ALCO In Practice: Essential Reports Analysis and Risk Management

So this can change it a little bit, but I'm going to lay out what I think is should be in a typical Elko 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 validations. 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 Elko packages out there, even though it's not in an exhaustive, all inclusive list.

1st, 1, credit unions operate in an environment out there. So somewhere within our Elko 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, and 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, there should be just some general economic information that shared across the committee, because they're going to be determining tactics. Thanks.

And while credit unions should not make huge bets on the economy, they do have to take a position and make reasonable decisions on how they're going to 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 going to go.

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 tactics? Do we need to change pricing if things aren't going as the board expects?

I'm a big believer in compliance dashboards and within this, there's lots of things. So there's key performance indicators, key risk indicators, 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 for them and that strategic plan.

You can get really carried away with these and maybe overburden the committee, but you also need to have enough where, what's going on with each of those risk areas in the organization and have a way to measure your performance against your strategic and business plans within those performance indicators. Risk indicators. 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 an outgo and even for boards of directors, and, we've talked about board governance before that these 1 spot where people can see them all in 1 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.

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 going to be deploying the funds available to us into loans and investments? How are we going to be gathering up those deposits? What's our risk of deposits leasing? What's going on with our borrowed money? Those become very important indicators.

And I'll just throw something else out here. Some ALCOs, they will get reports like this from various places, so they might generate an in house cash flow forecast. Their ALM vendor might give them another one. And you'll see some of this with interest rate risk reports too. They'll get them 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 going to be our decision making tool. We can use other reports as a model validation type thing and other source of information, but you do have to be careful that you have 1 version of the truth going on. We've seen clients written up for this, especially with.

In their loan portfolio and their credit risk management where 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. It's cashflow reports. Very important 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? Cardings typically don't do these every month unless you're really large but 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 2, 000 of them that are in a report?

No, but they do need to have a good general understanding of 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 ELCO should be actively involved in establishing change control procedures for those numbers.

Now it's an important piece and examiners will criticize credit unions at the ELCO level if they don't have a good Handle around what those model assumptions might be investment portfolios and see ways regulation lays out. Here's required investment reports. Typically those flow to Elko. It's pretty common for Elko to actually be the party that. Sets 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. Backtesting 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 want to have our loan portfolio be 60 percent real estate and 40 percent consumer?

Or do we want to be a business lender where it's 60 percent business loans and 20 percent consumer loans and 20 percent residential real estate? Those things make a difference, and credit unions 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 and 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 examiners ask credit unions 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've seen a 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 going to make money or make money under this. And that was way back in 1990.

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

Another key part of Elko, and sometimes Elko re delegates this, but I think Elko really needs to stay on top of it, and that's your pricing decisions support. How do we price our assets and our, and liabilities, and what are we going to use to base that pricing on?

Now, just about every credit union will have surveys of what competitors have for loan and share rates, but If you follow competitors, you're going to 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 on 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 costs and 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 that 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 it hit, a lot of the folks had problems is because they followed the market in terms of pricing loans and the entire market underpriced for risk. And do you want to 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, because pricing decisions, even through the last little bit here, when interest rates shot up, a lot of cratings got into some earnings. issues for a short period of time.

Most of them adjusted pretty well and have adjusted today, but there's 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 ALCOs, 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 weeds, 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.

But that's Todd Miller's take on ELCO and that they need to have. control of that credit risk assessment as well. Agendas in minutes are really a key thing and 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?

So I'm trying to see things not going the way they're at. And I okay, we'll just watch that for a while, but we're not going to change anything. Your minutes should really be transparent that you made that decision intentionally and did so for specific reasons. And I think a lot of places miss this. They have their agenda. They don't put a thought into it. I think trender 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. Really where you spend your time should get dictated by, where your risk is at and where your risk is going. So those are critical things to me.

And a lot of times when you get issues with examiners, questioning a credit union's 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's critical that you lay out in your minutes, your Elko minutes that we made these decisions for these reasons, and we weren't operating in a vacuum.

You can avoid a lot of issues with your examiners and 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 with the vendor. They end up in court because of accuso. 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 want to talk about model risk a little bit in line with the reporting, because a lot of what Elko's does and bases their decision on are based on forward looking models, be that cash flow forecast, interest rate risk models. All the 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 needed 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.

The second piece of this is model validations, and this happens in different places and different size credit unions, and 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 and different size organizations. The point I want to make is community members should be comfortable with the efforts made to validate their models. How frequently do we do it, within an organization from a governance perspective, 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 1 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 a 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, and CUA 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,

And when I get to my laptop, I need to forward this episode to my committee, et cetera, because 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 able if I hold it here, you can see I got two different pens. I got a black one and a red one.

And as you were talking on some things that I wanted to, I didn't want to interrupt you because I don't want to break your flow because that was fabulous, but I wrote a couple different things down that link to things that it triggered for me. I'm going to walk through. Some of those, I'm going to ramble with some of those and then you can pivot and see if there's anything that I said that that you want to respond to.

So you talked about, stress testing and, everybody's hearing that there's empty buildings and that's a type of commercial loan risk and that you need to have better tools that are doing stress testing. And I believe we've given guidance and, or NCOA.

Has criticized credit unions that when you're doing that stress testing, you don't want to just stress commercial over here and then stress real estate, residential real estate over here and then stress your visa over here and 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 want to 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 want to 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 document 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 and is what we've seen because people have come through this cycle and they have. Re evaluated what the reality is and then projecting that forward. And I'm going to get some of this wrong, but I think you're going to get the point I'm trying to make here.

But when NCOA asks you to do some backtesting, that backtesting sometimes will actually work the opposite of what NCOA 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 and a couple different points. We have a separate podcast on governance.

We are seeing NCUA almost link every examiner finding, maybe not examiner finding, but document resolution. If NCUA 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 another podcast.

It almost seems has done training on a national level or pointed out that they need to do this because 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 when I'm going back to when I was actually doing exams, you go in and so he doesn't do an audit. There's the supervisory committee or the CPA audit, but you'd have your regular trial balance. And, loans totaled up to 15. 24179 million dollars.

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 sometime where they where they're doing analysis and loss analysis.

And I don't want to name particular companies, but there are other vendors out there that will provide these other analyses. And we saw in some situations where an examiner said, Hey, you have all this ALM 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 it's purpose isn't to be that trial balance.

And. In that instance, we gave some guidance to this credit union that they might want to get those ALM reports as of April instead of 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 ALM reports be linked. And 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 added advantage of NSUA, 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, alright, that's 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 clarification or follow ups from what I said that you might want to add there?

It might be off a little bit from your accounting reports, and it's probably okay for them to be off a little bit, but examiners just want to reconcile things to the penny. And that's just. A waste of their time when you're in, a 1 or 2 or a 5 billion dollar organization, or even a 500 million dollar organization, but ratings themselves should have internal controls to reconcile these different reports and make sure they're appropriate reports here. People capital markets.

Who's ever looking at a lamb? 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 and your vendors, ALM 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 did happen once or twice, where there were material errors in an ALM model. And some of this was intentional on the part of the credit he not giving their vendor actually accurate information about items on their balance sheet. And see way tends to want to reconcile this stuff to the penny, because even though they don't catch very much fraud, it's usually caught.

or otherwise by internal audit or an employee writing out another employee, or caught by accident. But a lot of times when NCAA does catch fraud, it is because these reports don't reconcile or they'll see strange things they get their share alone 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 beef up sensitivity scenario analysis.

As an ALCO, 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, those core basic assumptions at all two very different purposes.

We go back to this credit modeling and you mentioned, we stress this credit portfolio, real estate differently from the consumer differently from the residential real estate and yeah, they're. But more and more, you're seeing 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 tests. Here's what the interest rate scenario is going to look like. Here's what the economy is going to look like. And those are very technical and very precise, but I think for a lot of credit unions, the scenario analysis and different concentration 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 they're. 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 optimally serve your members. You're going to need more capital than that regulatory capital in the real world. And as your competitors have more capital, you're going to need more capital to keep up with them.

Yeah, capital planning is Unnecessary part of every organization and, I can see a day where these required tests for 10 billion get moved down to credits at 5 billion and examiners are going to 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 it's 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 going to 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. It's just the 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? You

And then you'd go back and you'd look at in blue, 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 non sequitur to this, but all that color code made me think of that. So that made my heart smile.

All right, Todd. So what else as we wrap this up, is there any final thoughts you want to make relative to what we've discussed here?

And I guess that kind of leads to 1 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