BID® Daily Newsletter
Jul 7, 2009

BID® Daily Newsletter

Jul 7, 2009

PROBABILISTIC ESTIMATES IN STRATEGIC PLANNING


One of the problems with static rate shocks or forecasts in bank risk management is that they do not give managers information about how likely a scenario might be to occur. What is the probability of rates rising 100bp in the next year, versus not rising at all? Banks expecting rates to rise 100bp in 2010, may be interested to learn that the likelihood of this happening is dropping quickly and rates may actually decline in 2010.
We come from the school of bank risk management that believes it is important for management to articulate a rate view when it comes to strategic planning, in order to better understand how decisions (and the background) are made. Probabilistic forecasting takes things one step further and assigns probabilities to different rate scenarios. These can then be incorporated in budget forecasting and asset-liability management. When these scenarios are combined and weighted as to their probabilities, the methodology provides a single, integrated set of risk estimates banks can manage towards. If you consider a bank's predominate rate view as the "most probable" case, then an important part of contingency planning is for management to understand the probability of the next most likely case. This exercise serves to focus management attention on more important scenarios. A bank will always have loss numbers should rates rise an immediate 500bp in 2010, but is that scenario worth planning for? Should the bank take a lower yield now if a rate scenario has less than 5% odds of occurring? After banks get back from their strategic planning sessions and start to model new initiatives, we suggest running different scenario through an ALM model to better understand strategy.
Later this week, we will go into the details of our economic projection (also in our free "Monthly Asset/Liability Package"), for now, let's say our primary view is not that of the forward curve (which has overnight rates going up 1.25% in 2010, with a time weighted average Fed Funds rate of 0.77%). Our primary rate view, which we place a 60% probability of occurring, is that short-term rates remain unchanged and rates are only 0.50% greater in the 2Y area one year from today. We assign a 25% probability to the path of the forward curve, which has short-term rates going up as previously stated and the 2Y part of the curve going up 1.00%. Finally, we place only a 15% probability of a strong recovery occurring in 2009 (where short-term rates rise 2.50% and the 2Y rises 1.50%).
Notice that our statement outlines what portion of the curve we are talking about and puts a time horizon on the analysis. Advanced banks also add the extra element of forecasting credit spreads, but most banks do not.
Each new strategy can be run separately through an ALM model given each rate view. By multiplying estimated earnings and affect on the economic value of equity with each of these set scenarios and averaging them together (essentially arriving at a weighted average), we can now choose the strategy that gives the best projected return. Rolling out a new mortgage product may outperform all other products if rates remain the same, but it would be disastrous if your bank placed a much higher probability on a sharply higher rate view. The same analysis can be had for a new branch, cash management product, waiving foreign ATM fees, becoming an SBA preferred lender or any number of strategic initiatives. Better still, expanding modeling to include volume, pricing, revenue and expenses, gives management a better understanding of strategy. The downside is that using probabilities of occurrence inserts subjectivity. This is OK, however, since it is better to focus management on high probability events, than to treat all the same, or to focus on the wrong ones. In other words, it is better to be approximate and probably right, than precise and probably wrong.
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