High-octane ALM: the lending division's role

The following article is an edited summary of remarks made by Jim Brown, a principal of the Darling Consulting Group, during an RMA audioconference in February. It discusses the value that high-performing asset/liability committees bring to the overall management of the bank.

Highly effective asset/liability committees (ALCOs) understand how they fit into the overall management of the bank's balance sheet and margins. The ALCO is the most productive decision-making forum in an institution because it is at these meetings that issues are analyzed and strategy is determined and implemented. The ALCO is a profit center; the institution makes money as a result of the discussions held and decisions made by committee members.

Many institutions find their ALCO to be an excellent vehicle for educating boards. In the most successful committees, members regard the meetings as a high priority and work their schedules around it. The CEO who believes the ALCO is important establishes buy-in by the rest of the senior management team, whose concepts and philosophies drive it.

ALCO Membership

All key areas of the bank are represented on the ALCO:

* Lending--could include a representative from commercial, residential, and consumer, depending on the size of the bank.

* Retail deposits.

* Finance.

* Wholesale and investment banking.

* Treasury.

* Marketing--helpful in the implementation phase.

Open dialogue is important during brainstorming sessions, and there should be a free exchange of ideas. The deposit person may discuss lending issues and vice versa. Egos should be checked at the door.

These meetings require a focused agenda and clear objectives. Although you can discuss past events as they relate to the current situations, the primary focus of discussions should be the future. For instance, given the current structure of your balance sheet, you may want to discuss whether you need to emphasize fixed- or floating-rate loans.

The emphasis needs to be on strategy, including:

* Decision making.

* Investment strategy.

* Loan-pricing and product strategy.

* Deposit pricing and product strategy.

In the current rising-rate environment, you may want to consider:

* How fast do you have to increase the rates of deposits?

* How much are you able to lag?

* Should you introduce new products to ease the pressures on the cost of funding today? (Wholesale funding or borrowing is a key component of bank funding and could include anything from Fed fund purchases to Home Loan Bank advances to brokered deposits.)

* If your interest-rate risk position requires a hedge, which hedges are available to you? What is the appropriate level and time frame to implement this strategy?

* What is the capital position of the bank relative to your ability to grow and support growth? (Growth is often a leading ALCO strategy that results from discussions about how to improve income.)

The Current Position

You need to understand the bank's current position to develop a strategy. By considering the following questions, the ALCO will gain the perspective it needs to develop a strategy.

* What is the bank's net interest income or the earnings or liquidity position?

* How much funding capacity does the bank have?

* What is the bank's interest rate risk?

* What are the bank's exposures to either falling rates or rising rates?

* What are the bank's measurement perimeters and tools to understand its position?

* What is the bank's capital position? Is it large enough to support growth or is it constrained by capital?

Other Important Operating Issues

You also need to determine what information is not captured by the questions above. For instance, if the bank plans to open two or three new branches, there will be short-term pressure on operating costs. The ALCO needs to consider steps to mitigate that pressure. Regulatory issues and accounting issues also may warrant some discussion.

Strategy Formulation

Clearly, your objective is to reduce risk and/or increase income. Determine if you need more liquidity and define the fundamental elements of your strategy. Determine if the interest rate environment will help or hurt your efforts to implement your strategy. Always outline your strategy in the context of your action plan and consider the anticipated result of that action; every strategy a bank deploys carries its own risk.

Action Plan

When an ALCO is functioning at its best, it decides which strategies to implement over a specific time period, and it assigns responsibility for the tasks. The person with accountability will report at a later meeting how the strategy worked and if the result is what the committee expected.

A few things to keep in mind for the report include the following:

* It should be clear and concise--a written summary of the overall position, not pages and pages of numerical charts with little descriptive material.

* It should have information that will be useful in helping people develop ideas and strategy.

* It should include helpful graphs and photos.

* It should accurately reflect the standing of the bank.

* Committee members should be involved in the development of the report. It helps establish their buy-in.

Top-performing ALCOs have clear policies that are understood and read by both the ALCO and the board. Keep in mind that regulatory issues are only part of the puzzle, and policies should reflect the business perspective of the bank as well.

The risk-reward profile that any bank is willing to underwrite is its own. Some banks underwrite more risk and some banks underwrite less risk, but the important consideration is whether reward is commensurate with risk.

Under-performing ALCOs

Under-performing ALCOs are reluctant to make changes. Their mentality is: If it's not broken, don't fix it.

Reporting at their meetings is driven by what the bank believes the regulators want. Their reports offer too much raw data accompanied by too little analysis, or they don't provide sufficient raw data. Other times their report packages are too bulky with large numbers of possible scenarios, making it difficult to determine the bank's position. When a bank runs 40 different scenarios for its ALCO meeting, it becomes difficult for the committee to determine which ones require the most attention.

Under-performing ALCOs are not considered important by the institution and are sometimes dismissed by the bank leadership as a finance function. The leadership in these institutions wants the committee to provide a backward-focused "state-of-the-bank" report dwelling on budget issues. These committees offer little for the bank to consider as it moves forward. They often have too many or too few members, resulting in inappropriate management representation. Their decisions are often based on a bias toward a rate forecast instead of on the risk profile of the bank.

Lending Division's Role

The lending division's objective is to maximize net interest income over both the short and long run while managing levels of liquidity, interest rate risks, and capital adequacy. The objective is not simply to maximize net interest income.

Liquidity management is a key issue for the lending division at ALCO meetings. The lending division must be able to provide ALCO with an estimate of the funding it needs to meets its growth forecast over the next one to three to six months.

This production planning process impacts deposit pricing. If you expect significant loan growth, you must be more aggressive in attracting deposits, either by increasing rates or developing new products. If you are unable to generate sufficient deposit growth, you must consider wholesale funding. The ALCO should discuss long- or short-term funding alternatives.

If the bank doesn't expect significant loan growth, it may choose to be aggressive in its investment portfolio. If its investment portfolio is a funding source for loan growth, make sure its investment strategy remains aligned with that function. This strategy depends on how much excess funding capacity is provided by the institution's investment portfolio. It can also depend on the loan strategy itself.

If you're out of capacity to add to the balance sheet, then you have to make a determination. Should you hold the loans that the bank is originating or should you sell? Should you offer them as participations? Should you securitize? The ALCO should discuss these questions, and representatives from residential, commercial, and consumer lending should participate.

In the past, banks placed more emphasis on the loan division's function in generating new deposits, but over the past five or six years, they have been placing more emphasis on loan generation. However, you need deposit relationships with your commercial loan accounts or you'll eventually run out of funding. By bringing in new deposits and requiring deposit relationships with your commercial borrowers, you create a self-funding mechanism.

Some banks offer their lending division incentive programs for generating deposits. Many banks try to gain the personal accounts and employee accounts of their business customers. Offering other types of financial services to those customers can be integral to that effort.

Pricing Strategy Implications

If a bank's liquidity position is tight, it may seek higher rates on loans instead of advertising lower-rate loans. Some banks in this position have chosen to grow both the commercial and residential loan portfolios by funding the commercial loan and booking it on their balance sheets, while selling the residential loans into the secondary market. They still can enjoy the fee income from residential loans.

Interest Rate Risk

With floating-rate or adjustable-rate loans, the ALCO should discuss repricing frequency and the repricing index. Banks must offer different alternatives and choices for borrowers, recognizing that, under certain market environments, borrower preferences will vary widely. When rates are low, borrowers want fixed-rate loans or loans that reprice less frequently. When rates are higher, borrowers tend to prefer adjustable-rate loans.

When you have a loan that reprices every three or five years, use a three- or five-year index. It's inappropriate to reprice that loan based on a rate that is spread over prime. That pricing puts your bank at the mercy of the short end of the yield curve. Today the yield curve is very flat, but if it steepens and you're repricing to prime instead of to the five-year rate, the loan may be significantly underpriced.

More banks are moving toward the London Interbank Offered Rate (LIBOR) as they aggressively try to manage a floating-rate portfolio in this environment. Why?

* It's a true market rate. Some argue that the prime is no longer a true market rate because it's a managed rate. If a portfolio of loans is tied to LIBOR, the market for hedging is very liquid.

* In a rising-rate environment, loans tied to LIBOR will reflect rising rates more quickly while loans tied to prime must wait for the Fed to move.

You need to be careful, however, about using the Treasury as an index because the Treasury curve can disassociate itself from other credit curves at inopportune times. Several times over the past five or six years, the Treasury curve has become extremely different in either shape or spread from other credit curves. By tying your pricing to the Treasury curve, you put your institution at risk because the spread variation can be large. Over the past 10 years, the change has been over 100 basis points of spread between the Treasury curve and the swap curve. The swap curve is much more indicative of the yield curve for cost of funds.

Loan-Pricing Issues

In most markets, banks have been faced with extremely competitive pricing over the past couple of years. It's important in determine how low a rate your institution can afford and to define the costs.

Be careful about forward commitments. For example, many banks are underwriting construction with permanent financing and are fixing the rate at the front end. In essence, this is a forward commitment. You're committing to a rate for an asset that may not be fully funded for nine to 15 months, based on today's market rate. A premium should be attached to that rate.

Prepayments created havoc over the past five years both in residential and in commercial portfolios. More banks are moving toward better structures for prepayment penalties than toward the use of caps and floors. In the last year or two, institutions have been writing adjustable-rate loans with very underpriced caps and not attaching a premium rate for the cap.

Floors are inexpensive now, so some banks are putting a cap on a loan if the borrower accepts a floor. But floors have very little value because the market believes rates are rising. You run a risk that if you cap, say, at six, you'll get a floor at five. It just doesn't work.

Other cost variables are credit quality and the liquidity position of the bank. In this market, you must consider marginal spreads and marginal costs.

Does your fixed-rate loan pricing produce prime-minus-50 loans to prime-plus credits? If you look at what you're offering to borrowers on a fixed-rate basis and translate it into the equivalent floating-rate price, you might be surprised to know how cheaply you're offering the floating-rate funding. You must have a mechanism for calibrating fixed rates to credit-adjusted floating rates. In this environment you need a yield curve and either a LIBOR or prime swap curve.

An understanding of these issues becomes part of your negotiation. You can determine whether to offer a lower rate or whether to get something in exchange for the low rate, such as a modified term or a larger deposit balance. Sometimes customers prepay a loan because they think they have a great offer from another institution, but the fine print of that offer often includes unfavorable terms, such as prepayment penalties. If the customer had understood those terms, they might not have accepted the loan offer. When your competition offers rates that appear too low, check the fine print.

Your bank's interest-risk position determines how aggressive it can be. If the bank is very exposed to rising rates, it may be willing to concede more to get floating rates. Again, it's very important to look at appropriate yield curves like the swap curve. And remember, you don't want to just exchange a cap for a floor, particularly in the current environment.

Banks are starting to consider loan-pricing models. Some models are more formal than others, but they all offer some basis for setting rates at an index outside the yield curve.

It's important for a bank to understand if it is getting its rightful share of the market. If it's not, it needs to understand why. Is it a function of pricing? Is it a function of rigid underwriting standards? Do you have the products the market is looking for? What terms are you building in? It's important to consider your prospects for growth versus your absolute need for growth.

Conclusion

ALCOs require high octane in participation from the lending division. Lenders need to actively participate in the overall asset/liability management process. Banks are taking a loan-pricing perspective, considering fixed- versus floating-rate pricing and understanding the importance and relative value of options like caps and floors and the use of the interest rate swap.

The index selection offers many banks room to negotiate. In the current market, banks need to be aggressive on pricing by considering shortening the term of the loan or offering a floating rate. Don't let your greed overcome your fear.

Contact Jim Brown by e-mail at JBrown@darlingconsulting.com.

Editor's note: Jim Brown also made a presentation on ALCOs at RMA's 2004 Risk Management Conference (see the issue of December 2004-January 2005, p.44). You may also find it useful to read "The Role of ALCO in Risk/Reward" by Jim Clarke (issue February 2004, p. 56).

Jim Brown is a principal of Darling Consulting Group, Newburyport, Massachusetts. He has many years of experience working with a diverse group of financial institutions and is a key resource for the firm's balance sheet management services. Prior to joining DCG's predecessor company in 1981, Brown worked in both the commercial credit and operation areas of a major international bank. His firm advises about 250 banks around the country in asset/liability management.

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