One important trait of an effective asset/liability management model is whether it uses a dynamic or static approach. What’s the difference?
A static approach examines the balance sheet as it is currently structured over a specific period, usually one to two years. It measures the impact of interest rate changes on earnings at risk and net interest margin, economic value of equity, liquidity sensitivity, and repricing gaps, assuming no shifting of balances between account types or changes in products.
By comparison, an ALM model using a dynamic approach takes into account not only the financial institution’s current balance sheet, but also any projections management has planned for asset/liability mixes in the coming years, said Abrigo Advisor Teri Grams. This allows the impact of rate changes to be evaluated in light of more realistic scenarios for the bank or credit union, since rarely does an institution’s balance remain exactly the same from year to year.
“Every financial institution has different management strategies, depending on where their current capital structure is and what their risk limitations are,” Grams said. “It’s important to be able to measure how those strategies may impact their interest rate risk measurements.”
A dynamic ALM model offers the ability to evaluate the potential impact of a strategy before it is implemented. Financial institution managers can simulate the projected results of a strategy and compare them to financial goals and interest rate policy limits, allowing a test of the risk/return trade-offs before implementation.
As the word implies, a dynamic approach to ALM is providing the bank or credit union a continuous and productive method for evaluating risk and return, rather than the more basic, static approach that might satisfy a regulatory requirement but adds little value to strategic decision-making.
Koch said that some ALCOs choose to take a more static, basic approach – running the necessary reports, confirming the institution is inside board-established limits, and signing off. “If that’s our approach, then we’re probably going to be more regulatory in nature,” he said.
A more dynamic, management-oriented approach to ALM and ALCO meetings can yield more decision-useful information to help run the financial institution and set it apart as a high-performing one. In that situation, Koch said, “We’re sitting in our ALCO meetings and we’re constantly looking for ways to improve the performance today. Are we generating enough earnings? Can we do something different? How can we get better today within the boundaries of where we think rates might go – both up and down?” Koch said that the crux of a dynamic approach to the ALCO involves looking at the institution’s numbers and analyzing the costs and benefits of different decision scenarios that are options for the bank or credit union. Such moves would be far more useful for managing the financial institution for improved performance than solely examining what might happen in the unlikely event of a sudden and indefinite extreme spike in interest rates.