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Asset/Liability Deposit Modeling

Essential liquidity and interest rate risk questions for ALCOs

Mary Ellen Biery
November 18, 2024
Read Time: 0 min

Prepare for regulator scrutiny on  interest rate risk & liquidity

Banks and credit unions that aren't paying attention to these critical issues can expect a tough review.

Key topics covered in this post: 

Regulators 'could not be more clear'

Today’s regulatory climate is turning up the heat on financial institutions when it comes to liquidity and interest rate risk management. With the uncertain economic outlook, regulators and examiners have been regularly conveying their top priorities for banks and credit unions.

“Regulators could not be more clear on what they are looking at,” said Susan Sharbel, Senior Consultant at Abrigo Advisory Services, during a recent webinar on controlling interest rate risk and liquidity challenges. It’s no surprise, then, that community banks, credit unions, and other financial institutions with recent exams have described how regulators “came down hard on liquidity,” she said. They’ve also been giving a lot of attention to interest rate risk.

Learn more in this webinar, "ALCO playbook: Managing liquidity & performance amid rate cuts."

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Interest rate risk & liquidity in focus for ALCOs

According to a poll of webinar attendees, interest rate risk and liquidity are top priorities of asset/liability committees (ALCOs). That’s good, because according to Sharbel, banks and credit unions that aren’t paying attention to these areas can expect a tough review.

chart of poll on asset/liability management committee concerns

To make sure they’re on track with managing liquidity risk and interest rate risk, financial institutions and their ALCOs should start asking some crucial questions described below. These inquiries can help institutions spot weak points, align with regulatory expectations, and keep their resilience strong. That’s especially important if the Federal Reserve continues to cut rates.

1. Are we prepared for shifts in liquidity needs and funding costs if rates fall?

Liquidity comes in cycles, and these cycles tend to move faster than interest rate cycles, Sharbel noted. Financial institutions need to stay nimble and be ready to adapt to these shifts, especially if rates drop and liquidity pressures start building up. She described how prepayments usually pick up when rates fall as borrowers refinance, bringing cash back into the bank that needs to be redeployed—often at lower yields. This can turn into a real challenge if funding costs stay high while asset yields drop.

Regulators want to know that banks have flexible funding options and a robust contingency plan that addresses this kind of situation. Financial institutions should anticipate funding costs and ensure access to both core and contingent liquidity sources.

With prepayment risks and falling yields likely ahead, it’s a good time to evaluate how well your institution can maintain profitability if rates decline and loan repayments accelerate.

2. How resilient are our key assumptions under different stress scenarios?

“Make sure that you are stress testing, stress testing, stress testing,” Sharbel said. “It’s never been more important." Today’s regulators expect institutions to examine their risk assumptions under various high-stress scenarios. This means testing core assumptions around your depositors’ behavior, loan prepayment speeds, funding sources, and betas. It means identifying the risks that are specific to your institution. As rates shift, these and other factors can significantly impact your institution’s balance sheet stability and profitability, so seeing how these assumptions hold up in extreme conditions is important.

Sharbel suggests running scenarios like “large depositors withdraw funds” or a “runoff of all uninsured deposits” to uncover potential weaknesses that might not be obvious in routine operations. Is there a major employer that affects both commercial loans and depositors? What if they suddenly left or shut down? Do you roll up mortgages, package them, and sell them? What if overnight, you had no outlet for them? “This actually has happened before,” Sharbel noted.

Both static and dynamic scenario analyses can show how different strategies hold up under stress. This approach not only prepares the institution for unexpected events but also provides management with a clear picture of areas that may need shoring up.

“Make sure that your ALM process is robust enough to identify, measure, monitor, and control risk,” Sharbel said. “My family, my boys are all motorcycle riders, and there's a saying among the motorcycle community that you want to purchase the most expensive helmet that you can afford. You can ride anything, but make sure that you have the most expensive helmet that you can afford.”

An interest rate risk model doesn’t have to be the most expensive, Sharbel said. “But it should be the most robust interest rate risk model that you can afford because you want to be able to identify every risk possible in the bank so that when the unexpected comes, we're prepared.”

3. Do we have a clear, robust governance structure in place for managing these risks?

“The ALCO committee is responsible for managing your interest rate risk and liquidity,” Sharbel noted.
As a result, regulators are really looking to make sure that all ALCO members are aware of everything going on that could affect asset/liability management.
Regulators are not just concerned about financial institution’s liquidity. “It's not just your liquidity position because what they're finding is folks that don't have great liquidity positions, don't have a strong governance behind that.”
The liquidity and funds management process should be very clear in terms of policies and procedures, she added.
“Make sure that your ALM policy, liquidity policy, and contingent policies have been updated. They’re required to be done annually, but if you’re even close [to that timeframe], I’d get it done now.”
Sound governance includes policies and procedures for the daily analysis of liquidity and the funds management position, including what should happen when there is a liquidity gap. It should incorporate periodic monitoring through stress testing and spell out the periodic reporting of liquidity (how, who, and when) to senior management and the ALCO or board.
In Sharbel’s view, regulators will be closely watching how effectively institutions manage these governance aspects as part of their overall risk management approach.

4. What are our most significant concentration risks, and how could they impact our liquidity and interest rate risk?

The collapse of Silicon Valley Bank (SVB) and other recent bank failures illustrate the dangers of unchecked concentration risks. As Sharbel pointed out, SVB’s downfall started as a concentration risk—too much reliance on high-yield depositors and a concentration of investments because their depositors did not have a lot of lending needs. When rates rose, this turned into an interest rate risk issue, as the bank’s long-term assets were funded by shorter-term deposits, creating a mismatch.

Ultimately, SVB faced a full-blown liquidity crisis as it had to liquidate investments at a loss to cover deposit withdrawals. “Some of their investments were at 1%, yet they’re having to pay their depositors, 5%,” Sharbel said. The bank’s failure reminds ALCOs that concentration risks can create a domino effect, quickly affecting several areas of an institution’s risk profile.

Sharbel emphasized that regulators are watching closely for concentration risks and how those might cascade into others. They’ll want to see if institutions are adequately managing related risks that could affect liquidity and interest rate exposure.

5. Do we understand whether we are asset-sensitive or liability-sensitive, and how does this affect our margin?

Knowing if your institution is asset-sensitive or liability-sensitive is critical when preparing for changes in the rate environment. Sharbel noted that “most institutions are asset sensitive,” which means their assets are more sensitive to repricing than their liabilities, often increasing margin as rates rise. “The real concern is, if there's this much volatility going up, what happens when rates fall,” she said. As rates fall, asset-sensitive institutions may face margin compression, with variable-rate assets repricing downward while funding costs may not drop as fast.

Understanding this sensitivity can help financial institutions prepare strategies for margins, income, and funding so they can balance risk and return.

6. How well do we understand our clients’ behavior, particularly regarding core deposits, in a changing rate environment?

Understanding customer or member behavior is essential, particularly as rates change. Sharbel recommends core deposit studies to get insights into depositor patterns. Those insights are especially valuable in a falling-rate environment.

Institutions need to understand how customers or members might respond when rates drop, she said. Knowing these patterns can help adjust funding strategies and optimize deposit pricing.

In addition, depositor behavior has shifted in recent years. As a result, institutions can benefit from studies examining both historical and future depositor behaviors. A core deposit study looks at the institution’s pricing behavior (the beta and the lag in pricing) and the member or customer’s behavior (the decay) to inform pricing strategies.

A core deposit analysis that examines both historical and future depositor behavior considers factors like:

  • deposit beta (how deposits change in response to rate shifts)
  • decay (the rate at which deposits leave the institution)
  • timing lags between market rate changes and deposit repricing.

These insights help institutions predict how quickly deposits might move to other products or institutions as rates move.

As noted above, banks and credit unions also need to understand how changes in prepayments could affect income and profits. A prepayment study helps identify the unique impact an institution could face as rates go down since every portfolio is different and since loans have different rates.

Expecting the unexpected as rates change

“If the last five years have taught us anything, that’s to expect the unexpected,” Sharbel said. “Global pandemic, 525 basis-point increase in rates over 18 months, inverted yield curve. Expect the unexpected.” Financial institutions should anticipate continued scrutiny of liquidity and interest rate risk management. Those that are proactive, have solid governance frameworks, and keep up with regular stress testing will be much better prepared to navigate the road ahead. ALCOs and their leadership can identify gaps in risk management by asking:
  1. Are we prepared for shifts in liquidity needs and funding costs if rates fall?
  2. How resilient are our key assumptions under different stress scenarios?
  3. Do we have a clear, robust governance structure in place for managing these risks?
  4. What are our most significant concentration risks, and how could they impact our liquidity and interest rate risk?
  5. Do we understand whether we are asset-sensitive or liability-sensitive, and how does this affect our margin?
  6. How well do we understand our clients’ behavior, particularly regarding core deposits, in a changing rate environment?
By integrating these questions into strategic planning, banks and credit unions can better meet regulatory expectations, enhance resilience, and be prepared even in a changing rate environment.
This blog was developed with the assistance of ChatGPT, an AI large language model, and was reviwed and revised by Abrigo's subject-matter experts.

Key Takeaways

Examiners have been scrutinizing liquidity, and a focus on interest rate risk also aligns with regulatory priorities.

ALCOs should make sure they're on track with managing liquidity risk and interest rate risk, especially as rates fall. 

Understanding prepayment ramifications and how depositors might react will help manage falling interest rates.

Abrigo offers ALM outsourcing and consulting. Get help when you need it.

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About the Author

Mary Ellen Biery

Senior Strategist & Content Manager
Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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