How to Manage Your Risks
   Asset Liability Management and Portfolio Management
   
  By Kristina Muller, CFA, Senior Portfolio Manager, Balance Sheet Solutions, LLC

Here in the financial industry, we commonly say, “The market doesn’t pay you because it likes you.” To earn a yield in today’s market you need to assume some form of risk. These risks may vary depending on your credit union’s balance sheet and investment portfolio. In any situation, it is important to be aware of the risks you are assuming when making decisions on behalf of your credit union so you can best manage these risks from an overall perspective.

Asset Liability Management (ALM)
ALM can be challenging for credit unions because it necessitates that various risks be balanced while certain objectives are met. Understanding the different types of risk to which your credit union is exposed can make the process a little easier. One of the best ways to manage ALM risks is to run ALM modeling based on your risk profile. Through regular review of the modeling results, a picture of where your credit union stands in relation to the current interest rate environment can be obtained. Let’s take a closer look at a few types of interest rate risk modeling techniques.

Income Simulation
One form of modeling that can help manage interest rate risk exposure is income simulation. Income simulation examines the behavior of the income statement (given your credit union’s current assets and liabilities structure) under various extreme interest rate environments. As an example, if a large dollar balance of your members’ certificates of deposits were scheduled to mature within the current year without an accompanying amount of investments and/or loans, an income simulation model may show how your credit union’s net interest income could be negatively impacted if rates increased. Is the change in both the net interest dollar and percentage amount acceptable by your management and board? If not, you may need to take actions to shift this balance.

Net Economic Value
Another way to measure interest rate risk is by monitoring your credit union’s Net Economic Value (NEV) sensitivity. NEV attempts to identify the market value of your assets vs. its liabilities, assuming no change in interest rates and under various interest rate shock scenarios. 
Measuring NEV is especially appropriate for credit unions with complex and/or longer maturity assets such as fixed-rate term mortgages and callable securities. Because these types of assets have multiple variables that affect a credit union’s cash flow and accompanying market value, this more advanced form of modeling is preferred. Again, your credit union’s management and board are challenged to ask: Is the change in the dollar and/or percentage amount of our NEV reasonable or excessive? If the latter is the case, a repositioning of your credit union’s balance sheet might be in order. 

ALCO
Finally, there are several general steps that your credit union can take to improve its ability to monitor overall ALM risks. One step is to ensure that your credit union has a knowledgeable Asset Liability Management Committee (ALCO). 

The committee should be fully aware of ALM concepts, receive reliable and accurate information regarding your credit union, and have a good knowledge of both the local and national economy. The committee should serve as a guide to help management make wise decisions—those that will not place your credit union at risk. 

Another step is to verify that well-trained staff are producing the ALM reports. Data input should be verified by at least one staff member other than the input operator. Reports are only as good as the quality of the data used to produce them. Therefore, careful attention should be spent ensuring that the data is accurate. Furthermore, reports should be clear and understandable to all who are examining them. 

Portfolio Management
If the investment portfolio plays an important role in your credit union’s income flow, it is especially important to understand and monitor the risks to which your credit union can be subject. The number one rule for managing risk in an investment portfolio is diversification. A well-diversified portfolio should allow your credit union to weather different types of interest rate environments without suffering major portfolio losses. 

Since most credit unions are limited to purchasing only fixed income investments (not equities), they may be tempted to think that they are unable to diversify their portfolios like other investors. But credit unions can, and should, diversify their fixed income investments. Different sectors of the fixed income markets, including corporate credit union CDs, U.S. Treasuries, Taxable Municipals, U.S. Agencies, and insured credit union and bank CDs, vary in their performance based upon market conditions. By diversifying among these sectors, your credit union can move among the various investment groups as they become more attractive. One way to force diversification is to state in your credit union’s written investment policy the maximum exposure that your portfolio may have to any investment sector. 

The investment portfolio may be further diversified by the level of embedded option risk it contains in the form of callable investments. In a portfolio, this risk refers to the option that the investor has given to the issuer, for which the investor has been compensated in the form of a higher interest rate. This option enables the issuer to call back the security, subject of course to the terms identified in the security’s official statement or prospectus. This call option may be in the form of total or partial principal call. 

An example of a partial principal callable investment is mortgage-backed securities. With these types of securities, cash flows are dictated by the prepayment behavior of the underlying mortgages. Ensuring that the investment portfolio does not have excessive exposure to option-embedded risk is important. If rates decline, and if the investment portfolio has too much exposure to callable investments, your credit union will have excessive cash flows that it must end up investing in a lower interest rate environment. This was the case during 2000-2003. If rates rise and your credit union is relying on securities to be called, it may find itself with investments with actual effective maturities much longer than expected. This has been the case the last two years. 

As in the case for investment sectors, one way to ensure that the investment portfolio does not have excessive exposure to option-embedded risk is to document maximum limits in your credit union’s written investment policy. Recognize, however, that limiting call risk can come at the expense of reduced return in the short-run. However, longer-term structures should be rewarded with overall stronger performance.

Liquidity Risk

Finally, one additional risk that is often forgotten in the investment portfolio is liquidity risk. Speaking in investment terms, liquidity risk is the risk that your credit union will be unable to sell its investment in the market at a fair price when funds are needed. 

Several investments, particularly U.S. Treasuries, are highly liquid investments that can be sold immediately at fair prices. Because the quotations are widely available, the pricing is highly efficient. Your credit union can sell such investments today and have the proceeds tomorrow (subject to gains or losses depending on the market movement from the time it was purchased). 

Other investments, such as insured credit union and bank CDs, may charge hefty penalties if they are redeemed early. It can also take several days before you receive your funds. Recognize that the dollar size of investments sold may also impact the price received. Most often the standard quotation seen is for $1 million investments. If your credit union is selling less than that, the price could be considerably lower than the standard quote. 

With any investment decision, it is important to fully understand the investments purchased and know the risks involved. If your credit union needs to liquidate some investments because of unexpected cash demands, it might be prudent to maintain a minimum percentage of highly liquid assets. That being said, this assumes that your credit union has designated these investments as available for sale (AFS) for accounting purposes.

Conclusion
Managing risk is not an easy task, but attempting to balance some of the risks at your credit union should provide some peace-of-mind for your management and board. The key is understanding the risks involved with any investment vehicle you purchase, and monitoring those risks regularly to ensure you are not placing your credit union at undue exposure.