Testing of the ALM Process:
What Should it Really Entail?
Tuesday, June 18, 2013
2:00 PM – 3:15 PM
Presented by:
Bert Purdy, CPA, CTFA
Senior Manager
BKD, LLP
211 N. Broadway, Suite 600
St. Louis, MO 63102
P: 314.231.5544
E: rpurdy@bkd.com
www.linkedin.com/in/bertpurdy
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“Perhaps when a man has special
knowledge & special powers like my
own, it rather encourages him to
seek a complex explanation when a
simpler one is at hand.”
– Sherlock Holmes
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Questions to be Answered
1. What testing of the ALM process is
required?
2. What are the differences between
model validation & ALM testing?
3. How can you perform model backtesting?
4. What are examiner expectations?
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Regulatory Guidance
• Joint Agency Policy Statement on
Interest Rate Risk (1996)
• Comptroller’s Handbook on Interest
Rate Risk (1997)
• Advisory on Interest Rate Risk
Management (2010)
• Interest Rate Risk Management:
Frequently Asked Questions (2012)
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Regulatory Guidance
• FDIC’s Risk Management Manual of
Examination Policies, Section 7.1 –
Sensitivity to Market Risk
• Comptroller’s Handbook, Community
Bank Supervision, Sensitivity to
Market Risk (pages 77-85)
• FRB’s Commercial Bank Examination
Manual, Section 4090.1
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Related Guidance
• FIL-84-2008 – Liquidity Risk Management
• Interagency Policy Statement on Funding &
Liquidity Risk Management
• OCC 2011-12 – Supervisory Guidance on
Model Risk Management
• FRB’s Commercial Bank Examination Manual,
Section 4027 (Model Risk Management)
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Required Testing
• Internal controls, policies, procedures
(Process testing)
• Model validation
• Back-testing
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Process Testing
• Purpose: “to ensure that the interest
rate risk measurement & management
processes are sound.”
- FDIC Exam Manual
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Process Testing
• Complexity
• Structure
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Process Testing
• Independent: Person testing “should
not have any involvement in either
developing the measurement system or
performing any of the routine internal
functions such as reconciling data
inputs, developing assumptions, or
performing variance analysis.”
- FDIC Exam Manual
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Process Testing
• Independence can be achieved via
internal audit staff, an outsourcing
arrangement or a combination of the
two
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Process Testing
Four phases of process testing
• Input process
• Assumptions
• System output
• Management & oversight (ALCO)
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Process Testing
• Input Process
– Knowledge & skills
– Reconciliation
– Numbers in right places
– Contractual terms
– Review
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Process Testing
• Assumptions
– How are they developed?
– Review & approval at set-up
– Periodic review
– Supporting documentation
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Process Testing
• System Output
– Accuracy
– Interest rate scenarios
– Ramps & shocks
– Timeliness & frequency of reporting
– Compliance with policy
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Process Testing
• Management & Oversight
– Policy
– ALCO membership
– Frequency
– Policy exceptions
– Assumptions
– Vendor due diligence
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Model Validation
• Institutions that use vendor-supplied
models are not required to test the
mechanics & mathematics of the
measurement model. However, the vendor
should provide documentation showing a
credible independent third party has
performed such a function.
- Advisory on Interest Rate Risk
Management
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Model Validation
• Third party validation reports
– Frequency
– Review
– Implement changes
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Model Validation
• Use of a separate model provider
– Use same processes for input
– Use same assumptions
– Compare results
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Back-testing
• Purpose
• Frequency
• Complexity
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Back-testing
• Independence
• Performance
• Results
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Examinations
• Independent Review
– “The person responsible for conducting the
annual independent review is not
independent of the control of the model as
this person is responsible for monthly data
inputs, reconciliations & assumption
changes”
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Examinations
• Independent Review
– “A contravention of the Joint Agency Policy
Statement on Interest Rate Risk is
identified as an independent review of the
bank’s input & assumptions has not been
conducted”
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Examinations
• “Management’s analysis of the bank’s
exposure to interest rate risk does not
include interest rate shocks of at least 300
to 400 basis points according to FDIC’s
Financial Institution Letter entitled
Financial Institution Management of
Interest Rate Risk dated January 20,
2012”
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Examinations
• “Only two formal Asset/Liability Committee (ALCO)
meetings have been held since the last examination,
although bank policy calls for quarterly meetings.
Management meets informally outside of ALCO
meetings to discuss IRR & maintains notes of those
meetings; however, the notes are not presented to
the Board for review. Further, while management
stated IRR matters are discussed at the Board
meetings in the absence of ALCO meetings, Board
minutes lack sufficient detail of those discussions.”
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Examinations
• “Guidelines in the Asset Liability
Management Policy remain liberal, as was
noted at the prior examination.
Management should narrow the risk
parameters which continue to allow for NII
changes of 10, 15 & 201 percent for 100,
200 & 300 basis point rate shocks,
respectively.”
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Examinations
• “Though the bank’s sensitivity to market
risk is satisfactory, many parameters
established in the policy are liberal & allow
for an inordinate amount of risk. The policy
should be amended to incorporate
parameters that minimize risk & establish
limits for the level of risk the bank is willing
to accept.”
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Questions?
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