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A/LM Education and Anticipating What is Top of Mind

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We are looking forward to hosting 3 days of asset/liability management (A/LM) education next week. Often our education classes will have a similar foundation of how to use A/LM to make decisions, how to identify what environmental factors to watch, and how to see potential problems that might be hiding in the modeling—to name a few. Beyond the base topics, there are always new things happening that also become part of the discussion. These new topics are driven by the things at the top of decision-makers’ minds. As part of preparation for the A/LM education courses, we always work to anticipate what people are most worried and excited about.

Here are some of the things we think will be a focus of attendees during our upcoming classes.

Rates

How are rates changing and what it could mean about the economy? A great example of uncertainty has been happening in the past two short months of 2016.  Consider short-term rates, where the news has confidently expressed each of the following perspectives:

  • The Fed is going to increase rates at least four times in 2016 – Much of January
  • The Fed is not going to increase rates in 2016 – Much of February
  • The Fed is going to increase rates two times in 2016 – Currently

While the rate change amounts are small – from a big picture perspective – the larger concern for credit unions is often the reason for the change, since it represents different outlooks for the economy. The various paths that the economy can take may have an impact on members’ mindsets, and result in shifting behavior. The behavior can impact different areas of credit union growth. For example, which of the above paths could play a role in slowing the fast consumer loan growth the industry has been experiencing?

Of course, beyond short-term rates, there are also a lot of questions swirling around long-term rates.

Stock Market

Another area of uncertainty has been the stock market:

  • The market is falling quickly and could experience another 10% correction – Much of January
  • The market is rebounding and should stabilize – Early February
  • The market is dropping, and this time it could be sustained – Mid February
  • The market is climbing and making up most of the loss this year – Currently

Each of these paths also impacts the mindset of members. Which of these paths, if they were to continue, may lead to more deposit growth? Which could cause deposits to shrink? What could each of the paths do to lending?

Technology

What new technologies are being released and what are their potential impacts on how people will look to get things done in the future? Three days could be spent on this topic alone, but a prime example of this is Amazon Echo, which came out in 2015. So far this year, there are a lot of parties looking to interface with this product, so they can be part of the new generation of home automation, with the objective of making it easy for consumers to get things done. Currently, Amazon Echo is making it easy to get a lot of things answered or done – such as what the weather will be, if a team won, what the best Italian restaurant is in the area, adding events to your calendar, buying things from Amazon, or adding items to your shopping list.

As other parties are hooking up to the Echo, they are providing new conveniences like making it possible to change the temperature in your house from your car, or helping you locate your misplaced keys. What does this have to do with uncertainty for credit unions? Beyond the potential direct impact of even more routine shopping happening through Amazon (where hopefully your member set up your credit card for one-click payments), there are other potential impacts to depository institutions. Will people be asking their device where the best place is to get a loan, or which places will give the best rate? The same could be true for members looking to transfer money to a better money market rate, or finding the best rate on a 1-year CD. Will people be able to send instant payments just by vocalizing it as soon as the thought occurs? Adoption of technology is always a hard thing to predict, but the impact on a member’s mindset, and their desire for things to be even easier, is to be expected.

It is impossible in a blog to cover all of the things that will be on attendees’ minds in our 3 days of A/LM education, but these are a few of the things that we think will be brought up.

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c. notes – Aggregating Risks to Inform Strategy

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To remain successful as the world changes and becomes more complex, risk management processes must keep pace.

Risk management begins with identifying and quantifying strategic risks. An effective process also recognizes that it is not adequate to only quantify and understand risks in silos. Risks should also be quantified and understood in aggregate. As history repeatedly taught us, bad things don’t usually happen in isolation.

Understanding and communicating risks in aggregate allows decision-makers to evaluate if the credit union is taking on too much risk, or if the credit union may be poised to strategically accept more risk. Also note that understanding risks in aggregate permits management to consider the credit union’s capacity for strategic opportunities; strategic risks and opportunities are two sides of the same coin.

To continue reading, please visit the article here.

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Are Your Predictions Limiting Your Strategic Thinking?

I think there is a world market for maybe five computers.

— IBM president Thomas Watson, 1943.

Apple is already dead.

— Nathan Myhrvold, former CTO of Microsoft, 1997.

Neither RedBox nor Netflix are even on the radar screen in terms of competition. It’s more Wal-Mart and Apple.

— Blockbuster CEO Jim Keyes, 2008.

These Google guys, they want to be billionaires and rock stars and go to conferences and all that. Let us see if they still want to run the business in two to three years.

— Bill Gates, founder of Microsoft, 2003.

Predictions are a tricky business.

Leaders assess how the world might or might not change. Whether it’s new non-traditional competition, cutting-edge technologies, evolving business models, or changing member behaviors, developing successful strategies today relies on decision-makers opening their minds to the possibilities and then choosing a path. Are you thinking creatively enough about how the world might change around you and how to ensure your credit union does not get left behind?

Consider the disruptions in financial services today. Like Blockbuster above, should strategy focus on behemoths like Wal-Mart and Apple, or are there greater threats in newer business models like M-Pesa, SoFi, and The Lending Club? Perhaps the greater threats and opportunities are evolving technologies. All of this is happening on top of traditional competition, regulation, and the economy.

Good strategy begins with careful consideration of possible threats and opportunities. Identifying the future you’re planning for is an important first step. With the future uncertain, even the best-laid plans are likely to run into unanticipated challenges. It can be useful, then, to ask, “What if the strategies we pursue are based on expectations that don’t come to pass?”

We recommend going through a process of test driving difficult and hard-to-imagine environments. Creating stories around such environments and discussing how the credit union could respond can be extremely valuable. Institutions are often amazed at the insight this can provide whether the environment actually occurs.

It’s not easy to foresee the future. We’ll leave you with some great historical examples, demonstrating that even the smartest people can misjudge the future.

 

The Americans have need of the telephone, but we do not. We have plenty of messenger boys.

— William Preece, British Post Office, 1876

This ‘telephone’ has too many shortcomings to be seriously considered as a means of communication.

— William Orton, President of Western Union, 1876

Fooling around with alternating current is just a waste of time. Nobody will use it, ever.

— Thomas Edison, 1889

The horse is here to stay but the automobile is only a novelty – a fad.

— President of the Michigan Savings Bank advising Henry Ford’s lawyer, Horace Rackham, not to invest in the Ford Motor Company, 1903

Who the hell wants to hear actors talk?

— Harry M. Warner, co-founder of Warner Brothers, 1926

Stocks have reached what looks like a permanently high plateau.

— Irving Fisher, Professor of Economics, Yale University, 1929

There is not the slightest indication that nuclear energy will ever be obtainable. It would mean that the atom would have to be shattered at will.

— Albert Einstein, 1932

Television won’t be able to hold on to any market it captures after the first six months. People will soon get tired of staring at a plywood box every night.

— Darryl Zanuck, 20th Century Fox, 1946

If excessive smoking actually plays a role in the production of lung cancer, it seems to be a minor one.

— W.C. Heuper, National Cancer Institute, 1954

There is practically no chance communications space satellites will be used to provide better telephone, telegraph, television or radio service inside the United States.

— T.A.M. Craven, Federal Communications Commission commissioner, 1961

With over 50 foreign cars already on sale here, the Japanese auto industry isn’t likely to carve out a big slice of the U.S. market.

— Business Week, 1968

There is no reason for any individual to have a computer in their home.

— Ken Olsen, Chairman and Founder of Digital Equipment Corp., 1977

I predict the Internet will soon go spectacularly supernova and in 1996 catastrophically collapse.

— Robert Metcalfe, founder of 3Com, 1995

Two years from now, spam will be solved.

— Bill Gates, 2004

There’s just not that many videos I want to watch.

— Steve Chen, CTO and co-founder of YouTube expressing concerns about his company’s long term viability, 2005

There’s no chance that the iPhone is going to get any significant market share.

— Steve Ballmer, Microsoft CEO, 2007

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.

— Ben Bernanke, Federal Reserve Chairman, 2007

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OBSERVATIONS FROM ALM MODEL VALIDATIONS: DO DECAY RATES MATTER?

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Yes. Decay rates do matter, but they are often not appropriately applied in the asset/liability management (ALM) process. Decay rates are essential for capturing the risk of evolving member behavior, namely deposit migration, as rates change. This blog will focus on using decay rates when simulating net economic value (NEV).

Model validations typically reveal two common issues as it pertains to the setup and implementation of deposit decay rates.

1) Decay rates are not being incorporated

Model users are often surprised to find out decay rates are not being incorporated. Common reasons for this include the fact that input fields can be hard to locate or reports summarizing key assumptions are not reported effectively (sometimes assumptions reported in a summary are not actually the assumptions in the model). To better illustrate, lack of decay rates from a recent model validation were organized by c. myers in the table below.

Decay Rates (Annual CPR) NOT INCORPORATED

The risk of decay rates not being incorporated in NEV can be dramatic, especially in the various rate shocks. If decay rates are not included, it will result in longer deposit cash flows, an unrealistic market valuation of deposits and, ultimately, an understatement of interest rate risk in a rising rate environment.

Credit unions should check their ALM models to make sure reasonable decay rates are appropriately applied and coincide with key assumption reporting.

2) Decay Rates Do Not Change As Market Rates Change

The issue of decay rates not changing as the world around us changes was discussed during a blog in September 2014. Back then, we pointed out that,

[Assuming decay rates don’t change as market rates change] is like saying non-maturity deposit cash flows will remain constant and unchanging regardless of what rates do. History shows that this is not a valid assumption and, if used, can provide a false sense of security regarding NEV results.

In the table below, c. myers organized decay rates from a recent model validation we performed.

Decay Rates (Annual CPR) STATIC AS MARKET RATES CHANGE

Notice that while decay rates are unique for the three different deposit products, decay rates remain constant regardless of changes in market rates. Said differently, this model assumes members will not consider the evolving advantage they might have to withdraw funds as rates change. However, as demonstrated in the chart below, history does not support the assumption that member behavior does not change as rates change.

The following graph shows when market rates increased from roughly 1% to 5% in 2004 and 2005, the industry experienced a material decrease in the concentration of regular shares and increase in member CDs. However, over the past 8 years, that trend has reversed as member certificates have declined while regular shares have experienced significant growth.

Distribution of Funding as a % of Assets

Keep in mind as you review decay rates, it is not about getting the “right” assumption, because that is virtually impossible. It is about reasonably representing changes in consumer behavior in your base-case risk analysis, then stress testing a range of assumptions to understand the impact.

While the focus of this blog has been on NEV, deposit behavior is a material component of income simulations as well. Ignoring deposit and member behavior will understate the cost of funds in higher rate environments and likewise hide risk. This is an issue that shows up with the static balance sheet approach and has been discussed frequently in previous blogs. To learn more, refer to the links below.

Observations from ALM Model Validations: Cost of Funds Back Testing
Observations from ALM Model Validations: Extremely Profitable New Business ROA in Static Balance Sheet Simulations
Isolating Interest Rate Risk with a Static Balance Sheet