ALM modeling is used to gain insight into the potential impacts of changing interest rate environments on both the credit union’s equity or capital as well as its profitability or ability to generate earnings. In short, ALM modeling is for measuring interest rate risk.
To understand interest rate risk, it is important to understand the competing objectives for credit unions. Low dividend rates and high loans rates will likely generate the most amount of earnings for a credit union, but higher dividend rates and lower loan rates can also directly benefit credit union members.
The same tug-of-war is true for the contractual terms of loans and deposits. Most savers would like to be able to withdraw their deposits at any time, while borrowers would like the longest possible term on a loan, to lock in a low rate or minimize monthly payments. Thus, Assets and Liabilities are mismatched in term on the balance sheet, and their corresponding cash flows will be different. These mismatches present a risk to the credit union’s ability to generate earnings and thus their equity/capital positions.
ALM is a process to address and understand the inherent mismatch of assets and liabilities due to changes in the interest rate environment. Because interest rates can move in different directions and to greater or lesser extents, examining multiple scenarios will be necessary to prepare the institution for all interest rate environments.
Interest Rates can move in a wide array of ways. Typically, as we’ve seen in recent years, interest rate increases are made in 25 bps increments, and interest rate cuts are often done 50 bps at a time. The timing can vary depending on the Fed’s intent. Instantaneous rate changes are used for more drastic intentions, and rate changes over time are made to make more gradual changes (sometimes called normalization). The important take away is that instantaneous rate changes and rate changes that are larger in size present larger risks to credit union earnings due to the mismatch of assets and liabilities.
Let’s consider an example:
Let’s say that your credit union has some fixed-rate loans with an average yield of 4% that are funded by money market account deposits that pay 1%. The interest margin (or profit) on that part of the balance sheet is 3%. If the Fed increased short-term rates by 300 bps (3%), all of the profit would be immediately wiped out for the remaining term on the loans, because money-market deposits reprice almost right away. On the flipside, if those same loans had been funded with member certificate deposits of similar term, the profitability would be relatively unaffected as the funding cost would be locked in.
This example highlights one of the fundamental strategic questions of the ALM process. A larger mismatch between assets and liabilities (i.e, more interest rate risk) often offers a higher current yield, but also less stability in income. Therefore, the ALM process uses a standard array of scenarios to assess what happens if interest rates go down, stay the same, or go up. Ultimately, balance sheet managers need to weigh how much income is necessary in order to achieve the credit union’s strategic objectives in all interest rate environments.
By Phil Lucas