Aligning Key Systems and Management Structures to Maximize Value

Management information systems (MIS) have been developed for almost every aspect of banking. The three most important of these systems are asset/liability management (ALM), planning and profitability. We will look at how properly synchronizing them will benefit bank management, directors and shareholders.

The core purpose of ALM systems is to quantify and manage interest rate and liquidity risk. The dramatic interest rate changes following deregulation in 1980 wiped out the savings and loan system and created ALM systems and asset/liability committees (ALCO). Today’s ALM systems are the single best management tool available to executive managers and boards. Regulators require banks to manage interest rate risk and directors should be advised of the bank’s interest rate and liquidity risk position and options for mitigating those deemed excessive.

Modern ALM systems are incredibly fast and granular and can calculate hundreds of interest rate scenarios. Ad hoc scenarios can be created and analyzed on the fly, literally during ALCO meetings. Granular attributes of each instrument are included in the calculations, including prepayment assumptions, caps and floors. By quickly running many scenarios, management can select the most likely scenario to achieve the required income goals.

The main drawback with ALM forecasts is that they are run at the top of the house and are not efficient when running scenarios in a disaggregated manner. Disaggregated forecasts are best run in the planning system.

Modern planning systems utilize granular cash flow engines like ALM systems, some using the same engine, and generate income simulations on a disaggregated basis. Unlike ALM systems, planning systems typically run on one market scenario which can be quickly recalculated at granular department or business unit levels. Modern planning systems utilize the same market scenario from the ALM system, which are the weighted averages of the entire bank. Business managers can adjust these assumptions to reflect their individual markets, thus producing more accurate income simulations at more granular levels.

It should be noted that these forward-looking assumptions are what the ALCO committee expects to happen and those in the planning system are what business unit managers want to happen. These expectations and aspirations quickly become wrong guesses and wishful thinking. To adjust for these changes, equally granular reporting of actual results is required, which is what profitability systems provide.

The double entry ledger system was the first profitability reporting system and still provides the basis for modern profitability systems. Since general ledgers report aggregated income and expenses, they cannot provide granular reports showing who, what and where the deviations from the budget or forecast are occurring. Modern profitability systems are designed to provide this level of granular reporting.

Profitability systems adjust generally accepted accounting principles’ general ledger reports by adding funds transfer pricing, assigning direct and indirect expenses and assigning capital on a risk adjusted basis at the instrument level. These adjustments enable managers to determine if pricing covers the value of the dollars exchanged, the operational costs of each instrument and the capital consumed due to the risk of the counterparty, product, market and other factors.

In short, profitability systems reveal where and why changes creating material deviations from the ALM and planning forecasts are occurring. These revelations inform ALCO to run revised scenarios identifying how the bank can adjust and achieve its income, return on equity and earnings per share goals. These new market assumptions can then be utilized in the planning system so each business unit manager can create a revised plan to achieve the unit’s income goals.

By synchronizing these three systems to work together and inform each other, they enable the various management, risk and pricing committees to coalesce into a single performance management committee with representation from other key committees. The knowledge each member brings from their area of expertise is informed by the profitability system. This informed expertise enables more realistic ALM scenarios to be created and vetted during ALCO meetings. The most likely ALM scenario can then be pushed down to business unit managers so they can revise their plans and achieve their individual income goals.

Markets and economic conditions change quickly within each fiscal year. Synchronizing these three critical systems and your bank’s management committees empower board members to understand what is driving the changes to net income, where changes are occurring and what can be done to mitigate problems and maximize your bank’s value. Many banks have adopted these system and committee changes, and reaped significant rewards. If your bank has not, you should ask the management team to investigate them.