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Static and Dynamic Methodologies – Critical ALM Modeling Issues That Can’t Be Ignored

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7 minute read – As rates have increased materially, and liquidity pressure continues to build, leaders will continue to be faced with high-impact decisions that can have longer term consequences.  Reliable and timely financial decision-information is a huge component of a successful decision-making process.

This blog on Static Balance Sheet Analysis (sometimes referred to as Static NII or Net Interest Income) and Dynamic Simulations is part of a series addressing critical ALM modeling issues.

Static Balance Sheet Analysis, by definition, assumes that the balance sheet structure never changes, even if rates change.  The static methodology was developed prior to advanced computing power.  Unfortunately, it has remained pervasive in modern risk analysis.  This simplified methodology is particularly dangerous and misleading in the rate environments decision-makers are facing today, as it can understate risk.  For example, many institutions’ ability to attract funding is shrinking and the mix of funding is changing to higher cost sources.  This is completely ignored in a Static Balance Sheet simulation.

Problem:  Static reflects none of the potential liquidity pressure that has historically occurred when rates rise, ignoring the resulting change in funding mix and its impact on the cost of funds.

Solution 1:  First and foremost, make sure the limitations of the Static Balance Sheet Analysis are clear to other decision-makers to avoid unpleasant surprises.    

  • Caution – It is common for people to think that their ALM model has decay/withdrawal assumptions, so they think the risk is covered. A confusing reality in most models is that those assumptions ONLY apply to their EVE/NEV answers, but NOT their risks to earnings and capital.
  • Caution – We have heard some people say that they also do a Dynamic Simulation, so they are covered.  A Dynamic Simulation can address some of the risk if it assumes a shift from lower cost deposits to higher cost deposits like certificates.  The problem is most Dynamic Simulations don’t factor in that the shift should get worse as rates go higher.

Solution 2:  Incorporate a methodology that automatically changes the mix of deposits as rates change.

Problem:  There are no fixes to the Static Balance Sheet methodology that also preserve the true definition of static.  However, there are some work-arounds if your modeling capabilities or policies are limited to Static Balance Sheet Analysis.

Solution:  Create a non-maturity deposit category to represent the non-maturity deposits that could shift to CDs as rate advantages develop.  Move some of the starting funds into that account and have it reprice to your new CD rates.  (Keep in mind your average balance per account pressure along with the consumer’s advantage to move to CDs)

  • This doesn’t address the reality that the amount that may move should be expected to change as rates change. Typically, as rates go higher, the difference in pricing between products increases, meaning that the consumer has more of an advantage to move their funds to higher-priced products.  For example, more migration is likely to happen if rates increase 300 basis points than if they increase 100 basis points.
  • Consider moving the maximum you think will migrate in the highest rate environment to capture additional risk exposure.
  • The representation of migrating funds could be included either in your base simulation or as a what-if.  We encourage decision-makers to include it in the base simulation if you think it is more realistic that some funds will move to higher-cost products as market rates rise.  A starting point for the amount to move could be based on your assumed decay rates.
  • Caution – It can seem simpler to move the balance into a current CD account and assume that the term is a year or more, but this fails to capture the volatility that should result from funds migrating from lower rates to higher rates during the simulation, hiding risks from decision-makers.

There are also problems with Dynamic Simulations, many of which are solvable.  Here are just a few considerations.

Problem:  Similar to the issue with Static Balance Sheet Analysis, many Dynamic Simulation models do not incorporate decay rates when quantifying risks to earnings and capital.

Keeping the same future balance, regardless of market rates, doesn’t appropriately address the exposure and can understate the volatility.  It misses the risk that the funding mix can change and the resulting impact to the cost of funds.

Ask Yourself:  As discussed in previous blogs, why is it standard practice to apply decay assumptions when doing EVE/NEV and yet this practice is ignored in typical Static and Dynamic Balance Sheet Analysis?

Solution:  You will need to make manual adjustments to represent the potential reductions in balances on the lower-priced products and the shift to higher-priced products, if appropriate.  While it is not difficult to make this assumption for one environment, most models do not have the ability for the non-maturity balance to automatically change for each rate environment simulated.

Problem:  Assumptions regarding new business can hide risks that currently exist or introduce risks that don’t exist.  This muddies the waters for decision-makers and can lead to overconfidence in the risk position or unnecessary de-risking.

Solution:  Run simulations that isolate existing risk/return, focusing on the potential profit and capital impact in the current structure.  A benefit of this is to see the potential timing of risk and what it may take to offset the risk if exposure is too high.  This will help decision-makers have more clarity as to the sources of risks and returns before deciding the best course of action.

Problem:  Focusing on the relative rate environment and consistency in assumptions is overrated.   The rate environment has changed drastically in recent months and assumptions assigned to current and up/down rate environments deserve a thorough review.  These types of assumptions can heavily influence the results of risks to earnings, capital, and EVE/NEV.

Solution:  Dig deep into your decay rate assumptions to ensure that the actual current rate environment, which changes over time, is being considered.  This is a hard, yet critically needed, shift in ALM modeling mindset.  This is only one of many examples regarding assumptions that need to be reviewed.  This is addressed in detail in our blog on decay rates.

As we said in the beginning, reliable financial decision-information is critical to thriving in this type of environment.

We run thousands of risks to earnings, capital, and EVE/NEV simulations and what-ifs each year, so we understand the considerations facing finance teams today – this blog just scratches the surface.  We know that timing is critical and finance teams need to move fast.  Please feel free to call us if you have questions on the information provided in this blog.

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4 Proven Tips to Create FOMO Around ALCO Meetings

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4 minute read – The following blog post was written by c. myers and originally published by CUES on November 7, 2022.

Asset/Liability Committee meetings are an opportunity to create compelling collaborations that are interesting, relevant, and result in better member value and better asset/liability management – AND you get to check the compliance box.  If you’re not experiencing the first part of that sentence, it might mean you are thinking too much about where things have been rather than where things could potentially be – which is the fun part.

It’s important to understand where things stand, especially in relation to policy limits.  Once that is established, moving away from reporting the numbers and using them as a springboard for anticipating what the future could look like is where it gets interesting.  But it’s not just about making it interesting, it’s about engaging people from different areas, whether they’re “numbers people” or not, so they can contribute in meaningful ways.  The numbers tell a story.  Here are some things to consider as you tell that story:

 

1.       Every financial person started out as a non-financial person:

  • ALCO meetings are an opportunity to include more voices in financial discussions.  Financial discussions and member value are inextricably linked, so bringing non-financial people along in their comprehension of financial concepts and how they connect to the organization enhances the ALCO’s effectiveness.
  • The involvement of people not in the numbers every day can create observations not yet discovered.  Encouraging participants to push their thinking beyond their comfort zone will foster learning and bring new ideas to light.

2.       Re-imagine the meeting:

  • Define the objectives for each meeting.  Go beyond creating an agenda and articulate what the ALCO members should walk away with, such as awareness of a trend, specific decisions, robust conversations around a particular opportunity or risk, or good old- fashioned strategic thinking without the pressure of having to make a decision.
  • Determine how the meeting time will be divided, including how much will be devoted to decision making, education, emerging trends, strategic thinking, etc.

3.       Get to the point:

  • There is no need to read every number.  Dashboards can help quickly cover the overall current state so you can move on to meaningful conversations about trends, events, and situations that need attention.
  • Use business intelligence to add depth to discussions.  For example, if deposits are slowing, are there decreases in high-balance accounts, low-balance accounts, or slower member growth?
  • Focus on what the future may hold.  For instance, as payments behaviors continue to shift due to technologies and high inflation, what trends is your membership showing and what could happen if it continues?
  • Include relevant what-ifs to beef up the discussions.  Changes in payments and deposit behaviors, interest rate changes, and recessions can often be anticipated months before they show up in the numbers.
  • Plan for the critical discussions that must be had.  Encourage people to get out of their own lanes and participate.  The ALCO’s decisions span the organization, and every member should be connecting those decisions to their impact in other parts of the business.

4.       Bring in multiple perspectives for balance:

  • The ALCO’s purpose – bringing value to the membership consistently over time – needs to be top-of-mind.
  • Consider both opportunities and risks when making decisions.  Decisions to control risk or capitalize on opportunities rarely exist without trade-offs.
  • Alignment with strategy is key.  Connect the ALCO’s discussions and decisions to strategy.

ALCO isn’t just about the numbers themselves.  The numbers are a reflection of everything the institution has been working toward.  Loan balances, for example, are the culmination of the efforts of a vast array of employees, from Marketing to IT, and beyond.  If the numbers are a boiled-down version of all of the employees’ efforts, combined with the environment, ALCO’s job is to take those numbers and layer on future possibilities in order to make insightful, informed decisions so the institution can thrive.  When you think of it that way, who would want to miss out?

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Bringing Younger Customers Into Your Organization

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4 minute read – The following blog post was written by c. myers and originally published by CUES on September 19, 2022.

Targeting younger customers is so common that you could say it’s ubiquitous, but the reasons why are often fuzzy.  Gaining traction with this group in a way that benefits both younger people and the institution requires more than good marketing and growth in the desired age group.  It requires well-articulated reasons for why they are being targeted, along with a clear definition of success.  Knowing what the institution hopes to accomplish makes it more measurable and provides guidance for how to home in on success.

A common reason for targeting younger customers is because the customer base is aging, and younger people are needed to fill the pipeline for the future.  Simply bringing in a lot of new younger customers clearly won’t help the institution if they’re mostly inactive, so dig deeper with some questions to help define success:

  • How young are we targeting?
  • What business do we expect from this group?
  • When do we expect this group to start being active or profitable?

What does the data say?

Are those young folks really filling the pipeline?  Use your data to answer relevant questions that challenge underlying assumptions.  For people who became customers at your targeted ages 5 or 10 years ago:

  • What percentage are still customers?
  • What percentage are active customers?
  • What products and services are the active customers using?

Even if the data doesn’t show the trends you want, it doesn’t necessarily mean abandoning the idea of targeting younger people.  It could change how you strive to keep them engaged until they need other products and services.  Industry data shows that the highest lending balances are held by people in their 40s.  Looking back at when those customers started with you and what their paths have been can also be enlightening.  The same can be done for those who hold deposits, mortgages, or other products and services you desire.

3 Key Questions

If you feel like there’s room for improvement in engaging younger people, consider these key questions:

Do you have a good understanding of what their lives are like?  The financial lives of younger people carry certain challenges associated with their age.  Common challenges include credit scores that are lower on average, more student debt than previous generations, and starter salaries.  Many fear they will never be able to own a home.

Here are a few data points to illustrate:

Do you want to target the typical young person or are you actually looking for a younger person with the credit profile of an older person?

Some say that young people aren’t loyal, but many haven’t been given a reason to be loyal.  Helping people accomplish their goals, especially when others won’t, is a golden opportunity.  All of this should be connected to your appetite for risk.

Do your products and services meet their needs, and do they resonate?

View your products and services through the lens of their lives.  Asking questions to learn from  younger people can be helpful and it doesn’t have to be a big project.

Consider what changes you could make.  How can you clearly illuminate a path for home ownership or getting debt under control?  Even the names of products and services make a difference.  How well does the purpose or label of share drafts resonate?  How long will it be before no one knows what a checking account is?  As an example, non-traditional competitor PayPal doesn’t talk about a “payment account.”  They lead with, “Shop. Send. Manage.”

Do they know you’re meeting their needs?

Step back and inventory how you are silently supporting their way of life, even if they don’t know it.  If you have first-time car and home buying programs, pay available before payday, buy now pay later, credit building, and other programs that hit the mark, make sure they know about it.

Bringing value to the lives of younger people is the foundation for filling the pipeline for the future.  Having a clear understanding of your definition of success and monitoring to see how you are delivering value over time can help gauge progress and guide you forward.

Adding younger customers and helping them develop good financial habits can be a great way to set the customers and the financial institution up for longer-term success.  If good relationships with the younger customers are developed over time, their use of the institution’s services over time is likely to increase.  There is a greater chance that they will have both higher incomes and a greater need for a broad array of financial services.

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Liquidity Takes Center Stage – 5 Questions to Ask Yourself

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5 minute read – Feast or famine.  It was only a couple of years ago that deposits were coming in a deluge, but things change quickly and the need for liquidity is now top of mind for many. 

It’s not that deposits have dried up.  Balances are still far higher than they would have been without the unusual influx seen in 2020 and 2021.  But deposit growth has slowed and the focus is shifting.  Liquidity has never left the radar – deposit and payments strategies have been major topics in planning sessions, and liquidity analyses and what-ifs have been discussed all along, but it’s clear that the urgency has increased. 

The systemic effects of scarcer liquidity, such as pricing pressures, tend to affect everyone whether your liquidity position is tight now or not.  Getting clarity around these strategic liquidity questions will help your organization mount a well-thought-out and cohesive response: 

  • What’s happening beneath the surface for your customers?  Digging into trends surrounding average deposit balances can provide insights into what people are experiencing and inform relevant responses.  For example, how much of the growth over the past few years has come from higher average balances and how much has come from new accounts?  What’s been happening more recently?  Average balances that are coming down could be people having to spend more to compensate for inflation, or it could be outflows to other institutions, the market, or cryptocurrency.  Can your data tell you this?  More insights can be gained by understanding whether lower average balance accounts or higher average balance accounts are experiencing outflows.  Customers who are having to spend more and simply don’t have the money to deposit, is a situation that calls for a different response than customers who are finding better returns on their money. 
  • What is your deposit and payments strategy?  Get clarity on your ideal sources of liquidity.  Many business models depend on building deposits through checking/spending accounts, which are generally less expensive than other forms of liquidity.  Other business models regularly rely on borrowings and are built to cover the higher costs.  Take a clear-eyed view of how successful you feel the strategy will be going forward and whether more needs to be done to ensure access to funds. Once you are clear on what your ideal sources for liquidity are, it’s time to consider the next question. 
  • What levers are you willing to pull to bridge liquidity gaps?  Sometimes your ideal sources of liquidity aren’t enough.  Proactively thinking through which actions you’re willing to take, and in what order, can help ensure there is consensus when gaps need to be bridged quickly.  Be sure to take into account the amount of time it takes to pull different levers.  Some options require significant lead time to get set up.  Also factor in how long they can be sustained.  Common sources to consider include: 
    • Promotional rate CDs – usually pull in “hot money” while also shifting less expensive existing deposits to more expensive products 
    • Borrowings 
    • Brokered CDs 
    • Selling investments – many are at a significant loss 
    • Slowing lending or certain types of lending – could also help rebalance the loan portfolio 
    • Selling loans through participations or in the secondary market 
  • How could your response to tight liquidity affect strategy and goals?  As an example, when market rates rose, some institutions experienced fast loan growth because their loan rates remained lower than market for a time.  While this likely helped meet lending goals, adding loans at low rates while utilizing more expensive sources of liquidity to meet asset growth goals or loan demand might result in an undesirable profitability picture.  Goals are not made to be changed lightly, but keep in mind that rapid changes in market rates, consumer behavior, product pricing, and liquidity costs could cause some goals to become detrimental to the overall financial picture, at least in the short term.  Good analysis and conscious decision-making on how to adjust, if necessary, is key. 
  • Are your sources of liquidity still valid?  It’s a good idea to dust off the plan and confirm that borrowing sources are still in place.  It’s also a good idea to test the emergency funding plan.  Bear in mind that in bad financial times borrowing capacity is sometimes reduced by suppliers, so include that possibility as you think through meeting liquidity challenges.  Consider collateral and how selling loans or investments could change borrowing capacity.  Also think through what options you’ll have if promotional CDs are not as effective as you thought or demand for participations decreases. 

Staying a few steps ahead of liquidity needs is always a good idea, but it’s especially important now.  As you think through your options, consider a range of what-ifs to help prepare for a variety of scenarios. 

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c. myers live – Using Talent as Your Institution’s Competitive Advantage

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One of the most talked about topics in the financial industry is talent.  In this c. myers live, we take the talent conversation to the strategic level and give you ways to use it as a competitive advantage.  This is crucial for any business model and can make a huge impact on your institution and the talent you attract and retain.  


About the Hosts:

Sally Myers

sally myers headshotSally is a founder of c. myers corporation and one of five owners. Driven by a deep commitment to helping financial industry leaders and regulators for more than two decades, her guidance has shaped c. myers’ focus on helping clients create opportunities and approach problem solving from a scalable perspective. She has also been a strategic force behind the development of c. myers’ financial models.

Learn more about Sally

Charlene Leland

Charlene LelandSince joining c. myers in 2004, Charlene has become one of the most diverse facilitators within the industry, especially with regard to helping credit unions of all sizes address three necessary business objectives: relevancy, differentiation, and sustainability. Over the years, she has honed her skills for facilitating various types of sessions, including Strategic Planning, Strategic Implementation, Member Journey and Experience Improvement, and Strategic Financial Planning.

Learn more about Charlene

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