What is the Credit Union Board’s ALCO Role?

The Federal Reserve Board issued risk management guidance in 1995, which emphasizes that all financial institutions’ boards are responsible for their organizations’ condition and performance. While board members can’t be expected to understand the full details of their institution’s activities, the guidance makes it clear they should fully understand the types of risk exposures they face and should receive reports that identify the size and significance of those risks.

One of a credit union’s most important operating committees is the Asset and Liability Management Committee (ALCO), which oversees balance sheet risk management. ALM can get very complicated, and effective direction requires the board to rely on the ALCO to produce sound strategies based on ALM outputs. In turn, ALM outputs are based on the correct use of models.

ALM systems can be extremely complex, with stochastic modeling capabilities that can generate multiple types of duration calculations. Assumptions include prepayment forecasts, statistical measurements for non-maturing deposits and hundreds of market rates that depend on vintage, term, coupon and type of loan. Although very important, effective board oversight requires more than simply evaluating model outputs; it also requires a broad perspective on all business lines and products, strategic goals and risk management. As an example, the Dodd-Frank Stress Test has placed the limelight on capital adequacy planning, which includes setting minimum acceptable capital ratios after rigorous stress scenarios. Regulatory guidance can help, and ALCO practices were updated in January 2012 offering essential elements of the ALCO process.

Directors should ensure that the ALCO focuses on these key areas: Interest rate risk (IRR), liquidity risk and capital adequacy. Board members should rotate through the committee for educational purposes and sometimes officially become part of it, requiring them to seek guidance on ALCO-related functions.

Guidelines for Board ALCO Responsibilities

• Learn IRR basics, as well as sources of other potential risks, risk measurement techniques and risk mitigation strategies.
• Provide appropriate guidelines for risk-tolerance levels. The board sets the tone for risk tolerance, including quantitative risk limits, and both permissible and impermissible activities.
• Establish and conduct annual reviews of ALM, investment, liquidity and concentration policies.
• Monitor exposures with careful review of policy violations. This is usually performed at least quarterly.
• Keep the full board informed of ALCO activities.
• Understand the credit union’s risk position and actual performance, compared with stated objectives and relative to peers.
• Stay current on economic news and issues.
• Ensure that every major strategy or new business has a supporting ALM “what if.”
• Become educated on risk management by reading credible articles or attending conferences.
• Review and approve the strategic goals and objectives prior to proposing them to the full board.
• Assist in formalizing capital plans.
• Be committed to board responsibilities related to the ALCO.

Actions the Board ALCO Shouldn’t Take

• Set rates.
• Allow personal concerns as a credit union member to override the fiduciary duties of a board member.
• Micromanage management.
• Develop strategies that are inconsistent with risk tolerance levels; i.e., high ROA targets with low credit and interest rate risk.
• Forecast or bet on rates – balance sheet and investment strategies should be independent of rate forecasts or rate bets.

ALM Policies

One of the most effective tools the board can provide to management is a sound policy directive for the credit union’s various activities and risk exposures. Sound policies consolidate the board’s expectations for interest rate and liquidity risk exposures and oversight. According to the Federal Reserve System Community Banking Connection (2013) “Effective Asset / Liability Management: A View from the Top” by Doug Gray, below are what examiners look for in ALM policies:

• The policy should state the credit union’s objectives and provide a well-articulated strategy for management risks associated with balance sheet accounts.
• It should set appropriate aggregate risk limits for interest rate and liquidity risk exposures. Risks should be set in relation to earning and capital exposures usually framed in terms of limits to net interest income, net income and/or the economic value of equity.
• Policies should address forward-looking analyses for sound liquidity risk management.
• Risk limits should address the credit union’s activities and be reevaluated periodically in light of other risks such as credit, operational and reputation, as well as any new products or business activities.
• The policy should provide clear lines of authority, responsibility and accountability.
• The policy should delineate the types of activities that an institution may conduct. This might include which types of financial instruments or activities are permissible.
• When managing liquidity risk, the policy should indicate what types of funding are acceptable.
• If the credit union uses derivatives, the policy should address the appropriate use of these instruments, including a discussion of permissible derivative activities, an independent review of derivatives and the effectiveness of hedging activities.

ALM Validation

At times, management or even the board may be uncertain about the accuracy of the underlying ALM reports, making it vital to seek a validation. This is critical, given that strategy development depends on the validity of these reports.

A validation includes a review of the ALM model’s calculations and processes. Validations can be viewed as an “audit” of the ALM process, ensuring accuracy and the strength of internal controls. They also conduct a review of the logical and conceptual soundness of a credit union’s ALM model.

The financial services landscape has changed significantly in the past decade, as heightened regulation required additional focus on ALM risk management. It has become imperative that risk tolerance levels are set by the board and ALCO, and communicated throughout the organization to ensure success.

Emily Hollis, CFA is CEO of ALM First Financial Advisors, LLC. She can be reached at 214-451-2401 or ehollis@almfirst.com.