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The following article is excerpted from “Power Up Your ALCO, Seven Simple Strategies to boost your ALCO performance,” Best Practices Report from Darling Consulting Group (DCG) of Newburyport, MA. Frank Farone and Bob Lallo of DCG were featured speakers at FHLBank Pittsburgh’s 2007 Regional Conferences, held in June.
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Seven Simple Strategies To Boost Your ALCO Performance
High-performing Asset-Liability Committees (ALCOs) are proactive and forward thinking. While many see their ALCO meetings simply as a time and place to report on past activities, our view is that ALCO can and should help you set direction, develop prudent strategies, implement action plans and plan for future growth. When this is done properly – when your ALCO truly becomes a strategic, decision-making committee – you will see the positive results in many ways. You will see an improved focus of your ALCO meetings...added enthusiasm from your ALCO members...increased confidence in your ALCO decisions...and greater respect from regulators and stakeholders. Above all, you will see it in your earnings and your growth – both short-term and long-term.
So how do you create a high-performing ALCO? Here are seven simple strategies:
1. Change your ALCO agenda
More than likely, your ALCO needs to change its focus. It needs to shift from a traditional financial and regulatory reporting function to a “roll-up-your-sleeves” strategy development function that focuses on key ALM issues like effective pricing, liquidity management, capital management, funding alternatives and, of course, interest rate risk. With this new approach, your ALCO members will come into the meeting expecting to play a role – to make key recommendations that ultimately lead to decisions that will improve your bank’s performance. Your ALCO meeting will still need to report on your risk position and regulatory compliance, but your focus will shift to strategy development.
2. Change your ALCO reporting package
One of the most common problems with ALCO meetings is the reporting package itself. Sometimes the reporting package has too much data, sometimes it has too little data and sometimes it simply has the wrong data. Often the right data exists but the problem lies in the presentation of the data. We believe your ALCO reporting package should include information related to the key ALCO metrics that will actually contribute to the discussion and decision-making process. All too often, the reporting package incorporates too few interest rate scenarios and/or ignores the shape of the yield curve when developing alternative scenarios. Additionally, most ALCO packages are heavy on IRR analysis with too little emphasis on liquidity. A bank’s liquidity position is a key element in strategy development. Just as importantly, your ALCO package should be easily readable and understood by everyone on the committee – and should be seen as a tool to facilitate dialogue among the members that ultimately leads to decisions and action plans.
The ALCO reporting package should include a written summary of the bank’s overall position. As the saying goes, “a picture is worth a thousand words.” Heavy use of pictures, not just numbers, will enable committee members to quickly identify trends, inflection points and degree of risk relative to changes in rates. NII simulation analysis should extend out to five years to capture potential changes in a bank’s risk position. Gap reports and 24-month simulation reports are insufficient for identifying risks that may lie ahead. With an appropriately focused ALCO reporting package, you will immediately see increased participation and enthusiasm from ALCO members.
3. Review your ALCO membership
Take a look at your ALCO members. Do they all play a role in the decision-making and execution process? Are you missing some key people/players who could contribute to the process? Do they all understand the bank’s business strategy? ALCO shouldn’t be confined to executive management. To be effective, you need to include selected functional department managers who have real insight into the day-to-day operations of your institution. It’s more than just brainpower. A well-rounded ALCO should also include individuals who are ultimately responsible for implementing the strategies.
4. Review your bank’s risk/return profile
With the complexity of banking today, it is no longer wise – or even acceptable – to take a “one-size-fits-all” formulaic approach to risk management. Risk/return profiles vary too greatly from one bank to another to rely on this outdated approach. Decisions should be based on the bank’s risk/return profile, not interest rate forecasts. It is important to understand what the bank’s true IRR position is and what key drivers are causing the risk. Only then can you begin to develop strategies to mitigate or eliminate these risks. Too often banks rely on unrealistic rate or growth assumptions. Additionally, the vast majority of banks use too short of a time horizon, namely 12-24 months, in their simulation approach. If you use outdated call report type ratios, such as loan/deposit and non-core funding dependency, you may not have the tools in place to plan for today’s risk. Moreover, your risk profile needs to take into account not just interest rate risk but also your institution’s liquidity, earnings power and capital.
5. Change your pricing methodologies
Product pricing for both assets and liabilities is critical for retaining existing business and acquiring new business. Many traditional methods of determining price are either too simplistic or unnecessarily detailed and complex – both of which are counterproductive. A bank’s liquidity, capital and interest rate risk positions are also critical components that need to be factored into the pricing equation. By introducing institution-specific data along with external market variables, your ALCO will be equipped to set pricing that is reasonable, defensible and profitable.
6. Update your ALCO policies
ALCO policies set the bank’s standards for acceptable levels of risk – IRR, liquidity, capital, etc. Most often, this “acceptable” level of risk is driven by regulatory concerns – not business strategy. To maximize your return, your ALCO needs to review and update its policies as they relate to your bank’s business strategy and practices. You may discover your policies are preventing you from maximizing earnings because they do not provide the necessary flexibility to develop appropriate strategies. The evolution of the capital markets has rendered many bank policies inadequate, ineffective and incomplete.
ALCO-related policies should be sufficiently detailed to provide governance and controls while being broad enough to facilitate appropriate management flexibility and judgment. Policies should be reflective of management’s operating philosophies versus only regulatory appeasement.
7. Call to Action
Even if the first six out of seven strategies outlined above are being done at the highest levels, the ALCO process is only effective if there is a plan of action following ALCO meetings. All strategies and ideas discussed should be documented, responsibilities assigned and a timetable for implementation established. An effective ALCO process does not end with the conclusion of the meeting but rather continues on as the lifeblood of the organization.
FHLBank Pittsburgh has reprinted this article for informational purposes only. The opinions, views and comments expressed in the article are not necessarily those of the FHLBank. FHLBank makes no representations or warranties, express or implied, as to the accuracy, completeness and timeliness of any assumptions or any other data presented in the article.
The information presented in the article is not investment or business advice, nor is it an offer to extend credit or buy any security or financial product. Readers must not rely on any of this information when making any investment, business or credit decision.
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