Pub. 6 2015 Issue 1

www.wvbankers.org 8 West Virginia Banker Conducting an Independent Review of ALCO Processes: Clarity from FDIC Jeffrey F. Caughron, Chief Operating Officer/Managing Director of The Baker Group LP, has worked bank- ing, investments, and interest-rate risk management since 1985 and currently serves as a market analyst and portfolio strategist. Contact: 800- 937-2257, jcaughron@GoBaker.com. By Jeffrey F. Caughron, The Baker Group LP O nce again, regulators are emphasizing the importance of sound interest rate risk (IRR) management systems and processes. The winter 2014 issue of the FDIC’s Supervisory Insights publication is dedicated almost entirely to the subject. It contains articles discussing specific IRR topics including key assumptions analy- sis for measurement systems, corporate governance processes, detail on examiner expectations, and a general framework of independent review of overall ALCO processes. This last subject, independent review of processes, has been a particular source of confusion for many bankers with respect to the exact scope and meaning of the guidance. The FDIC reminds us: “Banks are expected to monitor the effectiveness of their key internal controls either as part of the internal audit process or by means of an appropriate independent review, and the frame- work for managing IRR is no exception.” To this end, management should routinely review and assess the effectiveness of the bank’s policies, processes, and procedures for measuring and managing IRR. The findings of this assessment should be reported annually to the board of direc- tors. Notably, it is made clear that the review may take the form of an internal audit. The FDIC points out that there is no single template for a proper inde- pendent review. While a third party may be engaged to do the review, the FDIC specifically notes: “There is no requirement or expectation for a bank to hire a consultant, and most community banks should be able to identify an existing qualified employee or board member to periodi- cally conduct this review.” The article outlines five elements that give structure to the goals of an independent ALCO review. In particular, the review should assess the following elements: 1. Adequacy of the internal control system – are reasonable policies estab- lished and being followed? 2. Appropriateness of the risk measure- ment system – does the model capture necessary components of risk, given the complexity and characteristics of the bank? 3. Accuracy and completeness of the data inputs into the risk measurement system – is accurate data going into the model, and are key behavioral assumptions reasonable? 4. Reasonableness and validity of scenarios used in the measurement system – is risk to earnings and risk to capital adequately measured through simulation analysis and stress testing? 5. Validity of the risk measurement calculations – has the vendor secured validation of the math and methodol- ogy of the model itself, and have our bank’s prior reports been back-tested? Most of the five elements above address corporate governance concepts that are, of course, important. From the standpoint of proper measurement, however, the es- sential part of the independent review in- volves assessing the data and key assump- tions that go into the IRR measurement system (element number three on the list). Obviously, the raw inputs must be accurate and broken into enough detail to provide meaningful analysis. Data input should be checked to ensure accuracy when com- pared to source files or documents. This is the old “garbage-in, garbage-out” concern. As for key assumptions, an independent review should consider how reasonable and appropriate are those assumptions given the unique characteristics of the bank, its business model, its customer base, etc. For example, how competitive is our market, and therefore how aggres- sively might we need to price and re-price loans or liabilities when rates move higher or lower? This must be reflected in key be- havioral assumptions such as pricing betas or shift sensitivities. Finally, and very helpfully, the FDIC provides a sample step-by-step process for performing an in-house independent review of an IRR management system. The article in Supervisory Insights pro- vides a single page that lists eleven specific steps for management to use as a guide for designing an independent review. The publication and all of the IRR articles can be found on the FDIC’s website. n