding sources – wholesale, reciprocal or listing service?
- What are concentrations amongst the various sources and what are their investment objectives (rate, diversification, etc.)?
- What degree of interest rate sensitivity exists and how are you hedging it?

By answering these questions, a financial institution can obtain a quick snapshot of its deposit mix and begin to effectively define an operating and contingency funding plan.


Which Funding Sources Are Right for Your Institution?
After recognizing current funding sources and any pitfalls that may exist, a financial institution should look to bridge the gaps. Once appropriate funding options have been determined, the next step is to identify the role each option will play within an operating and contingency funding plan. It is critical that diversification, credit sensitivity and concentration limits be included.

A good test of these attributes can be identified through analysis of the strengths, weaknesses, opportunities and threats (SWOT). For example, a SWOT analysis of a municipal depositor may resemble the following:

Strengths – A municipal depositor is typically local, has a predictable deposit cycle and can be a stable funding source

Weaknesses – Deposit capabilities can fluctuate and are cyclical, usually requiring some form of collateralization (per state statute or investment policy); credit restrictions may also be present

Opportunities – A municipal client can become a significant, multifaceted relationship through transaction activity, long-term banking service contracts, borrowing, safekeeping, etc.; additionally, diversification among multiple municipalities may mitigate cyclicality risk

Threats – General economic conditions may deteriorate, creating revenue shortfalls from a declining tax base and/or a delay in state or federal aid

Regulators expect a financial institution to have established funding policies, ensuring that proper controls are in place to adequately address the environment in which it operates. Testing sources on a regular basis allows the institution to readily access funds as needed, while eliminating the element of surprise.


Monitor and Maintain Your Funding Sources
To avoid undue stress, it’s important for financial institutions to monitor the inherent risk characteristics of its funding sources, as well as the evolving needs of those sources. Gaining a comprehensive understanding of your funding sources and the relationships to their investors and depositors provides much needed information to help understand how those deposits will respond under stress.

Adverse effects to a financial institution’s credit profile will increase the cost of funds and may limit its ability to access funding. Different depositors have diverse investment criteria and yield expectations. A comprehensive understanding of these metrics will enhance the financial institution’s ability to price and access funding sources. Furthermore, it allows the institution to execute a risk-averse operating and contingency funding plan. To build a solid, ongoing understanding of its funding sources, a financial institution should continually ask these important questions:

-How does the market view my institution? Do I know the credit criteria my funding sources monitor (qualitative and quantitative)? What are the implications if the criteria are breached?
-Do I understand my funding sources’ (depositors’) investment objectives (safety, liquidity, yield, etc.)?
-Have I identified, and do I monitor, the factors that could affect my ability to access various funding sources?
-Does my funding source have concentration limits?
- Have I documented each funding source’s role and communicated it where applicable?


Conclusion
Developing reliable, diversified funding sources is critical to the success of a financial institution. By defining, identifying and maintaining funding sources, an institution can gain further insight and discover tools that help mitigate risks when issues arise. A well-defined plan will help maintain stability, provide sound liquidity and interest rate management, and add value through increased earning.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Authors

D. James (Jim) Lutter, Senior Vice President of Trade Operatons, PMA Financial Network
D. James Lutter is is the Senior Vice President of Trading and Operations at PMA Financial Network, Inc. and PMA Securities, Inc., where he oversees PMA Funding, a service of both companies that provides over 1,000 financial institutions with a broad array of cost-effective funding alternatives.

Todd A. Terrazas , Business Development & Product Manager, PMA Financial Network
Todd Terrazas is the Business Development & Product Manager for PMA Funding, where he is responsible for developing financial institution partner relationships and managing funding product solutions and association affiliations.



July 18, 2017
Identifying Defendable Modeling Assumptions 
By Jerry Clark, Senior Vice President – Sales and Marketing, ZM Financial Systems

The words “Asset Liability Management” make our field sound very precise, but often the most important part of managing your risk and profitability is overlooked: assumptions.

Assumptions are critical when modeling potential future outcomes, as the data your model reports is only as good as the data put into the model. Where do you get your assumptions and how do you know they are “right?” First, a few key points to consider when developing modeling assumptions:

1.  Assumptions should be grounded in specific historical experience whenever possible.
2.  Adjustments should be made to reflect changes from the past (such as new management).
3.  Common sense and intuition are allowable.
4.  Industry averages and/or third-party supplements may be appropriate when lacking quantifiable experience.
5.  Stress testing your assumptions is very important.

AL models differ in look and feel, but most offer the ability to perform valuation and income simulation. Assumptions are grouped into those that impact cash flows, pricing and economic factors, but before delving into an assumption discussion, it is important to reiterate the age-old saying “garbage in garbage out.” The data you use as a foundation for your modeling must be as accurate and complete as possible. Layering assumptions on top of bad data, regardless of the correctness of the assumptions, can magnify inaccuracies and lead to wrong conclusions. Loan and deposit details should be loaded by instrument to correctly capture attributes such as caps, floors, pricing and payment structures.


Cash Flow Adjustments
1. Prepayments occur when borrowers make payments ahead of schedule on their loans. These should be layered onto contractual cash flows for lending-based products such as mortgage loans, commercial loans and mortgage-backed securities.

Most AL models allow the use of prepayment speed projections (e.g., CPR) and allow you to vary the speeds by forecast scenario. Commercial and other loans can be more challenging given their unique structure. Regression analyses and formulas are more appropriate, although it may be simplest to calculate historical averages and apply them to your projections for these loans. Some AL models also allow integration with third parties to incorporate multiple factors beyond rates, providing more dynamic prepayment modeling.

On a related note, prepayment penalties exist in many loan contracts and should be modeled when they exist.

2. Structured Cash Flows are unique to instruments such as CMOs. The correct way to model these is to use an engine backed by a deal library containing the payment rules for a particular scenario. Another approach is to import scenario-specific cash flows for your portfolio from the broker who provides the instruments – this is acceptable as long as the scenarios you receive match up with the scenarios you are modeling. Many institutions model CMOs like regular mortgages, ignoring the payment rules and only applying simplified prepayment matrices. This is rarely an acceptable approach and can lead to hidden risk. You should strongly consider the significance of these balances before taking such an approach.

3. Defaults and Recoveries happen when loans cannot be repaid under the contractual terms. Modeling for these has become common in AL models, given that DFAST, CCAR and CECL have hit the mainstream. Probability of default (PD) and loss given default (LGD) are the most common projection metrics, although migration matrices are also popular.

4. Early Withdrawals are very similar to prepayments, and occur when depositors withdraw their money prior to maturity for their term deposits. Decays are declines in deposit balances that do not have specific maturities. Deposit studies may be required to understand your unique behavior. As with loans, early redemption penalties often exist on term deposits and should be modeled when they exist.


Pricing
1. Pricing/Spread is an assumption driven more by policy and committee than historical experience. A recent historical analysis is a great place to start. You might look at loans or deposits originated last month against a driver rate or yield curve to get a baseline; however, understanding your pricing process could lead you to model future business differently than past business. One hint here: remember that business is negotiable – published spreads often differ from reality, so spend a little time researching and comparing before settling on spread assumptions.

2. Rate Responses and Lag Effects are used to mimic the timing delay between market rate moves and rates on products such as deposits. Single- and multi-betas are often the assumptions derived and then put into AL models for forecasting these rate movements.

3. New Business Term Structure is tied to pricing/spread in most models: instruments are priced by referencing term points on a yield curve. Development of this assumption also requires research of your recent history to understand patterns and behaviors. A data warehouse can be an excellent tool for understanding both the pricing and term structure behavior in your new business.


Economic Forecasts
1. Determining the Rates to use when modeling depends on your purpose:
-For valuations, an implied curve derived from market rates is preferable. Bloomberg and Reuters are commonly used sources of market rates.
-Stress testing can take many forms. Rate shocks, ramps and twists are usually derived from market rates, again from a source such as Bloomberg.
-When projecting earnings, it is generally appropriate to use an internally-developed rate forecast. The premise is that you plan based on expectations, so your budgets and goals should be set based on some sort of most likely forecast. Some institutions are uncomfortable making projections, in which case they rely on S&P (Global Insights) or another consensus-type forecast.

2. Balance and Fee Projections usually come from either line of business feedback or top-down goals. Advanced institutions may use econometric models to estimate behavior, but direct feedback and estimates are usually preferable. Mortgage servicing contains very unique attributes that may require external assistance to model.

3. Economic Factors such as CPI, GDP and unemployment are important ingredients when moving beyond basic income forecasting to projecting losses, capital, liquidity and other aspects of your business.

AL models contain other broad assumptions such as discount curves and volatilities, as well as instrument-specific assumptions, including discounting methodologies and spreads. Assumptions in your modeling process should be understood and defendable by someone in your organization. The last thing you want is for an examiner or your manager to ask a question you cannot answer.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Jerry Clark is Senior Vice President of Sales and Marketing for ZM Financial Systems and has more than 30 years of experience in market risk, treasury, accounting and finance.


June 15, 2017
FMS Quick Poll: Succession Planning
By Financial Managers Society

What will become of your community institution when the current senior leadership decides to call it a career and head to the golf course? Is there a CEO-in-waiting ready and able to take the reins in a seamless transition? Is your next CFO just down the hall? Will you have to go outside your bank or credit union to find the talent needed to keep the institution growing?  

Those are the questions we had in mind when we went out to the FMS membership with our latest Quick Poll. Among the almost 140 responses received, we found that succession planning is certainly an item on the agenda at most institutions, but where it ranks on that to-do list – and why – varies quite a bit.   

Of the 137 respondents in the poll – 117 from banks and 20 from credit unions – 49% characterize the level of concern around succession planning at their institution to be “significant,” viewing it as one of their top concerns in the near term, while 13% see it as a “critical” issue in need of immediate attention (Figure I). Meanwhile, 28% have succession planning on their radar, but only as a lower-level priority for the coming years, and 10% of poll participants see it as a lukewarm issue that can fall in line behind other more pressing areas of concern.  

FMS Quick Poll

So how much work do they have to do to address their succession planning issues? That is, where do their efforts currently stand? Most respondents are at least headed in the right direction, with 60% reporting they have a strong plan in place already and another 31% noting they’re in the process of formatting a plan; the remaining 9%, however, don’t have in a place and have yet to take steps toward getting started (Figure II).

FMS Quick Poll

These results align closely with the responses from 400 community institution leaders in “Community Mindset: Bank and Credit Union Leadership Viewpoints 2017,” a recent FMS research survey of the industry. Responding to the same question, more than half of respondents (57%) said they have a strong plan in place for succession, 33% noted they were working toward a plan and 10% reported that they did not have a plan.

Those 52 institutions in the Quick Poll still in the early stages of trying to pull a plan together are encountering a number of challenges, including a lack of qualified internal candidates for leadership positions, the absence of an in-house program or track for grooming such candidates, a lack of urgency from the board to get a plan in place and, most of all, a lack of time and resources, as other priorities take precedence (Figure III).

FMS Quick Poll

When they do find the time and motivation to get down to the serious business of putting together a plan, those institutions can take a lesson from the 82 respondents who are further down the road as they hone their efforts. Among those institutions with a strong plan in place, having a clear process for identifying and cultivating internal talent and having a solid written plan both ranked highly as key elements toward a good succession plan, while buy-in from leadership and the board also came into play (Figure IV).

FMS Quick Poll

Thanks again to everyone who participated in our latest FMS Quick Poll. If you didn’t have a chance to complete the poll, be sure to weigh in with your views on social media or on FMS Connect!







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Mark Loehrke
Editor and Director, Publications and Research
Direct: 312-630-3421
Email: mloehrke@FMSinc.org