With no end in sight for a shaky economy, the likely continuation of an historically low interest rate environment through 2022, and the complex challenge of transitioning from LIBOR to SOFR, asset/liability management (ALM) models are under constant pressure to manage a fluid financial future. In response, ALM model developers and validators have a lot on their plates as they prepare for what comes next.
Here are four keys to future success for ALM model developers and validators looking to finish out 2020 and start 2021 strong:
1. Brace for rates to go even lower for even longer
Many market participants have heard the phrase “lower for longer” regarding the interest rate environment. After the great recession, lower interest rates seemed to be the long lasting and effective tool to keep the economy chugging along, albeit below historical recovery growth trajectories. The historic growth trajectory post-recession has also typically been followed by a gradual normalization of the interest rate environment with short-term rates returning to their approximate long-term averages and the yield curve moving to clear contango.
Gray shading indicates U.S. recessions. Source: http://www.nber.org/cycles/cyclesmain.html
Blue shading indicates Great Inflation, Jan. 1965 to Dec. 1982. Source: https://www.federalreservehistory.org/essays/great_inflation
Source: Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, September 11, 2020.
As shown in the above chart, the average fed funds effective rate at month end since 1954 is approximately 4.73% with the median value nearly 40 basis points below that at 4.37%. However, if we remove the hyper inflationary periods of the late 70s through early 80s, a better benchmark for long-term fed funds rates is probably somewhere in the 3%-3.5% range. With this range as a benchmark, we would need to go back to January 2008 to get close to that range.
Even more striking is the increasing recovery time for rates to return to pre-recessionary/stress levels, if they do at all. The post-1990 trend for short-term rates has been down with rates showing increasing difficulty reaching their pre-recession levels. The recent trough is of historic length with evidence given the pandemic that we will return to and remain at these historic lows. All of that said, be prepared for even lower – possibly negative – interest rates for even longer.
2. Keep pushing the move from LIBOR to SOFR
Banks fund themselves at retail rates for individual deposits and wholesale rates for everything else. Wholesale rates depend strongly on the credit quality of the bank, while these very same banks hedge their funding liabilities currently in the LIBOR market, which is closely connected to bank credit. However, in the future, they will hedge themselves with SOFR, which has no credit component. Therein lies the problem: liability costs move with the credit market, whereas the asset side (the hedge) does not, since it only moves with interest rates.
As the regulatory agencies will no longer require the submitting banks to submit and the legal and regulatory risks of submitting will be too high for any bank to remain a submitter after the technical end date, we should expect LIBOR to disappear entirely.
Even though SOFR is not a perfect hedge for many community banks and even many regional banks, the preparation will put banks in a better position for however they plan to tackle the transition. For instance, many community banks are considering Ameribor as a better alternative as they believe it better reflects their funding costs. And regulators and legislators are recognizing these funding differences across the different types, sizes, and regions for banks as evidenced by recent statements from Federal Reserve Board Chairman Jerome Powell and Senator Tom Cotton:
“We have been clear that the ARRC’s recommendations and the use of SOFR are voluntary and that market participants should seek to transition away from LIBOR in the manner that is most appropriate given their specific circumstances.”
- Jerome Powell (answering a question for the record)
“While [Ameribor] is a fully appropriate rate for the banks that fund themselves through the American Financial Exchange or for other similar institutions for whom Ameribor may reflect their cost of funding, it may not be a natural fit for many market participants.”
- Sen. Tom Cotton (R-Ark)
Keeping this background in mind, the keys to success in any transition are having:
- An inventory of the impacted models and products (discussed below)
- A plan developed for how to address each product and model (whether SOFR or some other rate)
- A list of clients connected to existing products and a plan for moving those clients/products forward
- And finally, the fallback language for existing contracts readily available
3. Review deposit modeling assumptions
As rates are in this “even lower for even longer” environment, banks need to review their deposit modeling assumptions. Clearly, FDIC-insured deposits give banks an advantage over many short-term, non-insured alternatives, but regional competition is high as the pandemic-led recession has had different regional impacts. Reviewing and closely monitoring deposit betas and adjusting as appropriate will be key to retaining these low-cost funding sources.
4. Conduct a comprehensive model inventory
As mentioned earlier, a strong model inventory and inventory tool reflective of the number of bank models is critical for tracking the connection and interconnection between model inputs (like LIBOR), the impacts of these variables on the bank’s or client’s balance sheet and risk profile, and the actions needed given the transition from LIBOR to an alternative risk-free rate.
A good inventory process not only details the models used by a firm, but the variables (at least key variables) that the model utilizes and the data sources for those variables. A further step in the direction of making the firm’s inventory strong is being able to easily track the upstream-downstream connection of these models and in particular the variable connection. As a simple example, if LIBOR is a key component of an asset valuation model, and in turn that model is key to determining the asset value for asset/liability management and capital, then that connection should be highlighted and easy to track in the model inventory to facilitate corrective actions.
For assistance with any of the above initiatives, you can count on the experts at the RMA Model Validation Consortium (MVC). Not only do we specialize in ALM model validation, but we also provide model risk management consulting at a competitive price point to help RMA member banks effectively measure, monitor, and mitigate risk across their entire model inventory. Contact us today to learn more!
As the Managing Director of the RMA Model Validation Consortium, Kevin is passionate about providing high-quality model validation services at a competitive price point for RMA member banks. Kevin holds a Ph.D. in math from UCLA and was a leader in risk management and model validation for Wells Fargo Bank.
Will Kutteh is the Senior Manager of Risk Products at RMA, overseeing the RMA Model Validation Consortium and Dual Risk Rating solution. Will has over five years of experience in the financial services industry, with a focus on Enterprise Risk and Model Risk Management. He has performed validations of models used in liquidity measurement, credit analysis, interest rate risk management, CCAR stress testing, and CECL. Will holds a BA in economics from Wake Forest University.