Pub. 7 2012-2013 Issue 2

July/August 2012 13 Extraordinary Service for Extraordinary Members. Average Lives of Non-Maturing Liabilities Widely considered the most mystifying assumptions for the model, the question here is what kind of “maturi- ties” do the balances of your non-maturing liabilities have? Financial institutions should perform an analysis of non- maturing liability behavior and identify those funds that can be considered volatile versus core funding. Once separated, more volatile balances should be assigned shorter average lives versus core funding, which typically carries a longer average life. Asset Prepayment/Liability Decay Asset prepayments and liability decay rates are important to capture optionality on certain accounts. For assets, loans and mortgage-related securities have the ability to prepay principal. On the liability side, non-maturing liabilities incorporate decay rates to simulate the effect of depositors withdrawing balances in certain interest rate environments. A higher prepayment or decay rate usually would imply a shorter average life of the particular account. Stress Testing Assumptions One approach is to routinely “stress test” the assump- tions in the model. Management may find this helpful as it identifies which items have the most significant impact on model results. An example of stressing an assumption would be removing time lags on non-maturing liabilities and doubling rate sensitivities. This adjustment would highlight the potential increase in interest expense if the institution would have to be more competitive from a pricing standpoint for those particular products. Conclusion Because an assumption is, by definition, a thing that is accepted as true without proof, there isn’t necessarily a right and wrong way to model them. Also, while back testing is necessary and history may be insightful, it can’t predict the future. Prudent risk managers are aware of these limita- tions and will strive to maintain reasonable and supportable modeling assumptions. They also will consistently tweak and adjust their assumptions to better understand the impli- cations those assumptions have on their model output and ultimately asset/liability management strategy. Z Since 1979, The Baker Group has helped clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. For more information, visit www.GoBaker.com , or contact Matt Harris at The Baker Group at (800) 937-2257 or mharris@GoBaker.com . 1125 South 103rd Street Omaha, NE 68124 402.390.9500 koleyjessen .com COMMERCIAL LOANS - TIF/BOND FINANCING DIP FINANCING - BANKRUPTCY/CREDITORS’ RIGHTS REGULATORY COMPLIANCE - GENERAL CORPORATE Max Burbach & Tom Ackley