ADNEOM Benelux Training
ALM Different businesses - Commercial Bank : making loans to customers and hoping to earn a return because the cost of the funds borrowed is less than the interest earned on the funds lent out. - Investment bank : institutions are paid a fee for their services, and acts as agent rather than principal - Trading
ALM Different risks Interest rate risk : There should be a positive difference between the interest paid on money borrowed (the liability), and that received on money lent (the asset). However, typically the interest rates payable on assets and liabilities will be subject to change over the life of transactions. Liquidity risk : a bank may make a 5-year loan, and raise the cash through a 6-month deposit that it hopes to refinance. Risk exists because, in six months' time, the bank may not be able to raise cash easily at reasonable rate, or even at all. Credit risk : In the case of a loan, will a counterparty be able to repay borrowings? In the case of trading markets, will a counterparty be able to pay for any securities that might have been purchased? Other risks : Market risks, foreign exchange risks, etc.
ALM Risks & ALM Bank = risk factory The ALM function of a financial organization focuses on interest rate risk and liquidity risk. A bank might raise money through the deposits of a current account. Although a retail customer typically leaves money on deposit at the bank for a long period, the customer has the right to withdraw money on demand. If the money has already been lent out for a long period of time, then liquidity risk (the classic 'run on the bank') must be taken into account.
ALM • ALM Scope • When using funds to generate assets (making loans, investing in securities, and so on) or raising funds and generating liabilities, the individual transactions will differ as to: • Rate type (fixed, variable) • Maturity : * the values of long-term fixed rate instruments become more volatile as maturities lengthen. • * A current account has no maturity; the money can be withdrawn by a depositor at any time. • * Credit lines - the bank has no precise way of knowing when or how much a counterparty will need to withdraw under an agreement. • * Mortgages : a borrower may choose to refinance a mortgage as rates fall; just when the mortgage is becoming more profitable it gets repaid.
ALM - Liquidity : If a bank adopts the 'traditional posture' of lending long term funds and borrowings in the short-term, then the borrowings will need to be repaid or refinanced before the asset becomes payable.
ALM Liquidity & Central Banks Most central banks impose or recommend prudential liquidity requirements that oblige banks to keep some amount of cash on hand, or on deposit with the central bank, or both. Furthermore, central banks operate as 'lenders of last resort'
ALM • RiskMeasurement • Sensitivities : How much will a given value, such as the market value of an investment, change given a particular movement of a market variable? • Volatilities : How likely is it that the market will move by certain amounts such as to change target values? • Scenarios : The central form of scenario analysis is to take the distribution above and analyze the 'worst cases' at the relevant tail of the distribution. This is fundamentally the value at risk (VaR) approach
Some sources of interest rate risk - Repricing risk :
ALM • YieldCurveRisk: • Normal YieldCurve :
ALM • Basis Risk: that instruments which reference different indices will experience different sized rate shifts at different times. • Options : many financial instruments contain embedded options, such as the call or put provisions contained in certain securities. These allow bonds issuers or bonds investors to change the final maturity of an instrument. • In the case of variable rate loans, 'caps' may exist which state a maximum value for a rate, irrespective of that which is observed. • Asymmetry of fixed rate mortgages due to optionality of refunding when interest rates are decreasing.
ALM Sources of liquidity - Funding Risk : Can the institution borrow at an appropriate market rate? If the perceived creditworthiness of an institution declines, then it may be forced to borrow at increasingly higher rates. Perceptions will tend to deteriorate if the institution persistently borrows more and more funds. - Funding alternatives : Where can the institution borrow money? A retail-oriented operation may rely on depositors, and it may not be easy to quickly change the size of flows from this source. Alternatively, a large international operation may be able to borrow money form a greater variety of markets than those open to small operations. - Market/Asset liquidity risk : There may be a general deterioration in market conditions and it may not be possible to raise the funds required easily if conditions are 'tight'. Furthermore, if an institution was hoping to raise funds through the sale of assets, the liquidity of such assets may be impaired.
ALM • GAP Reporting • All of the individual interest rate sensitive assets and liabilities are collected together and separated out into individual 'time buckets'. • Each bucket represents a collection of asset/liabilities that have similar repricing dates. For instance, a floating rate loan that had 6-month Libor resets, and where the next reset was due in four months' time, would appear as an asset in the relevant bucket covering four months. • The sum of repricing assets is compared with the sum of repricing liabilities in a particular bucket. • A positive gap therefore should represent an increase in interest income if rates rise.
ALM • Liquidity/maturity Gaps • Another gap analysis which focuses on the maturity of outstanding assets/liabilities is needed to manage the risk of refinancing assets. • Problems with GAP Analysis • The simplification process of gap reports means that certain issues may be hidden • If 2 instruments with different maturities exists in the same bucket. • for instruments where maturity is unstated; a statistical analysis should be made.
ALM Risk & reward In financial markets risk and reward are positively correlated. The objectives of ALM units thus differ widely between banks because they will not have the same risk appetite. There is no single dominant risk-reward strategy that applies to all financial institutions. ALM Objectives Tactical: Existing or projected interest rate and liquidity risks need to be identified and hedged in accordance with an institution's guidelines. The tactical components of ALM are typically the responsibilities of a central treasury. Strategic: It may be necessary to adjust long-term business decisions so that the overall business mix of an institution reflects a desired risk profile. Strategic decisions are more likely to be taken by some senior management forum.
ALM Tactical ALM – Hedging in the treasury The job of a central treasury is to manage any interest rate or liquidity risks that have been identified. It will often be looking to neutralize, or immunize, outstanding risks in the portfolio.
ALM Managing the repricing risk may increase liquidity risk. the liability would need to be continuously refinanced every six months until the maturity of the loan. To avoid the risk, the treasury might be offered the opportunity to issue a fixed rate 5-year bond. However, although the liquidity risk would be largely eliminated (ignoring the minor issue of coupon cash mismatches), interest rate risk would be increased.
ALM • Risk Management with derivatives • With Interest rate swaps : • With options : for example, the income on a variable rate capped loan will be restricted by the 'cap' rate of the loan, even if rates rise.
ALM • Issues with derivatives • Market limitations : the relevant derivatives may not exist in all markets, or there may only be limited liquidity for certain maturities. • Liquidity risk : the more customized agreement will probably have a higher cost and lower liquidity. • - Contractual restrictions : The use of derivatives is thus usually accompanied by a significant documentary burden, and requires that a counterparty is of sufficient creditworthiness to enter into the trade. Access to the market is limited. • - Other factors : For example, mortgage prepayments may be due to economic factors, which can generally only be estimated.
ALM ALM & Funds Transfer Pricing (FTP) It is the role of ALM to consider the funding risks of the whole bank across its different business lines. While the FX department may be responsible for managing currency risks, they will require funding in order to carry out business. This money will generally be delivered from a central source - the treasury. Similarly, while a syndicated loan department might be responsible for pricing and executing term loans for clients, the treasury will generally arrange for actual funds to be transferred to the loan desk - at a particular price.
ALM • Asset/Liability Committee (ALCO) • Determine the relevant risk targets • Outline guidelines for the management of current and future risks and the range of actions permitted to the treasury function. • Define policy for key internal issues such as FTP • Guide to the future business mix of the bank (level of mortgages, shorter or longer-dates loans, etc.). This have an impact on the pricing for different products.
ALM Who is the ALCO The decisions made by the ALCO are fundamental to the viability of an institution, and will determine the positioning of the institution within a market. Consequently the membership of the committee will tend to include senior executives such as the CEO. Since the decisions affect most business lines within an organization, the committee will also tend to include the key executives from individual business lines. There will also be input from independent risk management or governance executives.