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Asset/Liability Management Certification
Training Program
Day 4 Session 2
Presented by:
Leonard Matz
February 7-10, 2012
www.sheshunoff.com
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Topics for This Session
2
1. Making ALCO effective.
2. Best practice IRR reporting.
3. Contents of a best practice IRR policy.
4. Oversight, internal controls and audit.
5. Review Q&A
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Making ALCO Effective
3
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4
Flawed Decision Making
The non-decisionlets just debate the rateoutlook
Wishful thinking the problem will go away
Delayed decision makinglets have anothercommittee meeting before we act
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Asset / Liability Committee (ALCO)
Two reasons why a committee is at the center of rate risk management:
1. Many of the risk management issues requires the CEOs and CFOs
attention and also have strategic ramifications
2. Typically the CEO and the CFO lack day to day familiarity with all f the bank
activities impacting the risks
ALCOs mission should include:
1. To be responsible for setting interest rate risk limits, developing interest rate
risk strategies, and making sure that the bank stays within these limits
2. Setting investment portfolio strategy is another responsibility that often falls
under the ALCO umbrella
3. Liquidity management
5
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ALCO Membership
Membership should include senior managers from each major lending,
investment, deposit, and funding area in the bank.
The following bank functions should be represented on ALCO:
Chief Executive Officer
President
Chief Financial Officer
Treasurer
Senior Investment Officer
Asset/Liability Manager
Senior Credit Officer
Senior Branch Officer
Senior marketing Officer
6
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7
Poor Delegation of Risk Management Authority
Confusion among managers as to which person or which
department is responsible for aspects of risk measurement,management, or oversight.
Lack of an owner responsible for all aspects of risk positions.
Policy restrictions that focus on actions rather than on risks.
Ambiguous delegation of authority. For example, insufficientdistinction between responsibility for final approval,responsibility for review, and responsibility for activemeasures.
Delegation of responsibility without authority.
Delegation of responsibilities to one or more committeeswithout making the committee chairman or some other officerresponsible.
Duplicative, redundant, or overlapping delegations ofauthority.
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8
Characteristics of Ineffective AL Committees (1)
The chief executive officer does not attend
meetings.
ALCO members are unsure of what the ALCO is
required to accomplish.
ALCO members are uncomfortable with the validity
of the risk information presented.
The agenda is cluttered with review items, leaving
insufficient time for decisions and providing a lot of
excuses to avoid making decisions.
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9
Characteristics of Ineffective AL Committees (2)
Risk reports provided to committee members are
too voluminous, complex, or late to support
informed decision making.
Too much time is spent discussing the current
interest rate and economic outlook instead of
alternative management decisions.
ALCO discussions are dominated by the individuals
directly responsible for monitoring IRR exposure.
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10
Characteristics of Ineffective AL Committees (3)
Risk management decisions are not implemented.
The results of previous decisions are not measured.
The only managed portion of the banks IRR and
liquidity risk is the risk in assets, liabilities, or off-
balance sheet positions that are managed inTreasury.
Risk management decisions are made in response
to the present situation and short-term objectives.
Longer term strategic considerations are given littleor no thought.
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11
Characteristics of Ineffective AL Committees (4)
Management of the banks liquidity position is
inconsistent with policy guidelines adopted by the
ALCO.
The profitability and riskiness of key loan and
deposit products are not monitored by the ALCO.
New loan and deposit products or new variations of
existing loan and deposit products are introduced
without ALCO discussions about their risk
characteristics.
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12
ALCO Functions and Responsibilities
1. Select IRR and liquidity measurement systems and
methodologies.
2. Select the rate risk variables that the bank believes
best describe the rate risk.
The ALCO has to choose whether it is concerned aboutmost likely rate changes or other potential rate changes
and how those potential rate changes will be selected.
The ALCO must also choose whether it is concerned with
changes in projected net income, projected economic
value of equity, etc. (selection of the dependentvariables).
3. Select liquidity scenarios and stress levels.
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13
ALCO Functions and Responsibilities
4. Establish specific limits on the acceptable level of
risk on a consolidated basis and recommend those
limits to the board for its approval and for
incorporation into the policy. In addition, the ALCO
may establish less-official limits that are more
restrictive than limits established in the policy.(More restrictive limits may be established when
circumstances require a temporary change.) From
time to time, the ALCO may want to recommend
changes in limits established by the board ofdirectors
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14
ALCO Functions and Responsibilities
5. Regularly review analysis of the banks exposure to
adverse consequences from rate changes. Eventhough the projected exposure may be within policylimits, the ALCO may decide that actions should beundertaken to change this exposure. In addition toresponses to changes in rate expectations, ALCO
may want to change the banks IRR exposurebecause other changes, such as poor earnings, makeit appropriate to temporarily reduce the banksexposure to rate risk.
6. Regularly review analysis of the banks exposure toliquidity risk under defined stress scenarios. Identifypotential vulnerabilities and respond as appropriate.
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15
ALCO Functions and Responsibilities
7. Review reports indicating whether previous ALCO
decisions were implemented, the extent to which
previous ALCO decisions resulted in the intended
changes to the banks IRR exposure, and whether IRR
exposure limits have been exceeded.
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16
ALCO Functions and Responsibilities
8. The ALCO must also keep minutes of all meetings. This
rule should hold for informal meetings as well as formal
meetings. Also, outside auditors and bank examiners
usually review ALCO minutes, and they expect to see a
complete record. ALCO minutes do not have to be
lengthy or unusually detailed. At a minimum, theminutes should identify:
When the meeting was held
Who attended
Major topics discussed
Specific decisions made
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17
Sample ALCO Agenda
10:00-10:15 Status Reports
1. Minutes of prior meeting.2. Review of implementation status of decisions
from prior meeting.
3. Review of any policy violations, proceduralproblems, etc.
10:15-10:30 Review of Historical Information
4. Review of the trend in rate risk exposure levels.5. Review of the trend in related information, such
as liquidity and capital ratios.
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18
Sample ALCO Agenda
10:30-10:40 Competitive Situation6. Review of relevant competitive information,
such as deposit rates.
7.Analysis of current loan and deposit strategies,planned promotions, securitizations in process,
and other planned changes.
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19
Sample ALCO Agenda
10:40-11:10 Current Risk Assessment
8. Current rate risk exposure and projection measures(model reports of EVE andEAR for a range of possible future interest rates).
9. Current rate outlook/forecast.
10.Confidence level in current rate outlook.
11.Comparison of current rate risk exposure to board-
approved limits and to ALCOsmost recent target.
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20
Sample ALCO Agenda
11:40-11:50 Related Issues
16. The impact of the current and targeted rate risk
exposure on the banks capacity to
meet its budget.
17. The adequacy of current liquidity.
18. The impact of the current and target rate risk
exposure on liquidity risk levels.
11:50-12:00 Open Discussion
12:00 Noon Adjourn
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Five Steps for Sound Decision Making
21
AGENDA ITEM COMMENT NEEDED INPUT
Review IRRperformance history.
Goals: Provide background Reinforce connectionbetween ALCO decisionsand banks financial
performance Ensure that prior ALCOdecisions were implemented
(oversight)
History (e.g., past 12 months)of banks IRR exposure and
of rate movements Performance of margin, netinterest income, economicvalue, etc.
Review current IRR
exposures.
Enables the ALCO tocompare with limits
Exposure reports (exposuresvs. limits)
Determine rate outlook. Steps: Select base case scenario,highlighting expectations
vis--vis types of rate
change Determine analystsconfidence in base case Articulate and documentlogic
Economic and market data
Decide on IRR
positions.
Expressed in same terms asexposures are measured(including as a percentage of
limit)
Output: decision summary
Determine basic
implementation
strategy and delegate
implementationresponsibility.
This usually takes the formof on-balance sheet and/or
off-balance sheet actions to
alter the banks riskexposure profile
Source: Adapted from a table developed by J. Kimball Hobbs.
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Best Practice IRR
Reporting
22
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Best Practice ALCO Reports
23
Good ALCO reporting has fourcharacteristics:
It must include all of the
information that decision makersneed.
It must clearly call attention to the
most important issues.
It must be timely.
It must be actionable.
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What do Risk Managers Need to See?
24
Compliance with Risk Exposure Limits.
Non-limit policy violations.
Current exposures.
History. Information that relates current risk
exposures to exposures in prior time periods and to
prior risk management decisions provides both
context and continuity.
Support for new decisions. The package should alsocontain economic data or forecasts to help guide
ALCO members.
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US Interagency Requirements
Reportable items may include but are not limited to:
cash flow gaps,
cash flow projections,
asset and funding concentrations,
critical assumptions used in cash flow projections,
key early warning or risk indicators,
funding availability,
status of contingent funding sources, or collateral usage,
the use of and availability of government support, such as lending
and guarantee programs, and implications on liquidity positions,particularly since these programs are generally temporary or
reserved as a source for contingent funding.
Format revised.
25
Interagency Policy Statement on Funding and Liquidity Risk
Management, Paragraph 20, March 2010
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Management Reports
27
Multiple levels of details
Focus on key metrics
Appropriate aggregation
Appropriate disaggregation currencies
Clarity for non-specialists
Flexible content special situations and topicsreviewed infrequently
Flexible frequency for scenarios
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Advice for ALCO Packages
28
An executive summary is a big help for busymanagers.
Report formats should be uncluttered, emphasizing
graphs and simple tables.
Use color to highlight key information.
Use the same description each time you prepare a
package, and show the history for each major
exposure as a line graph.
Try to keep supporting detail in appendices.
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More Focused ALCO Reporting and Risk Dashboards
29
Percentage Point Variance
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Percentage Point Variance
Under Various Rate Scenarios
30
EARNINGS AT RISK
Rising Interest Rate ScenarioFlat Rat
Scenario Declining Interest Rate Scenario
Up 300 bp Up 200 bp Up 100 bp No change Down 100 bp Down 200 bp Down 300 bp
Business
strategy 1:5.41%
Business
strategy 2:
3.76%
Business
strategy 3:2.17%
Base case
strategy:0.0%
Business
strategy 4:-2.44 %
Business
strategy 5:-5.14%
Business
strategy 6:-7.97%
Source: BancWare ALM 5
Comparisons of Risk Limits
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Comparisons of Risk Limits
and Measured Exposures
31
-200
-150
-100
-50
0
50
100
150
200
Q0 Q1 Q2 Q3 Q4 Q5 Q6
NetInterestIn
come
rates rise no change rates fall
Trend in Net Income:
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Trend in Net Income:
Actual Plus Four Projected Scenarios
32
20
25
30
35
40
45
50
1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q
NetInterestIncome
Actual
Declining
Rising
Budget
Current
Forecast
Sample Output of Economic Value
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Sample Output of Economic Value
Simulation Model Interest Rate Scenario(in thousands of dollars)
33
Down 300 bp Down 200 bp Down 100 bp Base Case Up 100 bp Up 200 bp Up 300 bp
PV of Assets 606,537 589,107 574,333 560,866 548,097 536,172 524,713
Percent Change 8.14% 5.04% 2.40% 0 -2.28% -4.40% -6.45%
PV of Liabilities 491,109 484,877 478,866 472,727 466,530 460,391 454,413
Percent Change 3.89% 2.57% 1.30% 0 -1.31% -2.61% -3.87%
PV of Equity 115,429 104,230 95,467 88,140 81,567 75,781 70,300
Percent Change 30.96% 18.26% 8.31% 0 -7.46% -14.02% -20.24%
Source: BancWare ALM 5
Comparisons of Risk Limits
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Comparisons of Risk Limits
and Measured Exposures
34
-35%
-30%-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
-300 -200 -100 Base
Case
100 200 300
Policy Limit
- all months
% Value at Risk
June 200X% Value at Risk
September 200X
% Value at Risk
March 200X
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Products Ranked by Economic Value Sensitivity(for a 200-basis point decrease in rates scenario)
35
No Change in Rates Down 200 Basis Points Scenario
Economic Value Economic Value Change PercentageChange
Fed Funds Sold 8,936 8,939 3 0.03%
Personal Loans Floating 5,070 5,074 4 0.08%
US Treasuries Treasury 17,239 17,295 56 0.33%
US Treasuries Fixed 17,080 17,181 100 0.59%
Commercial Loans - Floating 111,440 112,235 795 0.71%
CDs LT 100k 71,252 71,842 590 0.83%
Personal Loans - Fixed 24,774 25,009 235 0.95%
Commercial LOC 61,924 62,602 678 1.10%
Agencies 21,225 21,544 319 1.50%
CDs GT 100k 193,918 197,620 3,703 1.91%
Municipals 9,167 9,357 190 2.07%
Savings Accounts 19,193 19,872 679 3.54%
NOW Accounts 33,537 34,723 1,186 3.54%
ARMs 79,150 82,242 3,092 3.91%
Money Market Accounts 74,620 77,840 3,220 4.32%
Lines of Credit 25,007 26,161 1,153 4.61%
Commercial Loans Fixed 97,334 107,325 9,991 10.26%
Mortgages 23,507 29,302 5,794 24.65%
MBS 23,012 28,842 5,830 25.33%
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Just Because We Can, Doesnt Mean We Should
36
24
moderate confidence -- rates up
moderate confidence -- rates down
low confidence
or no direction
high confidence -- rates down
AssetSensitive
LiabilitySensitive
% of limit
high confidence -- rates up
12-month history of position-taking, expressed as % of limit
IRR Position History
(% of Limit)
prior 12 months
100
80
20
-20
0
-80
-100
x
recommended
target
Sample ALCO Report
Improving Rate Risk Disclosure: Bank of Americas Are More
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Improving Rate Risk Disclosure: Bank of America s Are More
Realistic
37
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Contents of a Best
Practice IRR Policy
38
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Five Good Reasons to Have A Formal, Written Policy
1. Bank examiners require it2. The policy communicates managements intentions and rules to
everyone involved in the process
3. Establishes specific objectives and responsibilities
4. Establishes priorities for goals
5. Helps establish goal congruence and coordination throughout the
bank
39
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General Qualities for Effective Policies
40
Policy provisions should be specific enough to achieve the banks
goals.
The policy should not include excessive detail. Confine most details
to either policy appendices or procedures manuals.
The best policy provisions provide clear, focused, and practical
guidance.
Policies should delegate responsibility for developing procedures or
assumptions rather than dictating the procedures or assumptions.
The best policies are customized to the financial institutions
resources, markets and strategies.
The best policies are living documents.
Policies must reflect constraints resulting from legal entity structure,
regulations and international activities.
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Policy Perspectives
41
Strategic risk management how muchliquidity risk, measurement and managementconditions, etc.
Tactical risk management what to do about
liquidity risk in todays bank and marketconditions.
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Rate Risk Policy Scope and Content.
42
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Why Do We Need a Formal IRR Policy?
43
1. Bank regulators require it. Necessary but notsufficient.
2. A more important reason to have a policy is that itcommunicates managements intentions and rules toeveryone involved in the process. If you dont knowwhere you are going, any road will take you there.
3. The policy establishes specific objectives andresponsibilities. Creating the policy forces managersand directors to identify their objectives and to assign
responsibilities.
4. The policy establishes priorities for goals..
Eleven Elements of An
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Eleven Elements of An
Effective IRR Policy
44
1. Frequency and Method for Monitoring Interest Rate Risk
Exposure
The IRR policy should address which methodsthe bank uses to measure and monitor rate risk,
How is interest rate risk defined (earnings or
value).
What target of rate risk exposure is the bankaiming to manage?
What time frame(s) or time horizon(s)?
How often is rate risk measured?
Eleven Elements of
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Eleven Elements of
An Effective IRR Policy
45
2. Rate Risk Exposure Limits Consistent with risk appetite. (Managing
to risk neutral or positioning?)
Appropriate given the banks risk
management expertise? Consistent with path to the exit.
Li it f St T t ( t h k ) M d t
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Limits for Stress Tests (rate shocks) are Mandatory
46
Management should establish limits, triggers, or thresholds for stress
scenarios in order to compare risk measurement results with theinstitutions risk tolerance. Typically, institutions establish a set of
stress scenarios as part of the regular IRR assessment process. Long-
standing supervisory guidance provides that an appropriate limit
system should permit management to control IRR exposures, initiate
discussion about opportunities and risk, and monitor actual risk takingagainst predetermined risk tolerances. Risk measurements and limits
generally focus on the level of volatility on earnings and capital.
Source:Answer to Question 7, Interagency Advisory on Interest Rate
Risk Management Frequently Asked Questions, January 12, 2012, pages
5 and 6.
Eleven Elements of
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Eleven Elements of
An Effective IRR Policy
47
3. Clear Identification of Authority/Responsibility
The policy should clearly identify the authority andresponsibility for specific elements of rate risk managementand oversight. Individuals and committees responsible formaking rate risk management decisions should be identified.
IRR policies typically include many specific requirements forthe creation and operation of an ALCO. A sample list of IRRpolicy specifications for an ALCO includes:
ALCO membership
ALCO duties and responsibilities
How often the ALCO should meet
Decision-making authority of the ALCO
Form of reports from the ALCO to senior managementand the board
Frequency of required reports from the ALCO
Eleven Elements of
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e e e e ts o
An Effective IRR Policy
48
4. Reporting
The rate risk management policy must specifyand describe required reports. An accurate,informative, and timely management reportingsystem is essential for both monitoring and
managing rate risk exposure.
The policy should identify what position ordepartment is responsible for preparing reports.
The policy should stipulate the frequency ofreporting.
Eleven Elements of
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An Effective IRR Policy
49
5. Acceptable and Unacceptable Courses of Action for ManagingInterest Rate Risk
Major hedging strategies and risk management actions,such as the use of derivatives, should be authorized by thepolicy.
The IRR policy should define:
When capital markets hedging is permitted.
How much capital markets hedging is permitted. What hedging instruments are acceptable.
Hedge limits by instrument.
What department or area in the bank is responsible forusing capital markets hedge instruments.
What hedging strategies are acceptable. How hedging activities will be reported, to whom they
must be reported, and how often they must be reported.
What controls will be required.
Eleven Elements of
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An Effective IRR Policy
50
6. Measures to Take to Monitor Compliance with the IRR Policy
Regular reports of compliance with all policy provisions,especially limits are necessary.
The policy should identify:
who prepares compliance reports,
who receives compliance reports and how often is compliance reported.
Last but not least, some independent report of compliancewith the IRR policy is a good idea. The policy might, forexample, require the audit department to make an annual
review and report of compliance with policy provisions.
Eleven Elements of
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An Effective IRR Policy
51
7. Measures to Test the Accuracy of Data,Assumptions, and Calculations Used in the RateRisk Measurement Process
Data reconcilement
Date testing (exception trapping) and scrubbing Assumption validation/backtesting
Model audits
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An Effective IRR Policy
52
8. Measures to Test the Accuracy of Estimated orProjected Exposure to Changes in PrevailingInterest Rates
It is also important to establish procedures forperiodic comparisons of forecasted rate
sensitivity with actual changes in the banksincome or EVE after subsequent rate changes.The term backtesting mainly refers to this typeof output verification. EVE backtesting is limitedto outputs for which there is a corresponding,
observable market price.
Eleven Elements of
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An Effective IRR Policy
53
9. Measures to Test the Effectiveness of Rate Risk
Management Activities
IRR management activities do not alwaysaccomplish what we expect. The best-intentioned- and implemented plans do not
always produce the desired results. Whilemeasuring and managing IRR is imperfect atbest, bank managers should have someprocedures to follow so that the effectivenessof their rate risk measurement and
management can be monitored and adjustedas necessary. The procedures themselves donot belong in the policy. However, the policyshould at least establish the requirement forsuch follow-up and testing.
Eleven Elements of
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An Effective IRR Policy
54
10. Regulatory Compliance
A general policy declaration to the effect that thebank will comply with all applicable laws andregulations never hurts, but a broad statement tothat effect is clearly not sufficient by itself.
Regulators usually expect to see some specificrequirements included in ALM or IRR policies.
Eleven Elements of
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An Effective IRR Policy
55
11. Policy Coordination
For all banks, an IRR policy paragraph shouldaddress how policy will be coordinated withpolicies for lending/credit, investments, liquidity,strategic planning, and capital. One way to
coordinate these would be to have proposedchanges in any one policy made subject to areview process that includes individualsresponsible for enforcing the other policies.
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Oversight, Internal
Controls and Audit
56
IRR Oversight Elements
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IRR Oversight Elements
Monitor compliance with policy limits and approved procedures Review the impact of previous changes in interest rates to
evaluate the accuracy of previous measurements of rate risk
exposure
Monitor implementation of previous risk management decisions
to determine the quality, timeliness and completeness ofimplementation
Audit the integrity of the risk measurement and risk reporting
process
57
IRR Oversight Procedures and Controls
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IRR Oversight Procedures and Controls
1. Financial Institutions should develop procedures requiring: Appropriate methods for quantifying assumptions
Documentation of how assumptions were quantified, when it was done and who
did the work
Test of critical assumptions
Documentation of assumptions reviews
Controls for assumptions changes
Controls for assumption changes are particularly important
2. Controls for compliance with policies and risk management
procedures Periodic reviews to validate that bank enforces its IRR policy
Whether exceptions to policies or procedures receive the prompt attention
58
Internal Controls
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Internal Controls
59
The regulators expect institutions to have an adequate
system of internal controls to ensure the integrity of allelements of their IRR management process, including the
adequacy of corporate governance, compliance with policies
and procedures, and the comprehensiveness of IRR
measurement and management information systems. Thesecontrols should be an integral part of the institutions overall
system of internal controls and should promote effective and
efficient operations, reliable financial and regulatory
reporting, and compliance with relevant laws, regulations,
and institution policies.
FFIEC Advisory On Interest Rate Risk, page 8.
Requirements for Audit
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Requirements for Audit
60
Focus on risks not reconcilements
Training
Testing data
Testing assumptions
Testing output
Testing for compliance with limits, policy constraints and
regulatory requirements.
Testing internal controls for key vulnerabilities such asassumption modifications.
Controls for Assumptions
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Controls for Assumptions
61
Appropriate methods for quantifying assumptions.
Documentation of how assumptions were quantified, whenthe work was done and who did the work.
Tests of critical assumptions (sensitivity tests and/or backtests).
Documentation of assumptions reviews both periodicreviews and reviews following changes in bank activities ormarket conditions.
Controls for assumption changes.
Controls for assumption changes are particularly important.Internal and external auditors should review changes andcontrol procedures for changes. All changes should beundertaken for valid risk management reasons and not toavoid violating a risk exposure limit.
Essential Non-Audit Oversight Tasks
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Essential Non-Audit Oversight Tasks
62
Review the impact of previous changes in interest
rates to evaluate the accuracy of previousmeasurements of rate risk exposure.
Monitor implementation of previous risk managementdecisions to determine the quality, timeliness, and
completeness of implementation.
IT Resources A Critical Risk Management Requirement
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IT Resources A Critical Risk Management Requirement
63
Supervisors have observed that an inability to
aggregate risk data in an accurate, timely, orcomprehensive manner can undermine the
overall value of internal risk reporting. For
example, whereas most firms focus on
establishing a management information
reporting framework to meet operational
requirements, internal risk reporting standardsdo not articulate the type of critical reporting
that would be required in a crisis or the speed
at which these reports would have to be
produced. We believe that in order to meet the
needs of the business line and risk
management staffs, firms should establishstandards, cutoff times, and schedules for
internal risk reports.
Source: SSG, Observations on Developments in Risk Appetite Frameworks and IT Infrastructure,
December 23, 2010, page 2 and page 12.
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Review Q&A
64
Do you have a question that you would like
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y q y
answered during the Q&A session?
Simply follow the instructions below.
To ask a question, please press *1 on your
touchtone phone.
If you are using a speaker phone, please lift the
receiverand then press *1.
If you would like to withdraw your question, press
*1.
65
Copyright Notice
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Copyright Notice
Portions of this presentation are copyrighted by Sheshunoff
Information Services, Inc. The remainder is copyrighted by Leonard
Matz.
No part may be reproduced in any form or incorporated in any
information retrieval system without prior written permission from
the copyright owner.