At just about every banking conference we attend, Asset Liability Management and the Asset Liability Committee (ALCO) that handles that task are hot topics. Understandably so. It’s critical that banks proactively manage their balances appropriately. This is and should be a strategic imperative.
There are lots of speakers, breakout sessions, workshops and vendors all promoting various aspects of this important function. However, we’ve noticed that much of the discussion tends to be focused on the liability side, or “L”, side of the balance sheet. So much so that it often seems like bankers are talking about an LCO instead of an ALCO.
Even when there is some focus and discussion about the asset side of the balance sheet, it ends to center around the bank’s investment portfolio. That’s not a bad thing – the investment portfolio is also critically important to a bank’s ALM success. But the investment portfolio is really more of the lower case “a” in ALCO.
(Source: FDIC)
The big “A”? That‘s the bank’s loan portfolio. It’s the largest asset class on the balance sheet of most commercial banks, and as an industry, loan income makes up over 50% of total revenue. Yet the loan book is often relegated to a few slides toward the back of the monthly or quarterly ALCO deck. It’s not analyzed with a great deal of rigor. Nor is much thought given to the strategic levers that drive this large asset class.
Say it loud and it sounds pretty absurd. “The loan book generates the bulk of the revenue for my bank and we spend almost no time discussing it.”
So why don’t banks give the big “A” the time and attention it deserves? Here are a few insights we’ve gleaned:
- ALCOs almost never include anyone in a senior role from lending. Typical ALCO members are treasury, finance and accounting folks. Many of these personnel don’t have enough insight into what it takes to grow and manage the loan portfolio. They’re not close enough to the borrowers. Loan pricing is not in their areas of expertise. Thus, the ALCO deck is stacked in favor of undervaluing, or worse ignoring, the strategic elements of the bank’s primary revenue engine.
- Bank leadership often views (at least subconsciously) the loan portfolio as something that’s out of its control. The sentiment seems to be that loan pricing, and therefore the loan portfolio, is driven entirely by the competitive market place. So the bank will take what it can get, knowing there is little it can do to effect the outcomes. This attitude is easy to understand when you compare loans to the investment portfolio, where securities prices are highly transparent with a liquid market. The portfolio manager can pick up the phone and buy and sell securities in and out of the portfolio with ease. It feels much more controllable and the analytics are easier.
- ALCOs often lack the loan pricing tools and techniques needed to properly understand relative loan performance across multiple products, structures, risk profiles and customer relationships. There often is no mechanism linking the long-term balance sheet strategy (e.g. what do we want the balance sheet to look like in six months or a year) to the day-to-day tactics determining the prices that are set and the deals the bank wants to win. When a bank is ill equipped to properly analyze and understand those nuances it’s easier for the ALCO to simply gloss over them and focus instead on the areas where there is more comfort and expertise.
It doesn’t have to be this way, though. The big “A” can be restored to its rightful place in the ALCO by following some of these steps.
- Admit the Problem – Acknowledge the shortcoming and agree that more focus on ALL asset classes but especially the loan portfolio is a must.
- Get Everyone Board – Ensure that there is proper buy-in from the senior leadership on both the management ALCO and the board ALCO, as applicable, for focusing more on the loan portfolio.
- Get Representation – Invite your Chief Lending Officer and/or Chief Pricing Officer to be a full-time member of your ALCO.
- Get Informed – Develop a process to share the right information with ALCO as it relates to the loan book, so that you can obtain feedback and adjust your loan sales and pricing strategies accordingly.
- Don’t Look Back – Make the analysis more forward-looking on the strategic elements of the portfolio and less about historical scorekeeping. The discussion of the big “A” should be at the front of the ALCO deck and not at the end. Make it a priority!
- Get the Right Tools – Implement a pricing and profitability management system that will allow you to support the strategic portfolio goals by creating the right tactics and behaviors at the lender level and measuring the progress.
It will take some work, but making sure the “A” in your ALCO is a big one will go a long way toward making sure the “R” in your ROE is a big one as well.
