Is Your ALM System Lying to You? - LBA · Is Your ALM System Lying to You? ... and in combinations across a range of interest rate scenarios. Measuring the trade-off between short

Is Your ALM System Lying to You? What Ever Happened to Interest Rate Reward?

Philip M. Nussbaum, Chairman

PT Capital Partners

LBA CFO Conference | Baton Rouge, LA | May 21, 2015

© 2015 PT Capital Partners. All Rights Reserved. Is Your ALM System Lying to You? 2

ALM is not simply a compliance exercise. We don’t call it ALC.

Measuring the risk vs. reward of assets and liabilities individually

and in combinations across a range of interest rate scenarios.

Measuring the trade-off between short-term and longer-term income.

Generating and quantifying potential profitability enhancement strategies.

What is Asset/Liability Management?

Goals For Today’s Talk

Recognize that:

1. Traditional asset liability metrics have significant shortcomings in measuring risk versus reward

2. These shortcomings can be eliminated through a relatively small analytical adjustment

3. The benefit of making this adjustment is potentially significant

4. Core deposit assumptions are a really big deal when determining economic value, especially the average life assumptions of those that are truly core


Everything should be made as simple as it can be,

but not simpler.

ALBERT EINSTEIN THEORETICAL PHYSICIST


Today, the industry is largely oversimplifying and undervaluing ALM

This oversimplification is leading to less than optimal decisions

These less than optimal decisions are costing significant dollars

The Cost of Oversimplifying


We model risk and reward separately, not versus one another

We oversimplify A/L management, robbing the process of much value

An examiner’s A/L worldview is necessarily different than a banker’s

Core deposits are often incorrectly measured as shorter than they are

In general, A/L management is not highly valued

Problems with the Current State of

Asset/Liability Management


We model risk and reward separately, not versus one another








Brief History of ALM

GAP

Reporting Income Simulation Economic Value

Measures the expected

re-pricing and/or

maturities of assets

and liabilities and

compare the net

position over time

Measures the impact of

instantaneous rate

shocks on the net

interest margin over a

horizon (one year, two

years, three years)

Measures the impact of

instantaneous rate

shocks on rate sensitive

assets and liabilities on

a present value basis

SHORT-TERM REWARD LONG-TERM RISK


Are you asset sensitive as your net interest income simulation indicates?

-200 -100 Base 100 200 300 400

Net Interest Income

Net Interest Income Measures Short-Term Reward


Are you asset sensitive as your net interest income simulation indicates?

OR

Are you liability sensitive as your economic value simulation indicates?

-200 -100 Base 100 200 300 400 -200 -100 Base 100 200 300 400

Net Interest Income Economic Value

Economic Value Measures Long-Term Risk


This makes it very difficult to measure the trade-off between risk

and reward. As risk is increased by one unit, is reward increased

by one unit, two units, or maybe only one half of a unit?

We Model Risk and Reward on Separate Scales

RISK REWARD


Bonds


DURATION

YIELD


Economic

Value

(EV)

Income

Simulation

ALM



AND

NOT Risk AND Reward

We Should Not Model Risk and Reward

on Separate Scales

RISK REWARD


RISK

REWARD

But rather Risk VERSUS Reward

We Should Model Risk and Reward on One Scale

Investors should measure RISK vs REWARD to make objective decisions.


1-Year Income Simulation

Cash flow 4

Cash flow 1

Cash flow 2

Cash flow 3

Time Zero Year 1

Short-term Income

What about this portion of the cash flow?

WE

IGNORE

THEM!


Economic Value (“EV”)

Time Zero

Cash flow 4

Cash flow 1

Cash flow 2

Cash flow 3


Economic Value (“EV”)

Present Value (different rate scenarios)

Cash flow 4

Cash flow 1

Cash flow 2

Cash flow 3

What’s the

problem with

EV?

Time Zero

How is income

over time

incorporated? IT IS NOT!


Scenario-Based Total Return

Time Zero Horizon

Cash flow 4

Cash flow 1

Cash flow 2

Cash flow 3

Short-term

Income PV of Future Income + = Total Return

Income

Simulation + Economic Value = Total Return


Income Simulation and Economic Value Example

Asset #3

5-Year Maturity

3.15% Coupon at Par

Callable after 2 years

Asset #2

5-Year Maturity

3.00% Coupon at Par

Non-callable

Asset #1

2-Year Maturity

1.50% Coupon at Par

Non-callable


Net Interest Income

2-Year Income Simulation Example

20,000

30,000

40,000

50,000

60,000

70,000

-400 -300 -200 -100 0 100 200 300 400

2 Yr @ 1.5% 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000

5 Yr @ 3% 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000

5nc2 @ 3.15% 63,000 63,000 63,000 63,000 63,000 63,000 63,000 63,000 63,000

Clearly the 5-year (longer assets)

rainbow the 2-year (shorter assets)


EV % Change

Economic Value Example

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

-400 -300 -200 -100 0 100 200 300 400

2 Yr @ 1.5% 3.00% 3.00% 3.00% 1.99% 0.00% -1.95% -3.84% -5.70% -7.50%

5 Yr @ 3% 15.00% 15.00% 9.90% 4.83% 0.00% -4.58% -8.92% -13.04% -16.94%

5nc2 Yr @ 3.15% 5.99% 5.99% 5.99% 4.43% 0.00% -4.56% -8.89% -12.99% -16.89%

Which one would you buy?


EV % Change


-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

-400 -300 -200 -100 0 100 200 300 400

2 Yr @ 1.5% 3.00% 3.00% 3.00% 1.99% 0.00% -1.95% -3.84% -5.70% -7.50%

5 Yr @ 3% 15.00% 15.00% 9.90% 4.83% 0.00% -4.58% -8.92% -13.04% -16.94%

5nc2 Yr @ 3.15% 5.99% 5.99% 5.99% 4.43% 0.00% -4.56% -8.89% -12.99% -16.89%

Breakeven

at rates

unchanged



EV % Change


(instantaneous shift)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

-400 -300 -200 -100 0 100 200 300 400

2 Yr @ 1.5% 3.00% 3.00% 3.00% 1.99% 0.00% -1.95% -3.84% -5.70% -7.50%

5 Yr @ 3% 15.00% 15.00% 9.90% 4.83% 0.00% -4.58% -8.92% -13.04% -16.94%

5nc2 Yr @ 3.15% 5.99% 5.99% 5.99% 4.43% 0.00% -4.56% -8.89% -12.99% -16.89%


Consider this risk


2-Year Total Return

Total Return Analysis

(not an instantaneous shift)

-2%

0%

2%

4%

6%

8%

-400 -300 -200 -100 0 100 200 300 400

2 Yr @ 1.5% 1.49% 1.49% 1.49% 1.49% 1.49% 1.51% 1.51% 1.52% 1.53%

5 Yr @ 3% 7.13% 7.13% 7.12% 5.73% 4.33% 2.97% 1.62% 0.30% -1.01%

5nc2 @ 3.15% 3.09% 3.09% 3.09% 3.09% 3.10% 3.09% 1.77% 0.45% -0.85%

Now, which one

would you buy?


= Short-term Income + Change in Unrealized Gain/Loss

= Short-term Income + Long-term Income

= Income Simulation + Economic Value at Horizon

FINALLY, a management methodology that completely

measures risk vs. reward, empowering you to seek

superior balance sheet decisions.

TOTAL

RETURN


Income

Simulation (“IS”)

Economic Value

(“EV”)

TOTAL

RETURN

Accounts for

Passage

of Time

Counts ALL

Cash Flows X


Income


Economic Value

(“EV”)

TOTAL

RETURN

Accounts for

Passage

of Time

Counts ALL

Cash Flows

X

X


Income


Economic Value

(“EV”)

TOTAL

RETURN

Accounts for

Passage

of Time

Counts ALL

Cash Flows

X

X


OR

-200 -100 Base 100 200 300 400 -200 -100 Base 100 200 300 400

-200 -100 Base 100 200 300 400

VS

Net Interest Income EV

3-Year Total Return

Total Return:

The Marriage of Income Simulation and EV


TOTAL RETURN =

CHANGE IN MARKET VALUE

Income + - Ending Price Beginning Price


“Yield” + “Duration”

WHICH IS ESSENTIALLY

TOTAL RETURN =

Income + Change in Market Value


Total Return Shape Basics

Floating rate asset without caps/floors or

short fixed-rate asset

Longer term fixed-rate liability without options

Floating rate asset with caps (no floors)

Longer term fixed-rate liability with call

option not controlled by the bank

Floating rate asset with floors (no caps)

Longer term fixed-rate liability with call

option controlled by the bank

Longer term fixed-rate asset without options

Floating rate liability without caps/floors or

short fixed-rate liability

Longer term fixed-rate asset with call

option not controlled by the bank

Floating rate liability with floors (no caps)

Longer term fixed-rate asset with call (put)

option controlled by the bank

Floating rate liability with caps (no floors)

NO OPTIONS SOLD OPTIONS OWNED OPTIONS

Down Base Up Down Base Up Down Base Up

Down Base Up Down Base Up Down Base Up


Shapes Are Additive


=

Total return shapes are additive (dollar weighted)

Down Base Up Down Base Up


Shapes Are Additive


Shape Management® on the entire balance sheet

consists of assessing and adjusting the proportional

contributions of all balance sheet instruments.

=

► Adjusted Allocations

Down Base Up

Initial Allocations


12 Months

Sample Bank Loan Shape Comparison


36 Month

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

-200 -100 0 +100 +200 +300 +400

Loan - 5/25 @ 2.5+1L Loan - 5/25 @ 4.5% Fixed

Loans: Fixed vs. Adjustable

CHANGED SCALE


36 Month

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

-200 -100 0 +100 +200 +300 +400

5/25 @ 4.5% - Fixed - w/ PO 5/25 @ 4.5% - Fixed - NO PO

5/25 @ 4.5% - Pool

Loans with and without Prepayment “Options”


36 Month

Retail CDs with and without Surrender “Option”

-10%

-5%

0%

5%

10%

15%

-200 -100 0 +100 +200 +300 +400

5 Yr @ 2% - With Option 5 Yr @ 2% - No Option


-5%

-3%

0%

3%

5%

8%

10%

13%

15%

18%

20%

23%

-200 -100 0 +100 +200 +300 +400

Brokered 3YrNC6 @ .95% Brokered 10YrNC6 @ 2.9%

Brokered 20YrNC6 @ 3.75%

36 Month

Short vs. Long Callable Brokered CDs

CHANGED SCALE


We model risk and reward separately, not with one another








Broad categories (e.g., Call Report) instead of instrument level detail

Apply general industry assumptions as opposed to institution specific

Embedded option risk is not accurately modeled in many cases

Certain instruments often mismodeled (e.g., municipal bonds)

Oversimplifying ALM


We model risk and reward separately, not with one another








Examiners are charged with protecting the deposit insurance fund

Consequently, they care very much about the “Armageddon” scenario

Thus, they care very much about instantaneous rate shocks

We care about the Armageddon scenario, but should we manage to it?

Many instruments behave differently over time than they do instantaneously

We need to take “a movie” of our bank through time, not a “snapshot”

Instantaneous Rate Shock vs. Shock over TIME


We model risk and reward separately, not one with another








Core Deposit Assumptions:

The…


Sample Bank: EV Comparison

Core Deposit Assumptions

Can Cause Big Changes in EV

50,000

60,000

70,000

80,000

90,000

100,000

110,000

120,000

130,000

-200 -100 0 +100 +200 +300 +400

Original EVE Book


Sample Bank: EV Comparison

Core Deposit Assumptions

Can Cause Big Changes in EV

50,000

60,000

70,000

80,000

90,000

100,000

110,000

120,000

130,000

-200 -100 0 +100 +200 +300 +400

New EVE Original EVE Book


Since the crisis, core deposits as a percentage of assets, has

increased significantly. The leverage nature of the assumptions

for core deposits is even greater today than it has been in the past.

All are rightfully concerned about this increased in “surge” balances.

How many will be retained when rates rise?

However, there is a second item that deserves significant attention.

Of those NMDs that are not surge deposits, how long are they?

Core vs. Non-Core

All Insured Commercial Banks*

Dec-03 Dec-07 Change Dec-08 Dec-12 Change

ALL CORE 70.03 63.30 -9.61% 62.11 79.07 27.31%

* % of Average Assets


Many institutions are estimating core deposit durations shorter

to much shorter than they actually behave

In addition, most core deposit studies essentially ignore new deposits

Is there a difference between a 3-year bond and a 10-year bond?

Is there a difference between a 3-year and 10-year liability?

Our ALM reports seem to say no

How Long is Core?


Average Life of Deposits when considering “surge” balances

Core vs. Non-Core

% of Non-Core ("Surge") Deposits (1 yr Avg Life)

10% 20% 30% 40% 50% 60%

Tru

e C

ore

Dep

osits (

Avg L

ife

)

4 3.7 3.4 3.1 2.8 2.5 2.2

5 4.6 4.2 3.8 3.4 3.0 2.6

6 5.5 5.0 4.5 4.0 3.5 3.0

7 6.4 5.8 5.2 4.6 4.0 3.4

8 7.3 6.6 5.9 5.2 4.5 3.8

9 8.2 7.4 6.6 5.8 5.0 4.2

10 9.1 8.2 7.3 6.4 5.5 4.6

11 10.0 9.0 8.0 7.0 6.0 5.0

12 10.9 9.8 8.7 7.6 6.5 5.4

13 11.8 10.6 9.4 8.2 7.0 5.8

14 12.7 11.4 10.1 8.8 7.5 6.2

15 13.6 12.2 10.8 9.4 8.0 6.6

Base Stressed

Which is the bigger issue?


NMD/Total Deposits

0

10

20

30

40

50

60

70

80

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

The Run Up in “Surge Deposits”

Source: Performance Trust


NMD/Total Deposits

0

10

20

30

40

50

60

70

80

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Could Our Deposits “Surge” Down This Much? Our NMD assumptions suggest they will.

Average Life = 5.4


$0 Balance


NMD/ Total Deposits (+300 Standard)

Non-Maturity Assumptions

0

10

20

30

40

50

60

70

80

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

16% drop in

2 years

19% drop in

6 years Average Life = 10.2


$0 Balance


NMD Balances +300

Non-Maturity Assumptions

0

10

20

30

40

50

60

70

80

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

FRANCHISE VALUE



Median M&A Core Deposit Premiums vs. Prime and Fed Funds Rate Since 1/1/2000

M&A Core Deposit Premium vs. Interest Rate Analysis

5.8% 5.0%

3.0% 2.5%

1.0%

2.9% 2.1%

9.2%

15.5%

18.4%

16.8%

15.3%

13.6%

8.8% 9.5%

11.1%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2Q141Q1420132012201120102009200820072006200520042003200220012000

Median Core Deposit Premium Prime Rate Fed Funds Rate



Since the crisis, NMD as a percentage of assets, has increased

significantly (55% vs 70%) – Some of these are non-core deposits.

The impact of the assumptions for NMD is greater today than

in recent history.

Most NMD frameworks have unrealistic decay profiles —

Are we being too conservative?

Decay of non-maturity principal is equivalent to those dollars

repricing with overnight funding at market rates.

Concede sooner on % of non core than maturity of remaining core.

The Elephant: Non-Maturity Deposits


We model risk and reward separately, not one with another





Problems with the Current State

of Asset/Liability Management


We don’t really trust our own output — this becomes self-fulfilling

We are not convinced that the upside for getting it “right” is worth it

ALM is Not Highly Valued


Are these improvements achievable with better risk

versus reward decision-making tools?

ROA Improvement (Annual)

0.01% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.40% 0.50%

AS

SE

T S

IZE

(M

ILL

ION

S)

250 25,000 125,000 250,000 375,000 500,000 625,000 750,000 1,000,000 1,250,000

500 50,000 250,000 500,000 750,000 1,000,000 1,250,000 1,500,000 2,000,000 2,500,000

750 75,000 375,000 750,000 1,125,000 1,500,000 1,875,000 2,250,000 3,000,000 3,750,000

1,000 100,000 500,000 1,000,000 1,500,000 2,000,000 2,500,000 3,000,000 4,000,000 5,000,000

1,250 125,000 625,000 1,250,000 1,875,000 2,500,000 3,125,000 3,750,000 5,000,000 6,250,000

1,500 150,000 750,000 1,500,000 2,250,000 3,000,000 3,750,000 4,500,000 6,000,000 7,500,000

1,750 175,000 875,000 1,750,000 2,625,000 3,500,000 4,375,000 5,250,000 7,000,000 8,750,000

2,000 200,000 1,000,000 2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 8,000,000 10,000,000

2,250 225,000 1,125,000 2,250,000 3,375,000 4,500,000 5,625,000 6,750,000 9,000,000 11,250,000

2,500 250,000 1,250,000 2,500,000 3,750,000 5,000,000 6,250,000 7,500,000 10,000,000 12,500,000

2,750 275,000 1,375,000 2,750,000 4,125,000 5,500,000 6,875,000 8,250,000 11,000,000 13,750,000

3,000 300,000 1,500,000 3,000,000 4,500,000 6,000,000 7,500,000 9,000,000 12,000,000 15,000,000

Is It Really Worth It??


Is this your institution?

Asset Duration 2 years

Liability Duration 5 years

Difference -3 years

Treasury Curve

2-Yr 0.5

5-Yr 1.75

5-Yr – 2-Yr 1.25

Asset Size Cost of Mismatch

$500,000,000 $6,250,000

$1,000,000,000 $12,500,000

Is It Really Worth It??

Are these improvements achievable with better risk

versus reward decision-making tools?


Total Return models risk vs. reward together (literally in the same equation)

Don’t oversimplify. Take a moving picture of your bank not a snapshot

Realize an examiner’s A/L worldview is necessarily different than yours

Spend the resources necessary to more accurately measure core deposits.

Realize this assumption dramatically influences other balance sheet

decisions. This issue significantly impacts your members

Highly value ALM. The upside to improving your ALM is very significant,

which for many, it can result in the hundreds of thousands of dollars and

possibly, millions of dollars

Solving the Current Problems of ALM

Goals For Today’s Talk

Recognize that:

1. Traditional asset liability metrics have significant shortcomings in measuring risk versus reward

2. These shortcomings can be eliminated through a relatively small analytical adjustment

3. The benefit of making this adjustment is potentially significant

4. Core deposit assumptions are a really big deal when determining economic value, especially the average life assumptions of those that are truly core


Questions and Comments

© 2015 PT Capital Partners, LLC (which, along with its affiliates, is referred to as “PT”).

All Rights Reserved. This material is for your internal use only and may not be disclosed to

third parties. The content is the proprietary and confidential material of Trust and so designated

pursuant to a confidentiality agreement between the intended recipient and PT. The research

and other information provided herein has been prepared for informational purposes only

and is not an offer or solicitation to purchase or sell securities. PT may make a market,

or have a position in the securities discussed herein and may purchase or sell the same

on a principal basis or as an agent. Investing involves risks, including the potential for

principal loss. There is no guarantee that the strategies and services will be successful

or outperform other strategies and services. Certain assumptions may have been made

in connection with the analysis presented herein, and changes to the assumptions may

have a material impact on the analysis or results. Past performance is no guarantee of future

results. The investments discussed herein may be unsuitable for investors depending on their

specific investment objectives and financial position. Investors should independently evaluate

each investment discussed in the context of their own objectives, risk profile and circumstances.

The information contained herein has been obtained from sources considered to be reliable,

and is subject to change without notice. PT does not guarantee its accuracy, adequacy or

completeness and is not responsible for any errors or omissions or for the results obtained

from the use of such information. FOR INSTITUTIONAL USE ONLY.

Documents

Is Your ALM System Lying to You? - LBA · Is Your ALM System Lying to You? ... and in combinations across a range of interest rate scenarios. Measuring the trade-off between short