Until a few years ago, many credit union executives viewed Asset Liability Management (ALM) as an exercise in futile number crunching being thrust upon them as a necessary evil by the regulators. The general practice was to outsource this function to a third-party for a periodically generated "Asset Liability Management Committee (ALCO) Reports Package" to satisfy the regulators. These reports were then stuffed in a drawer to gather dust.
Then credit union executives began having "aha" moments, recognizing the usefulness of the information goes well beyond alternative rate environment balance sheet and net interest margin modeling. Today's executives use ALM tools as their earnings and performance measurement models-their basic framework for key decision-making, budgeting and forecasting, as well as testing the feasibility of new product strategies and establish actionable business plans.
Net Interest Margin Components-Understanding Strategic Impacts
In many cases, credit union executives "didn't know what they didn't know" when it came to ALM, making isolating the unknowns a good starting point. At this point strategic information can begin to be gathered to help the credit union executive management team better understand their position and impact of specific strategies.
At The Simple Level
At a basic level, a credit union's net interest margin is a simple equation:
+ Interest rate x average outstanding loan balances
+ Interest rate x average outstanding investment balances
- Interest rate x average outstanding deposit balances
- Interest rate x average outstanding borrowings balances
= Net Interest Margin Before Provision
- Provision for Loan Losses
= Net Interest Margin After Provision
At A More Complex Level
It is helpful to consider a credit union's balance sheet measured against time (see chart above). Ongoing net interest margin is dependent upon the dynamics of today's balance sheet and strategic decisions made with regard to the future balance sheet. It is critical to have the ability to analyze the current balance sheet and understand the dynamics of contractual maturities, prepayments, non-performing assets and repricings and the impact on earnings inherent in the current structure. Once these are understood, future strategic alternatives can be more easily evaluated.
The complexities and practical challenges in managing the net interest margin components become clear when consideration is given to details such as:
* Competitive market loan and deposit pricing and demand conditions-balancing volumes, liquidity and desired returns including non-interest fee components.
* Loan pricing by product line considering credit risk, interest rate risk, and minimum ALCO returns desired on incremental loans.
* Loan and Investment volumes by product line considering contractual maturities, pre-payments and repricings, and new originations desired vs. internal product pricing vs. market pricing.
* Deposit and borrowings volumes by product line including rate-sensitive "non-core" member deposits dependent upon price, amount of contractual maturities/time deposits, and new deposits desired vs. internal pricing vs. market pricing.
* All of the above behavior in alternative market interest rate environments.
The balance sheet strategies undertaken today impact the future balance sheet and therefore, net interest margin. In a simple credit union balance sheet and steady economic environment, these components are easier to determine than in more complex situations where significantly more interest rate sensitivity and economic valuation modeling is required. To manage and understand all of the net interest margin dynamics is much more than a CFO-finance department related exercise, it requires ongoing participation from all key "member-touch point" areas of a credit union: marketing, lending and operations.
Additionally, based on board and ALCO direction the following must also be strategically weighed:
* Desired vs. current capital levels.
* Desired vs. current performance ratio measurement.
* The behavior of net interest margins and net economic value in increased and decreased market rate scenarios vs. ALCO limits.
* The feasibility of new product offers.
* Non-interest income competitive strategies.
Using ALM Tools for Competitive Advantage
Successfully translating the above data into usable strategic ALM information requires both senior management commitment as well as proper ALM tools. Today, many credit unions are using these reports as their basic framework for strategic business planning and decision-making.
Credit Union ALM Challenge:
To improve the quality of earnings while effectively managing and monitoring balance sheet risk.
ALM Considerations:
* Start an ALCO and ALM process if you do not have one. A sound ALM process integrates strategic, profitability, and net worth planning with risk management.
* Consider establishing an ALM policy even though not required by regulators.
* Bring your ALM function in house if your current vendor does not provide timely best practice consultative ALM support.
* Educate the board and senior management team on ALM basics and the dynamics of your earnings.
* Tap into critical member information tools and resources and determine how to use this information to your advantage
* Use ALM strategic reports as the basic framework for key decision making and the basis for establishing your strategic business plan going forward.
Terry Treadwell is a CPA with extensive banking ALM experience and can be reached at ttreadwe
