As interest rates rise, financial institutions are revisiting whether an in-house asset liability management (ALM) model or a third-party (outsourced) ALM model is the best option for monitoring and assessing interest rate risk (IRR). Many variables and factors need to be considered when making such a critical decision. The following four factors will help institutions identify when it is best to implement an in-house model and when to outsource to a third-party vendor to ensure compliance with regulatory mandates associated with measuring and monitoring interest rate risk:
1. Balance Sheet Complexity and Risk Positions
Third-party ALM vendors have been successful in providing customized IRR analyses to address the differing liability management needs of financial institutions. However, an institution with extensive asset and liability categories, extensive structured financing products or unique lines of business is a better candidate for an in-house ALM model. An Institution with a less complex balance sheet composition may want to consider the third-party IRR analysis option.
Additionally, third-party ALM models are great options for institutions with more dependable baseline earnings and less overall risk exposure, related to capital, credit, liquidity or other elements of risk. When there are fewer risks and a greater earnings cushion, a third-party model may be a sound alternative.
2. Cost and Staffing Considerations
Developing, implementing and maintaining an in-house ALM model often requires a significant budget commitment. Outsourcing the IRR analysis to a third party changes fixed costs to variable costs, shared by its collective users. While costs are incurred for outsourcing, specifically for project management and oversight, considering whether the reduction in fixed costs outweighs the variable costs incurred will be an important criterion in the decision-making process.
Moreover, staff traditionally used for maintaining an in-house ALM model are valuable resources that can be re-allocated to other assignments that require institution-specific or unique and nuanced analysis.
3. Regulatory Mandate and Institution Culture
Regulatory mandates for IRR analysis are consistent across institutions including: rate shocks, non-parallel yield curve moves and basis risk analyses. Third-party vendors can perform a standard set of IRR scenarios that can provide necessary assessments to meet both business and regulatory needs.
An institution’s culture is another consideration when choosing an internal or third-party model. If an organization’s internal stakeholders rely heavily on model outputs for critical financial and business strategy decisions, an internal model may be more appropriate. Your internal model team must have extensive knowledge about the assumptions and methods used in the analysis. However, if the ALM is primarily addressing a regulatory mandate, a third-party solution may be adequate.
4. Model Governance Requirements
Both the third-party ALM model and the in-house model require governance, but the scope of that governance varies. An in-house model requires more extensive governance because it involves policies, documentation, user controls and ongoing model-monitoring programs. An outsourced model still requires documentation based on assumptions and processes for providing data and reviewing results, but it is more limited. However, keep in mind, good governance, under either model, requires outcomes analysis to prove its dependency and accuracy. If the outsourced solution is the answer, a back test of model results will still need to be performed to assure the institution that the model can accurately predict outcomes.
The four factors stated will enable financial institutions to ask the right questions related to in-house vs. outsourced ALM model use. However, there are many more idiosyncrasies to consider beyond these four factors. A successful ALM model (in-house or outsourced) will need to define cash flow characteristics from the underlying data, apply the right assumptions, and accurately forecast IRR outcomes.
The Financial Managers Society (FMS) will soon publish its seventh edition of “Choosing the Right ALM Modeling Solution,” revised and edited by Christine N. Mills, Managing Director at MountainView Financial Solutions, a Situs Company. This report will provide detailed information on how to choose the right in-house or outsourced ALM model.