It’s time to review your financial institution’s liquidity and ALM practices: leverage your data to mitigate risk

By Kevin Schalk, Ivan Cilik and Sean Statz, Baker Tilly

How can your financial institution prepare, but more importantly, thrive in an uncertain risk environment? Over the past year, banks and credit unions have experienced changes in how they go about managing liquidity and interest rate risk, while also considering what asset liability committees (ALCOs) and examiners may be looking for.

During the pandemic, liquidity was not an issue for most financial institutions because of the massive influx of deposits, and due to the low interest rate environment, many invested in longer-term securities. However, as interest rates have risen over the last year, the value of these investments has declined, and many banks have decided to reclassify to held-to-maturity (HTM) securities to mitigate mark-to-market earnings impacts, which made them relatively illiquid. With the recent bank failures creating fears regarding our banking system, we believe that liquidity oversight and stress-testing requirements will be a huge focus within the banking industry for the remainder of 2023 and beyond.

Understanding and utilizing asset liability management

Asset liability management (ALM) is the process of managing financial risks that result from mismatches between assets and liabilities and the timing of cash flows. The concept of ALM focuses on the timing of cash flows and ensures that assets are available to pay debts as they come due. Changes in interest rates and illiquidity can cause a mismatch between assets and liabilities, and ALM helps to ensure that this does not occur. ALM is a regulatory requirement for both banks and credit unions to monitor interest rate risk, and it focuses on short-term (earnings) and long-term (market value of equity) risks. It is common to run tests quarterly and look at trends in order to gauge the current risk environment and its potential impact on cash flows.

By calculating the economic value of equity (EVE), financial institutions can measure long-term interest rate risk by measuring the fair value of its assets and liabilities over their respective terms. In other words, EVE is calculated by taking the present value of all asset cash flows and subtracting the present value of all liability cash flows. This is a long-term economic measure used to assess the degree of interest rate risk exposure, whereas net interest income (NII) reflects short-term interest rate risk.

As an earnings simulation, NII scenarios project future earnings on assets and cost of funds on its liabilities. This is calculated by subtracting the interest a bank must pay to its clients from the revenue it generates. The amount of NII a bank generates will depend on many factors, including the composition of its balance sheet, quality of the loan portfolio and the collective interest rates each type of loan carries.

ALM’s most common stress tests are changes in interest rates, known as interest rate shocks, because they have a large impact on cash flows. Most ALM models run monthly cash flow projections based on contractual instrument data – loans, investments, deposits, borrowings and assumption data. They model cash flows over each instrument’s life in order to get a full balance sheet cash flow stream. Cash flows are aggregated for purposes of ALM policy metrics.

The pandemic played a large role in impacting balance sheets and today’s interest rate environment. More specifically, it has greatly affected market rates and prepayment rates, which went from a short-term high to a short-term low in a matter of only 24 months, greatly increased interest rate volatility and had a huge impact on cash flow.