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Jun 20 2018

ALCO – Always Looking Constructively

Article

Written by Cynthia R. Walker - CEO

4 min read

The Asset Liability Committee plays a large role in the strategizing and performance of a credit union. Understanding the ALCO’s role and how to organize and utilize an effective ALCO can be ever changing and worth reviewing. Whether you have a strong ALCO in place, are organizing your first ALCO, reorganizing your ALCO, or redefining the ALCO responsibilities, the following points may be helpful.

Establishing an effective ALCO reminded me of preparing to run a large and difficult whitewater rapid. My family and I are avid whitewater rafters and evaluating the ALCO process reminded me of some of the steps in preparing to run a technical and challenging rapid. Experienced boatmen know a rapid will change at different water levels, and they also anticipate there may be other obstacles in the river that were not there the last time. Most will take the time to get out of the raft and scout a large rapid. Part of the scouting process is to get to the best vantage point possible, then strategize how to line up the boat, where to enter the rapid, evaluate how the water is moving and breaking, then anticipate where adjustments or maneuvers will need to be made to avoid large holes or obstacles that are dangerous. Sometimes it even involves choosing between two less than desirable options and picking the less risky option. The strategizing and how the boatman will line up and enter the rapid can be the difference between a successful run and one that ends with passengers and equipment being put at risk. Just as running a credit union or many other events in life, including river rafting, no matter how long you observe, strategize, and plan, the actual run or experience is always different than the plan and improvisations and adjustments are to be expected.

The ALCO acronym could stand for “Always Looking Constructively” or to be solution and strategy oriented. The committee is sometimes like the boatman preparing to enter a rapid. They need to step away from the daily operations, move to the best vantage point possible, scout the environment, gather all the information available, then strategize how management and the board can set up and maneuver or avoid obstacles that could negatively impact the credit union’s performance and earnings. Regularly scheduled ALCO meetings allow for adjustments and revisions as events change and unforeseen challenges arise.

Credit unions are required by regulation to have a policy and process in place to identify, measure, monitor, manage, and control interest rate risk. The policies and controls start at and are set by the board of directors. The process is usually delegated to the ALCO. The committee oversight may also include investments, liquidity, funding, rate setting, and concentrations. It is essential that the committee be comprised of key decision makers within the organization or board to facilitate strong, collaborative discussions and evaluate the credit union operation from several points of view. The purpose of the committee is much greater than appeasing the regulators and should be strategic focused, identify exposures, develop responses to exposures, and oversee adherence to applicable policies. A well-functioning ALCO will be instrumental in the success and profitability of the credit union.

Just like scouting or looking at an upcoming rapid, the committee will look at or evaluate the credit union’s exposures to some of the following events and develop strategies or responses. This list is not all inclusive but is a good starting point.

Monitor changing interest rates.
Evaluate impact of changing rates to earnings.
Set loan and deposit rate to maximize profitability.
Know your competition loan and deposit rates.
Identify pressures to change loan and deposit rates.
Understand and anticipate changes in balance sheet composition.
Track loan and deposit trends.
Differentiate core funding vs. rate sensitive funding.
Estimate balance sheet term extension or shortening.
Monitor current liquidity position.
Forecast future liquidity needs.
Run stress liquidity scenarios.

When rafting a difficult and technical river that is new to the boatman, they prepare by gathering as much information as possible about the river. There are detailed river maps, other people who have run the river, and videos on social media available as resources. These are starting points but do not replace the scout on the day of the run. To evaluate and understand the credit union as well as the economic environment and competition, there are reports from sources such as the ALM models, current financial statements, financial ratios, trends, industry publications, and local and national rate data, to name a few. While this information is important, it does not replace the need for the ALCO to meet regularly, understand the credit union’s current situation, review, discuss, and strategize as they develop how to move forward and get the best results.

Having the right equipment in good working order can also help in the enjoyment and success of many sports or professions. A proper working interest rate risk and liquidity forecasting model is essential to an ALCO committee. The committee should understand the interest rate risk analysis, ensure the assumptions are reasonable and supportable, and capture all options such as balloons, steps, and calls. Sensitivity testing the major assumptions and taking a fresh look at the assumptions annually to ensure they still represent the credit union balance sheet is also prudent.

One final step, just like taking pictures of your adventure, the ALCO committee meetings, agenda items, discussions, decisions, and action items should be accurately documented and retained. Mark H. Smith, Inc. specializes in interest rate and liquidity risk analysis and assists clients and their ALCOs in understanding and utilizing the ALMPro Reports. If you would like us to help your credit union with interest rate risk analysis or get assistance in utilizing the reports to benefit and help during ALCO meetings, please contact us. We recently presented a webinar on this topic that is archived on our website.

Related/Popular Articles

Jan 14 2021

Five Top Credit Union Topics For 2021

As we move into 2021, the following topics might be worth discussing and considering with your management team.

Earnings

During the first half of 2020, net interest margins came under substantial pressure as market interest rates were shocked dramatically downward. Net interest margins are expected to remain under downward pressure throughout 2021 as investment portfolios continue to reprice lower and share growth continues.

One of the easiest and quickest responses to declining interest income is to address the cost of funds. Many credit unions still have room to decrease their cost of funds, as shown in the September 2020 ending period graph below.

Source: NCUA

Delinquency

Based on the September 2020 call report data, loan delinquencies and net charge-offs remained low and were below September 2019 delinquencies. Loan forbearance and other assistance programs in place through the entirety of 2020 may have helped delinquencies. Also, certain sectors of the economy are not as impacted as others. The unemployment rate is expected to continue drifting lower in 2021. However, as the assistance programs are lifted, delinquencies and charge-offs are expected to increase as unemployment remains substantially above the years leading up to the pandemic.

Source: MHSI Online Peer Analysis Module through September 2020

Credit Union Philosophy

Serving the underserved has always been a hallmark of credit unions, and now more than ever, there is an opportunity to do this for many credit union members. As these times have been challenging, credit unions can continue to evaluate and prioritize how to best serve members in the coming year, especially those under financial stress. Exploring how to provide service to those that are underbanked might be an opportunity. One option may include evaluating risk-based lending policies and programs, especially given the robust liquidity on most credit union balance sheets. New and alternative avenues to bolster income should continue to be explored.

Digital and Technology

As the pandemic shifts and prolongs, credit unions should evaluate if their electronic delivery channels meet members and potential members’ needs. Moving to or improving digital delivery channels should be accelerated and prioritized. Digital delivery should include evaluating loan origination and servicing channels to maximize new loan volumes. Online and remote financial services will continue to grow and may be the preferred way members access and manage their financial activities.

Balance Sheet Growth

Before the pandemic, many experts anticipated credit union loan growth to taper off but remain positive. After the first quarter of 2021, loan production became unpredictable, however, by the end of the third quarter, annualized loan growth was 6.34%. Real estate lending, driven by the abruptly lower interest rate environment, helped with the growth. Experts anticipate loan growth to be around 6.0% to 6.5% over the next 12 months as the economy recovers.

The first few months of 2021 may see strong share growth as the second round of government assistance and stimulus takes hold, and households remain reluctant to spend until signs of COVID easing and warmer weather occur. Share growth last year increased at an annualized rate of over 18% and is expected to be approximately 8.0% to 10.0% in the coming year. If double-digit growth continues, earnings sufficient enough to sustain capital will be critical. If economic conditions improve and overall consumer activity increases, loan growth and increasing long-term interest rates could counter some of the anticipated income pressures. Fortunately, the credit union industry is very well capitalized and able to ride out the adverse conditions and absorb some more growth, even if earnings are reduced.

Nov 04 2020

The Bottom of the Frog Market

Several years back, I went to Mexico for a vacation. While there, I found a ceramic hand-painted frog-shaped planter that I wanted. My husband loves the hunt, and his quest began. Every time we saw a frog-planter, he would start negotiating with the vendor to get the lowest possible price. We searched for several days and would stop in different towns and check the markets while enjoying our vacation and exploring. When we found a frog, he would inquire about the price and negotiate for further discounts. After a few days and no success at getting the cost of the frog below a certain point, my husband declared, “we have hit the bottom of the frog market.”

…

The Bottom of the Frog MarketRead More »

Sep 30 2020

Economic Uncertainties and Interest Rate Certainties – Asset Allocation Assessments and Considerations

Future GDP Projections

In September, the Federal Reserve Chairman spoke publicly on several occasions and reiterated that the central bank is committed to helping the economy “for as long as it takes.” He noted continued improvements in the economy, but also acknowledged a highly uncertain path ahead. The September FOMC (Federal Open Market Committee) projections are now projecting a full-year GDP decline of 3.7%. This is substantially better than their previous expectation of a 6.5% decline. However, they lowered their 2021 outlook from 5.0% to 4.0% and their 2022 outlook from 3.5% to 3.0%. Their 2023 outlook is at 2.50%.

Interest Rates and Economic Uncertainties

The FOMC also indicated that they would allow inflation to run above 2.0% on a sustained basis before any federal funds rate increases. As such, most individual members of the Committee indicated that the federal funds rate could remain close to zero through 2023. Some economists and analysts even think that we may not see an increase in the federal funds rate until 2024 or 2025. They believe that it will take up to five years for the global economy to fully recover to pre-pandemic levels.

The risks to the FOMC economic growth projections are high. Even the Chairman of the FOMC acknowledged the economic uncertainty of the path ahead. Following the sharp rebound in many economic data measures and drop in the unemployment rate, some recent measures have disappointed compared to expectations and some are indicating a recovery that is stalling. At the current time of this article, the nature of further fiscal stimulus continues to be negotiated in congress and some are not expecting a resolution until after the presidential election. Of course this only adds to the current economic uncertainty.

What is highly certain over the short to medium term timeframe is that interest rates will not likely be increasing more than just relatively minor fluctuations in the medium to long end of the U.S. Treasury yield curve. It is more likely that potential risks on the horizon could drive medium and longer-term U.S. Treasury yields even lower.

Reassessing Balance Sheet Strategy

Given the above outlook, it would certainly seem that some credit union balance sheet strategies of recent years should be reevaluated for the foreseeable future. Reassessing asset allocation strategies is possibly more relevant at the current time than at any time in the past several years. For example, the credit union may want to ask itself how much should we be redeploying assets into two to three year investment CDs given current interest rates on those maturities. If the answer is less than previous years, then what are the alternatives we can explore.

Priorities Going Forward

In exploring alternatives, the first priority for credit unions is of course serving members. Assessments and considerations could include expanding the types of loans offered, reevaluating risk based lending allocations, increasing real estate concentrations, debt consolidation programs, and loan payment support alternatives to name just a few. Secondary to the first priority are considerations such as allocations to loan participations and alternative investments. For example, should the credit union assess CUSO or similar investment possibilities. What are all of the possibilities for these type of investments that may be available to the credit union? After all, an alternative of earning five basis points at the corporate credit union with too much of assets is not likely to accomplish any priorities or goals for the credit union.

The present time and foreseeable future is a great time for credit unions to really show how they can serve and support members during these challenging times. Being there for your members is for sure the highest purpose for the credit union and always assessing ways to provide service and assistance to them will always be the credit union’s first priority. In addition and secondarily, now more than any time in recent years it may make sense to really take a deep dive into the above asset allocation assessments, considerations, and possibilities. Ideally, the best answers going forward would combine the first priority with the second to optimize balance sheet performance while best serving members.