Assumptions Behind ALM Models

Amid a rising rate environment, now might be a good time for credit unions to take a step back and re-evaluate their ALM models, which are only as valuable as the accuracy of the underlying assumptions.

 
 

Does your credit union have the perfect asset liability management model? Amid a rising rate environment, now might be a good time for credit unions to take a step back and re-evaluate their ALM models. Several popular tests such as Net Economic Value (NEV), Net Interest Income (NII) simulations and GAP exist to help credit unions quantify interest rate risk; however, the results of these tests can offer a false sense of security if not viewed with a measure of caution.

Supported by NCUA, NEV is a widely used test that many credit unions utilize to evaluate the interest rate risk inherent in their balance sheets. Yet the results of the test can vary depending on a number of assumptions that go into the model. Valuation of non-maturing deposits, for example, is difficult because of uncertain cash flows and because it depends on accurate assumptions of duration, decay rates, and discount rates. Using projected values in these calculations can create results that indicate more or less risk than actually exists. In addition, the assumption that balance-sheet cash flow evaluations can accurately predict future earnings and net worth is not always accurate since members’ deposit withdrawal rates depend on interest rate fluctuations.

Net Income and Net Interest Income Simulations are widely used to predict hypothetical future performance of a credit union under various interest rate scenarios. These results can also be misleading if inappropriate assumptions are used for the test. For example, assumptions must be made about the rate-sensitivity and repricing lag for non-maturing deposits. In addition, the model’s dependence on future business performance estimates can skew interest rate risk predictions.

GAP analysis is a third test that various credit unions use as a benchmarking tool and an additional method of analyzing their short-term financial situation. However, credit unions must be careful not to rely too heavily on the method’s results, as GAP unrealistically assumes that the balance sheet has predictable maturities.

Each of the aforementioned models can provide credit unions with a unique perspective, and many credit unions choose to use them in conjunction with one another to generate a comprehensive evaluation of their risks. Even with a multi-dimensional analysis strategy, credit unions should remember that the results of the model are only as valuable as the accuracy of the inputted data. As the ALM consulting firm c.myers warned in their assessment of NEV, “Even when being careful, well-intentioned examiners, CEO’s, and members of management can still be misled by such an assumption-driven methodology.” While most credit unions maintain policies that require them to examine the results of certain tests quarterly, few have established guidelines regarding the derivation or validation of critical assumptions. Validating ALM assumptions to ensure balance sheet stability becomes particularly important in a rising rate environment.
On Tuesday, August 3rd at 2 p.m. EST, Callahan & Associates, Inc. will host a webinar on Techniques in Developing and Validating ALM Assumptions. Attendees will hear how other credit unions are deriving and verifying the assumptions they use in their ALM models. Please click here for more information and to register.

 

 

 

July 19, 2004


Comments

 
 
 
  • A lot of meat in this article, not much for credit unions to grab ahold of. The need for cu's to assess and analyze their ALM models is something we all know, more details and examples would really provide incentive for credit unions to evaluate sooner rather than later.
    Anonymous