ALM Basics for Directors August 17 th , 2014 • Economics & Investments Pre-Conference Workshop

1. ALM Basics for Directors August 17th, 2014 • Economics & Investments Pre-Conference Workshop Mike Schenk Vice President, Economics & Statistics Credit Union National Association Telephone: 608-231-4228 Facsimile: 608-231-4924 E-Mail: mschenk@cuna.com

2. Macro Economics Output (GDP) • Personal Consumption (68%) • Private Investment (16%) • Government Spending (19%) • Net exports: Ex–Im (-3%) A dual policy mandate: • Maximize output & employment • Stable prices Monetary Policy (Fed) • Reserve requirements • Discount rate • Open market operations • Quantitative easing Two Primary Tools: • Monetary policy • Fiscal policy Fiscal Policy • Government spending • Taxation

3. U.S. Inflation Rate (%) Source: BLS.

4. U.S. Unemployment Rate (%) Source: BLS.

5. Federal Funds Interest Rate (%) Source: BLS.

9. Market Interest Rates & CU ROA Source: BLS.

10. ALM Basics What is ALM? Ratios Financial Statements Spread analysis

11. Introduction to Asset-Liability Management • ALM is • The PROCESS of • Planning • Directing • Controlling • The • Flow • Level • Mix • Yield • Cost of funds • To • Control financial risk • Optimize financial returns

12. Introduction to Asset-Liability Management • ALM is…. • Nomenclature/acronyms (e.g., Equity - Net Worth – Capital - Reserves and Undivided Earnings) • Risk/return tradeoff • Timing, magnitude, certainty of cash flows • Identify and quantify key CU balance sheet risks • Credit Risk - likelihood members don’t pay us when they say they will • Liquidity Risk – likelihood we’ll lose money when trying to fulfill financial obligations • Interest Rate Risk – likelihood that earnings will change when interest rates change • Examination/supervision: CAMEL rating system: • Capital adequacy – one key ratio: Net Worth/Total Assets (+7%) • Asset quality – two key ratios: Delinquencies/Total Loans (<1.25%); Net chargeoffs/Average Loans (<0.25%) • Management – no key ratios • Earnings – one key ratio: Net Income/Average Assets (>1.00%) • Asset/Liability Management – no key ratios • What’s missing? • Three pillars of success: Make money; Stay solvent; Grow!

13. Asset Quality: Delinquency(Percent of Total Loans. Source: NCUA and CUNA)

14. Asset Quality: Net Chargeoffs(Percent of Average Loans. Source: NCUA and CUNA)

15. Liquidity Risk(Total Loans/Total Savings. Source: NCUA and CUNA)

16. Interest Rate Risk(Net Long Term Assets as a % of Total Assets. Source: NCUA and CUNA) • Real estate loans that do not reprice, refinance or mature within 5 years; • Member business loans; • Investments that mature in more than 3 years; • NCUSIF deposit; • Land and building; • Other fixed assets

17. Interest Rate Risk(Net Long Term Assets as a % of Total Assets. Source: NCUA and CUNA)

19. Inflation & Interest Rates1960-2011 S&Ls? Fed funds: 77-78 +200bp 78-79 +330bp 79-80 +380bp 80-81 +520bp Fed funds: 12/93 = 3.00% 4/95 = 6.00% Fed funds: 12/03 = 1.00% 7/06 = 5.25% • Other differnces: • * Huge exposures • Low capital ratios • Little liquidity Fed funds: 1/99 = 4.60% 8/00 = 6.60%

20. CU Net Worth/Assets(Source: NCUA and CUNA)

21. High Earnings(Percent of Average Assets. Source: NCUA and CUNA)

22. Fast Membership Growth(Source: NCUA and CUNA)

23. Faster Loan Growth(Source: NCUA and CUNA)

24. Growth / Net Worth / ROA Tradeoff Beginning net worth ratio = 10% Assumed asset growth rate = 10% Required return on ending assets to maintain net worth ratio = Beginning net worth ratio x Assumed asset growth rate = .10 x .10 = .01 = 1.00%

25. Required ROA

26. Tools of the Trade • Simulation analysis: Spread analysis Measures: • Change in net income • Changes in capital (MVPE, NEV, etc.) • Gap analysis: Maturity “buckets” - focus on rate-sensitive assets and liabilities Measures: • Dollar gap • Ratio of rate sensitive assets to rate sensitive liabilities • Gap-to-asset ratio • Duration analysis: Weighted average term to maturity Weights = time period of each cash flow Used for single instrument or portfolio Measures: • Duration • Modified duration • Cash flow assumptions are key for all! • Contractual cash flows • Loan prepayments • Deposit account repricing (i.e., “decay” rates)

27. Spread Analysis • A Four-Step Process…… • Examine the balance sheet (stocks) • 2) Examine the income statement (flows) • 3) Combine information from both into an interest yield/cost analysis • 4) Combine information from income statement & interest yield/cost analysis

28. BASE CASE CU A point in time (i.e., “snapshot) /A “stock” measure of financial health Assets: things we own + + + + /5 = Total Assets = Total Liabilities & Equity Cash + building + furniture + etc. Liabilities & Equity: things we owe Net Worth/Capital/Equity = past earnings that weren’t distributed to members Asset Liability Management? Earnings? Capital? Growth? Risks?

29. BASE CASE CU Over time (i.e., a “movie”) /A “flow” measure of financial health Generally related to things on the asset side (fees a big exception) + + + = Generally related to things on the liability side Income – Expense = Net Income Asset Liability Management? Earnings? Capital? Growth? Risks?

30. Asset Liability Management

31. Basis Points (bp) • One “basis point” = 1/100 of a percentage point • So 100 basis points = 1 percentage point = .01 • 200 basis points = 2.00 per. pts. = ____.0200_ • 30 basis points = 0.30 per. pts. = ____.0030_ • 150 basis points = 1.50 per. pts. = ____.0150_ • 6 basis points = 0.06 per. pts. = ____.0006_ • 97 basis points = 0.97 per. pts. = ____.0097_

32. BASE CASE CU • Detail is key • Why assets in denominator? • What is “normal”?

33. Spread Analysis

34. 4.00% in base + 1 percentage point increase = 5.00% $300 balance x 5.00% new effective rate = $15.0 $15.0 5.00% $31.0 3.10% $12 + $4 + $15 = $31 $31 / $1,000 = 3.10% $31.0 310 $32.0 320 $7.0 70 $4.0 40 vs 70 bp in base case!!

35. $300 in base, but ½ goes away = $150 $300 in base, but ½ goes away = $150 $150 x 4% = $20 $150 x 3% = $4.50 $150 $4.5 $150 $6.0 $850 $58.5 $850 $22.0 • Average vs Marginal Costs • Estimating member rate sensitivity • Rate vs. non-rate features • Early withdrawal penalties • Funding outflows • Member service issues • Growth/shrinkage and capital ratios $58.5 688 $22.0 259 $36.5 429 $11.5 135 $8.5 100

36. Questions?

37. Net Economic Value: Book Value vs. Market Value • Net economic value (NEV) measures the effect of interest rate risk on capital • NEV is a measure of the balance sheet’s value at a fixed point in time • NEV = “present value” of assets - “present value” of liabilities • Book Values (assuming 30yr mtg & 6mo. certificate): • Assets - Liabilities = Capital Capital Ratio • $1000 - $ 900 = $ 100 $100/$1000 = 10% • Market Values (after a 1 Percentage Pt. increase in market rates): • Assets - Liabilities = Capital Capital Ratio • $ 918 - $ 896 = $ 22 $22/$918 = 2.4%

40. Duration Analysis: Weighted average term to maturity - typically measured in years -Duration x rate change = change in value Example: If duration of a mortgage is 6 (years) and rates increase 3 percentage points: -6 x +.03 = -.18 or -18% Translation: If market rates increase by 3 percentage points immediately and permanently, the mortgage will lose 18% of its value. Can repeat for all assets and all liabilities to estimate market value of equity.