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5 Steps to Better Budgeting for 2020

The strategic planning season is ramping up and many financial institutions have initiated the process of preparing for 2020 – identifying likely challenges, defining strategic direction, and forecasting the balance sheet and financial performance through the budgeting process. One of the top questions we field this time of year, whether lighthearted or not, is what rates are going to do over the coming year. Will the Fed cut rates, and if so, how many times and when? Will the 10-year Treasury yield face continued downward pressure stimulating a late 2012, early 2013 wave of refinance activity? We may not have a crystal ball, but we do have a few thoughts on how to keep speculation from dominating your strategic conversations and how to budget more effectively.

While no strategic plan is
bulletproof, the planning and budgeting process should incorporate the key
tenets of ongoing successful balance sheet management – namely funds management
and capital planning. By prioritizing both components within the planning and
budgeting framework, institutions should find that preparing for the upcoming
year and determining the most appropriate strategic course of action should be no
more challenging than the daily balance sheet management process.

Step 0: Establish Your Risk
Appetite and Strategic Goals

Policies are the starting point
for any strategic conversation, detailing the general goals of the institution
and the risk parameters to operate within to get there. If your institution’s risk
policies are well structured, comprehensive, and include statements defining
the general strategic goals and risk appetite of the Board, then this step is
likely already complete. However, if you can’t easily identify goals and risk
preferences, pump the breaks on detailed planning and have this conversation

Defining what success looks like
– growth, member/customer value, financial performance, etc. – is a critical
aspect of the planning process. Once goals are established, risk expectations
and parameters must be clearly and succinctly outlined. Having reasonable
expectations of risk exposure given institutional goals is like filling your
gas tank with the appropriate fuel for your engine. Without the right level of
risk allocation, performance will suffer. Financial performance is the life
blood of any depository institution, allowing it to better serve its members/customers,
employees, and community in the most impactful ways.

Step 1: Evaluate Current Risk
Allocation and Performance

Once goals are established and
risk tolerance is clearly defined, the next step is to pinpoint the
institution’s starting position. To do this, financial institutions should
construct a dashboard incorporating performance and risk metrics to better understand
how each risk factor is being utilized and how effectively it generates financial
performance. Determining which measurements to monitor comes down to
identifying the drivers of performance – those factors which either enhance or
diminish returns and help reveal the current business practices which might be
dragging performance down. Interest rate risk, liquidity risk, credit risk,
capital leverage, and operational efficiency are principal factors to financial
performance. Without adequate measurement of how each is being used to generate
current performance, it is nearly impossible to develop forward-looking strategy.

Step 2: Align Strategy with
Risk Needs and Return Targets

With adequate performance
insights, an institution can then target the changes necessary to modify the
current business plan to better align with long-term goals. For instance, if
performance analysis indicates high capitalization and mediocre returns on
equity, management can easily determine the need to leverage capital to boost economic
returns and bottom line earnings. If an institution is facing lackluster loan
growth and collapsing net interest margins, adequate performance indicators
will highlight the need for asset acquisitions or credit risk surrogates in the
investment portfolio. Strategic needs are illuminated when the appropriate
gauges of performance are consistently monitored, allowing management to spend
their time evaluating how to best execute those strategies.

Step 3: Assess Relative Value
and Tune Strategy

Tuning the approach relies on the
funds management process to compare various opportunities for strategy
execution. The process requires analytical rigor and a comprehensive
risk-adjusted evaluation framework to properly assess economic compensation
across multiple opportunities and isolate the choices with the best fitting
risk-return profiles. Evaluating alternatives in an economic return framework helps
keep all internal departments on the same page, aware of how each choice either
contributes towards or takes away from financial performance and eliminates the
influence of conflicting incentives. Without this type of quantitative
framework, institutions may critically underestimate risk, make unsound
economic decisions using gut feel rather than defendable analytics and stray
from performance goals.

Step 4: Forecast Performance
and Risk Exposure

In addition to the standard pro forma
budgetary projections, institutions should evaluate the comprehensive, honed balance
sheet strategy through analysis of risk from all angles. The forecasted balance
sheet should be run through a stochastic ALM model and evaluated to confirm
that the projected risk exposure is commensurate with the intended results.
Liquidity risk should also be evaluated by assessing adequacy of comprehensive
liquidity under normal business conditions and variations to the business
environment. Scenarios to consider include varying degrees of funding stresses
or systemic stressors such as economic downturns or more localized and
institution-specific concerns. After working through these simulations and reviewing
all risk exposures, the budget should be sufficiently vetted and ready for
final Board approval and implementation.

Step 5: Rinse & Repeat

Risks aren’t stationary – markets
move, the balance sheet evolves, and new pressures and challenges will arise. Institutions
that work through this process throughout the year are better equipped to
identify the factors driving unanticipated variance in performance and risk exposure,
allowing successful modification of the strategic plan to meet long-term goals.
Meaningful analysis should be kept front and center at the ALCO and Board level,
emphasizing forward-thinking strategy rather than excessive rear-view reporting.
A rinse and repeat approach to this process prevents the institution from
getting off-target and having to make sweeping, and likely costly, changes to get
back on track.

Recipe for Success Budgeting doesn’t need to be a burdensome and daunting process. With the consistent application of a risk-adjusted, quantitative decision-making framework, speculation is removed from the decision-making process and effective strategies can be employed quickly and confidently in any market environment. The funds management process is a critical aspect of long-run success, requiring diligence to keep management well-informed of current progress and aware of all viable strategic opportunities. Ultimately, focused ongoing strategic planning, supplemented by annual strategy summits leads to a more cohesive balance sheet management effort, consistently solid performance, and better value for all stakeholders.

Brittany Rollek joined ALM First Financial Advisors in 2013. As a Director for the firm, Brittany is primarily responsible for the client’s management team to customize and implement actionable and effective ALM and investment strategies to maximize client performance. Additionally, Brittany proactively designs sensitivity analyses and scenarios to test client balance sheet exposure to various factors and formulates action plans to optimize client performance within policy and risk tolerances. As a Director, Brittany also ensures our clients receive accurate and timely information.
Prior to her current role, Brittany held the role of Manager of the Financial Modeling Group, responsible for overseeing and ensuring the quality of financial reporting including ALM analyses, MSR valuations, “what-if” analyses, and other financial modeling results.
Brittany holds a bachelor’s degree in economics from Davidson College in North Carolina.

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