ALCO In Practice: Essential Reports Analysis & Risk Management

So, Todd, last week we discussed Alco governance essentials and building an effective committee structure, who should be on the committee, et cetera, et cetera. Now we're gonna pivot to a LM or ALCO reporting and, you know, policies, et cetera. So with that, I'm gonna give you free reign to share your wisdom. So this should be all laid out in policies.

I'm gonna go through some general things and, um, that I think should be part of most ALCO report packages and part of most al alcohol's functionings. This shouldn't be intended to be an inclusive list, that this are the only things you need. If you wanna add other reports, feel free to do that. Some of this is how do you lay out your business plan and how does the board lay out performance, key performance indicators and key risk indicators.

So this can change it a little bit, but I'm gonna lay out what I think is. Should be in a typical Elco package, and some of what I lay out here might not be in the package every month. It might be in once a quarter. We'll even talk about model validation is that might only have to occur a couple times a year, but we'll go through just some general things that I think should be in most Elco packages out there, even though it's not in an exhaustible inclusive list.

First one, credit unions operate in an environment out there. So somewhere within our Elco and our organization, we should have some basic economic data that we're keeping track of what's going on nationally and more important what's going on locally when, especially with managing credit risk, what's happening in our local housing market? If you're a business lender, what's happening in our local commercial real estate market?

What are employment trends within our local area and our fields of membership? Um, there should be just some general economic information that's shared across the committee because they're gonna be determining tactics, strategies, and well, credit union should not make huge bets on the economy. They do have to take a position and make reasonable decisions on.

How they're gonna operate their lending and investment programs, their deposit gathering programs, and that's going to be influenced by their local economic factors or their expectations of which direction the economy is gonna go. And you, you can't really manage any risk out within the organization unless you have some basic information about your financial statements and your budgets and how are you doing on budgets and comparisons. Along that line, they're the biggest ones that responsible.

How do we address variances in our budgets? Do we need to change strategy? Do we need to change topics? Do we need to change pricing if things aren't going as the board expects? I'm a big believer in compliance dashboards. Um, and within this, there's lots of things. So there's key performance, syndicators, key risk indicators. NCA gives you an exam report. It has key ratios.

I do think each board, as they lay out their business plans, they should lay out what are the key performance indicators and key risk indicators bring down. And that strategic plan, you can get really carried away with these, uh, and maybe overburden the community, but you also need to have enough what's going on with each of those risk areas in the organization and how the way to measure your performance against your strategic and business plans within those performance indicators and.

I'm a big believer that especially concentration risk is important for most organizations, and I think a lot of organizations, they will have these types of ratios, but they're spread out. I really think to be effective with analco and even for boards of directors, and we've talked about board governance before, that these compliance numbers really need to be put in one spot where people can see them all in one place. Liquidity reports and there's different kinds of liquidity reports.

A lot of people use historical measures for liquidity, and I think that's fine for compliance purposes. Uh, for an ALCO type, someone who's responsible for managing liquidity and interest rate risk, they need cash flow forecasts. And especially they need to be looking at them out there three to six months from now, how are we gonna be deploying the funds available to us into loans and investments? How are we gonna be gathering up those deposits?

What's our risk of deposits losing what's going on with our borrowed money? Those become very important indicators Then. I'll just throw something else out here. Some alcoves, they will get reports like this from various places. Well, they might generate an in-house cashflow forecast. Their A LM vendor might give them another one. And you'll see some of this with interest rate risk reports too. They'll get 'em from multiple vendors.

I'm a big believer there needs to be one version of the truth though in the organization. And which of these reports are you going to use? It's not, let's use this one today. This other one tomorrow, which everyone makes us look good. Let's lay out in policy, which of these reports is gonna be our decision making tool. We can use other reports as a model validation type thing, another source of information. But you do have to be careful that you have one version of the truth going on.

We've seen clients written up for this, especially with in their loan portfolio, in their credit risk management. They have different systems giving them different versions of the truth. What does that say about your organization when you have different versions of the truth? It's not looks well, it doesn't necessarily look very well when you have different versions of the truth Inside the organization is cashflow Reports very important. Uh, interest rate risk reports.

This is traditionally the role of the alco. How, what does our net interest income and what does our NAV numbers look like under various scenarios? Card unions typically don't do these every month unless you're really large. The quarterly is quite common along the lines with the interest rate risk report at the elco level. Elco members need to have a good general understanding of the model assumptions in those reports. Do they need to see all 2000 of 'em that are in a report?

No, but they do need to have a good general understanding which assumptions move the numbers the most, and at least occasionally they need to have some good documentation of what those numbers and those assumptions look like. And that Alco should be actively involved in establishing change control procedures for those um, numbers.

It's an important piece and examiners will criticize, uh, credit unions at the Elco level if they don't have a good handle around what those model assumptions might be. Investment portfolios in C'S regulation lays out here is required investment reports tickly those flow to Elco. It's pretty common for Elco to actually be the party that. Step's investment strategy inside that business plan. Based on other things that are going on.

There should be some good reports related to that whole investment portfolio and their analysis. Another piece of this, and credit unions will hear this all the time from examiners. They want scenario and sensitivity testing of their models back testing of liquidity models. I think that scenario and sensitivity analysis is an important piece of this.

Like I said, members of the Alco committee, they should know which variables will move these numbers the most and which ones they need to pay attention to in terms of their member behavior. The scenario analysis, it's really important for your capital planning and building your whole strategic plan. What does our results look like if A happens or if B happens? Do we wanna have our loan portfolio be 60% real estate and 40% consumer, or do we wanna be a business lender?

We're it's 60% business loans and 20% consumer loans and 20% residential real estate. Those things make a difference and credit union need to build those into scenario analysis. What happens if. What happens if all these CDs that we've gathered up in the last couple years walk back out the door, we can't replace them. What happens if our whole deposit structure changes? Those types of things should be laid out in scenario analysis, especially as we're building up our business plans.

Increasingly, we're seeing, and the examiners ask credit ease to stress test their loan portfolios. This is a new thing. To credit unions, it's not a new thing. In fact, the first time I seen the stress test was way back in the 1990s. They had an egg lender where they had an in-house database where they could actually just change the price of commodities and it would spit out, here's all your farmers that were not gonna make money or make money under this. And that was way back in 1990.

Um, so it's not a new thing, but it's new that examiners are increasingly. Asking credit unions to do these stressed and scenario analysis on their loan portfolio, especially if they have concentrations of number business loans, because everyone's reading that commercial real estate buildings are empty or less full than they used to be in certain markets though. But scenario type of testing and analysis, it informs your decision making in a very positive way.

Another key part of Alco and sometimes Alco delegates this, but I think Elco really needs to stay on top of it, and that's your pricing decisions, support. How do we price our assets and how are and liabilities and what are we going to use to base that pricing on? Now just about he, Carine will have surveys, what a competitors have for loan and share rates, but. If you follow competitors, you're gonna get their results and their expenses and capital might be very different than yours.

So I think you need just a little bit more than that, and it's where, here's an analysis of the yields and returns and our loan portfolio. Here's analysis of our cost of funds, here's our analysis of our borrowing and deposit structure. You don't see this very often, but I think it's very critical is what's our marginal cost. In marginal yields so many times as a problem, case officer and a director of special actions, you get into institutions that have earnings problems.

And what you really find out is they've mispriced things, they price things to meet the competition, but it doesn't meet the needs of the institution. And if you go back to the last recession in 2008 before Covid hit. A lot of the folks had problems is because they followed the market in terms of pricing loans in the entire market. Underpriced for risk, and you wanna have control of that decision or not. And cost accounting systems come into this.

It really depends on size and complexity, but in general, you need a good pricing decision, support set of reports, whatever that might be for your organization that you need to understand. 'cause pricing decisions, even through the last little bit here, when interest rates shot up, a lot of card unions got into some earnings issues for us short period of time. Most of them adjusted pretty well and have adjusted today.

But there are still some that are still having some challenging issues with earnings because they made poor pricing decisions in the past. Before that even hit. This isn't in all Alco, but I do think more and more it's becoming a big piece of Alco is they need a comprehensive set of credit risk management reports. Now, do they need to be having discussions at Alco about individual borrowers? No. Should they have a general idea of what's going on in their loan portfolios? Absolutely, yes.

How do you build that out so you don't cross the line into getting into the weaves, so to speak? That becomes an individual credit union's kind of challenge, but I do think in general it's very hard for a credit union to manage liquidity and interest rate risk without assessing credit risk. I just don't see how you can manage those two without having a handle on credit risk. Are you worried about an NCUA exam and process or looming on the horizon? Don't face it alone.

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We're here to ensure your credit union passes your exam with flying colors. Contact Credit Union Exam Solutions today to learn more about our services and how we can help your credit union succeed. But that's Todd Miller's take on Alco and that they need to have control of that credit risk assessment as well. Agendas and minutes are really a key thing. The way I would lay out, what does your agenda in minutes do and what should they accomplish? They should make it really transparent.

What you're using to make decisions, the decisions you made, why decisions were made. And if you've got adverse trends, why are you not doing nothing about it? Some credit, ENC, things not going the way they're on. And I, okay, we'll just watch that for a while, but we're not gonna change anything. Your minutes should really be transparent that you. Made that decision intentionally and did so for specific reasons. Um, it, I think a lot of places miss this. They have their agenda.

They don't put a thought into it. I think trend reporting is a big piece of this in getting it right. We have one, we have more than one client. They'll rate their risk categories and you should put that on the agenda. Liquidity risk this month, right on the agenda. Moderate, increasing, moderate, stable, high, increasing, high stable. Like really where you spend your time should get dictated by where your risk is at and where your risk is going.

Uh, so those are critical things to me and a lot of times when you get issues with examiners question, questioning a credit union decision. It's because as they go through their exam process and they read your minutes and they look at your reports, it's not clear and transparent to them what decisions you made and why you made them. So it, it's critical that you lay out in your minutes, your alco minutes that we made these decisions for these reasons we weren't operating in a vacuum.

You can avoid a lot of issues with your examiners. From a board governance perspective, it should be clear and transparent. So if your board picks up these minutes and looks through it, they should be able to understand why you did what you did with the authority they've given you as well. So you don't do it just for the examiners, you do it for the benefit of the organization, and it's the way you keep everyone on the same page. It's really unfortunate. There's a few times.

We've been involved with credit unions that end up in court and with the vendor. They end up in court because of a qo. They end up in court because of some investment. Broker did something to them and you start deposing people and it's, they don't remember why and they look at their own minutes and it's, why did you do that? I don't remember. I don't know. That's really not a good place to be in as an organization when you don't understand why you made the decisions you made.

So that kind of covers the reporting. I just wanna talk about model risk a little bit in line with the reporting, because a lot of what Alco has done, does and bases their decision on are based on forward-looking models, be that capital forecast, interest rate, risk models, all this scenario stuff we talked about in sensitivity testing. Those are all done as part of forward looking models, credit stresses on your loan portfolio. That's all models.

Model risk is something that is a challenge for everyone. I do think for Alco committees, committee members need a general understanding of key assumptions In all of these models, if they're basing decisions on them, they should have a basic understanding. Do they need to be an expert on the model and know everything? No, but they should have a good general understanding. Um, the second piece of this is model validations.

And this happens in different places in different size credit unions on some really large credit unions. It's a whole separate function of internal audit and the ERM process. In smaller credit unions, it actually falls a lot of times to the Alco committee itself to validate their own models, and sometimes it's even down to the finance department to just validate their own cash flow forecast. It doesn't really.

There's right, there's different answers to who handles model validation in a different size organization. The point I wanna make is community members should be comfortable with efforts made to validate their models. How frequently do we do it within an organization? From a governance perspectives, it can be happening in different departments and be driven by different people, but at the end of the day, the folks using those models to make decisions should be comfortable.

With what their organization has done to validate those critical models and make sure they're accurate. That covers most of what I have to say. I think that gives people a good general understanding of things. Maybe any one of these days, you can get another person to do a podcast just on the whole credit risk reporting piece of it, because it can be as big as the other pieces. And I think it's an ever-growing important piece and we see more and more examiners.

Want justification for concentration risks, whether that's in your investment portfolio, loan portfolio. NCUA hasn't really talked about liability concentrations, but I guarantee you it will be coming in the future on their part as they get comfortable with their whole concentration risk on the asset side of the balance sheet today.

Todd, as you're talking through that, I'm envisioning a couple d, you know, different listeners, not specific people, but someone out for a walk listening to this on their iPhone versus someone sitting at their laptop versus someone driving in their car and they're you. You had so much information packed in there. I know that some of the listeners are gonna go, when I get to my laptop, I need to re-listen to this and I need to take some notes.

And when I get to my laptop, I need to forward this episode just to my committee, et cetera. 'cause there was just tons of information there. I wrote a lot of different things down. And the listeners can't see this, but you might not even be, if I hold it here, you can see it. I got two different pins. I got a, a black one and a red one. And. As you were talking on some things that I wanted to, I didn't wanna interrupt you 'cause I didn't wanna break your flow 'cause that was fabulous.

But I wrote a couple different things down that linked to things that it triggered for me. I'm gonna walk through some of those. I'm gonna ramble with some of those and then you can pivot and see if there's anything that I said that that you wanna respond to. So you talked about stress testing and everybody's hearing that there's empty buildings. And that's a type of commercial load risk and that you need to have better tools that are doing stress testing.

And I believe we've given guidance and or NCUA has criticized credit unions that when you're doing that stress testing, you don't wanna just stress commercial over here and then stress real estate, residential real estate over here and then stress your visa over here. Then stress your deposits over here. There needs to be some sort of cascading effect where you might, you might stress two factors or three factors. That was one thing I wanted to mention.

And there we, I also wanna mention that we have a separate, you and I did a separate podcast. With the sole topic of model risk. And so if someone is listening and you wanna hear more about what Todd said relative to model risk, I think we probably have a 20 or 30 minute podcast that we did specifically on model risk scenario and sensitivity analysis. I think if I'm linking this right to some of our conversations.

We've had situations where a documented resolution or an examiner finding was given to a credit union where they said that you need to update those and you need to be reevaluating those things and careful what you ask for in CA is what we've seen because people have come through this cycle and they have. Reevaluate, uh, what the reality is and then projecting that forward. And I'm gonna get some of this wrong, but I think you're gonna get the point I've trying to make here.

But when NCA asked you to do some back testing, that back testing sometimes will actually work the opposite of what NCA thought and your assumptions might. Show that your deposits are more sticky. So that's something that I wanted to throw out there to governance. Many of these things, if any, NCA, you hit on governance at a covered couple different points. We have a separate podcast on governance. We are seeing NCA almost link every examiner fighting.

Maybe not examiner fighting, but document resolution If NCA is unhappy about something that happened since the last exam. They seem to always now link it back to corporate governance, which makes some sense in most instances. But it just impresses upon me that the corporate governance is even more important that it's ever been. I've said in another podcast, it almost seems like it's done training on a national level or pointed out that they need to do this 'cause we're seeing it so consistently.

And then here's my last comment and then I'll let you respond to any of these that you might might want to What? Going back to what I was actually doing, exams, you go in and. NSU A doesn't do an audit. There's the supervisor committee or the CPA audit, but you'd have your regular trial balance and you'd loans totaled up to $15.24179 million, and you'd compare that to the regular loan trial balance. Then you'd have the visa trial balance, which was different.

Then you'd have the commercial loan trial balance, which might have been different. Then you might have the real estate loan trial balance, and then on top of that, you've got these. Big systems that credit Union seems to have some time where they, where they're doing analysis and loss analysis, and I don't wanna name particular companies, but there are other vendors out there that will provide these other analysis.

And we saw in some situations where an examiner said, Hey, you have all this a LM stuff that says that this loan type is X at the end of March and it's off by. $4,000 on a multimillion dollar program because its purpose isn't to be that trial balance. And in, in that instance, we gave some guidance to this credit union that they might wanna get those a LM reports as of April instead of as, as of March, so that the examiner doesn't try and link it back to their call report.

And there's no requirement that those a LM reports be linked. I think you might have said, even you've seen some situations, so there's a lot of workload tied to that for that vendor. The vendor might give you a discount. Not only do you have the avid advantage of NCA, not trying to link it to something that it shouldn't, and that doesn't happen that often. That was really more of a one-off, but all right.

Those are the brain dump of what I wrote and read on different things I wanted to mention relative to the notes I have here. Did that any of that trigger any, uh, clarification or follow ups from what I said that you might want to add there? I think I'll respond to all of them just briefly and we will do the last one first. Balancing reports, and this is back to my one version of the truth type thing. You do need within your organization processes to reconcile reports.

Now, you might run credit risk, things that might be done at a mid bunt or not a quarter end. You built this workflow in there and most organizations now have large data warehouses. Information is lodged in a couple different places. It might be off a little bit for ER accounting. Reports, and it's probably okay for them to be off a little bit, but examiners just wanna reconcile things to the penny.

I mean, that's just a waste of their time when you're in a one or two or a $5 billion organization or even a $500 million organization. But Freddy and themselves should have internal controls to reconcile these different reports and make sure they're appropriate. A LM reports your a LM people capital markets. Who's ever looking at a LM? Uh, I always looked at them and tied them to a balance sheet. The, these roughly look good.

Okay. Within, and this happens almost all the time within your loan type codes in your vendors, a LM type codes. Sometimes things just don't map exactly. Small errors never bothered me. Simple things were investment securities where you know exactly what the balance is on exactly that day. Those should tie exactly every time, and it didn't happen often in my career, but it, it did happen once or twice where there were material errors in an A LM model.

In some of this was intentional on the part of the card, not giving their vendor actually accurate information about certain items on their balance sheet. NCUA tends to wanna reconcile this stuff to the penny because even though they don't catch very much fraud, it's usually caught other ways by internal audit or an employee writing out another employee or caught by accident. But a lot of times when NCUA does catch fraud, it is because these reports don't reconcile.

Or they'll see strange things as they get their share loan download, and that's not tying with a general ledger or there's a. Funky account within that trial balance that's been used to hide errors. So that's why MCUA is sensitive to that issue is because the frauds they have caught, it's been caught for that reason, not the point of our thing here today. We'll go back to sensitivity scenario analysis. You see this a lot in exam reports. They want you to beep up sensitivity scenario analysis.

As an Elko though, you need to keep in mind those are two totally separate things, even though examiners often use the words interchangeably. Sensitivity analysis is about determining which factors move those model results the most and which assumptions move it the most. Scenario analysis, you're trying to figure out what could or might happen under different conditions. It's not related to you. Those core basic assumptions at all two very different purposes.

We go back to this credit modeling and you mentioned where we stress this credit portfolio, real estate, differently from the consumer, differently from the residential real estate. And yeah, they're done differently, but more and more years theme for credit unions to really justify their capital adequacy. They're almost going down to a capital planning path. And so you get into the ones credit unions and they're over 10 billion.

They're required to do this combined stress test and the Federal Reserve even sets the conditions for those stress. And here's what the interest rate scenario's gonna look like. Here's what the economy's gonna look like. Um, those are very technical and very precise, but I think for a lot of credit unions, the scenario analysis and different conation levels.

They can do that on a less precise way and probably need to do a combined analysis of some of these stresses to determine if their capital is adequate. You have regulatorily required capital levels. The reality is in many marketplaces, and depending on the way your balance sheet structured is those regulatory capital levels are probably not sufficient for you. To be competitive and optimal. You serve your members, you're gonna need more capital than that regulatory capital in the real world.

And as your competitors have more capital, you're gonna need more capital to keep up with them. Yeah. And capital planning is a necessary part of every organization. And. I can see a day where these required tests for 10 billion getting moved down to credit unions at 5 billion, and examiners are gonna start wanting people at 1 billion to do it, even though the reg might not require it.

It's just an evolution that examiners go through where best practices, they tend to filter it down to smaller and smaller organizations, and I don't necessarily see that as a bad thing in many ways. It's a good thing. And I just started out the whole thing. Large organizations have committee charters and small organizations put it in policy, and I said, even these small organizations, you should think about having committee charters. So it's just a natural evolution of things.

So I think more and more you're gonna see examiners push organizations of all size to go to a comprehensive capital planning type, and we help people out with some of that. You see it consistently in exam reports. They want support for concentration risk, which is really another way to say, prove you have enough capital to do this, which is the, uh, other side of the coin. Which words do you use? Prove you have enough capital or prove you can support your concentration risk?

It's the same question, just different sides to it. Did I hit all the points you had written down there and you did. You did fabulous. Yeah. You hit 'em all. I have different color pens too and I have notes and I always say I'm gonna check off on my notes when I address something. But I get talking and I never do. So I make and then I just don't really look at very much star he are podcast that, that just makes me smile too. 'cause it reminds me of my dad.

I used to go to a lot of race horse races with my dad. He had the daily racing form and he had four different colored highlighters and he had three different colored pens and everyone meant something. And then you'd get there, you'd do all your handicapping, which is almost as fun as going to the race. And then you'd get there and you'd see the odds and you'd do something different.

Then you'd go back and you'd look at in blue, he, he said he wanted blue as his top horse, for example, in each race. And then you only went with that like half the time. You'd go home and you'd do the debrief of the, all that color coding and, and you'd realize that you were onto something you just needed to follow with your convictions and the assumptions you had going in. So that's a total sack word to this. But all that color code made me think of that. So that made my heart smile.

Alright, Todd, so what else as we wrap this up, is there any final thoughts you wanna make relative to, to what we've discussed here? No, I think we'll just go reiterate something at the beginning. There's no one right answer for all of this that you're trying to accomplish the same general things, but really you make all this fit in work within your corporate culture. It's all part of your corporate culture. You build this around the knowledge, skills, and abilities of your staff and.

A good reason to do this and have this in a very formal way is it improves the knowledge, skills, and abilities of the rest of your staff. And I guess that kind of leads to one thing that examiners do bring this up occasionally, is it's important to continue the training of all your staff. That they have ongoing training and various areas that they're responsible for listening to our podcast as part of that. But um, that's right. That's right.

That is an important piece for and be members, and it's an important piece for any organization that you dedicate resources to improving those knowledge, skills, abilities of your staff members. Fantastic. This is gonna be an instant classic episode. I got a feeling that, uh, that people are again, gonna wanna listen to this more than once. There's a lot of really good advice and counsel in this and I, I wanna thank you for your time today, Todd. It was my pleasure, mark. I enjoyed doing these.

These are fun. These are very fun and listeners, I want to thank you for listening. I hope you'll listen again soon. This is Mark TriCal signing off with Flying Colors.