With rates on the rise, interest rate risk (IRR) will become an increasing issue for community banks for the foreseeable future.
In particular, the regulators have intensified their scrutiny on asset liability management (ALM) model validation as it relates to IRR. In this environment, even small non-complex community banks are being held to the same high modeling standards as their larger counterparts. A formal ALM model validation has become a standard regulatory request.
The prolonged low rate environment has, and continues to, compress net interest margins. The regulators are primarily concerned about community banks going out too far on the yield curve in search of earnings and thus increasing their interest rate risk position. Industry-wide, we have seen long-term assets as a percentage of total assets increase fairly significantly in the last 6-7 years. This is one IRR indicator that regulators use in determining the level of risk an institution is taking on.
Definition of ALM Validation
Regulatory guidance defines ALM validation as:
“the set of processes and activities intended to verify that models are performing as expected, in line with their design objectives and business uses.”
Or, in other words, validation tests how well your ALM model is performing in relation to its intended use and that it actually produces accurate forecasts of earnings and value. As with any model, it has its own risks and validating it is one way to control that risk.
To be credible and effective, your ALM model validation process must meet two main criteria:
- The validation must be independent of the modeling process and whoever is responsible for the modeling.
- The process must meet requirements detailed in the regulatory guidance.
Your model validation should include reviews of the base case, as well as the rate ramp and/or shock scenarios. Doing this will ensure that the model captures all balance sheet behaviors.
One of the main things regulators will be looking at is the assumptions that are used in your ALM model. In the FDIC’s Supervisory Insights, it states:
“a systematic approach to developing common-sense assumptions for use in interest rate risk management systems is an important part of a bank’s strategic planning.”
The use of unsupported or stale assumptions is one of the most common issues identified by examiners, Supervisory Insights adds. Common weaknesses found during regulatory review of assumptions include:
- Using peer averages without consideration of bank-specific factors.
- Not differentiating between rising- and falling-rate scenarios.
- Oversimplifying balance sheet categories, which can lead to potentially faulty analysis.
- A lack of qualitative adjustment factors to historic data, such as not considering a higher run-off factor for surge deposits.
Related Post: Stress Test for Rising Rates and Other Adverse Outcomes
Banks often don’t attempt to evaluate how the results of their IRR measurements would change in response to changes in assumptions, according to Supervisory Insights. If the results would be significantly impacted by changes in critical assumptions, you should plan for a range of values for these assumptions.