The ongoing raft of bank failures and an evolving regulatory landscape have renewed the focus on balance sheet, interest rate, and liquidity risk management. In a recent series of webinars, experts from Moody’s Analytics covered a wide range of topics including investment portfolio risk, liability and deposit side risk, how to employ a 5-step balance sheet playbook to navigate the current market dislocation with greater efficiency and confidence, and best practices in developing an effective ALCO. In this article we summarize “How to Develop an Effective ALCO for the Future.”
The fourth webinar in the series focused on the importance of having an asset liability committee (ALCO) that is engaged and knowledgeable about the risks faced by their financial institution. Moody’s experts discussed the function of ALCO with respect to risk and return, looked at some sample agendas to help drive ALCO conversations that are focused on managing risk and balance sheet strategy, and provided an overview of some key tools and metrics that can be used to provide ALCO with a robust view of interest rate risk.
The role of ALCO is three-dimensional. First, the committee is responsible for proper governance, in terms of understanding the inherent risk of the organization, and establishing a policy framework that supports its risk appetite. Secondly, it is responsible for ensuring that such risk is measured properly and continuously, through a suite of approaches that may include EVE, and earnings at risk. Lastly, ALCO must ensure that such measurements and changes in risk trends over time are effectively and regularly reported and communicated to the board and other key stakeholders, through a set of comprehensive—but also transparent and meaningful—reports.
ALCO meeting agendas may take a variety of forms. For example, a traditional approach may be as follows:
- Section 1: fundamental analysis, including an economic and market review
- Section 2: IRR
- Section 3: Liquidity
- Section 4: balance sheet strategy
- Section 5: capital
Alternatively, some ALCOs take a return on equity (ROE) approach to the agenda:
- Section 1: economic market review and current ROE decomposition
- Section 2: Interest rate risk (IRR)
- Section 1: Balance sheet strategy
- Section 1: capital
- Section 1: ROE forecast
This second, more narrative approach begins with a discussion of where the firm’s ROE is in the present day, before delving into the individual components of return and how it contributes to the bank’s overall performance. This approach can often encourage a more targeted and inclusive conversation, by providing a focused risk lens with common goals that stakeholders across the organization can get behind.
When it comes to developing a well-functioning ALCO, the “art and science” of communicating risk to a broad range of stakeholders is at the top of the agenda. According to Moody’s experts, best practices include:
- Don’t expect all members of your board and ALCO to be risk management experts.
- The message can be lost in the numbers; make sure you explain scenarios, assumptions, and outcomes clearly.
- You don’t have to cover every area of risk in every meeting. Schedule different areas and methodologies on a rotating basis each quarter.
- Put your conclusions or recommendations in policy terms, to make it more concrete and meaningful for your audience.
- Keep the number of participants at a reasonable level, so ALCO is able to make effective decisions.
- Make sure to include business line leaders who have the power to affect change in your meetings. Deposits cover every area of the business right now, so these key managers should be part of the conversation.
Click here to watch the webinar replay.
For more information on how Moody's is helping financial institutions with balance sheet management, please visit our ALM page to learn more about the offering.
