Originally published by DCUC.
Every financial institution wants to create and maintain an optimal balance sheet – a mix of assets and liabilities that maximize returns while mitigating risks. However, determining the optimal balance sheet is a complex process and there is no one right answer.
Here are a few of the most common challenges we see:
- Imperfect information – obtaining accurate data regarding market conditions, borrower profiles, and asset quality is challenging which leads to uncertainties in decision making
- Different access to opportunities –Differences in size, location, and membership can limit available opportunities and funding sources
- Ever-changing return profiles – return profiles change with the economic environment. As risk and compensation for risk changes, products deserving capital allocation change
Aligning on Growth Expectations
Before quantifying an approach to pursue an optimal balance sheet, key executives and board members must be aligned on growth expectations for the next 5 to 10 years.
Understanding Risk Appetites
For teams to align on future goals and targets, they need to understand the institution’s risk appetite. Where does your organization’s risk come from? Are leaders comfortable with the amount of risk being taken, or is there capacity to take on more risk to help drive returns? Creating a risk appetite statement that clearly identifies how comfortable an institution is with taking on credit risk, market risk (interest rate and liquidity risk), operational risk, and compliance risk will help ensure that the depository does not stray too far during the pursuit of an optimal balance sheet.
Evaluating the Feasibility of Growth Targets
Management teams should also discuss the feasibility of growth targets. If an institution wants to grow their mortgage portfolio to increase balance sheet duration but does not have the local demand for such products at appropriate rates, then the strategy may need to pivot away from organic origination. When the feasibility of growth is effectively challenged, management will have a clearer picture of where they can grow at current rates and opportunities to capture market share.
Building a Decision-Making Framework
With risk appetite outlined, strategic goals defined, and growth areas assessed, finance teams can start building out a decision-making framework that integrates quantitative analysis with qualitative insights. Throughout the process, organizations need to assess risk and project potential returns on a risk-adjusted basis to help elect which opportunities the institution should fund.
Remaining Agile, Sticking to Long-Term Objectives
Successful institutions are nimble and adapt quickly as the economic environment changes. To achieve an optimal balance sheet position while sticking to long-term strategic plans and objectives, it is imperative that depositories remain agile enough to capitalize on emerging opportunities or pivot away from under performing assets.
A Never-Ending Journey
Keep in mind that the optimal balance sheet is not one-size-fits-all. In addition to institution-specific drivers, several economic factors like rates, spreads, and liquidity, will all impact where value is being derived on the balance sheet. Achieving and maintaining this optimal position is more like a never-ending journey than a specific destination.
