Asset Liability Management (ALM)
A well-functioning ALM model should be the most current, complete and accurate source of information that can be used to understand how a bank makes money, yet most banks only use their ALM models to quantify their exposure to IRR (and possibly LR) in a way that is never truly reconciled with their internal earnings forecasting and earnings management processes.
At DGA, we believe that risk and profitability management are one in the same problem. To forecast and reconcile earnings with any degree of accuracy, it is mandatory that forecasters understand the internal and external forces which influence the evolution of earnings. If they do not acknowledge and understand these forces, how can they, or anyone else, truly have confidence in their forecasts?
IRR and LR are intrinsic to the business of banking. These are the risks to earnings and economic value associated with changes in market interest rates and the price of liquidity. In addition to explaining the nature of earnings and economic value changes, these risks also explain the level of earnings.
When most bankers describe how their firms make money, they tell you about the investment portfolio, lending, deposit gathering and other customer-related segments, but they almost never acknowledge the earnings that are associated with IRR and LR positions. In fact, their answers treat these risks as if they are inconsequential to the earnings generation process or they indicate a belief that their firms do not have IRR or LR. Neither of these is likely to be correct.
Why is this the case? Bankers and regulators have come to believe that IRR and LR are simply problems of the bank as a whole and therefore only need to be managed at this level. What this view fails to acknowledge is that if the bank has IRR and LR, then these risks must show up somewhere within the bank. If you are not acknowledging this fact, then you could be ignoring key drivers of earnings and earnings volatility.
At DGA, we can help you improve the quality of your IRR and LR measures by showing you how to link them to your earnings management processes. Of course, this will also lead to an improvement in the quality of your earnings estimation and management processes as it will reveal detailed sensitivities to IRR and LR. Our approach leverages a comprehensively-designed FTP process.
For more information on our comprehensive approach to ALM, contact us.