July 8, 2010

Credit Union Management magazine’s Web-only “CFO Focus” column runs the second Thursday of each month.

Did you hear the one about how interest rate risk—improperly interpreted—can rapidly change into resume risk?

Bill McGuire, Ph.D., told this anecdote in his company’s recent Webinar, “ALM Model Verifications: Complying with 2010-1A IRR Regulatory Guidance and Uncovering Value.” McGuire is president/CEO of McGuire Performance Solutions, Scottsdale, Ariz.

The story goes something like this:

Credit union executives and members of the asset/liability committee need to make sure the model they’re using for their institution’s performance in various marketplace scenarios is pointing them in the right direction, McGuire related. Otherwise, the executives may be job hunting and the ALCO may lose its credibility with the board.

“I don’t want to be telling the board that everything is fine in a rising-rate environment when in fact we’re going to struggle,” he said. “I’d much rather have a situation where I’ve got that red forecast in hand and that I’m working on a way to protect the institution or a way to turn that around. An accurate ALM model is going to point you in the right direction; it’s going to accurately quantify the magnitude of whatever changes in earnings or value occur as interest rates change. And of course that creates a resume opportunity as opposed to a resume risk.

“If the AL model is not forecasting correctly (for example, predicting the exact opposite of what has usually happened in certain conditions), there’s always someone on the board that makes that correlation and has difficulty believing ALCO. Board credibility is a key component of ALCO success. We want to make sure we’re telling them the right things.”

Regulatory reasons to have a solidly functioning ALM model also exist. The new interest rate advisory published by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Financial Institutions Examination Council State Liaison Committee says financial institutions must work to have a model that’s making correct forecasts. Leaders of financial institutions must make sure the model is doing its job, including making sure it is set up correctly and being used with the correct assumptions in place

McGuire says he usually calls this process “model verification,” while regulators usually call it “model validation.”

“Whatever it’s called, it’s about modeling for success,” he said. “What is the chance that embedded in your ALM management model is an incorrect forecast that will lead to exposure to the deposit insurance fund or also, from a business perspective, create an exposure to earnings?”

Model risk is an issue because interest-rate-risk analyses are a big part of a balance sheet, he added. What comes out of the model has huge repercussions in terms of the institution’s indicated earnings at risk or equity at risk.

According to McGuire, model risk results when incorrect financial decisions are made based on faulty projections from a financial model. Unfortunately, a certain amount of model risk is present in all analysis and projection tools.

And this risk can easily become an issue due to complexity of models, production pressures and balance sheet evolution. Plus, staffing is rarely adequate in the area of financial institutions usually charged with ALM—an area that is considered a “cost center” by most institutions, McGuire noted.

Financial institution leaders have to watch model risk “out of the corner of our eye,” he said, encouraging attendees to carefully test their models (This column next month will launch a two-part series on how to certify and verify yours). “If we get any wrong model forecasts, that could constrain us from making the right decision or, worse, lead to surprises in earnings—and of course that’s surprises in capital.”

Lisa Hochgraf is a CUES editor.