Managing the Balance Sheet over the Economic Cycle: Recent History Provides Important Lessons for Your Bank's ALCO

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This article is the first in a series addressing asset/liability management and market risk. Here, we learn how the business cycle and yield curves (as a result of interest rate fluctuations) influence balance sheet management and ultimately have an impact on a bank's performance and risk profile--particularly market risk.

The past seven years have been a roller-coaster ride for banks' asset/liability management committees (ALCO). In 1999 and 2000, the U.S. economy was at the top of a cycle: Banks had good loan demand, interest rates were high, and the yield curve was flat. The economy reverted to recession in 2001, and for the next three years interest rates were low and the yield curve was steep. In the past two and a half years, short-term interest rates have increased and the yield curve is inverted.

In managing a bank's balance sheet, a number of factors are beyond the control of an ALCO, including accounting rules, industry regulations, and the business and interest rate cycles.

The Business Cycle

Figure 1 presents the phases of a business cycle, using current history as a framework to explain the impact on bank balance sheet management.

The business cycle expanded throughout the 1990s and reached a peak in 2000. The top of a cycle usually features strong loan demand, and because businesses are prospering, loan quality is also strong. At the peak of the cycle, interest rates are relatively high and the yield curve flattens. Balance sheet liquidity tightens due to the rising costs of funding a loan. (Loan demand and lenders have a lot to do with ultimate ALCO decisions.) Market risk, notably interest rate risk, increases as the economy reaches its peak.

In 2001, the economy reversed direction and entered a decline, referred to as a recession, in 2001.

In January of that year, the Federal Reserve lowered short-term interest rates in response to the recession. Because short-term interest rates generally continue to fall until the recession has run its course, the yield curve became steeply sloped in 2001. Simultaneously, loan demand fell off. The bottom of the cycle is when loan problems usually arise, although in 2001 there were few problems. Because loan demand fell off, liquidity was abundant. The current cycle bottomed out in 2001, and, beginning in 2002, the economy began a slow, steady recovery that has lasted into 2007. As noted in Figure 1, loan demand rose during the recovery and picked up the pace in 2005 and 2006. The results were rising interest rates, flattening yield curves, and declining liquidity.

It is important for all members of the ALCO to understand the nature of the business cycle and to realize that it is beyond the bank's control. It is also important to realize that business cycles create opportunities and threats to balance sheet management.


The Interest Rate Cycle and the Yield Curve

The yield curve is a product of the business cycle, but it needs to be addressed separately because of its direct impact on bank performance and ALCO decision making. The recent history of the yield curve is shown in Figure 2. The red line represents the top of the cycle in 2000, the green line represents the beginning phase of expansion in 2002 through 2004, and the blue line is the current yield curve. In 2000 and again in 2006, the yield curve was relatively flat; short-term and long-term interest rates were similar, and rates were relatively high. At the bottom of the cycle in 2003, we experienced low interest rates and a steep yield curve. Again, it is important for all members of the ALCO to understand the rhythm of interest rates and the implications for balance sheet decision making.

To better understand the implications for balance sheet management, let's examine the impact of the yield curve on the banking industry from 2003 (green line in Figure 2) to 2006 (blue line)--that is, during a rising-rate environment. …