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Asset Liability Management Vikram Singh Sankhala
Asset Liability Management
Vikram Singh Sankhala
TopicsThe definition and implications of Liquidity RiskThe role of the ALCOThe concept of funding gapsThe concept and implications of duration gapsSome measures of liquidity riskThe concept of funds transfer pricing
Reading MaterialsALCO (The Essentials of Risk Management, pp. 185-188)Gap Analysis (The Essentials of Risk Management, pp. 188-195)Earnings at Risk (The Essentials of Risk Management, pp. 195-199)Duration Gap (The Essentials of Risk Management, pp. 199-203)Liquidity Measures (The Essentials of Risk Management, pp. 203-205)Funds Transfer Pricing (The Essentials of Risk Management, pp. 205-206)
Case StudiesContinental Illinois: A Case StudyDaiwa Bank
ExampleConsider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years. For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations.
The net transaction appears profitablethe bank is earning a 20 basis point spreadbut it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 3.20 it is earning on its loan.
Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The bank is in serious trouble. It is going to be earning 3.20% on its loan and paying 6.00% on its financing.
The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970's, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to asset-liability mismatches were small or trivial.
Many firms intentionally mismatched their balance sheets. Because yield curves were generally upward sloping, banks could earn a spread by borrowing short and lending long.Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued into the early 1980s.
Some Concepts
Liquid AssetsLiquid assets are assets that can be turned quickly into cashLow transaction costsLittle or no loss in principle valueTraded in large market (trading does not move the market)
Liquid AssetsExamples: T-bills, T-notes, T-bonds
Ratio of liquid assets to anticipated short-term liability cash flowsMultiple time horizons might be consideredAsset-Liability Management*Liquidity Ratios
Asset-Liability Management
Measures the sensitivity of the value of a series of cash flows to changes in interest ratesDuration is approximately the average point at which the projected cash flows occurFor example, if a portfolio of assets has a duration of 4, a 1% increase in interest rates will cause a 4% decrease in its valueAsset-Liability Management*Duration
Asset-Liability Management
Measures the sensitivity of the duration of a series of cash flows to changes in interest ratesConvexity measures how rapidly duration changes as interest rates change
Compare duration and convexity of assets with those of liabilitiesAsset-Liability Management*Convexity
Asset-Liability Management
Create portfolios with offsetting cash flowsUsesReduce systemic or non-diversifiable riskScopeFor a business segmentAcross business segmentsApproachesStatic or dynamicRely on business cash flows or supplement with derivativesAsset-Liability Management*Hedging
Asset-Liability Management
Cash flow matchingStructure portfolios to match asset and liability cash flowsImmunizationStructure portfolios so that the impact of a change in interest rates on the value of liabilities offsets the corresponding impact on asset values
Asset-Liability Management*Hedging Techniques
Asset-Liability Management
Cash flow testingProject cash flows under various interest rate scenariosExamine the adequacy of asset cash flows to meet liability cash flows under each scenarioValue at risk (VaR)Probability-based boundary on lossesUsed by banks to measure risk in trading portfolioEconomic capitalAssets required, in excess of liabilities, to avoid ruin at a given confidence level
Asset-Liability Management*Other Measurement Techniques
Asset-Liability Management
LIQUIDITY RISK
LIQUIDITY RISK
What is liquidity risk?Liquidity risk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations
WHAT ARE THE EFFECTS OF LIQUIDITY CRUNCH
Risk to banks earningsReputational riskContagion effectLiquidity crisis can lead to runs on institutionsBank / FI failures affect economy
LIQUIDITY RISKFactors affecting liquidity riskOver extension of creditHigh level of NPAsPoor asset qualityMismanagementReliance on a few wholesale depositorsLarge undrawn loan commitmentsLack of appropriate liquidity policy & contingent plan
TYPES OF LIQUIDITY RISKSBroadly of three types:
Funding Risk: Due to withdrawal/non-renewal of deposits
Time Risk: Non-receipt of inflows on account of assets(loan installments)
Call Risk: contingent liabilities and new demand for loans
TACKLING LIQUIDITY RISKTackling the liquidity problemA sound liquidity policyFunding strategiesContingency funding strategies Liquidity planning under alternate scenariosMeasurement of mismatches through gap statements
Approaches
Traditional regulatory approachBroadly, regulators have developed 2 approaches to liquidity regulation:The first is to monitor banks mismatch between out-flows and inflows at short maturities (e.g. 1 day, week or month). Banks should measure the potential outflows over the period & ensure that they have sufficient liquidity to meet the funding requirement.The second requires banks to hold, at all times, a stock of highly liquid assets that can be used in the event that they encounter problems raising liquidity.
Traditional regulatory approachFor authorities, ensuring that banks hold adequate liquid assets makes banks individually, and the system as a whole, more robust and better able to withstand shocks without recourse to central bank supportBut there is an obvious public policy trade-off between risk and efficiency in the size of the buffer banks hold.
Traditional regulatory approachThis approach is fine as a starting point, but it has a number of limitations:It is a broad-brush, one size fits all approach which is not tailored to the circumstances of particular banks;It places insufficient emphasis on qualitative factors, particularly the adequacy of systems & controls for managing liquidity risk; &It does not reflect the latest liquidity risk management practices of major banks.
LIQUIDITY RISKMETHODOLOGIES FOR MEASUREMENT
Liquidity indexPeer group comparisonGap between sources and usesMaturity ladder construction
1. Liquidity indexLiquidity index: Weighted sum of fire sale price P to fair market price, P*, where the portfolio weights are the percent of the portfolio value formed by the individual assets. I = S wi(Pi /Pi*)
2. Peer group comparisons :Peer group comparisons: usual ratios include borrowed funds/total assets, loan commitments/assets etc.
Other Measures:Peer group comparisons: usual ratios include: borrowed funds/total assets, loan commitments/assetsLoan Losses / Net loansTotal Deposits./ Total AssetsReserve for Loan losses / Net Loans
3. Sources and UsesNet liquidity statement: shows sources and uses of liquidity.Sources: incoming deposits, revenue from sale of non deposit services, Customer Loan repayments, Sale of bank Assets, Borrowing in money marketUses include: Deposit Withdraws, Volume of Acceptable loan requests, repayments of bank borrowing, other operating expenses, dividend payments
4. Maturity ladder Construction
Maturity ladder/Scenario AnalysisFor each maturity, assess all cash inflows versus outflowsDaily and cumulative net funding requirements can be determined in this mannerMust also evaluate what if scenarios in this framework
For Liquidity PlanningImportant to know which types of depositors are likely to withdraw first in a crisis. Allow for seasonal effects. Delineate managerial responsibilities clearly.
Liquidity ManagementLiquidity can be managed from either the asset side of the balance sheet or the liability side. Asset based managementMain goal is storing liquidity in the form of liquid assets.Less risky and often used by smaller institutionsCostsOpportunity cost of foregone earnings if soldOpportunity cost of liquid assetsTransaction CostsWeakened Balance Sheet
Liquidity ManagementRaising funds via borrowing if neededAdvantagesOnly borrow if funds are neededVolume and composition of asset portfolio is unchangedCan always attract funds (by increasing rate)DisadvantagesDependent upon market rateWithdrawal risk (funding risk)
Balanced Liquidity ManagementCombination of Asset and Liability ManagementBorrow only for unanticipated (usually short term needs)Plan for long term liquidity needs via asset management.
Interest Rate Risk
Net Interest Income= Interest Income-Interest Expenses.
Net Interest Margin= Net Interest Income/Average Total Assets
Important Terms
Net Interest Margin
Net interest margin (NIM)
Example:$100 million 5-year fixed-rate loans at 8% = $8 million interest$90 million 30-day time deposits at 4% = $3.6 million interest$10 million equityNet interest income = $4.4 millionNet interest margin (NIM) = ($8 - $3.6)/$100 = 4.4%If interest rates rise 2%, deposit costs will rise in next year but not loan interest. Now, NIM = ($8 - $5.4)/$100 = 2.6%.
Interest Rate RiskInterest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM). Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.
Sources of Interest Rate RiskInterest rate risk mainly arises from:Gap RiskBasis RiskNet Interest Position RiskEmbedded Option RiskPrice RiskReinvestment Risk
Interest rate risk is the volatility in net interest income(NII) or in variations in net interest margin(NIM).Gap:The gap is the difference between the amount of assets and liabilities on which the interest rates are reset during a given period.Basis risk:The risk that the interest rate of different assets and liabilities may change in different magnitudes is called basis risk.Embedded option:Prepayment of loans and bonds and/or premature withdrawal of deposits before their stated maturity dates.
Price RiskWhen Interest Rates Rise, the Market Value of the Bond or Asset FallsReinvestment RiskWhen Interest Rates Fall, the Coupon Payments on the Bond are Reinvested at Lower Rates
Interest Rate Risk: GAP & Earnings SensitivityWhen a banks assets and liabilities do not reprice at the same time, the result is a change in net interest income.The change in the value of assets and the change in the value of liabilities will also differ, causing a change in the value of stockholders equity
How to mitigate the effect To mitigate interest rate risk, the structure of the balance sheet has to be managed in such a way that the effect on assets of any movement in Interest rates remains highly correlated with its effect on Liabilities, even in Volatile interest rate environments.
Interest Rate RiskBanks typically focus on either:Net interest income or The market value of stockholders' equity GAP Analysis A static measure of risk that is commonly associated with net interest income (margin) targetingEarnings Sensitivity AnalysisEarnings sensitivity analysis extends GAP analysis by focusing on changes in bank earnings due to changes in interest rates and balance sheet composition
FUNDAMENTALS OF ALMHow does it work?Asset-Liability Management*
Asset-Liability Management
What is ALMALM or Asset Liability Management is the structured decision making process for matching the mix of Assets and Liabilities on a firms Balance Sheet.
Asset-Liability ManagementThe Purpose of Asset-Liability Management is to Control a Banks Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity
Techniques used by ALM to control RiskGap AnalysisDuration Gap AnalysisLong Term Var
ALM Strategy is the responsibility of the treasurer of the company.But the control of Risk in the Balance Sheet is typically the mandate of the risk management function.
ALM is especially critical in the case of Financial Institutions such as commercial banks and Insurance Companies.Financial Intermediation generates two types of imbalances.
FirstAn imbalance between the amount of funds collected and Lent.
SecondAn imbalance between the maturities and interest rate sensitivities of the sources of funding and the loans extended to Clients.
Deposits normally have lower maturities than loans.The rate of interest normally increases with the term of the loan.
Cash flows from both assets and liabilities must be projectedThe timing and amount of some cash flows are highly predictable, but many are notAsset-Liability Management*ALM is built on cash flows
Asset-Liability Management
ALCOThe asset liability management committee is the traditional name in the banking industry for what is often known today as the senior risk committee.ALCO is typically chaired by the CEO and composed of senior executive team of the bank along with Senior executives of Risk and Treasury.It is co-chaired by the Chief Risk Officer and the treasurer.
Asset-Liability Management*ALM must strike a balance
Asset-Liability Management
An historical perspectiveBefore Oct. 1979, Fed monetary policy kept interest rates stable.Due to the above factors, banks concentrated on asset management.As loan demand increased in the 1960s during bouts of inflation associated with the Vietnam War, banks started to use liability management.Under liability management, banks purchase funds from the financial markets when needed. Unlike core deposits that are not interest sensitive, purchased funds are highly interest elastic. Purchased funds have availability risk -- that is, these funds can dry up quickly if the market perceives problems of bank safety and soundness.
Liquidity PlanningImportant to know which types of depositors are likely to withdraw first in a crisis. Composition of the depositor base will affect the severity of funding shortfalls. Example: mutual funds/pension funds more likely to withdraw than correspondent banks and small businesses Allow for seasonal effects. Delineate managerial responsibilities clearly.
Causes of Liquidity RiskAsset sideMay be forced to liquidate assets too rapidly resulting n fire sale pricesMay result from loan commitmentsTraditional approach: reserve asset management
Alternative: liability management.
Asset Side Liquidity RiskRisk from loan commitments and other credit lines:met either by borrowing funds or by running down reserves
Causes of Liquidity RiskLiability sideReliance on demand depositsCore deposits (provide long term source of funds)Need to be able to predict the distribution of net deposit drains.
Net Deposit DrainsDeposit withdraws are in part offset by the inflow of new funds and income generated by from both on and off balance sheet activities.The amount by which the cash withdraws exceed the new cash inflows is the Net Deposit Drain.Positive NDD implies withdraws are greater than inflows. Negative NDD implies that inflows are greater than withdraws
Using CashThe most obvious asset side management technique is to use the cash reserves of the firm.
Gap AnalysisGap is defined as the difference between the rate sensitive assets and rate sensitive liabilities maturing within a specific time period.
Gap AnalysisGap Analysis- Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates. - If a negative gap occurs (RSARSL) in a given time band, an decrease in market interest rates could cause a decline in NII.
Measuring Interest Rate Risk with GAPTraditional Static GAP Analysis GAPt = RSAt -RSLtRSAtRate Sensitive AssetsThose assets that will mature or reprice in a given time period (t)RSLtRate Sensitive LiabilitiesThose liabilities that will mature or reprice in a given time period (t)
MATURITY GAP METHOD(IRS)THREE OPTIONS:A) RSA>RSL= Positive GapB) RSL>RSA= Negative GapC) RSL=RSA= Zero Gap
What Determines Rate Sensitivity? An asset or liability is considered rate sensitivity if during the time interval:It maturesIt represents and interim, or partial, principal paymentIt can be repricedThe interest rate applied to the outstanding principal changes contractually during the intervalThe outstanding principal can be repriced when some base rate of index changes and management expects the base rate / index to change during the interval
Interest-Sensitive AssetsShort-Term Securities Issued by the Government and Private BorrowersShort-Term Loans Made by the Bank to Borrowing CustomersVariable-Rate Loans Made by the Bank to Borrowing Customers
Interest-Sensitive LiabilitiesBorrowings from Money MarketsShort-Term Savings AccountsMoney-Market DepositsVariable-Rate Deposits
ExampleA bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The banks initial spread is 4%.
What is the banks one year gap?
Sheet1
$10,000 Car loan
4 year Car loan at8.50%
1 year CD at4.50%
Spread4.00%
4 year Car Loan8.50%
1 Year CD4.50%
4.00%
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ExampleTraditional Static GAP AnalysisWhat is the banks 1-year GAP with the auto loan?RSA1yr = $0RSL1yr = $10,000GAP1yr = $0 - $10,000 = -$10,000The banks one year funding GAP is -10,000If interest rates rise (fall) in 1 year, the banks margin will fall (rise)
Measuring Interest Rate Risk with GAPTraditional Static GAP AnalysisFunding GAPFocuses on managing net interest income in the short-runAssumes a parallel shift in the yield curve, or that all rates change at the same time, in the same direction and by the same amount.
Asset-Sensitive Bank Has:Positive Dollar Interest-Sensitive GapPositive Relative Interest-Sensitive GapInterest Sensitivity Ratio Greater Than One
Liability Sensitive Bank Has:Negative Dollar Interest-Sensitive GapNegative Relative Interest-Sensitive GapInterest Sensitivity Ratio Less Than One
Aim is to stabilise the short-term profits,long-term earnings and long-term substance of the bank.The parameters that are selected for the purpose of stabilizing asset liability management of banks are: -Net Interest Income(NII) -Net Interest Margin(NIM) -Economic Equity Ratio
Net Interest Income- Interest Income-Interest Expenses. Net Interest Margin- Net Interest Income/Average Total Assets
Economic Equity Ratio-The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. The fact assesses the sustenance capacity of the bank.
Net Interest Margin
Factors Affecting Net Interest IncomeChanges in the level of interest ratesChanges in the composition of assets and liabilitiesChanges in the volume of earning assets and interest-bearing liabilities outstandingChanges in the relationship between the yields on earning assets and rates paid on interest-bearing liabilities
ExampleConsider the following balance sheet:
Sheet1
Expected Balance Sheet for Hypothetical Bank
AssetsYieldLiabilitiesCost
Rate sensitive$5008.0%$6004.0%
Fixed rate$35011.0%$2206.0%
Non earning$150$100
$920
Equity
$80
Total$1,000$1,000
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)
NII = 78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
78.5
37.2
41.3
4.86%
-100
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Examine the impact of the following changesA 1% increase in the level of all short-term rates?A 1% decrease in the spread between assets yields and interest costs such that the rate on RSAs increases to 8.5% and the rate on RSLs increase to 5.5%?Changes in the relationship between short-term asset yields and liability costsA proportionate doubling in size of the bank?
1% increase in short-term ratesWith a negative GAP, more liabilities than assets reprice higher; hence NII and NIM fall
Sheet1
Expected Balance Sheet for Hypothetical Bank
AssetsYieldLiabilitiesCost
Rate sensitive$5009.0%$6005.0%
Fixed rate$35011.0%$2206.0%
Non earning$150$100
$920
Equity
$80
Total$1,000$1,000
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NII = 83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74%
GAP = 500 - 600 = -100
83.5
43.2
40.3
4.74%
-100
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1% decrease in the spreadNII and NIM fall (rise) with a decrease (increase) in the spread. Why the larger change?
Sheet1
Expected Balance Sheet for Hypothetical Bank
AssetsYieldLiabilitiesCost
Rate sensitive$5008.5%$6005.5%
Fixed rate$35011.0%$2206.0%
Non earning$150$100
$920
Equity
$80
Total$1,000$1,000
NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)
NII = 81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09%
GAP = 500 - 600 = -100
81
46.2
34.8
4.09%
-100
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Proportionate doubling in sizeNII and GAP double, but NIM stays the same. What has happened to risk?
Sheet1
Expected Balance Sheet for Hypothetical Bank
AssetsYieldLiabilitiesCost
Rate sensitive$1,0008.0%$1,2004.0%
Fixed rate$70011.0%$4406.0%
Non earning$300$200
$1,840
Equity
$160
Total$2,000$2,000
NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)
NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
157
74.4
82.6
4.86%
-200
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Changes in the Volume of Earning Assets and Interest-Bearing LiabilitiesNet interest income varies directly with changes in the volume of earning assets and interest-bearing liabilities, regardless of the level of interest rates
RSAs increase to $540 while fixed-rate assets decrease to $310 and RSLs decrease to $560 while fixed-rate liabilities increase to $260Although the banks GAP (and hence risk) is lower, NII is also lower.
Sheet1
Expected Balance Sheet for Hypothetical Bank
AssetsYieldLiabilitiesCost
Rate sensitive$5408.0%$5604.0%
Fixed rate$31011.0%$2606.0%
Non earning$150$100
$920
Equity
$80
Total$1,000$1,000
NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)
NII = 77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
77.3
38
39.3
4.62%
-20
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Changes in Portfolio Composition and RiskTo reduce risk, a bank with a negative GAP would try to increase RSAs (variable rate loans or shorter maturities on loans and investments) and decrease RSLs (issue relatively more longer-term CDs and fewer fed funds purchased) Changes in portfolio composition also raise or lower interest income and expense based on the type of change
Measuring interest rate sensitivity and the dollar gapDollar Gap:Interest rate forecasts can be important in earning bank profit.If interest rates are expected to increase in the near future, the bank could use a positive dollar gap as an aggressive approach to gap management.If interest rates are expected to decrease in the near future, the bank could use a negative dollar gap (so as rate declined, bank deposit costs would fall more than bank revenues, causing profit to rise).Incremental and cumulative gapsIncremental gaps measure the gaps for different maturity buckets (e.g., 0-30 days, 30-90 days, 90-180 days, and 180-365 days).Cumulative gaps add up the incremental gaps from maturity bucket to bucket.
Measuring interest rate sensitivity and the dollar gapGap, interest rates, and profitability:The change in the dollar amount of net interest income (NII) is:
NII = RSA$( i) - RSL$( i) = GAP$( i)
Example: Assume that interest rates rise from 8% to 10%. NII = $55 million (0.02) - $35 million (0.02) = $20 million (0.02) = $400,000 expected change in NIIDefensive versus aggressive asset/liability management:Defensively guard against changes in NII (e.g., near zero gap).Aggressively seek to increase NII in conjunction with interest rate forecasts (e.g., positive or negative gaps).Many times some gaps are driven by market demands (e.g., borrowers want long-term loans and depositors want short-term maturities).
Measuring interest rate sensitivity and the dollar gapThree problems with dollar gap management:Time horizon problems related to when assets and liabilities are repriced. Dollar gap assumes they are all repriced on the same day, which is not true. For example, a bank could have a zero 30-day gap, but with daily liabilities and 30-day assets NII would react to changes in interest rates over time.A solution is to divide the assets and liabilities into maturity buckets (i.e., incremental gap).Correlation with the market rates on assets and liabilities is 1.0. Of course, it is possible that liabilities are less correlated with interest rate movements than assets, or vice versa.A solution is the Standardized gap. For example, assume GAP$ = RSA$ - RSL$ = $200 (coml paper) - $500 (CDs) = -$300. Assume the CD rate is 105% as volatile as 90-day T-Bills, while the coml paper rate is 30% as volatile. Now we calculate the Standardized Gap = 0.30($200) - 1.05($500) = $60 - $525 = -$460, which is much more negative!
Measuring interest rate sensitivity and the dollar gapThree problems with dollar gap management:Focus on net interest income rather than shareholder wealth.Dollar gap may be set to increase NIM if interest rates increase, but equity values may decrease if the value of assets fall more than liabilities fall (i.e., the duration of assets is greater than the duration of liabilities).Financial derivatives could be used to hedge dollar gap effects on equity values.While GAP$ can adjust NIM for changes in interest rates, it does not consider effects of such changes on asset, liability, and equity values.
Duration gap analysisHow do changes in interest rates affect asset, liability, and equity values?Duration gap analysis:n general,V = -D x V x [i/(1 + i)]For assets: = -D x A x [i/(1 + i)] For liabilities: L = -D x L x [i/(1 + i)]Change in equity value is: E = A - LDGAP (duration gap) = DA - W DL, where DA is the average duration of assets, DL is the average duration of liabilities, and W is the ratio of total liabilities to total assets.DGAP can be positive, negative, or zero.The change in net worth or equity value (or E) here is different from the market value of a banks stock (which is based on future expectations of dividends). This new value is based on changes in the market values of assets and liabilities on the banks balance sheet.
Duration gap analysisEXAMPLE: Balance Sheet Duration
Assets $ Duration (yrs)Liabilities $ Duration (yrs) Cash 100 0 CD, 1 year6001.0Business loans 400 1.25CD, 5 year3005.0 Total liabilities $9002.33Mortgage loans 500 7.0Equity 100 $1,000 4.0 $1,000
DGAP = 4.0 - (.9)(2.33) = 1.90 yearsSuppose interest rates increase from 11% to 12%. Now, % E = (-1.90)(1/1.11) = -1.7%.$ E = -1.7% x total assets = 1.7% x $1,000 = -$17.
Duration gap analysisDefensive and aggressive duration gap management:If you think interest rates will decrease in the future, a positive duration gap is desirable -- as rates decline, asset values will increase more than liability values increase (a positive equity effect).If you predict an increase in interest rates, a negative duration gap is desirable -- as rates rise, asset values will decline less than the decline in liability values (a positive equity effect).Of course, zero gap protects equity from the valuation effects of interest rate changes -- defensive management.Aggressive management adjusts duration gap in anticipation of interest rate movements.
Earnings at RiskOn a periodic basisThe potential impact of the firms various gap positions On the income statement for the current quarter and full year.
Duration of equityNet worth = Market Value of Assets Market Value of Liabilities.Duration of Equity = (Market Value of Assets * Duration of Assets Market Value of Liabilities*Duration of Liabilities) divided by Net Worth
Long Term VarCan be achieved only by the Monte Carlo Method.Purpose is to generate statistical distributions of Earnings at Risk and Net worth at different time horizonsIn order to produce the worst case EAR and NW at a given confidence level say 99%.
Input ParametersTerm structure of interest rates which will include a random component.Implied VolatilitiesInterest rate sensitive prepaymentsLoan defaults etc.Simulation conducted at the pool level.Pricing models need to be developed at each stage of the simulation to assess the value of assets and liabilities at that point of time.
Complex Relationship ModelSince the EAR and NW is a function of the range of input parameters, one needs a complex pricing model to represent the function as well as assumptions about the dynamics of interest rates.Inconsistent assumptions both on the relationships and the interest rate dynamics, can distort the results.
Liquidity Risk MeasurementLiquidity can be quantified by using a symmetrical scale.There is a rank score for the dollar amount of the product.The process is done both for liquidity suppliers and Liquidity users.The amount is multiplied by the rank score.The sum on both sides is netted out.
Funds Transfer PricingHere each business unit is taken separately.If one business unit obtains funds and the other applies them, instead of taking the resultant profit margin,We take an independent benchmark like the LIBOR for each business unit and arrive at the profit margin of each business unit independently.The independent margins of Business units result in the overall margin of the Business.
Statements
OperationalCreditIncomeCorporateBankingWealth ManagementPrivateBankingLiquidityInterest RateV@RMarketReportOperationalCreditIncomeLiquidityV@RMarketOperationalCreditLiquidityV@RMarketReportReportBehaviorIncomeLiquidityInterest RateV@RMarketReportReportReportReportReportReportReportRisk Management ProfileOperationalBehaviorCreditIncomeAssetManagementWealth ManagementFundManagementPrivateBankingLiquidityInterest RateV@RMarketReportReportReportReportReportReportReport
STATEMENT OF STRUCTURAL LIQUIDITYPlaced all cash inflows and outflows in the maturity ladder as per residual maturityMaturing Liability: cash outflowMaturing Assets : Cash InflowClassified in to 8 time bucketsMismatches in the first two buckets not to exceed 20% of outflowsBanks can fix higher tolerance level for other maturity buckets.
Statement of Structural LiquidityAll Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:1 to 14 days15 to 28 days29 days and up to 3 monthsOver 3 months and up to 6 monthsOver 6 months and up to 1 yearOver 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years
STATEMENT OF STRUCTURAL LIQUIDITYPlaces all cash inflows and outflows in the maturity ladder as per residual maturityMaturing Liability: cash outflowMaturing Assets : Cash InflowClassified in to 8 time bucketsMismatches in the first two buckets not to exceed 20% of outflowsShows the structure as of a particular dateBanks can fix higher tolerance level for other maturity buckets.
An Example of Structural Liquidity Statement
BS
LIABILITIESASSETS
Capital200Investments2600
Liabilities6000Loans & Adv3600
Fixed2600Fixed600
Floating3400Floating1100
Other Liabilities300PLR Linked1900
Others Assets300
Total65006500
Duration5Duration4
Interest Rate8Change in Interest Rate-2
Liquidity
1-14Days15-28 Days30 Days-3 Month3 Mths - 6 Mths6 Mths - 1Year1Year - 3 Years3 Years - 5 YearsOver 5 YearsTotal
Capital200200
Liab-fixed Int3002002006006003002002002600
Liab-floating Int3504003504505004504504503400
Others50500200300
Total outflow700650550105011007506501050650013000
Investments2001502502503001003509002500
Loans-fixed Int5050010015050100100600
Loans - floating int20015020015015015050501100
Loans BPLR Linked1001502005003505001001002000
Others505000000200300
Total Inflow60055065010009508006001350650013000
Gap-100-100100-50-15050-503000
Cumulative Gap-100-200-100-150-300-250-30000
Gap % to Total Outflow-14.29-15.3818.18-4.76-13.646.67-7.6928.57
&C&"Arial,Bold"&16LIQUIDITY ANALYSIS
Interest
Repricing in Bucket No3
1-28 Days30 Days-3 Month3 Mths - 6 Mths6 Mths - 1Year1Year - 3 Years3 Years - 5 YearsOver 5 YearsInsensitiveTotal
Capital200200
Dep-fixed Int5002006006003002002002600
Dep-flg Int500350255000003400
Others300300
Total outflow100055031506003002002005006500
Investment3502502503001003509002500000000
Adv - Fixed100010015050100100600000000
Adv - Flg10020080000001100
Adv - PLR Linked250200155000002000
Others300300
Total Inflow800650270045015045010003006500
Gap-200100-450-150-150250800-2000
Cumulative Gap-200-100-550-700-850-60020000
&C&"Arial,Bold"&14INTEREST RATE ANALYSIS
Gap Analysis
Re-pricing in time bucket No3
Change in Int Rate - Assets-0.25%
Change in Int Rate- Liabilities-0.25%
Time BucketsAssetsLiabilitiesGapCumulative GapChange in interest amountChange in Int Received on Assetschange in Int Paid on LiabilitiesWorst ScenarioRevised NII due to change in interest rateRevised NIM due to change in interest rateChange in NIM due to change in interest rateRevised NII due to change in interest rateRevised NIM due to change in interest rateChange in NIM due to change in interest rateWorst Scenario
Rs in CroresRs in CroresCumulative
1234567891011
11-28 DaysA800.001000.00-200.00-200.000.000.000.000.000.0093.001.50%0.00%93.001.50%0.00%
229 Days to 3 monthsB650.00550.00100.00-100.000.000.000.000.000.0093.001.50%0.00%93.001.50%0.00%
33 to 6 MonthsC2700.003150.00-450.00-550.000.71-4.25-4.960.710.0093.711.51%0.76%93.711.51%0.76%
46 to 12 MonthsD450.00600.00-150.00-700.000.10-0.29-0.390.100.0093.101.50%0.10%93.811.51%0.87%
51 to 3 YearsE150.00300.00-150.00-850.000.000.0093.001.50%0.00%93.811.51%0.87%
63 to 5 YearsF450.00200.00250.00-600.000.000.0093.001.50%0.00%93.811.51%0.87%
7Over 5 YearsG1000.00200.00800.00200.000.000.0093.001.50%0.00%93.811.51%0.87%
8Non-SensitiveH300.00500.00-200.000.0093.001.50%0.00%93.811.51%0.87%
TotalI6500.006500.000.000.000.810.87%
JChange in Interest Income during 1 year horizon - with netting0.81
KWithout netting (Worst scenario)0.00
Note: 1)The change in interest amount is 0 if re-pricing is assumed after this time bucket period.
2)The changes in interest are annualised by taking midpoint of the respective time buckets
Total Rate sensitive earning AssetsLI1 - H1Rs in Crores6200.00
NIM of the BankM1.50%
NIINL3 * M3Rs in Crores93.00
Change in Interest rateOVariable-0.25%
NII after int changePN3+I5Rs in Crores93.81
NIM after Int changeQP3 / L31.51%
=R(Q3-M3)/M3EAR0.87%
Projected EAR-1.00%
Target Gap372.00
&CINTEREST SENSITIVITY - EAR - ANALYSIS
duration
FV1000
Coupon8.00%
Market Rate (YTM)5.00%
Time to Maturity3 Years
Frequency of Interest Payment1
1234= (2) *(3)5=4/Sum(4)6=(5) * (1)6/(1+ytm)
Cash FlowsDiscounting FactorPresent Value of Cash FlowsPV of cash flow as % of PV of BondDuration SegmentM-duration Segment
TimeFV * Coupon / Frequency1/(1+YTM)**tCash flow * Disconting FactorPV of cash flow / PV of the Bond(PV of Cash flow / PV of the Bond) * timeDuration Segment / (1+YTM)
1800.952380952476.19047619050.07043603260.07043603260.0670819358
2800.907029478572.56235827660.06708193580.13416387160.1277751158
310800.8638375985932.9446064140.86248203162.58744609492.4642343761
PV of Bond1081.69744088112.7920459992.6590914277
&CDURATION & M-DURATION
Duration
M - DURATION
Present Value of the Bond
Example
LiabilitiesAmountDuration
Fixed Deposit for 2 years1001.50
Fixed Deposit for 3 years2002.30
300
Portfolio Duration2.03
Assets
5 Years Term Loan1503.50
Cash Credit1500.60
300
Portfolio Duration2.05
Duration analysis
Market ValueMdurationMV* Mduration
Fixed Rate Liabiliites2600410400
Floating Rate Liabilities34000.51700
Total Liabilities600012100
Duration of Liabilities2.02
Investments2600513000
Fixed Rate Loans60031800
Floating Rate Loans11000.5550
PLR Linked Loans19000.5950
Total Assets620016300
Duration of the Assets2.63
Market ValueMdurationChange in MVNew MV
Assets62002.63-81.506118.50
Liabilities60002.02-60.505939.50
Equity2000.61-21.00179.00
Change in Interest Rate0.50%
&CDURATION - ANALYSIS
Duration - standard model
Standardised Approach to IRR
Time-bandNet Gap (Rs. Cr)Middle of time-bandProxy of modified duration (years)Assumed change in yield (BPS)Weighting factorCapital Required
Upto 1 month-200.000.5 months0.042000.08%-0.16
1 to 3 months100.002 months0.162000.32%0.32
3 to 6 months-450.004.5 months0.362000.72%-3.24
6 to 12 months-150.009 months0.712001.42%-2.13
1 to 2 years-75.001.5 years1.382002.76%-2.07
2 to 3 years-75.002.5 years2.252004.50%-3.38
3 to 4 years425.003.5 years3.072006.14%26.10
4 to 5 years-175.004.5 years3.852007.70%-13.48
5 to 7 years760.006 years5.0820010.16%77.22
7 to 10 years460.008.5 years6.6320013.26%61.00
10 to 15 years360.0012.5 years8.9220017.84%64.22
15 to 20 years-140.0017.5 years11.2120022.42%-31.39
over 20 years-640.0022.5 years13.0120026.02%-166.53
200.006.49
settlement16-Dec-02Capital200
maturity31/Dec/0220%40
coupon5%
ytm5%
price100
freq2
mduration0
var-cal
Computation of VAR
FOR A 5 CRORE POSITION IN 12.50%, GOI, 2000
Datehighlowaveragereturns
3-Apr-99103.70103.58103.6450000000Value of the Portfolio
5-Apr-99103.89103.61103.750.1061%0.0115%MEAN RETURN
6-Apr-99103.91103.80103.8550.1012%0.2747%SD OF RETURN
7-Apr-99104.00103.00103.5-0.3418%274699DEAR at 97.5% Confidence Level
8-Apr-99104.17104.02104.0950.5749%614245VAR for 5 day holding period
9-Apr-99104.16103.59103.875-0.2113%
10-Apr-99104.20103.97104.0850.2022%
12-Apr-99104.20104.15104.1750.0865%
13-Apr-99104.19104.16104.175-0.0000%
15-Apr-99104.16104.02104.09-0.0816%
16-Apr-99104.21104.18104.1950.1009%
19-Apr-99104.25103.95104.1-0.0912%
20-Apr-99104.87104.17104.520.4035%
21-Apr-99104.25103.45103.85-0.6410%
22-Apr-99104.22104.19104.2050.3418%
23-Apr-99100.24104.21102.225-1.9001%
24-Apr-99104.25104.18104.2151.9467%
26-Apr-99104.25104.18104.2150.0000%
28-Apr-99104.26104.24104.250.0336%
29-Apr-99104.50104.26104.380.1247%
3-May-99104.48104.41104.4450.0623%
4-May-99104.48104.46104.470.0239%
5-May-99104.48104.40104.44-0.0287%
6-May-99104.49104.44104.4650.0239%
7-May-99104.51104.42104.4650.0000%
8-May-99104.51104.46104.4850.0191%
10-May-99104.48104.45104.465-0.0191%
11-May-99104.45104.44104.445-0.0191%
12-May-99104.46104.44104.450.0048%
13-May-99104.45104.44104.445-0.0048%
14-May-99104.42104.41104.415-0.0287%
15-May-99104.40104.37104.385-0.0287%
17-May-99104.41104.37104.390.0048%
18-May-99104.45104.41104.430.0383%
19-May-99104.46104.44104.450.0192%
20-May-99104.45104.43104.44-0.0096%
21-May-99104.44104.43104.435-0.0048%
22-May-99104.44104.41104.425-0.0096%
24-May-99104.43104.40104.415-0.0096%
25-May-99104.43104.40104.4150.0000%
26-May-99104.48104.40104.440.0239%
27-May-99104.48104.35104.415-0.0239%
28-May-99104.38103.90104.14-0.2634%
29-May-99104.23103.99104.11-0.0288%
31-May-99104.39104.15104.270.1537%
1-Jun-99104.37104.22104.2950.0240%
2-Jun-99104.35104.32104.3350.0384%
3-Jun-99104.36104.32104.340.0048%
4-Jun-99104.54104.42104.480.1342%
5-Jun-99104.47104.44104.455-0.0239%
7-Jun-99104.46104.44104.45-0.0048%
8-Jun-99104.45104.43104.44-0.0096%
9-Jun-99104.46104.44104.450.0096%
10-Jun-99104.46104.44104.450.0000%
11-Jun-99104.45104.45104.450.0000%
12-Jun-99104.34104.34104.34-0.1053%
14-Jun-99104.34104.25104.295-0.0431%
15-Jun-99104.31104.29104.30.0048%
16-Jun-99104.24104.20104.22-0.0767%
17-Jun-99104.32104.24104.280.0576%
18-Jun-99104.33104.28104.3050.0240%
19-Jun-99104.35104.32104.3350.0288%
21-Jun-99104.35104.32104.3350.0000%
22-Jun-99104.34104.34104.340.0048%
24-Jun-99104.33104.31104.32-0.0192%
25-Jun-99104.33104.25104.29-0.0288%
26-Jun-99104.24104.24104.24-0.0479%
28-Jun-99104.20104.19104.195-0.0432%
29-Jun-99104.18103.91104.045-0.1440%
1-Jul-99104.05103.99104.02-0.0240%
2-Jul-99104.10104.05104.0750.0529%
3-Jul-99104.10104.10104.10.0240%
5-Jul-99104.38104.04104.210.1057%
6-Jul-99104.37104.30104.3350.1200%
7-Jul-99104.36104.35104.3550.0192%
8-Jul-99104.34104.30104.32-0.0335%
10-Jul-99104.36104.32104.340.0192%
12-Jul-99104.54104.34104.440.0958%
13-Jul-99104.32104.32104.32-0.1149%
14-Jul-99104.33104.32104.3250.0048%
15-Jul-99104.35104.32104.3350.0096%
16-Jul-99104.35104.32104.3350.0000%
17-Jul-99104.38104.33104.3550.0192%
19-Jul-99104.40104.36104.380.0240%
20-Jul-99104.41104.37104.390.0096%
21-Jul-99104.42104.39104.4050.0144%
22-Jul-99104.48104.42104.450.0431%
23-Jul-99104.56104.44104.50.0479%
24-Jul-99104.47104.43104.45-0.0478%
26-Jul-99104.47104.42104.445-0.0048%
27-Jul-99104.47104.45104.460.0144%
28-Jul-99104.52104.46104.490.0287%
29-Jul-99104.58104.50104.540.0479%
30-Jul-99104.71104.50104.6050.0622%
31-Jul-99104.86104.54104.70.0908%
2-Aug-99105.00104.72104.860.1528%
3-Aug-99105.15104.97105.060.1907%
4-Aug-99105.55105.13105.340.2665%
5-Aug-99105.95105.50105.7250.3655%
6-Aug-99105.89105.00105.445-0.2648%
7-Aug-99105.82105.60105.710.2513%
9-Aug-99105.70105.63105.665-0.0426%
10-Aug-99105.67105.56105.615-0.0473%
11-Aug-99105.50105.05105.275-0.3219%
12-Aug-99105.35104.95105.15-0.1187%
13-Aug-99105.18104.80104.99-0.1522%
14-Aug-99105.48104.48104.98-0.0095%
16-Aug-99105.53105.19105.360.3620%
17-Aug-99105.50105.45105.4750.1091%
18-Aug-99105.50105.46105.480.0047%
19-Aug-99105.49105.49105.490.0095%
20-Aug-99105.48105.40105.44-0.0474%
21-Aug-99105.46105.42105.440.0000%
23-Aug-99105.53105.42105.4750.0332%
24-Aug-99105.52105.47105.4950.0190%
25-Aug-99105.46105.40105.43-0.0616%
26-Aug-99105.41105.39105.4-0.0285%
27-Aug-99105.45105.41105.430.0285%
28-Aug-99105.45105.39105.42-0.0095%
30-Aug-99105.40105.37105.385-0.0332%
31-Aug-99105.41105.30105.355-0.0285%
1-Sep-99105.31105.17105.24-0.1092%
2-Sep-99105.22105.15105.185-0.0523%
3-Sep-99105.15105.05105.1-0.0808%
4-Sep-99105.14105.05105.095-0.0048%
6-Sep-99104.92104.96104.94-0.1475%
7-Sep-99104.92104.89104.905-0.0334%
8-Sep-99104.90104.84104.87-0.0334%
9-Sep-99105.20105.02105.110.2289%
10-Sep-99105.20105.20105.20.0856%
14-Sep-99105.20105.10105.15-0.0475%
var
Value of Portfilio500
DayRatesReturns
1101.23
2102.311.07%
3102.00-0.30%
4101.37-0.62%
5103.121.73%
6102.11-0.98%
7102.570.45%
8103.000.42%
9101.78-1.18%
10102.991.19%
11102.61-0.37%
Mean Return0.14%
Standard Deviation0.01
Probability68.30%90.00%95.50%98.00%99.70%50.00%
Confidence Level84.15%95.00%97.75%99.00%99.85%84.15%95.00%97.75%99.00%99.85%
Std Devision11.6522.333
VAR for 1 day (DEAR)4.918.119.8211.4514.74
7VAR for 7 days13.0021.4425.9930.2838.99
VAR fordays
&C&"Arial,Bold"&14VALUE AT RISK - AN EXAMPLE
STRATEGIES
To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.
Risk Management procedures vary vastly from institution to institution as well as the available data and environments
This implies Integrated Risk Management will be both expensive and time consuming
Therefore, Integrated Risk Management MUST be custom made according to the institutions requirements
Liquidity Risk in Banks
Cash versus liquid assetsBanks own four types of cash assets: vault cash, demand deposit balances at Federal Reserve Banks, demand deposit balances at private financial institutions, and cash items in the process of collection (CIPC). Cash assets do not earn any interest, so the entire allocation of funds represents a substantial opportunity cost for banks. Banks attempt to minimize the amount of cash assets held and hold only those required by law or for operational needs.
Why do banks hold cash assets?Banks supply coin and currency to meet customers' regular transactions needs. Regulatory agencies mandate legal reserve requirements that can only be met by holding qualifying cash assets. Banks serve as a clearinghouse for the nation's check payment system. Banks use cash balances to purchase services from correspondent banks.
Cash assets are liquid assetsonly to the extent that a bank holds more than the minimum required.Liquid assets are generally considered to be:cash and due from banks in excess of requirements, federal funds sold and reverse repurchase agreements, short-term Treasury and agency obligations, high quality short-term corporate and municipal securities, and some government-guaranteed loans that can be readily sold.
Liquidity versus profitabilityThere is a short-run trade-off between liquidity and profitability. The more liquid a bank is, the lower its return on equity and return on assets, all other things being equal. Both asset and liability liquidity contribute to this relationship. Asset liquidity is influenced by the composition and maturity of funds. In terms of liability liquidity, banks with the best asset quality and highest equity capital have greater access to purchased funds. (They also pay lower interest rates and generally report lower returns in the short run.)
Liquidity risk, credit risk, and interest rate riskLiquidity management is a day-to-day responsibility. Liquidity risk, for a poorly managed bank, closely follows credit and interest rate risk. Banks that experience large deposit outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired. Few banks can replace lost deposits independently if an outright run on the bank occurs.
Factors affecting certain liquidity needs:New Loan DemandUnused commercial credit lines outstanding Consumer credit available on bank-issued cards Business activity and growth in the banks trade area The aggressiveness of the banks loan officer call programsPotential deposit lossesThe composition of liabilities Insured versus uninsured depositsDeposit ownership between: money fund traders, trust fund traders, public institutions, commercial banks by size, corporations by size, individuals, foreign investors, and Treasury tax and loan accounts Large deposits held by any single entity Seasonal or cyclical patterns in deposits The sensitivity of deposits to changes in the level of interest rates
Asset liquidity measuresAsset liquidity the ease of converting an asset to cash with a minimum loss. The most liquid assets mature near term and are highly marketable. Liquidity measures are normally expressed in percentage terms as a fraction of total assets.Highly liquid assets include:Cash and due from banks in excess of required holdings and due from banks-interest bearing, typically with short maturitiesFederal funds sold and reverse RPs.U.S. Treasury securities maturing within one yearU.S. agency obligations maturing within one yearCorporate obligations maturing within one year and rated Baa and aboveMunicipal securities maturing within one year and rated Baa and aboveLoans that can be readily sold and/or securitized
Pledging requirementsNot all of a banks securities can be easily sold. Like their credit customers, banks are required to pledge collateral against certain types of borrowings. U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral.
What about loans?Many banks and bank analysts monitor loan-to-deposit ratios as a general measure of liquidity. Loans are presumably the least liquid of assets, while deposits are the primary sources of funds. A high ratio indicates illiquidity because a bank is fully extended relative to its stable funding.
The Loan-to-Deposit Ratio, continuedThe loan-to-deposit ratio is not as meaningful a measure of liquidity as it first appears.Two banks with identical deposits and loan-to-deposit ratios may have substantially different liquidity if one bank has highly marketable loans while the other has risky, long-term loans. An aggregate loan figure similarly ignores the timing of cash flows from interest and principal payments. The same is true for a banks deposit base. Some deposits, such as long-term nonnegotiable time deposits, are more stable than others, so there is less risk of withdrawal.In summary, the best measures of asset liquidity identifies the dollar amounts of unpledged liquid assets as a fraction of total assets.
Purchased Liquidity and Asset QualityA banks ability to borrow at reasonable rates of interest is closely linked to the markets perception of asset quality. Banks with high quality assets and a large capital base can issue more debt at relatively low rates. Banks with stable deposits generally have the same widespread access to borrowed funds at relatively low rates. Those that rely heavily on purchased funds, in contrast, must pay higher rates and experience greater volatility in the composition and average cost of liabilities. For this reason, most banks today compete aggressively for retail core deposits.
Funding AvenuesTo satisfy funding needs, a bank must perform one or a combination of the following:Dispose off liquid assetsIncrease short term borrowingsDecrease holding of less liquid assetsIncrease liability of a term naturee. Increase Capital funds
Liquidity planningBanks actively engage in liquidity planning at two levels. The first relates to managing the required reserve position. The second stage involves forecasting net funds needs derived, seasonal or cyclical phenomena and overall bank growth.
Liquidity planning: Monthly intervalsThe second stage of liquidity planning involves projecting funds needs over the coming year and beyond, if necessary.Projections are separated into three categories: base trend, short-term seasonal, and cyclical values.Management can supplement this analysis by including projected changes in purchased funds and in investments with specific loan and deposit flows.
Monthly liquidity needsThe banks monthly liquidity needs are estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits:Liquidity needs = Forecasted Dloans + Drequired reserves - forecasted Ddeposits
Liquidity GAP measuresManagement can supplement this information with projected changes in purchased funds and investments with specific loan and deposit flows.The bank can calculate a liquidity GAP by classifying potential uses and sources of funds into separate time frames according to their cash flow characteristics.The Liquidity GAP for each time interval equals the dollar value of uses of funds minus the dollar value of sources of funds.
Considerations in selecting liquidity sourcesThe previous analysis focuses on estimating the dollar magnitude of liquidity needs. Implicit in the discussion is the assumption that the bank has adequate liquidity sources.Banks with options in meeting liquidity needs evaluate the characteristics of various sources to minimize costs.
Evaluating Asset sales:Brokerage feesSecurities gains or lossesForegone interest incomeAny increase or decrease in taxesAny increase or decrease in interest receipts
Evaluating New borrowings:Brokerage feesRequired reservesFDIC insurance premiumsServicing or promotion costsInterest expense.The costs should be evaluated in present value terms because interest income and expense may arise over time.The choice of one source over another often involves an implicit interest rate forecast.
*LIQUIDITY RISK: Effects
EFFECTS OF LIQUIDITY CRUNCH Risk to banks earningsReputational riskContagion effectLiquidity crisis can lead to runs on institutionsBank and Financial Institutions failures affect economy
*LIQUIDITY RISK: FactorsFactors affecting liquidity riskOver extension of creditHigh level of NPAsPoor asset qualityMismanagementNon recognition of embedded option riskReliance on a few wholesale depositorsLarge undrawn loan commitmentsLack of appropriate liquidity policy & contingent plan
*LIQUIDITY RISK: SolutionsTackling the liquidity problemA sound liquidity policyFunding strategiesContingency funding strategies Liquidity planning under alternate scenariosMeasurement of mismatches through gap statements
*What is a Liquidity Contingency Plan?A documented process to ensure that your bank has the ability and means to obtain the necessary funds to manage through a liquidity crisis.Creates a process to follow to utilize management talent to expedite access to the financial markets and to inform shareholders, customers and the regulatory authorities that you are taking the appropriate actions to mitigate a liquidity crisis.
*When could a liquidity crisis occur?Intraday fraud, large wire out, etcEnd of Day Market crisis, etcOver several days.Over a month.Over several months.Stems from Market, Credit and/or Operational Risk EventsEither Bank Specific or Systemic
*Liquidity Contingency Plan: ObjectivesEnsure that a viable capability exists to respond to an event.Accomplish the LCP in an efficient, documented and orderly way.Minimize losses and reputational damage.Protect the Balance Sheet and financial position, even if the Balance Sheet moves to a new structure.Minimize the risk of legal liabilities.Ensure compliance with all applicable laws and regulations.Maintain the confidence and good relations with the shareholders, investment community, regulatory agencies, customers, service providers and other involved parties.
*How Do I know when the Liquidity Contingency Plan should be activated?When a pre-determined set of parameters are exceeded.When a pre-determined number of triggers are activated.Note Targets are difficult to assess without parametersExample A target rate of 2% - When is it way off?
*LCP Activation When do I do this?Level 1 Event Indicated by minor infringement on the liquidity parameters and/or triggers. Handled in the normal course of business.
Level 2 Event Indicated by additional triggers and parameter violations. Additional executives become involved in addressing the problem. Access to unsecured lines, pledging additional collateral, brokered CDs, etc
Level 3 Event At level 3, the LCP is formally activated. A pre-determined set of parameters/triggers are exceeded.Not handled during the normal course of business.Scope and duration could have a strong adverse effect on the bankNeed to utilize multiple internal and external resources.Could be as a result of a physical disaster (make sure this plan is referenced in your Business Continuity Plan)
*When should liquidity actions be taken?Below is an activation table that indicates when liquidity actions should be taken. This table is a guidance table. To use this table, add the parameters and triggers together. However, the plan may be activated with fewer or no parameters or triggers exceeded, especially in the case of a sudden event.
Level # of Parameters ExceededNumber of Triggers ExceededLevel I22Level II 44Level III Full Plan Activation66
*Parameter Examples
Liquidity and Funding RatiosLowHighGross Loans to Total Deposits70%140%Duration and Maturity Adjusted Liquidity75%90%Fixed Liability Ratio25%100%Pledgable Mortgage Loans to Total Residential Mortgage Loans70%80%Net Short Term Non-core Fund Dependence (Short term non core funding less short term investments divided by long term assets) 50%80%Net Non-core Fund Dependence (Non core liabilities less short term investments divided by long term assets)50%85%Brokered Deposits to Deposits0%20%
*Triggers for different eventsTriggers are used as the basis for scenarios for review by the Bank. The triggers are used in order to ensure their relevance to the liquidity situation at the Bank. Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases of uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy. Systemic risk events can be sudden and unexpected, or the likelihood of their occurrence can build up over time in the absence of appropriate policy responses. The adverse real economic effects from systemic problems are generally seen as arising from disruptions to payment systems, to credit flows, and from the disruption of asset values. This definition, from The Group of Ten: Report on Consolidation in the Financial Sector, captures both the timing and the scope of such an event. Systemic risk is diversifiable and the events that trigger the LCP should match the Banks exposures.
*Triggers - Examples
DescriptionChange/Cap/FloorProbability/SeverityStrong shift from accommodative to restrictive monetary policyQualitativeMedium/LowUnemployment rate changes to indicate a recession50% ChangeMedium/MediumLoss of confidence in a major capital markets participant by funds providers that may spill over to othersQualitativeLow/MediumIndications of a potential asset bubbleQualitativeMedium/HighAgency MBS spreads to the 5 year Swap 5 day moving average150 bp increaseLow/High3 month LIBOR to 3 Month T-Bills 5 day rolling average100 bp increaseLow/MediumCommercial Paper Issuance by Banks ($) year to year50% decreaseLow/Medium
*Parameters and TriggersParameters are established for overall management.Triggers are identified for three types of situationsNormal to Non-Normal Systemic Normal to Non-Normal Bank Specific Non-Normal with Further Deterioration Systemic and Bank Specific The most difficult triggers to identifyReports should be developed that contain this information and should be reviewed on a pre-identified schedule. In a crisis, critical reporting should be accelerated.
*Who Gets Involved? Liquidity Event Management Team (LEMT)
LEMT MembersPrimary ResponsibilityChief Executive OfficerLEMT LeaderActivate LCPEnsure necessary decisions are made by appropriate executives LEMT Leader role can be delegated to another executive Chief Risk OfficerActivate LCP (if necessary)Ensure necessary decisions are made by appropriate executives (if necessary)Chief Financial OfficerCoordinate all financial efforts related to the eventCoordinate communication with regulatory agenciesChief Treasury OfficerAlternate LEMT LeaderCoordinate activities in Investments, Deposits and LendingCoordinate actions to access and secure funds for the financial institutionLCP CoordinatorCoordinate all actions related to enacting the LCPCoordinate communication up to the LEMT and down to the identified interested parties, including the BCP if requiredTreasury Operations/ALMProvide data and run models to manage the event.Coordinate scenario planning.Corporate CommunicationsCoordinates all communications, with the exception of the Regulatory AgenciesServe as the point of contact for the media and other outside parties (except regulatory agencies) seeking information about the nature and status of the event and responses by the Bank
*Key individuals who support the LEMT
Other ExecutivesPrimary ResponsibilityChief Credit OfficerCoordinate response for all lending area activitiesSVP Retail BankingAssist in coordination of response for all regional community bank activitiesAssistant TreasurerCoordinate all investment decisionsSenior Trust OfficerCoordinate response for all trust area activitiesLegal CounselIdentify legal issues as they arise and advise the LCP on liability issuesExpedite review of contracts for procurement of necessary fundsCoordinate insurance documentation and recordkeeping requirements for claims processing, if necessaryCorporate ControllerBalance sheet accounting and budget forecasting.Human Resources DirectorEnsure officers and employees who are deemed to need to be exited are exited and access to sensitive systems and information is discontinued.Work with recruiters if key personnel are required with specific skill sets.
FIVE STAGES OF LIQUIDITY CRISIS MANAGEMENT
*Stage 1Declaration and Notification of Liquidity CrisisDeclaration of Formal Liquidity Crisis, based on pre-defined triggers.Notification of interested and involved individuals through use of the Contact List.Arranging the initial meeting to discuss actions to be taken to mitigate the Liquidity CrisisThe LEMT Leader assumes control of the response activities.Corporate Communications prepares necessary employee notifications and news releases for media, regulators and counterparties.
*Stage 2Initial Meeting of the Liquidity Event Management TeamDistribution of the LCP and the reasons for the declaration of the need for contingent liquidity.Establish meeting schedule, information requirements and potential actions.Arranging for full disclosure of issues to the LEMT.Ensuring actionable items come out of the initial meeting, enabling early intervention.Developing communication to the appropriate regulatory authorities regarding the reason for the activation and the intended actions.
*Stage 3Subsequent Meetings and Actionable ItemsProvide updates regarding liquidity status and projected needs.Review updated information.Determine how balance sheet, employees, customers, shareholders and counterparties are responding to draw downs of loan commitments, additional collateralizations, securitizations, sales and other actions.Determine next steps, responsibilities and next meeting.
*Stage 4Movement to Stabilized State of LiquidityAs liquidity stabilizes, determine methods to pay down loans, unwind positions and other steps to resume a stable liquidity state.Reforecast upcoming months to develop strategy.Identify communications requirements
*Stage 5Forensic Review of Crisis Conduct table top walk through of crisis.Amend plan as appropriate.Communicate forensic activities to appropriate personnel.
*LCP: The GoalIt is important to remember that the goal is to bridge the liquidity deficiency and not attempt to restructure the balance sheet for long term profitability. In fact, because of the liquidity issues, the profitability of the Bank should expect to suffer. The goal is to focus on short term solutions to enable the Bank to continue operating until longer term stability can be achieved.
*Actions to be taken during a Liquidity Crisis In order of consideration A liquidity crisis, whether a Level I, II, III, requires a concerted effort by the Bank to manage through. Because each liquidity crisis is somewhat unique, the actions outlined below are not specified as being required but are rather presented in menu form. In general, a financial institution should consider tapping funds that are readily available, unsecured and can be termed longer than originally projected. These types of funds will be made unavailable or priced out of range more quickly than funds that require collateral to access. Of secondary importance is the cost of these funds, as they are being used to deal with a crisis and should be expected to have a higher cost associated with them. At the same time, some diversification is considered prudent because of the message that is being sent to the market. It is important to keep in mind that the funds being accessed are to address the crisis until the Bank returns to a new level of stability, even if the new level is of a significantly riskier institution. In other words, the goal is to survive.The LCP Coordinator should keep a list of available sources of funds and understand any covenants associated with their use. This list should be updated at least monthly or more frequently in case of a crisis.
*Examples of Actions
ActionImpactDetermine severity and duration of crisis through current observations and estimates of the short-term outlook.Creates platform from which to build recovery strategy. Have all Business Units that could have large outflows of cash contact Treasury prior to OutflowProvides ability to negotiate on deposits or alerts Treasury on wire activity. Reduces cash outflow.Move maturing less liquid securities into more liquid instruments.Typically reduces yield but provides pledgable collateral. Preferable to total liquidation because investments remain after liquidity crisis subsides.Acquire fed funds to cover liquidity shortfall.Very short term strategy to cover intraday or interday liquidity needs. Reduce correspondent balances and move to paying fees for services instead of compensating balances.Short term strategy to cover immediate cash needs. Access unsecured lines. Counterparties noted in Appendix I.Accessing unsecured lines should be an early stage activity and addresses short term needs. These funds will typically not be available as the crisis unfolds. Early use saves collateral for use at a later stage. However, a blended approach should be used (unsecured and secured).Access unsecured term loans. Counterparties noted in Appendix I.Accessing unsecured term loans should be an early stage activity and addresses the need to lengthen maturities. These funds will typically not be available as the crisis unfolds. Early use saves collateral for use at a later stage.Move customer repurchase agreements away from pledged securities.Pledged securities (repos) used for customer deposits may need to be redirected to access market funds. While there might be some flight from the bank because of this, alternatives can be offered to customers to retain deposits for a short period of time.
LIQUIDITY RISKRBI GUIDELINESStructural liquidity statementDynamic liquidity statementBoard / ALCOALM Information SystemALM organisationALM process (Risk Mgt process)Mismatch limits in the gap statementAssumptions / Behavioural study
ALM - Funds Transfer PricingRateMaturityLoanDeposit
Questions for RevisionWhat are liquid assets ? What is a liquidity crisis ? What is its impact on an organization ? Illustrate with examples ?What is meant by liquidity Risk ? Why is it so important ?
Define the followingNet Interest IncomeNet Interest MarginStatic Gap Analysis in ALM.
Questions for RevisionWhat is Interest Rate Risk ? How does it affect a banks earnings ?What is meant by Asset Liability Management ? What is ALCO ? What is the composition of ALCO ?
Questions for RevisionWhat are the traditional regulatory approaches towards Managing Liquidity Risk?Discuss the methods that an organization can use to tackle liquidity risk ? What are the committees, contingency plans, triggers and actions that an organization put in place to tackle liquidity Risk ?
The End
*************************Managing Assets and Liabilities: Strategies for Insurance CompaniesOctober 2008*********Managing Assets and Liabilities: Strategies for Insurance CompaniesOctober 2008***************************************A liquid asset is one that can be easily and quickly converted into cash with minimum loss. Contrary to popular notion "cash assets" do not generally satisfy a bank's liquidity needs.If, for example, the bank experiences an unexpected drain on vault cash, the bank must immediately replace the cash or it would have less vault cash than required for legal or operational needs.
*******Aggregate ratios thus ignore the difference in composition of both assets and liabilities, along with their cash-flow characteristics.
***WORK EXAMPLE PROBLEM HERE!******************************
