FT. LAUDERDALE, Fla.–The way credit unions do asset/liability management has “fundamental flaws,” according to one analyst, and it’s costing them.
Phil Nussbaum, chairman and cofounder of Performance Trust Capital Partners, and a former bank examiner, told the NAFCU CFO Conference here that when it comes to ALM, “The hard part is in setting up the problem. Once it is properly set up, solving it and making decisions are not as hard. But we are not optimally setting up the problem, and that makes decision making that much more difficult.”
When it comes to ALM, Nussbaum built his remarks around four themes:
- Traditional Asset liability metrics fall short measuring risk versus reward
- Those shortcoming can be eliminated through a small analytical adjustment
- The potential benefit is significant
- Core deposit assumptions are a really big deal
The ‘Finance of Banking’
Nussbaum said that while credit unions can always get better at practices around the margins, those opportunities are relatively small. Instead, it’s in what he calls the “Finance of Banking” where the real opportunity lies.
What is the Finance of Banking? According to Nussbaum, it’s the “study and management of all asset/liability cash flows over time across scenarios to potentially maximize current future earnings.”
More specifically, Nussbaum said the Finance of Banking, a term he acknowledges he made up, is similar to ALM, but on a more detailed level as it’s the study of ALL cash flows.
“One of the weaknesses of the way we do ALM is we don’t look at all the cash flows we do,” said Nussbaum, adding that “time” is a good four-letter word, as opposed to snapshot evaluations.
Take a Movie, It Lasts Longer
Rather than snapshots, Nussbaum said he advocates for taking “movies” of cash flows.
“Does the frame of what we do to make decisions actually consider current versus future earnings?” asked Nussbaum.
Sitting on cash after the crisis of a decade ago, he reminded, did little to add value. Today, the decision becomes about taking more current income (despite low rates) at the risk of future income.
“Do we have a framing of the problem that actually measures the trade-off between current and future income?” Nussbaum asked.
The Finance of Banking also includes, according to Nussbaum”
- Bond portfolio
- Asset liability management
- Core deposit assumptions
- Loan structure (maturity and optionality)
- Loan pricing (are all risks and costs properly prices?)
“The fundamental challenge in the finance of banking is how to compare unlike cash flows,” said Nussbaum, adding that CFOs must ask themselves, “How do I decide between a lower risk, lower reward opportunity versus a higher risk, higher reward one?”
What is ALM?
Just what is ALM? After sharing definitions found on a number of sources, Nussbaum settled on “Coordinating assets and liabilities to earn an adequate return (Investopedia) and the “balancing a bank’s current and long-term potential earnings with liquidity and appropriate IRR exposures” (the Fed). The latter is his favorite.
Nussbaum told the meeting he believes IRR should also be defined as “Interest Rate Reward.”
ALM, he said, is about measuring all the risk vs reward of assets and liabilities individually and in combination across a range of interest rate scenarios, comparing the tradeoff between current and future income? Do credit unions do that? Nussbaum said he believes the answer is no.
“Most of us practice ALC, not ALM: Asset liability compliance,” said Nussbaum. “We do ALM because we HAVE to. But I’m a geeky cash flow guy who believes we GET to ALM.”
It’s not a small problem, it’s a big problem, and if solved, suggested Nussbaum, it could mean millions of dollars in rewards to credit unions.
Two Primary Ways to do ALM
Nussbaum noted there are two primary ways to do asset/liability management:
- Net Interest Income (which measures short-term reward)
- Economic Value (which measures long-term risk)
“Are you as liability sensitive as your economic value may indicate?” asked Nussbaum.
Nussbaum noted credit unions model risk and reward on separate scales. “This makes it very difficult to measure the trade-off between the risk and reward. As risk is increased by one unit, is the reward increased by one unit, two units, or maybe only one half of a unit?
In other words, why is a credit union’s duration three years on an asset instead of five, and how does the credit union arrive at that? “You can’t measure risk over here and reward over there? You have to measure them together. We can marry income simulation and NEV and get a better framework for decision making,” said Nussbaum.
What really occurs in income simulation? According to Nussbaum, such simulations are for every asset over a time period, typically over one year. More rarely does that simulation go out two or three years, meaning the risk is not captured in any simulation, which in turn means the highest yield always looks most attractive. “That’s why the regulators have foisted this NEV on us,” explained Nussbaum, adding he still supports use of NEV.
The flaw in NEV as a decision-making tool is it’s just one point in time, said Nussbaum.
Arriving at a Better Answer
To arrive at the Scenario Total Return, Nussbaum said the income simulation must be married to the economic mode.
“Income simulation and economic value both have significant decision-making flaws. These flaws are causing us to lose quality, sustainable earnings,” he said. “Economic value counts all the cash flow, but over no time. No time means no income, which is why many users don’t’ fully embrace EVE (economic value example). The marriage of income simulation and EVE creates a total return that combines the best part of income simulation, time, with economic value, which counts all the cash flows, leading to a better decision-making tool.”