Periodically on our blog we’re going to be posting Q&As taken from our longer podcast interviews. There’s a dual purpose to this. First, it gives you a sense of what was covered in the podcast, should you want to listen in to the full conversation there. Second, it serves as an alternative for those of you who prefer reading blog posts than listening to podcasts.
Today we’re revisiting our February conversation with Darnell Canada of the Darling Consulting Group (DCG), about Aligning ALCO with Loan Pricing. Remember, for the full conversation, you can access the original podcast.
Darnell Canada is a managing director at DCG, an independent solutions firm that partners with and advises over roughly 650 financial institutions across the country, specializing in asset liability management. DCG will hold its annual Balance Sheet Management Conference in Boston, June 6-7.
Having sat in on a lot of ALCO meetings, I’ve seen some that are very much just checking the box and saying ‘We have to do this because regulators required it of us and the examiners are going to ask for it.” Then there those that do a really good job of making that committee really the central strategy hub of the bank, really managing the overall balance sheet.
What we’ve tried espouse with our clients is, “This is a lot bigger a lot more important than just satisfying the needs of the stipulations from a regulatory standpoint. This is where you can make the most of your balance sheet in terms of driving performance.” More and more institutions over the course of time – this really accelerated after the ’08 crisis – made this transition. They said, “Okay these institutions can’t just be looking at models and the outputs of these models to understand what the picture looks like. There’s got to be a connection.”
That connection has to say, “Okay what does our profile look like? Do we like it, do we dislike it? How does it fit with what we’re trying to achieve and then how does that affect our decisions going forward?”
As banks have gotten more complex, I think we’ve seen a lot of the silo effect, where the loan group handles their own thing and the treasury group handles the stuff they manage and the deposit group, etc. I think that’s why we’ve seen so much focus from the regulators lately on this group, because it’s the one place where those silos should come together and as you say, where we make those connected decisions about how all the pieces of the balance sheet work together from performance and risk perspectives.
Have you noticed a change in actual “on the ground” regulatory expectations for your clients and if so what are the specific things they’re being asked to do now that they weren’t asked to do before?
It’s no longer sufficient to look at a small set of scenarios or look at one single isolated kind of analysis because, as we all know, with any kind of financial risk modeling there is a wide array of scenarios that can play out.
What tends to happen is that we pick a set of comfortable or normal scenarios and based upon those normal scenarios we might come to some conclusions as to what kinds of things make most sense for our balance sheet. What the reality is – and what we learned in 2008 – is that if things remain static for long enough, what becomes normal and the variety of scenarios that fall under the spectrum of “normal” starts to become more and more narrow. What that does is it begins to dilute our ability to identify what risks can actually do to our balance sheet, or how risk can actually metamorphosize our balance sheet.
If things become a little bit outside the norm they can have a material impact on our performance. Banks and credit unions now are saddled with analyzing data and analyzing a much greater number of scenarios. While this places a pretty good deal of burden and cost on the ALCO function, the C-suite executives really need understand that this is all for the betterment of the institution.
Again, it shouldn’t be viewed as a cost center. It shouldn’t be viewed as just another item we have to do because the regulators have nothing better to ask of us. It really does tie into how effectively we are able to manage our balance sheet.
The other part of it is the level of education within the organization and the expectation there. Banks and credit unions are expected to have a much deeper bench in terms of who knows what’s going on within the ALCO function and who understands the details of that process.
What we’ve seen in a lot of institutions is, even though loans typically make up the biggest share of the asset base, a lot of times they get a very small share of the ALCO agenda. That time tends to be dominated by discussions about funding strategies or what we’re doing with the bond portfolio.
What are some things that you all suggest when you come across that issue, to help banks and credit unions better incorporate the loan portfolio into that ALCO strategy and better connect those two things?
First and foremost, there has to be a dedicated effort to educate the staff. What we’re suggesting with a lot of our clients – and we’re seeing them do for themselves in many cases – is to bring in lending staff in particular to understand and to hear the kind of conversations that they’re having: Is it a good idea for us to put on fixed rate loans? Is it a good idea to originate and hold residential mortgages versus commercial real estate mortgages versus construction and development mortgages? A five-year loan might be acceptable where a seven-year loan isn’t. Why is that?
The other bigger strategic issue that banks need to really think about is the manner in which they’re developing the sales culture within the lending function. The banks that we see grow most successfully in volume and in spread and profit margin and in profitability and also in structure, are the banks that really have a dedicated sales culture. They have people who are out beating the streets developing business. But they’re doing so in a calculated and deliberate fashion.
They’re trying to understand the kind of business they should be looking for? All business, all customers, all borrowers are not the same. Some are consistent with the bank’s business strategy and some aren’t, and they may sometimes fit within the same loan classification or loan category.
When is it that we should be willing and able to say no to a borrower? What are the conditions under which a borrower is not a fit for our bank? A lot of banks suggest that they’re looking to build relationships, but what ends up happening is they end up executing on a lot of transactions and the relationships pass them by.
From that standpoint, how do lenders look at not only generating new business but also at how to retain that business? What are the needs and circumstances of the borrower that are going to make them want to do business with the lender on an ongoing basis? That helps that bank understand how to acquire new business but also, how to mitigate run-off.
One of the bigger things that’s starting to evolve right now since this rate movement is a pretty significant shift in the shape of the yield curve. Prepayment activity is again becoming a more frequent conversation we’re having with clients. Those that are at the greatest risk of exposure are the ones that haven’t established that relationship framework. Because the client is going to put them out to bid and look at them as more of a commodity, as opposed to a business relationship, where they have a certain need and they then look to the bank to say, “How can we work together to satisfy the need that I have right now.”
I love that approach of taking ALCO from not just talking about model results and getting way off into the weeds on specific assumptions, but instead really making that conversation more about that strategy. Not just what assets would we like to have on the books but how do we actually go about executing and getting those things on the books. That’s going to ultimately come down to things like strategy and pricing and marketing. It’s really big picture stuff that a lot of times banks don’t want to talk about that at the ALCO level, but that’s really where that conversation needs to start.
Absolutely, ALCO in it’s simplest form is nothing more than the tactical mechanism that allows the bank to execute on its longer term strategic plan. So within that framework, the bank needs to really understand and the staff, the business development staff needs to really understand what’s the value proposition of the institution. How do they develop a message that carries out to the marketplace that then allows them to do the things that they’re trying to do because you establish a paradigm shift from being a solutions provider to the clients that they’re looking to attain. As opposed to being a source for the lowest cost pricing that the customer would like to have.
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