Boost Performance and Reduce Risk with Liability-Driven Investing

In the world of financial institutions, interest rate risk has become a main concern of examiners. However, when investment managers discuss the investment portfolio, conversations often revolve around risk and return as they relate to the portfolio only. While return and risk of the investment portfolio are certainly important, they should not be the only driving forces behind a credit union’s investing strategy, nor should the investment portfolio be an entity that operates independently from other balance sheet components.

Too often financial institutions’ portfolios of loans and leases are not very liquid and carry substantial credit risk that can put the entire institution at risk. QuantyPhi, a CUSO that provides investing, liquidity, support, and risk modeling to credit unions, says liability-driven investing can remedy that situation.

With this practice, risk relative to liabilities is the primary concern. Risk objectives are determined by asset liability management (ALM) strategies that focus on funding liabilities. A good investment manager will structure the securities portfolio in such a way that it plays a balancing role in providing a ready source of liquidity while it offsets the loan portfolio’s credit risk. Income production comes from tactical asset allocation that involves underweighting or overweighting asset classes relative to target weights in the policy portfolio, adding value strategically.

Liability-driven ALM approaches focus on modeling liabilities, and then adopting optimal asset allocations to fund those liabilities. Two liability-driven strategies most relied on by financial institutions are the dedication strategies of cash-flow matching and immunization. Dedication strategies are specialized fixed-income strategies designed to accommodate the specific funding needs of the investor. Risk control within these strategies can be improved by matching the characteristics and constraints of the liabilities with the characteristics of the investor and the constraints of the financial institution.

Credit unions can sometimes use more conservative approaches to investing, but those conservative strategies often lower overall risk tolerance. The fact that credit unions must meet the demand of their borrowers at any given time and deliver products that are interest-rate sensitive oftentimes prevents management from looking at both sides of the balance sheet for opportunity. This can result in credit unions losing the ability to take on more risk in the more-profitable loan portfolio. The liability-driven ALM strategies of cash-flow matching and immunization address this issue.

For a more thorough analysis of liability-driven investing, read QuantyPhi’s full white paper.

To learn more about QuantyPhi, visit its virtual booth at the Strategic Link Trade Show. Chat directly with the team on Nov. 17, from 11 a.m. to 1 p.m. PDT (noon – 2 p.m. MDT). QuantyPhi is offering any credit union that visits its booth a 50% discount off its flagship benchmarking product. During the month of November, earn points as you explore the trade show floor for a chance to win a $250 VISA gift card!