Fast forward almost 15 years and many institutions still find themselves struggling to present a fully integrated view of risk management to their asset liability committee (ALCO). The state of the economy over the past few years has heightened the need to manage balance sheets more and more carefully. But most financial institutions struggle to achieve a stress testing process that is efficient and effective. Managing capital risk, credit risk, liquidity and interest rate risk (IRR) are siloed processes with results that do not reconcile and can even contradict each other. A very real example is the recent concerns over Federal Home Loan Bank (FHLB) borrowing and the Federal Housing Finance Agency (FHFA) definition of capital in light of increasing unrealized Available for Sale (AFS) losses and potential negative tangible equity capital.
“Institutions have a reason to be concerned,” comments Carmen Gracia Caceres, Director, Advisory Services, Moody’s Analytics. “They are required to maintain certain levels of tangible capital in order to get access to FHLB borrowings. However, recent rate increases have resulted in declining tangible equity and banks may be denied credit from FHLBs, unless their primary federal regulator requests in writing that an advance be made or rolled over.”
To ensure they maintain access to FHLB credit, a number of bank associations have asked the FHFA (the FHLB regulator) to replace tangible capital with regulatory capital, or Tier 1 Capital specifically, as part of the FHLBs credit assessment criteria. This is important because many institutions are or will be facing liquidity pressures in the current environment. The change to regulatory capital from tangible equity will ensure they maintain access to FHLB borrowings, which is a critical source of liquidity for many institutions.
Tangible Equity Capital vs. Regulatory Capital:
• Tangible equity includes AOCI (accumulated other comprehensive income). AOCI is reflecting large unrealized losses on AFS investment portfolios and other balance sheet items from higher rates
Institutions should have been incorporating liquidity stress testing into their ALM practices for the sole purpose of ensuring their liquidity contingency plans have a waterfall-type of structure built in for those worst “what if” scenarios. For example, if an institution needs to access cash, most opt for the quick access to funds through an FHLB. There is also the option to enter into purchasing agreements with other banks or sell assets. As we are seeing in the current economic environment, these strategies can be problematic.
• Relying solely on the FHLB for funding, institutions have overlooked the capital aspect the FHLBs are considering when they are trying to assess an institution for lending. If an institution does not meet the criteria (i.e., the institution has very low or negative tangible equity), they are not qualified for borrowing.
• With rising interest rates, market prices of assets have most likely gone down. Therefore, selling assets in an unstable environment is not a viable option, as those assets would be sold at a loss.
Some institutions are seeing unrealized losses in their portfolios simply because they didn’t take time to fully run the risks – what could happen – across their whole balance sheet. When interest rates were low several years ago, banks and credit unions were dealing with low margins. Many sought to boost their margins by taking on more interest rate risk by going out long on curves so they could, in turn, get higher yields (e.g., long-term rates were higher than short-term rates). This made short-term earnings appear better in reports. By not fully running integrated risk scenarios, the risk of rising rates didn’t appear as troublesome. We now know by locking into very low rates for a long period of time, there is no benefit if rates move up. Therefore, the assets purchased when rates were low have lost value.
Had institutions done a deeper dive into their scenario forecasting when running their ALM processes a few years ago, when durations of assets were being extended, they would have realized the inevitable: rising rates would cause their equity and market values to deteriorate. This current environment shouldn’t be a surprise. ALM managers should have used their ALM processes to understand where the risk exposure could occur and what their market value and capital value would be in a rising rate environment similar to the one we are seeing today. They then should have planned for how their institution could proactively make changes to either hedge that exposure or make some readjustment of their balance sheet.
What should banks be doing?
• Review and test your liquidity contingency plans before you need liquidity.
While it is important for institutions to have liquidity contingency plans to ensure they have identified future sources of liquidity in times of need, it is more important to test those contingency plans to ensure the institution can really draw from the lines they think they have access to.
“Unfortunately, for some institutions, they are asking regulators for relief for a requirement that shouldn’t be a surprise,” comments Gracia Caceres. “Institutions should be using ALM processes to understand the risks they are taking and how they are going to be mitigating that risk. In the past, regulators and the Fed have changed some of the ways institutions had to compute the capital ratios, for example, after COVID. Though, keep in mind, COVID was an economic reason – a completely different justification for why a regulator would change the way capital is measured versus a stress event in a rising rate environment. Somewhat of a surprise, yes, though not entirely unexpected.”
While no one is completely sure how the FHFA will react to requests for a change in the tangible capital configuration, there is the risk if liquidity dries up, some institutions will not quality for FHLB borrowings.
What will the FHFA do?
• It is hard to tell. Regulators have provided temporary relief in the past, for example the Fed relaxed some capital requirements when covid started, and then let those expire as economic conditions improved.
An institution’s ALM and liquidity management processes should not be an “easy button” that serves a function to just check the boxes and get reports done. Institutions should:
• Review and test liquidity contingency plans before liquidity is needed.
• Make liquidity stress testing a priority, and integrate it with existing ALM processes.
• Revamp ALM processes and make sure the whole institution understands interest rate risk exposure. The large unrealized losses of today are the result of the interest rate risk taken by institutions a few years ago, extending asset duration to improve margins after a long period of low rates. The ALM simulations developed back then should have uncovered some of what the institution is experiencing today, so spend some time at ALCO reviewing and reflecting on those prior decisions.
• Keep an eye on the bigger picture. Credit risk is also a real risk in the current environment. Make sure to look at interest rate and credit risk on an integrated basis to capture the true outlook under a wide range of economic outcomes.
In short, use your ALM model to do what it was made to do: run the risks, perform integrated stress testing , look at the whole balance sheet, and develop risk mitigation strategies.
For more information about Moody's Analytics Balance Sheet Management Solutions, please visit www.moodysanalytics.com/ALM-US