"Our bank bought a model, wrote policies and formed an ALCO (asset/liability committee), but somehow our asset/liability management isn't as effective as I think it should be. And now our margins are shrinking. What's wrong?"

[Expanded Picture]This question is echoed in varying degrees by CEOs at banks large and small. The reasons for these concerns vary and are often symptomatic of a multitude of underlying issues. Sometimes the issues are easy to fix, but sometimes they need a more in-depth assessment to formulate effective solutions.

While working with numerous bank management teams, we have had an opportunity to examine a variety of effective and ineffective processes. This work has allowed us to catalogue those characteristics common to successful A/L management processes and the ailments common to ineffective processes. Here is some of what we have learned about what works, and what doesn't.

The effectiveness of A/L management is directly related to the commitment made to the process. So simple, yet so often overlooked, is the degree of commitment to managing the balance sheet on a unified basis. Successful processes have a high level of commitment, usually starting with the board of directors and filtering down throughout management. Senior management and the board expect the process to deliver results and are willing to make changes if it isn't working as designed. A/L management information is reviewed frequently at senior levels and becomes the foundation for virtually every balance sheet decision. A total financial intermediation management culture has evolved.

Viewing A/L management as a burden undertaken only to pacify regulators is common to ineffective processes. No real value is perceived and no effort is expended on delivering results. Minimal reports are prepared and filed away, not to be reviewed until the next field examination. Making money by any means is the order of the day.

Effective A/L managers know their desired destination and conscientiously select paths to get there, using clearly stated objectives. Results-oriented A/L management processes have well-thought-out, compatible objectives, both financial and non-financial. Objectives support the bank's overall strategic plan. Goals are specifically identified and measurable.

Besides knowing the objectives, decision-makers in an effective balance sheet management process have well-defined roles and know their responsibilities. Each takes responsibility for providing input, dialogue and decisiveness in decisions and implementation of an agreed-upon plan. Ineffective processes have incomplete, haphazardly prepared plans and lack assigned responsibilities.

Tradeoffs Understood

Effective ALCOs understand basic concepts. They recognize the trade-offs between short-term opportunism and building long-term franchise value. They study and understand emerging risk/reward relationships, but don't necessarily jump at the latest universal remedy to prop up earnings. They take calculated risks, control their exposures and monitor their results. They don't bet the house. They take a longer-ter strategic viewpoint of managing the balance sheet's earnings capacity.

Effective ALCO meetings are decision-oriented. Ineffective ALCO meetings get bogged down in indepth reviews of mounds of data, often waiting for "perfect information" before making the "right decision." Sometimes decisions are indefinitely deferred for additional analysis, but more often than not, decision paralysis stems from the lack of clear objectives. Decision-making is paralyzed.

Good decision-making by ALCOs is followed by flawless implementation created through good communications. Effective ALCOs understand the importance of selling their decisions to shareholders, boards, regulators and--most importantly--to the employees who have to implement the strategies.

A common A/L language is well-understood and used. Strategies are designed and communicated in ways that avoid ambiguity and clarify who will carry out what, complete with the understanding of why. Risk and reward concepts are defined, documented and understood. Successes are celebrated. Failures are contained, and studied for their educational value. Policies and procedures include lessons learned and the "tuition" paid for past failures.

The ability of an ALCO to make informed decisions and monitor results rests on having appropriate and well-developed analytical capabilities, either in-house or acquired through a third-party provider. These capabilities focus on performance forecasting, risk measurement and profitability measurement. Systems and qualified staff operate in a manner that provides succinct, timely and appropriate information to the decision makers.

Capabilities to strategically forecast the balance sheet, based on agreed-upon business plans, and simulate results under a dynamic set of assumptions become the basis for the effective ALCO to make decisions. Systems to measure risks, with the appropriate level of detail, are in place and monitored on a continuing basis.

All financial risks are measured in dollars of earnings-at-risk or value-at-risk terms. Risks are decomposed and their respective sources and magnitude are quantified in relationship to one another. Only the most worthwhile risks are pursued. Earnings and value projections are compared with the underlying risk assumed.

Effective ALCOs are able to determine what contributes to the financial objectives at both the business unit and individual product level. Profitability measurement focuses on three distinct elements: the cost of operations, the value of funds provided or utilized, and the capital required to support the activity. Profitability assignments are risk-adjusted so that low- and high-risk strategies can be compared on an equal basis.

To evaluate return on equity performance across business lines, capital is also assigned on a risk-adjusted basis. These three profitability elements allow for effective management of the entire risk/reward characteristics of the financial intermediation business.

A/L management processes that lack one or more of these three analytical capabilities may still produce acceptable performance, but the entire continuous chain of the process is short-changed at several strategically important links. The links in the A/L management process chain are as follows:

* Gather data for analysis.

* Analyze current position and market opportunities.

* Evaluate risk/reward relationships.

* Develop strategies and tactical alternatives.

* Make decisions.

* Communicate decisions and plans.

* Implement plans.

* Monitor results.

Clearly this list is not all-encompassing, and there are many organizations that consistently produce admirable results without having all of the above-listed ingredients. Use this list of common characteristics to score your own organization's effectiveness.

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