Providing for Shade: 3 Concepts to Incorporate in Your ALM Modeling

Warren Buffett once said, “Someone’s sitting in the shade today because someone planted a tree a long time ago.” As Buffet’s quote reminds me, I would much prefer to leverage the efforts by others who came before me to my benefit. It just makes sense, doesn’t it? You don’t have to start from scratch, just utilize the tools that already exist to forge ahead.

The same concept is applicable when it comes to your ALM model, which is why I thought it would be a perfect opportunity to share the top three items we see when performing a model validation.

1. Share Tiers: If you have tiered share accounts, be sure to segregate the balances in the model. Typically, we will see a tiered account being grouped into a single balance account, often using the middle tier as the rate for the entire account. This can be misleading as, in most cases, the bulk of the balances are parked in the top tier. If it is not possible to break out the individual tiers, the next best option is to use a weighted average coupon to arrive at the correct blended rate. In a time when pricing deposits is critical for both liquidity and earnings, it is important to have this model assumption fine-tuned.
2. Adjustable Loan Reset Data: The model output is only as good as the input, which is especially true for adjustable products. Often, this data can be missing or not included properly, leading to a misstatement of interest rate risk. This data can be difficult to obtain at times, but every effort should be made to incorporate it correctly. An example of pertinent adjustable data is a period cap. If the cap is not included, then the model could reset the earnings higher than contractually possible and lead to incorrect results. The opposite is also true where period or lifetime floors should be properly modeled. Since it appears rates will be on the downturn soon, it is critical that floors are appropriately defined in the model for accurate risk analysis.
3. Deferred Loan Fees and Participation Premiums: This is an adjustment that is often overlooked but can cause overstatements in the earnings projection. Models have various methods to account for the amortization of these costs. If you are not sure whether it is incorporated in your model, ask your vendor or prepare a back test to ensure that the model projections and the actual earnings are in alignment.

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As the market experiences continued turbulence and interest rate risk remains under scrutiny, it is important to ensure your model is in good shape not only for your exam, but, most importantly, to be a reliable source of information as management evaluates the risk exposure.

So, take Warren Buffet’s advice – give yourself some well-deserved shade during this next rate cycle, and make sure your model is ready to take the heat.

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.