Western Banker - November/December 2016 - 16

Interest Rate Risk and ALM: Most Institutions Are Doing it Wrong '' continued Ultimately, institutions fail because they are unable to project risk inherent in the portfolio or prevailing market risk. Although financial models cannot completely insulate an institution from risk, sound modeling can greatly reduce the potential for catastrophic failure. refinance incentive is low for most newly originated mortgages. This may deter some institutions from taking the steps to calculate a more precise option value; however, capturing optionality is a critical component in the design of hedging strategies. Beyond offering the ability to perform intricate calculations to ensure more precise analytics, an advanced model provides an institution with significant management resources. In addition to interest-rate risk, financial depositories face credit and liquidity risk, as well as a multitude of esoteric factors. An advanced model will project credit losses for the life of a loan to estimate the credit risk inherent in a portfolio. These assumptions will also aid in projecting an institution's liquidity for a more holistic view of the major risks facing a depository. Sophisticated modeling software can also be used to estimate probability of rate movements, allowing balance-sheet strategies to be adaptive toward the market environment. Stochastic modeling uses Monte Carlo simulations (originally developed by gamblers) to project the path of interest rates through time. While these simulations are necessary to value optionality in a portfolio, Monte Carlo simulations can be expanded to provide an estimate of the progression of interest rates. With a well-calibrated model, the Monte Carlo simulations will project the path of interest rates over multiple iterations through time. This enables an institution to discern the assumed probability of a particular 16 www.wib.org Western Banker index increasing or decreasing a particular amount at a given time. The reliability of the Monte Carlo simulations in such cases is driven by the underlying assumption of the model. For example, assumptions ranging from the number of iterations each simulation performs to the model's volatility surface can influence the results of the simulation. Since assumptions can have such an impact on results, it is critical to frequently validate the model being used. If the underlying assumptions are deemed reasonable, an institution can use the results of the probability estimation to inform balance-sheet strategy to mitigate interest-rate risk. Reporting interest-rate risk is done through many metrics, but one of the most referenced metrics is effective duration. Effective duration is the price sensitivity of a security, given a change in underlying interest rates. However, the calculation for effective duration, while commonly referenced, has some flaws. The calculation itself is precise when the rate changes observed have only small variances. As market rates become more volatile, duration analytics lose precision. Another shortcoming of effective duration is the assumption that market rates move in parallel fashion, which can be a significant shortcoming when trying to develop a hedging strategy. Since rates rarely, if ever, move in parallel fashion and long-term assets can be sensitive to multiple points along a yield curve, key rate duration analytics are more appropriate '' to understand the true nature of a portfolio's sensitivity. Key rate duration reports each security's sensitivity along the entire yield curve by isolating each point along the curve and valuing the security as a single point is adjusted up and down. This results in a significant amount of processing time, emphasizing the need for a sophisticated model. With the resulting key rate durations, an institution can more efficiently hedge the balance sheet. Key rate duration analytics guide the institution to the appropriate notional allocation for interest rate swaps. By doing so, the balance sheet is better protected against parallel interest rate moves and changes in slope of the yield curve. Many factors can affect a depository's capital position, and interest-rate risk is only a single factor. However, it is one that may be mitigated with relatively greater ease than in the past and should not be overlooked. Instruments like interest-rate derivatives are more prevalent and accessible today than previous years. Such products are available as tools to manage an institution's interest-rate risk. The first step to hedging risk is to understand the depository's risk position. Understanding and trusting the accuracy of risk reporting will not occur unless a well-rounded ALM process is developed with a model that matches the institution's balance sheet complexity. ● About the author: Thomas Griswold is a director at ALM First Financial Advisors. http://www.wib.org

Table of Contents for the Digital Edition of Western Banker - November/December 2016

A Message from the President & CEO
Back to the Future to Manage Portfolio Performance
The WIB App Store
Managing Your Bank’s Reputation by Taking an “Inside-Out” Approach to Communicating News
Interest Rate Risk and ALM: Most Institutions Are Doing it Wrong
Everything Old is New Again — Updating FCRA Compliance in a CFPB World
Professional Development
Secrets to Employee Engagement for Bank Managers
March of the Millennials: Cultivating Relationships Within the Digital Generation
Welcome New Members
Index of Advertisers
Western Banker - November/December 2016 - cover1
Western Banker - November/December 2016 - cover2
Western Banker - November/December 2016 - 3
Western Banker - November/December 2016 - 4
Western Banker - November/December 2016 - A Message from the President & CEO
Western Banker - November/December 2016 - Back to the Future to Manage Portfolio Performance
Western Banker - November/December 2016 - 7
Western Banker - November/December 2016 - 8
Western Banker - November/December 2016 - 9
Western Banker - November/December 2016 - The WIB App Store
Western Banker - November/December 2016 - 11
Western Banker - November/December 2016 - 12
Western Banker - November/December 2016 - Managing Your Bank’s Reputation by Taking an “Inside-Out” Approach to Communicating News
Western Banker - November/December 2016 - 14
Western Banker - November/December 2016 - Interest Rate Risk and ALM: Most Institutions Are Doing it Wrong
Western Banker - November/December 2016 - 16
Western Banker - November/December 2016 - 17
Western Banker - November/December 2016 - Everything Old is New Again — Updating FCRA Compliance in a CFPB World
Western Banker - November/December 2016 - 19
Western Banker - November/December 2016 - 20
Western Banker - November/December 2016 - Professional Development
Western Banker - November/December 2016 - Secrets to Employee Engagement for Bank Managers
Western Banker - November/December 2016 - 23
Western Banker - November/December 2016 - March of the Millennials: Cultivating Relationships Within the Digital Generation
Western Banker - November/December 2016 - 25
Western Banker - November/December 2016 - Index of Advertisers
Western Banker - November/December 2016 - cover3
Western Banker - November/December 2016 - cover4
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