Asset/Liability Management Practices
Old/Additional ID: (Original # 281-OE)
January 15, 1991
To: Chairman, Board of Directors
The Chief Executive Officer
All Farm Credit Institutions
From: David C. Baer, Director
Office of Examination
Subject: Asset/Liability Management Practices
PURPOSE OF BOOKLETTER
The Farm Credit Administration (FCA) has studied the asset and liability management (ALM) practices and interest rate risk (IRR) exposures of Farm Credit institutions (FCIs) and has developed the following guidelines to inform boards of directors of the agency's views concerning this area. The FCA will be increasing its examination of ALM-related areas and may require institutions having inappropriate ALM practices or excessive IRR to reduce risk levels or increase capital.
The FCA is charged with the responsibility of ensuring that FCIs are operating in a safe and sound manner. Appropriate ALM practices and excessive IRR are therefore of primary concern to the FCA. FCA Regulation 12 CFR 615.5200(b)(7) requires boards of directors of FCIs to establish capital adequacy plans that take into consideration the impact of interest rate risks on their institutions.
FCA ALM EXAMINATIONS
FCA guidelines for the ALM and IRR areas apply to institutions having direct lending authorities. The scope of the FCA's examination of ALM practices and IRR exposures will depend on the agency's determination of the risks embodied in each institution's operations.
One of the areas reviewed in determining the scope of ALM examinations will be the IRR exposures of associations versus district banks resulting from the manner in which direct loans are structured. The extent to which loan pricing practices support financial goals will also influence the scope of ALM examination efforts.
Lending program options, such as an institution's use of contractual limitations on interest rates or prepayment penalties on loans, will be considered when setting examination scope. Another ALM concern that will be examined is the practice of pricing loans to borrowers based on an index that may not directly relate to the underlying cost of financing the loans.
The ALM process is the act of planning, acquiring, and directing the flow of funds through an organization. The ultimate objective of this process is to generate adequate/stable earnings and to steadily build an organization's equity over time, while taking reasonable and measured business risks. One obstacle to the achievement of this goal is interest rate risk, which is defined as the susceptibility of an institution's net interest income (NII) and market value of equity (MVE) to changes in interest rates.
ALM relationships embody the entire scope of a financial institution's operations (types of loans, loan rate structures, sources of funding, profit expectations, etc.). Because of this, an effective ALM program includes an integrated process of coordination, analysis, and communication that must include all operational units.
The FCA believes that boards of directors should institute the necessary policies and make sure that the appropriate procedures are in place and followed to ensure that their institutions have appropriate ALM practices and are not exposed to excessive levels of IRR. Board members should also understand the significance of IRR exposure, periodically review the exposure to ensure that it is commensurate with the institution's operations and that it is limited to prudent levels. Management is responsible for structuring the institution's balance-sheet and off-balance-sheet transactions in a manner consistent with the board's directives.
Listed below are several areas the FCA believes are important in an ALM program. These areas will be examined in institutions whose NII and MVE are exposed to changes in interest rates.
The issues discussed throughout this document should be considered normal expectations of the FCA in relation to institutions having IRR exposure. These expectations do not, of course, preclude institutions from engaging in additional techniques of measuring and managing asset/liability relationships.
1. ASSET LIABILITY MANAGEMENT POLICY
An important component of an acceptable ALM function is the development of an appropriate ALM policy. Policies provide boundaries for decision making and represent the philosophies and attitudes of an institution's board of directors.
Directors should assure themselves through their policies that decisions are not being made without measuring and considering the exposure of earnings and capital to potential interest rate movements. The ALM policy should contain at least the following areas:
1. Purpose statement;
2. A description of the ALM decision making process (this will normally include the composition, operation, and responsibilities of an Asset Liability Management Committee (ALCO));
3. The establishment of acceptable levels of interest rate risk (expressed in terms of the impact changing interest rates will have on an institution's net interest income and market value of equity) and how risks will be measured;
4. Authorizations and parameters on the use of off-balance-sheet transactions;
5. Delegations of authority and formalized accountability;
6. Permissible exceptions and related procedures; and
7. Monitoring procedures, internal controls, and reporting requirements.
A critical element of the board of directors' ALM policy is the establishment of explicit limits on the institution's exposure to IRRs. Because the ability to control IRR requires a clear understanding of risk exposures, a board policy in which the IRR limit is expressed only in terms of repricing gaps will not normally be considered sufficient.
In institutions having IRR exposures, policy limits should specify, at a minimum, the maximum percentage change the board of directors is prepared to accept over the next 12 months in the institution's projected NII and MVE. These changes should be computed as a result of a parallel plus and minus 200-basis-point instantaneous and sustained shift in interest rates from the yield curve in existence at the time of the projection. This simulated rate change will allow boards to see how the financial condition of the institution would be affected from one reporting period to another.
2. A/L MANAGEMENT PROCESS
An appropriate ALM process should begin with the development of an institution's plans and goals. Plans should define the major direction in which the institution wants to proceed, its character and mission, and how it proposes to position itself to achieve a profitable and competitive posture. Because of their critical role, an institution's ALM and strategic planning processes should be properly and effectively integrated.
Many problems can be averted by establishing a proactive financial planning process that stresses ALM. This process leads boards and management to define expectations. Corporate financial goals should be established at least in the areas of profitability, growth, operating expenses, interest rate risk, and capitalization. These goals represent the agreed-upon financial targets that have been set in pursuit of strategic objectives.
Another component of an appropriate ALM process involves the development of a formalized, disciplined management approach to the entire area. This process allows management and boards of directors to identify and understand the risks already embedded in their institutions' balance sheets. Boards and management need to be aware of the consequences of inaction compared with the costs and/or benefits of potential strategies and actions that might change the institutions' risk profile.
The ALM process requires management and board members to review the impact of simulated changes in future interest rates on their institutions' income and capital. Scenarios reviewed should include a best case, worst case, and most likely projection, and should be done at least quarterly. Where appropriate, simulations should also be used to analyze how interest rate swaps, financial futures, options, debt buybacks, and other planned ALM actions could be used to reduce the possible negative effect of future changes in interest rates.
FCIs should have an asset/liability management function. It is expected that in most institutions this function would be administered by an asset/liability management committee (ALCO) comprised of senior officers. An ALCO would be responsible for monitoring, coordinating, and directing the acquisition, allocation, and pricing of the institution's resources in such a way as to maximize profits, manage interest rate risks, and adhere to predetermined financial standards and goals established in the financial plan. The ALCO should review interest rate (income and expense) and operational projections, competitive pressures, economic conditions, and regulatory activities in arriving at necessary decisions. The committee's regulatory activities in arriving at necessary decisions. The committee's work should be ongoing and dynamic, the natural consequence of which is the development of operating instructions and guidelines for specific units of the institution. The ALCO should be responsible for developing appropriate strategies and have the authority to implement its decisions.
3. APPROPRIATE MANAGEMENT INFORMATION SYSTEM
Management and boards of directors need to maintain or have access to an effective management information system to ensure that their ALM responsibilities are being met. This system should be comprehensive enough to allow management to evaluate current IRR exposures, track an institution's performance, assist in developing meaningful planning initiatives, and run appropriate simulations.
An effective ALM process is predicated on a management information system that provides decision-makers with timely, accurate information. In an attempt to provide these types of information processing capabilities, all Farm Credit Banks have purchased computerized sensitivity/simulation models. These models should allow management to experiment with different strategies, interest rate assumptions, yield curves, pricing approaches, projected changes in volume, various prepayment levels, and a host of other variables. Management information systems of this nature give management the ability to develop a better understanding of how the complexities of future events may affect their earnings and capital positions.
4. APPROPRIATE LOAN PRICING PRACTICES
The establishment of appropriate loan pricing practices is critical to the development of an acceptable ALM function. Loan pricing programs need to be established to ensure that loans are being priced in such a manner as to cover the costs associated with the loans and provide the capitalization needed to protect the institution against losses and allow for growth.
FCA Regulation 12 CFR 614.4270 requires institutions to charge interest rates on loans to borrowers that take into account the cost of money, necessary reserves and expenses, capital requirements, and services provided to the institutions' borrowers and members. A letter concerning pricing practices was sent from the FCA to all FCIs on October 28, 1986, which stated that the establishment of rates that result in a return insufficient to cover expenses will be considered an unsafe and unsound practice and may require the FCA to initiate corrective action.
FCIs are encouraged to strengthen their loan pricing programs to ensure that new loans are priced according to their creditworthiness and inherent IRRs. FCIs are also encouraged to utilize transfer pricing programs where funding costs are assigned to individual loans and earnings credits are monitored on the profitability of the transaction. Lending programs of this nature can help increase accountability and assure that an institution meets its planning objectives.
5. CONTROL AND REPORTING MECHANISMS
Institutions need to have the appropriate controls and reporting mechanisms in place to ensure that operations are being conducted in a safe and sound manner. Controls include requiring staff to fully document the objectives of actions taken to mange IRR before implementation and requiring postanalysis to see if objectives are being met. Additional controls might include a separation of the risk measurement and reporting function from the risk management process and the development of appropriate internal audit programs.
Detailed reports should be prepared at least quarterly that tell directors what interest rate risks currently exist in the institution, what could happen to the institution under different interest rate projections, and what can be done at the time the analysis is completed to mange future risks. As previously stated, best case, worst case, and most likely interest rate scenarios should be reviewed and the effects of 200-basis-point shifts in interest rates on existing balance sheets should be analyzed.
Major assumptions, such as the lag time between increases in costs of funds and increases in lending rates, should be carefully documented and justified by historic analysis or based on board-approved future operating plans. The impact of changes in major assumptions should also be highlighted in subsequent reports presented to boards.
The FCA wants to be sure that directors and management of FCIs understand that they are responsible for establishing, monitoring, analyzing, understanding, and managing the ALM practices of their institutions. They are responsible for ensuring that their institutions are not exposed to excessive levels of IRR. These guidelines are intended to notify FCIs in advance how the FCA intends to exercise its discretionary authority in ensuring that ALM practices are being managed in a safe and sound manner.
Please direct any inquiries regarding the contents of this document to Gregory L. Yowell at (703) 883-4371.
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