REPORT Asset-Liability Management: Theory, Practice, Implementation, and the Role of Judgment John R. Brick, Brick & Associates, Inc. Foreword by Harold M. Sollenberger, Professor Emeritus, Michigan State University Acknowledgments Most research involves the collective efforts of numerous individuals who should be rec- ognized. This report is no exception. First, Ben Rogers of the Filene Research Institute was instrumental in encouraging me to weave the various components of a complex topic— asset-liability management—together into a single readable and reasonably comprehen- sive source. Ben’s goal was to meet what he correctly perceived as a pressing educational need in light of new regulations, one of which requires a certain level of financial knowledge for directors. To lay the groundwork for this research, the staff at Brick & Associates, Inc., conducted numerous risk assessments and analyses of the savings and loan (S&L) industry as it existed in the late 1970s, just prior to its col- lapse due to rising interest rates in the early 1980s. This analytical work was followed up continually with helpful comments, sugges- tions, and criticism of the many drafts and earlier research underlying the report. I am most grateful to Krista Heyer, Kerry Brick Zsigo, Bridget Balesky, and Jeff Brick for their insight and significant contribution to the literature on interest rate risk management. Finally, the comments and suggestions of the Filene reviewers and editors took the report to yet another level, for which I am also grateful. Filene thanks its generous supporters for making this important research possible. ASSET-LIABILITY MANAGEMENT: THEORY, PRACTICE, IMPLEMENTATION AND THE ROLE OF JUDGMENT TABLE OF CONTENTS (Rev. 8/21/14) FORWARD ................................................................................................................................................................................ 4 EXECUTIVE SUMMARY ...................................................................................................................................................... 6 CHAPTER I BACKGROUND & ALM CONCEPTS ......................................................................................................... 9 Historical Overview of the IRR Problem ........................................................................................................... 10 A The S&L Syndrome ........................................................................................................................................... 10 B Regulatory Response .......................................................................................................................................... 11 C Definition of ALM ............................................................................................................................................. 12 Analytical Procedures ........................................................................................................................................... 13 A Objective of ALM .............................................................................................................................................. 13 B NEV .................................................................................................................................................................... 13 1 Advantages of NEV ..................................................................................................................................... 14 2 Limitations of NEV ...................................................................................................................................... 15 3 OTS Approach ............................................................................................................................................. 17 4 NCUA Approach .......................................................................................................................................... 18 5 Perspective ................................................................................................................................................... 19 C Income Simulation ............................................................................................................................................. 19 1 Net Interest Income (NII)............................................................................................................................. 20 2 Advantages of Income Simulation ............................................................................................................... 21 CHAPTER II ALM METHODOLOGY AND THE S&L INDUSTRY—A POST MORTEM .................................... 22 A The S&L Balance Sheet ..................................................................................................................................... 23 B ALM Analyses of the S&L Industry .................................................................................................................. 25 1 Scenario 1—OTS Model.............................................................................................................................. 25 2 Scenario 2—NCUA Approach .................................................................................................................... 27 3 Scenario 3—Replicating Actual Events ...................................................................................................... 29 4 Contingency Funding Stress Tests ............................................................................................................... 31 C Perspectives on S&L and Credit Union IRR ..................................................................................................... 33 CHAPTER III THE INCOME SIMULATION HORIZON ............................................................................................. 36 Background ........................................................................................................................................................... 37 A Limitations of Economic Value Analyses ......................................................................................................... 37 B Income Simulation Procedure ............................................................................................................................ 38 The Simulation Horizon ....................................................................................................................................... 39 A The Short-Term Horizon ................................................................................................................................... 39 B The Case for a Longer Horizon ......................................................................................................................... 41 CHAPTER IV IMPLEMENTING ALM & THE ROLE OF JUDGMENT ................................................................... 47 A Scenario Testing ................................................................................................................................................. 47 1 Yield Curve Shifts ........................................................................................................................................ 48 2 No Rate Change Scenario ............................................................................................................................ 49 3 Ramped vs Immediate Shock Testing ......................................................................................................... 49 4 Interactive Effects of IRR & Credit Risk .................................................................................................... 49 B Non-Maturity Deposits (NMDs) ........................................................................................................................ 50 1 Average Life (or Decay Rate) ...................................................................................................................... 51 2 Responsiveness to Changing Rates ............................................................................................................. 51 3 Cost versus Replacement Cost ..................................................................................................................... 51 4 Risk Mitigation of NMDs ............................................................................................................................ 52 5 NMDs—Some Caveats ................................................................................................................................ 53 C Policy Issues, Conflicts, & Measurability ......................................................................................................... 56 D Qualitative Component of ALM ........................................................................................................................ 58 E Sensitivity & What-If Analyses ......................................................................................................................... 59 F Outsourcing ......................................................................................................................................................... 59 CHAPTER V THE ALM VALIDATION PROCESS ....................................................................................................... 60 Modeling Variances .............................................................................................................................................