Asset Liability Management: Interest Rate Risk Exposure Limits

When a credit union comes to me regarding updating asset liability management (ALM) policy limits, one of my first questions to them is: what is your risk tolerance? More often than not, I get the response: we are not sure, what does the NCUA say?. While it’s definitely important to satisfy the requirements of your regulator, it’s equally important to actually understand what ALM means in order to better manage the interest rate risk of the credit union. It seems like there is sometimes a gap between ALM policy limits and actually understanding what the results mean.

So, what exactly is ALM?

Well, ALM is the measurement and oversight of interest rate risk (IRR). A good ALM model is vital to a credit union’s existence, which means, it’s important to bridge the gap between just running the model and understanding the results you receive and how they relate to the established limits. One practical way to bridge this knowledge gap is for managers to work with their board to evaluate IRR exposure limits.

Here are some steps you can take to conduct this process:

1. Review assumptions in the model.
   In your model, if the information used to calculate the risk exposure parameters is inaccurate, then the results are not reliable. Be confident of the assumptions before looking in depth at the risk exposure.
2. Review the NCUA’s guidelines.
   The NCUA’s examiner guide will help the management team and board gain an understanding of the regulator’s views. While the NCUA’s guidelines should not be used verbatim for the limits of the credit union, they can provide guidance on IRR that can be used to establish the board’s limits. Ultimately though, the limit needs to be based on the board’s risk tolerance levels.
3. Review the exposure limits.
   Make sure the board of directors and management team has a complete understanding of the limits and how they affect the credit union’s stability. I would recommend communicating that the purpose of the limit is not to eliminate the risk, but rather to keep it within comfortable parameters.
4. Start at the beginning.
   Look at what the credit union’s actual exposure is today. Supplying the board with this knowledge will help them understand where the credit union currently stands and what the risks actually mean. These exposures will assist the board in their decisions to set risk tolerance levels. It might be helpful to note that most credit union’s we work with state they’ve had the most success with board comprehension when limits are expressed as a dollar amount instead of a percentage.
5. Establish a top-level approach.
   Create a report that will show your board whether or not the limits are met each time they review the ALM reports. It should encompass a trend of the risk as well. Showing the past exposures can help identify shifts in the risk levels.
6. Be prepared to reduce IRR exposure.
   If your credit union does not meet the established limits, you need to be prepared to reduce IRR exposure. Have options in place to manage your credit union’s IRR more effectively, when or if necessary. Often, it is a good idea to have contracts in place as well to allow business transactions to occur in a timely manner when the need arises, like selling loans or attracting non-member deposits.
7. Challenge and change the limits as necessary.
   Once the limits are set, don’t let them just collect dust. Be sure to continually monitor and refine them. They don’t need to be changed every time the board meets, but it should be stated in the policy how often the limits can change. Most credit union’s review these annually.

All in all, it’s vital to establish IRR limits because it will help you keep tabs on the risk exposure to your credit union and refresh the board’s and management team’s understanding of ALM. While it is important to satisfy the regulator, ALM should not be in place for just that reason, it should be a vital tool used to project and manage your credit union’s decisions. If this past year’s rapid rising rate environment has taught us anything, it’s we need to be prepared for an unexpected change in the market. ALM is the tool to keep you prepared for the unexpected.

Melissa Scott serves as Vizo Financial’s vice president of ALM services. In this role, she is responsible for managing and providing ALM reporting, modeling, validation and consulting services to credit unions. She is also responsible for providing ongoing training, support and education for ALM users, management and their board of directors. She also holds the designation of certified public accountant (CPA) and is a member of the North Carolina Association of Certified Public Accountants.