Managing Core Risks in Banking

8/3/2019 Managing Core Risks in Banking

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MANAGING CORE RISKS IN BANKING:

ASSET-LIABILITY MANAGEMENT (ALM)

BANGLADESH BANK



Asset Liability Management Policy Asset Liability Management (ALM) is an integral part of Bank Management; and so, it is essential to have a structured and systematic process for manage the Balance Sheet. Banks must have a committee comprising of thesenior management of the bank to make important decisions related to the Balance Sheetof the Bank. The committee, typically called the Asset Liability Committee (ALCO),

should meet atleast once every month to analysis, review and formulate strategy tomanage the balance sheet. In every ALCO meeting, the key points of the discussionshould be minuted and the action points should be highlighted to better position the bank’s balance sheet. In every ALCO meeting, action points taken in the past ALCOmeeting should be reviewed to ensure implementation. Specific functions of ALCO are:1. To receive and review reports on liquidity risk, market risk and capital management ascovered in this report. 2. To identify balance sheet management issues like balance sheetgaps, interest rate gap/profiles etc. that are leading to under-performance. 3. To reviewdeposit-pricing strategy for the local market. 4. Review liquidity contingency plan for the bank.



PART A EXECUTIVESUMMARY. ....................................................................................................4PURPOSE/METHODOLOGY/LIMITATIONS/DISCLAIMERS.....................................5POLICYSTATEMENT..........................................................................................................7

ORGANISATIONALSTRUCTURE.....................................................................................8PROCESS .................................................................................................................................9 1. ALCO ANDALM ................................................................................................................9 2. THECOMMITTEE ..........................................................................................................10 3KEYAGENDAS ...............................................................................................................10 4ALCOPAPER ...................................................................................................................10 4.1COMMENTARY......................................................................................................10 4.2

INTEREST RATE TREND OF THE MARKET .................................................11 4.3BALANCE SHEET..................................................................................................11 4.4INDICATORS ..........................................................................................................11 4.5MATURITY PROFILE...........................................................................................14 4.6LIQUIDITY TEST...................................................................................................15 4.7INTEREST RATE PROFILE.................................................................................16 4.8COMPLIANCE ........................................................................................................16 5.THE ALCO PROCESS ..................................................................................................176. ACTIONPOINTS ...........................................................................................................17 7.IMPLEMENTATION AND REVIEW OF STRATEGIES ........................................17 8.SPECIAL ALCO MEETING.........................................................................................189. MARKETRISK ..............................................................................................................18 KEYCONCEPTS ..................................................................................................................19



EXECUTIVE SUMMARY Changes in market liquidity and or interest rates exposes banks/ business to the risk of loss, which may, in extreme cases, threaten the survival of institution. As such, it is important that senior management as well as the Board of Directors must understand the existence of such risk on the balance sheet and they shouldensure that the structure of the institutions’ business and the level of balance sheet risk it

assumes are effectively managed, that appropriate policies and procedures are establishedto control and limit these risks, and that resources are available for evaluating andcontrolling interest rate risk. Increasingly Asset Liability Management has become anintegral part of Bank Management. Banks’ are exposed to Balance Sheet Risk, where it isabsolutely necessary for the management of the bank to understand the existence of suchrisk and best manage the exposure to the risk. The Asset Liability Committee (ALCO),comprising of the senior management of a bank, is primarily responsible for BalanceSheet Management or more specifically Balance Sheet Risk Management. The reportaims at promoting international best practices in Balance Sheet Management for the banking industry in Bangladesh. The purpose of the report/ guidelines is to provideguidance to management and to train new staffs. This is intended to be the basic

framework for further development as the skill sets go up the curve and also, to introducenew policies and processes as we make progress in understanding and implementing the basics.

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Bangladesh Bank Focus Group



Purpose This report is aimed to provide a detailed guideline on Asset LiabilityManagement (ALM) of the bank for optimum Balance Sheet Risk Management. Thisguide is prepared by the members of the ‘Focus group on Foreign Exchange Risk &Asset-Liability Management’, which emphasises on developing the market and the banking industry as a whole. The members include: 1) Kh. Khalidur Rahman Deputy

General Manager Bangladesh Bank 2) Ezaz Ahmed Senior Principal Officer Sonali Bank 3) Ahmed A Shah Head of Global Markets Standard Chartered Bank 4) Bashar M TareqVice President Citibank, N.A. 5) Md. Mohasin Miah Senior Vice President Dhaka Bank Ltd. 6) Syed Imtiaz Hasib Senior Executive Vice President Southeast Bank Ltd. Thisguide would cover the process of Asset-Liability Management and the role of ALCO inBalance Sheet management. Methodology The guideline is based on the internationaltools and strategies practiced by the banks to manage its balance sheet risk. Differentreports, researches, databases etc. published in Asset Liability Management were used as primary input for this paper. Limitations While utmost care has been given to cover every part of Asset Liability Management, a few complex issues related to Market Risk havenot been

5 Bangladesh Bank Focus Group



covered in details. For example, in Value at Risk (VaR) the complex formulas for calculating the VaR has not been included. Disclaimers All data used as references andexamples are hypothetical assumptions and does not relate to any bank or organization inany respect.

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PART A: POLICY STATEMENT Board or Management Committee of the Bank shouldset out the policy statement in at least for the followings and an annual review should bedone taking into consideration of changes in the balance sheet and market dynamics. 1)Loan Deposit Ratio (LD): The AD ratio should be 80%-85%. However, the Loan Depositratio of the bank should go upto 110%. The Loan Deposit ratio = Loan/

(Deposit+Capital+Funded Reserve) The ratio will be fixed based on the bank’s capital,Bank’s reputation in the market and overall depth of the money market. 2) WholesaleBorrowing Guidelines (WBG): The guideline should be set in absolute amount dependingon bank’s borrowing capacity, historic market liquidity. The limit should be capped at the bank’s highest level of past borrowings. However, this limit can be increased based onthe matchfunding basis. 3) Commitments: The commitments Guideline limits should notexceed 200% of the unused wholesale borrowing capacity of the last twelve months. Thelimit can be increased if there are natural limitations on customer discretion to drawagainst committed lines or a bank’s access to additional funds via realisation of surplusstatutory holdings. 4) Medium Term Funding Ratio (MTF): The MTF of a bank shouldnot be less than 30%. The ideal scenario should be 45%. Given, the overall scenario of

current market, it will be suitable to move towards the MTF limit of 45% as we progress.5) Maximum Cumulative Outflow: MCO upto I month bucket should not exceed 20% of the balance sheet. 6) Liquidity Contingency Plan: A liquidity contingency plan needs to be approved by the board. A contingency plan needs to be prepared keeping in mind thatenough liquidity is available to meet the fund requirements in liquidity crisis situation.An annual review of the contingency planning should be made. 7) Local RegulatoryCompliance: There should be a firm policy on compliance to the Bangladesh Bank inrespect of CRR, SLR, Capital adequacy etc.

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PART B: ORGANISATIONAL STRUCTURE OF ALM The Asset Liability Committee(ALCO) is responsible for balance sheet (asset liability) risk management. Managing theasset liability is the most important responsibility of a bank as it runs the risks for notonly the bank, but also the thousands of depositors who put money into it.

The responsibility of Asset liability Management is on the Treasury Department of the bank. Specifically, the Asset liability Management (ALM) desk of the TreasuryDepartment manages the balance sheet. The results of balance sheet analysis along withrecommendation is placed in the ALCO meeting by the Treasurer where importantdecisions are made to minimise risk and maximize returns. Typically, the organisationalstructure looks like the following:

CEO / MANAGING DIRECTOR

Head of Consumer Banking

Head of Head of Consumer Treasury Banking

Head of Corporate Banking

Head of Finance

Head of Credit

Head of Operations

Head of Asset Liability Mgt (ALM)

Treasury: Responsible for ALM

Money Market Dealers

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The key roles and responsibilities of the ALM Desk: 1) To assume overallresponsibilities of Money Market activities. 2) To manage liquidity and interest rate risk of the bank. 3) To comply with the local central bank regulations in respect of bank’sstatutory obligations as well as thorough understanding of the risk elements involved withthe business. 4) Understanding of the market dynamics i.e competition, potential target

markets etc. 5) Provide inputs to the Treasurer regarding market views and update the balance sheet movement. 6) Deal within the dealer’s authorised limit.

PART C: PROCESS

1. ALCO & Asset Liability Management (ALM) The bank’s asset liability managementis monitored through ALCO. The information flow in the ALCO can be diagramed as below:

Corporate Banking

Feedback & Recommendation Feedback & Recommendation

FinanceDepo-Adv Trend & Outlook Key Balance Sheet Features

Feedback & Recommendation

S T R A T E G Y &

Treasury

Analysis & Recommendation

ALCO Meeting

B/S Status & Recommended Actions

CEO

Depo-Adv Trend & Outlook

Other Balance Sheet Features Feedback & Recommendation

A C T I O N P O I N T S

Other Depts. Consumer BankingFeedback & Recommendation

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2. The Committee As the Treasury Department is primarily responsible for AssetLiability Management, ideally the Treasurer (or the CEO) is the Chairman of the ALCOcommittee. The committee consists of the following key personnel of a bank: Chief Executive Officer / Managing Director Head of Treasury / Central Accounts DepartmentHead of Finance Head of Corporate Banking Head of Consumer Banking Head of Credit

Chief Operating Officer / Head of Operations

The committee calls for a meeting once every month to set and review strategies onALM. 3. Key Agendas ALCO attends the following issues while managing BalanceSheet Risks: (i) (ii) (iii) (iv) (v) Review of actions taken in previous ALCO. Economicand Market Status and Outlook. Liquidity Risk related to the Balance Sheet. Review of the price / interest rate structure. Actions to be taken.

4. ALCO Paper An ALCO paper is produced every month (usually by the FinanceDepartment) which covers various issues related to Balance Sheet risk management. TheALCO paper is prepared before the ALCO meeting as the committee reviews the ALCO

paper to set strategies. An ALCO paper typically covers the following: 4.1 CommentaryA brief summary on the following issues for the last month are provided for review:

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• Combined as well as segmented (Current, STD, Term etc.) Deposit Trend for local andforeign currency. • Combined as well as segmented (Overdraft, Term etc.) AdvanceTrend for local and foreign currency. • Loan/Deposit Ratios. • Limit status and utilisation.4.2 Interest Rate Trend of the Market Interest rate and yield curve for Treasury Bills,Overnight funds, term money, competitive bank’s published customer rates are included

in the paper. 4.3 Balance Sheet A summarised or detailed version of the banks balancesheet for the current and previous month is provided to understand the trend in assets andliabilities. This portion also covers the variance in assets and liabilities against the targetof the bank. 4.4 Key Management Indicators (Limits and Utilisation) The management of every bank sets different limits in managing risk and exposures. The current limit of allindicators along with recent utilisation is included for management review. Also trend for last few months are also included for better understanding of the behavior of theindicators. Some of the key management Indicators are as follows: (a) WholesaleBorrowing Guidelines: A key control in the management of liquidity risk is a set of guidelines placed on each bank’s need to raise funds from the wholesale market. This is a bank’s standard source of marginal funding. Typically, defined as the ability of a bank to

raise funds from the wholesale market (or interbank market), it is also the mostvulnerable given the large size of individual deposits and the relatively small number of potential counterparties. To reduce the bank’s dependency on funds from the wholesalemarket (or the interbank market), the ALCO should examine the funding products presently offered and consider whether other funding products may diversify/expand the bank’s funding base. Separate amounts may be established for local currency and foreigncurrency balance sheets. A bank’s capacity to borrow from the external wholesale marketdepends on a number of factors: - the size and turnover of the local market; our share of that market - the credit limits imposed by our counterparties, etc.

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Given the various factors influencing the bank’s fund-raising from the wholesale market,it is not possible to be absolutely sure of our exact capacity. A number of factors areconsidered for setting the wholesale borrowing guideline (WBG), which include -Balance sheet size of the bank. - Historical trend of market liquidity. - Credit Rating of the bank (to understand counterparty banks’ limits on the concerned bank). - Stability of

liquidity and interest rates of the market. (b) Commitments: A bank’s liquidity is verymuch vulnerable to undrawn commitments by customers. Undrawn commitments may beunutilised by not drawing an overdraft limits of customers or any loan commitments,which has not been drawn by customers. Customers have the right to ask for these fundsat any point in time and the bank is obligated to pay the customer. Thus a ceiling should be set on a bank’s commitments to customers. The undrawn commitment guideline may be established which relates the maximum level of undrawn commitments to the bank’sremaining unused wholesale borrowing capacity. These measures are to ensure that the banks are able to raise funds in order to meet customers’ demands for drawing on linesthat they have granted to them. (c) Loan Deposit Ratio: Loan deposit ratio, typicallycalculated as the ratio of loans against deposits, is the most common way to see a bank’s

liquidity position. In an ideal scenario, loan deposit ratio should not exceed 80% (as 20%of DTL is required for statutory requirements). However, a bank may decide to lend outits capital or raise funds from the interbank with a view that market interest rates would be low. But excessive lending (a high Loan Deposit Ratio) may expose a bank in seriousliquidity and interest rate risk as the market liquidity may tighten any time. (d) MediumTerm Funding Ratio: Banks typically make money by running mismatches, that is, by borrowing short term and lending long term. However, short term deposits may go out of the bank upon maturity, whereas a bank cannot call back long term lendings. Thus a bank has to find the right combination for longer term mismatch. Medium term funding ratio iscalculated as the ratio of liabilities with a contractual maturity of more than one year toassets with a contractual maturity of more than one year. This ratio is intended tohighlight the extent to which we are dependent on being able to roll over short termdeposits in order to fund medium term assets.

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(e) Maximum Cumulative Outflow (MCO): Under normal conditions, the day-to-daymanagement of liquidity relies on the effective control of cash flow. Maximumcumulative outflow (MCO) guidelines control the net outflow (inflow from asset maturityminus outflow from liability maturity) over the following periods: overnight, one week and one month. The Treasury operation of a bank will review its funding capabilities and

recommend the guidelines to senior management. These guidelines will be based on theestimated wholesale funding shortfall after calculating the forecast/contractual cash flowof the entity under normal business conditions. The basis of cash flow measurement is toassume that funds are repaid on their contractual maturity date. For wholesale funds, thisis sufficient. However, it is not realistic to assume that retail business will behave in thismanner. In practice, current accounts and savings deposits are not withdrawn the next dayand overdrafts are not repaid on demand. Retail business can be expected to follow moreor less predictable patterns being influenced by seasonal factors and other trends. Inmonitoring liquidity, an estimate should be made of the expected change in suchassets/liabilities with the resulting need for higher/lower funding from the wholesalemarket. Whilst systems constraints will often impede frequent and timely updating of

cash flow data relating to retail business, it is nevertheless important to include realisticestimates within the MCO data which Treasury use to manage the bank’s aggregate cashrequirements. The ability to raise cash by selling marketable assets may be factored intothe MCO calculation but only to the extent that these assets are not already relied upon inorder to meet internal or statutory reserve asset requirements. The MCO guideline is a‘business as usual’ measure, which implies that necessary reserve liquidity must bemaintained at all times and so cannot be counted towards meeting the MCO requirement.Whilst it may not be possible to include specific figures within MCO controls, banksshould also be aware of cash flows from settlement of foreign exchange transactions andof intra-day exposures arising from the operation of the daily clearing systems.(f)Swapped Funds Guideline: A limit on the maximum amount (in absolute terms) thatcan be swapped from foreign currency liabilities in order to fund local currency assets, or,where appropriate, vice versa. The purpose of this measure is to prevent excessivedependence on the

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continued existence of an orderly foreign exchange market of sufficient depth to meet our funding needs. 4.5 Maturity Profile Mismatch A key issue that banks need to focus on isthe maturity of its assets and liabilities in different tenors. A typical strategy of a bank togenerate revenue is to run mismatch, i.e. borrow short term and lend longer term.However, mismatch is accompanied by liquidity risk and excessive longer tenor lending

against shorter-term borrowing would put a bank’s balance sheet in a very critical andrisky position. To address this risk and to make sure a bank does not expose itself inexcessive mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month, 1-3 months,3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-5 years, over 5 year)maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket. However, as most deposits and loans of a bank matures next day (call, savings,current, overdraft etc.), bucket-wise assets and liabilities based on actual maturity reflectshuge mismatch; although we know that all of the shorter tenor assets and liabilities willnot come in or go out of the bank’s balance sheet. As a result, banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current, overdraft etc. aredivided into ‘ core and non-core’ balances, where core is defined as the portion that is

expected to be stable and will stay with the bank; and non-core to be less stable. Thedistribution of core and non-core is determined through historical trend, customer behavior, statistical forecasts and managerial judgement; the core balance can be put intoover 1 year bucket whereas non-core can be in 2-7 days or 3 months bucket.

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An example of Forecasted balance can be as follows: In BDT MioTOTAL CALL 2-7D 8D-1M 1-3M 3M-1Y 1-5Y 5Y+

Reserve Assets Interbank Placings Custy Assets Other Assets Total Assets Interbank Deposits Custy Deposits Capital & Reserves Other Liabilities Total Liabilities Custy

Commitments Forward Contracts Total Off-B/S NET MISMATCH CUMULATIVE NET MISMATCH

1,000 750 4,000 500 6,250 (1,000) (4,500) (500) (250) (6,250) (2,000) 250 (1,750)(1,750)

200 250 300 200 950 (750) (1,200)

300 250 550 250 1,400 1,650 (250) (1,200) 250 300 550 250 250

500 1,000 300 1,800 500 500

(1,000)

(100)

(200) (100)

(800) (400)

(250) (2,200)

(1,000)

(1,450)

(100) (150)

(300) (1,850)

(1,200)

(0)

(0) (1,250) (1,250)

100 100 (350) (1,600)

50 50 250 (1,350)

100 (50) 400 (950)



(1,850) (1,900) (2,850) 600 (2,250) 500 (1,750)

Balance Sheet Gap2,000 1,500 1,000 500 0 (500) (1,000) (1,500) (2,000) (2,500) Total Assets Total

Liabilities NET MISMATCH

4.6 Liquidity Test for Contingencies The major risk a bank runs is liquidity risk. Under any circumstances a bank has to honor its commitments. As a result, it has to make surethat enough liquidity is available to meet fund requirements in situations like liquiditycrisis in the15 Bangladesh Bank Focus Group



market, policy changes by central bank, a name problem of the bank etc. So, a bank’s balance sheet should have enough liquid assets for meeting contingencies. Liquid assetscan be as follows: • • • • • Reserve Assets. Cash in Tills. Specific Government Securities.Foreign Currency in open position. Specific FDRs.

A liquidity contingency plan should be in place to ensure a bank is prepared to combatany crisis situation. A format of a liquidity contingency plan is attached in Appendix 3.4.7 Interest Rate Profile Apart from liquidity risk, a bank also runs interest rate risk,which is the exposure of a bank's financial condition to adverse movements in interestrates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose asignificant threat to a bank's earnings and capital base. To address interest rate risk, aninterest rate profile is prepared, where consolidated yield for assets and liabilities for different maturity buckets are shown for better understanding of interest profile. Anexample of the above is shown below:Variable/1 D 950 10% 2,200 0 1,250 5% 2D-1M 2,200 3,250 150 -900 11% 5.5% 1-6M

650 10% -150 100 600 7% 6-12M 150 -250 0 -100 12% 10% 1-5Y 1,800 14% -400 01,400 0% 5Y+ 500 -0 0 500 14.5 % 0%

TOTAL ASSETS TOTAL LIABILTIES Fwd Contracts Net Mismatch

4.8 Local Regulatory Compliance Compliance to all regulatory issues including CRR,SLR, A/D ratio, Capital Adequacy, large exposures etc. along with any non-complianceand reasons behind so.

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5. The ALCO Process The ALCO process or the ALCO meeting reviews the ALCO paper along with the prescribed agendas. The Chairman of the committee, that is theTreasurer or the CEO, raises issues related to the balance sheet. Treasurer suggestswhether the interest rates need to be repriced, whether the bank needs deposits or advancegrowth, whether growth of deposits and advances should be on short or longer term, what

would be the transfer price of funds among the divisions, what kind of interbank dependency the bank should have etc. In short, all issues related to liquidity and marketrisk are covered. Based on the analysis and views of the Treasurer, the committee takesdecisions to reduce balance sheet risk while maximising profits. 6. Action Points TheALCO takes decisions for implementation of any/all of the following issues: • Need for appropriate Deposit mobilisation or Asset growth in right buckets to optimise asset-liability mismatch. • Cash flow (long/short) plan based on market interest rates andliquidity. • Need for change in Fund Transfer Pricing (FTP) &/or customer rates in linewith strategy adapted. • Address to the limits that are in breach (if any) or are in line of breach and provide detailed plan to bring all limits under control. • Address to allregulatory issues that are under threat to non-compliance. 7. Implementation and Review

of Strategies All ALCO members are provided with the minutes (Appendix 2) of themeeting within the next day. The minute includes: • • • • The attendees. The issuesaddressed. The recommendations provided by the Chairman. The action points that werefixed in the meeting.

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The members communicate the action points to their respective divisions to implementthe strategies undertaken.

8. Special ALCO Meeting Apart from the regular monthly meeting, ALCO meeting isalso called as and when any contingent situations arise. A very good example may be,

during the Eid period. At those times, market liquidity dries out and overnight rates shootup. Banks who are net borrowers from the market may be exposed to huge interestexpense the high rates in the market. This is an ideal time for a special ALCO meeting,where the committee may take critical decisions for deposit mobilisation on an urgent basis for reducing dependency from the market. 9. Market Risk and Asset LiabilityManagement Market Risk measures the risk of loss due to adverse movements in market prices or rates such as interest rates, FX rates. Following are the key managementindicators for managing Market Risk: (a) Value at Risk (VaR): Value at Risk (VaR) is astatistical estimate of an upper boundary, within a specified confidence level, of the potential amount a trading position or portfolio could decrease in value during the timeneeded to close out a position. Specifically, it is a measure of potential loss from an event

in a normal, everyday market environment. VaR is denominated in a currency, say Taka,where it measures the chance of losing Taka for a movement in interest rates for a given balance sheet scenario. For example, if a bank only has 1 month borrowing to fund 1 year customer lending, an increase in 1 month rates would result in incremental expense for the bank. VaR is estimated by assuming a 97.5% confidence level for movement inrelevant Market Risk Factors. Let us construct a very simple example to understand theVaR methodology. In the following table a simple hypothetical balance sheet for a bank is shown, where it has BDT 100 mio 1 month borrowing to fund same amount of assets: 1Month (BDT Mio) 0 100 (100) 1 Year (BDT Mio) 100 0 100Bangladesh Bank Focus Group

ASSET LIABILITY MISMATCH18



Say the market interest rate for 1 month is 8% and 1 year is 10%. Now, if we need tosquare the balance sheet gaps, we need to lend in 1month at 8% and need to borrow in 1year tenor at 10%. Therefore, the expected Value at Risk to square the position will be:VaR = 100 * (8% * 30 days/360 days) – (100 * 10% * 360 days/360 days) = BDT (0.67 – 10) = BDT 9.33 mio Different organisations use different techniques or formulas for

calculating VaR. An example of such VaR calculation is included in Appendix 4. (b)Factor Sensitivity: It is the sensitivity of an instrument/book to changes in a particular risk factor. For example, PV01 = the impact of ‘+1bp’ parallel move in the zero curve. (c)Management Action Trigger: The MAT It is a trigger level to warn of a persistently loss-making position. It defines management's tolerance for accepting market risk relatedlosses on a rolling 30 day calendar day basis:

MAT level = current VaR + latest rolling monthly P/L (21 business days) When a MATis exceeded, trading management must review the current position and decide whether itshould be maintained, reduced or closed out.

PART D:

KEY CONCEPTS

Balance Sheet Risk Balance sheet risk can be categorised in to two major types of significant risk, which are liquidity and interest rate risks. Changes in market liquidityand or interest rates exposes banks/ business to the risk of loss, which may, in extremecases, threaten the survival of institution. As such, it is important that senior managementas well as the directors must understand the existence of such risk on the balance sheetand they should ensure that the structure of the institutions’ business and the level of balance sheet risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are availablefor evaluating and controlling interest rate risk.19 Bangladesh Bank Focus Group



Liquidity Risk The risk that bank or business will be unable to meet it’s commitment asthey fall due leading to bankruptcy or rise in funding cost. It is the solvency of businessand which has special reference to the degree of readiness in which assets can beconverted into cash with out loss. Banks traditionally use the statutory liquidity reserveand their borrowing capacity in the volatile interbank money market as the source of

liquidity. But a conscious approach to measure and monitor the liquidity is somewhatlacking in our market. We can learn and draw immense benefit by sharing the best practices, tools and techniques of liquidity management. Interest Rate Risk Interest raterisk is the exposure of a bank's financial condition to adverse movements in interest rates.Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose asignificant threat to a bank's earnings and capital base. Changes in interest rates affect a bank's earnings by changing its net interest income and the level of other interest-sensitive income and operating expenses. Changes in interest rates also affect theunderlying value of the bank's assets, liabilities and off-balance sheet instruments becausethe present value of future cash flows (and in some cases, the cash flows themselves)

change when interest rates change. Accordingly, an effective risk management processthat maintains interest rate risk within prudent levels is essential to the safety andsoundness of banks. Capital Adequacy The need to adopt the best international practices,given the globolisation of economies and businesses. As you are aware of “BaselCommittee on Banking Supervision” and the emphasis on maintaining the CapitalAdequacy commensurate to exposure or risk on balance sheet. The new “Basel CapitalAccord” stipulates that “ Banks must hold capital commensurate with the level of interestrate risk they undertake”. As mentioned earlier, Changes in interest rates expose banks tothe risk of loss, which may, in extreme cases, threaten the survival of the institution. Inaddition to adequate systems and controls, capital has an important role to play inmitigating and supporting this risk. As part of sound management, banks

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translate the level of interest rate risk they undertake, whether as part of their trading or non-trading activities, into their overall evaluation of capital adequacy, although there isno general agreement on the methodologies to be used in this process. In cases where banks undertake significant interest rate risk in the course of their business strategy, asubstantial amount of capital should be allocated specifically to support this risk.

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APPENDIX 1 AN ALCO PAPER FOR KOROTOA BANK LTD.

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APPENDIX 2 A Demo ALCO Minutes ACTION POINTS (Korotoa Bank) ALCOMEETING (Mar 03, 2003 ) Attendees: CEO (Name) Head of Corporate Banking (Name)Head of Consumer Banking (Name) Head of Treasury (Name) Head of Operations(Name) Head of Credit (Name) Head of Finance (Name) Issue and proposed action

Date 03/03/0 3

Item No 1

Section PREVIOUS MINUTES

To be Action by (initials) (Date)

1. Revision to customer interest rates were to be discussed & new rates to be established.Deposit growth to be reviewed. 1. 2. 3. 4. 5. 6. 7. 8. No significant change in macro-economic factors, other than inflationary growth. Inflation rose to 4.57% in November

2002, highest since FY1999. Foreign Exchange reserve stands at US$ 1.78 bio inFebruary 2003. Broad Money (M2) recorded an increase of 5.29% during July-Dec 2002 period compared to same period last year. ADP is expected to cut to BDT 16.5 bio fromBDT 19.0 bio for FY 2003 Overnight rates in the downtrend after Eid. Treasury Bill yieldcurve is expected to be stable with no major change in sight. Secondary Market for Treasury Bills is emphasised the BBK. AD ratio has increased since the last meeting inFeb’03 Lcy Deposits has no major change in February. Assets have grown by approx.BDT 250 mio in February. Inter-bank borrowing is approx. BDT 1,000 mio. AD ratiostill within limits but there is clearly a need to grow our core deposit baseBangladesh Bank Focus Group

2

ECONOMY/ MARKET

3

LIQUIDITY

1. 2. 3. 4. 5.

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and reduce reliance on inter-bank. 6. Medium Term Funding Ratio has improved due togrowth in longer term deposits. 4 5 PRICING ACTION 1. Need to mobilise deposits onan urgent basis to reduce interbank dependency. 2. Growth of Advance and Depositsshould be synchronised. 1. Introduce new (increased) customer rates to encourage depositaccretion and emphasize need to focus on account profitability for assets w.e.f. 1st Mar.

2. Finance to determine impact of new rates on avg CB & C&I balance sheet of Jan’03and advise ALCO. 3. Contingency action plan to manage stressed liquidity discussed &agreed.

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APPENDIX 3 Liq. Contingency Plan

KOROTOA BANK CONTINGENCY ACTION PLAN TO MANAGE STRESSEDLIQUIDITY SCOPE

To establish an action plan to manage a stressed liquidity situation created by a name problem in the market.PURPOSE OF THE PLAN To provide a framework within which an effective responseto a liquidity crisis can be managed. NB Stressed Liquidity is defined as a condition thatarises from a sudden deterioration of the perceived safety and credibility of the Bank,resulting in substantial withdrawal of funds by depositors. TRIGGER POINTS Plan to beactivated when two or more of the following conditions exist : 1. 2. 3. 4. BangladeshBank has declined to open the Rediscount/Repo window at our request. Call moneymarket rates have exceeded 25% for more than 7 consecutive days. Call facilities have been declined by the market or a premium over market rates has been imposed on our borrowing. Consolidated AD ratio has exceeded 100% for more than 15 days.

Version date: February, 2003

Approved at ALCO Meeting March 03, 2003

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KOROTOA BANK CONTINGENCY ACTION PLAN TO MANAGE STRESSEDLIQUIDITY

PHASE 1 – IMPENDING CRISIS 1. Phase 1 – Team (ALCO Members) Chief ExecutiveOfficer Head of Treasury Head of Finance Head of Corporate Banking Head of

Consumer Banking Head of Credit Head of Operations Responsibility Team

2. Action Points 2.1 Investigate the underlying cause of the crisis to establish: Extend andtiming of the crisis Duration of the crisis Remedial action to avoid the crisis, agree anyexternal/ internal communications statement etc.

2.2 Advise all Divisional Heads of the crisis and cancel leave commitments of key personnel. 2.3 Review liquid and market assets portfolio by maturity and prepare aliquidation strategy. 2.4 Liquidate any long forex positions and reduce forex open position to a minimum.

Chief Executive Head of Treasury Head of Finance Head of Treasury

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PHASE 2 - CRISIS SITUATION 1. Phase 1 – Team (ALCO Members) Chief ExecutiveOfficer Head of Treasury Head of Finance Head of Corporate Banking Head of

Consumer Banking Head of Credit Head of Operations Responsibility

2. Action Points 2.1 2.1.1 2.1.2 2.1.3 2.1.4 Communication Convene Emergency ALCOMeeting to review the crises, agree content of any external /internal messages anddelegate tasks. Inform Bangladesh Bank of crisis and proposed remedial action, if deemed necessary. Brief Dealers. Brief Relationship Managers and Branch Managers.

Chief Executive Chief Executive Head of Treasury Head of Treasury Head of CorporateHead of Consumer

27





PHASE 2 - CRISIS SITUATION (cont) 2.2 2.2.1 Assessment and Action Confirm theliquid and market asset portfolio for initial selective liquidation. Assess the level of

interbank borrowing capacity and raise funds to meet liquidity from the most reliablesources. Approach Bangladesh Bank for Repo. Selling Fcy from forex open position limitto generate Lcy liquidity. Approach Bangladesh Bank for extended use of the rediscountwindow. Monitor closely withdrawal patterns, under report to Head of Treasury. Do notapprove early redemption of deposits without specific approval of the Chief Executive/Head of Treasury Assess overall level of loans/OD and ensure no incremental drawdown. No excess to be allowed. Assess overall Advances portfolio and activate plancontract/recall/seek repayment from customers.

Responsibility

Head of Treasury

2.2.2 2.2.3 2.2.4 2.2.5 2.2.6 2.2.7 2.2.8 2.2.9

Head of Treasury Head of Treasury Head of Treasury Head of Treasury Head of TreasuryHead of Corporate Head of Consumer Head of Corporate Head of Consumer Head of Corporate Head of Consumer

28




KOROTOA BANK CONTINGENCY ACTION PLAN TO MANAGE STRESSEDLIQUIDITY CRITICAL CONTACT INFORMATION 1. Management Team Work Telephone Home Telephone Chief Executive (Name) XXXXXXX XXXXXXX Head of Treasury (Name) Head of C&IB (Name) Head of Finance (Name) Head of Consumer Banking (Name) Head of Operations (Name) Head of Credit (Name) XXXXXXX

XXXXXXX XXXXXXX XXXXXXX XXXXXXX XXXXXXX XXXXXXXXXXXXXX XXXXXXX XXXXXXX XXXXXXX XXXXXXX

2. Central Bank Governor General Manager (BR&PD) General Manager (FEPD)XXXXXXX XXXXXXX XXXXXXX XXXXXXX XXXXXXX XXXXXXX

29





Government and/or Central Bank Statutory Holdings / Liquidity RequirementsRegulation Cash reserve Liquidity reserve Parameter/Formula 4% of liabilities 16% of

liabilities Comprising Lcy cash at Central Bank Treasury Bills Cash in Tills Fcy balancewith Central Bank Lcy balance with Central Bank Selected Govt Bonds

Money Market Instruments Comprising Marketable Securities and Reserve LiquidityInstrument Features/Restrictions Included in Marketable Or Reserve M&R

Treasury bills

Issued by Central Bank weekly auction at discount Tenors are 28, 91, 182, 364 days, 2years and 5 years.

30





CONTINGENCY FUNDING PLAN Local Book Money Market • Term Deposit • CallMoney • Repo Central Bank (Marketable Securities and Reserve Portfolio) • • Other •

Repo of Treasury bills Encashment of surplus balance with Central Bank Cash in hand

FCY Book Money Market • Term Deposit • Utilisation of surplus Nostro balances

31





QUANTIFICATION OF AMOUNT OF CONTINGENCY FUNDS - LOCALCURRENCY BDT IN MILLION Sources of contingency funds During stressed liquidity

Money Market F Term Deposit Central Bank (Marketable Securities and ReservePortfolio) F Repo facility for Treasury Bills 900 9.00-10.00% Estimated MaximumAvailable Funds 500 Cost to Korotoa

12.00%

F Rediscounting window

500

6.00%

F Balance with CB (Excess of CRR) Other F Lcy Cash in hand

20

0.00%

50

0.00%

32




KOROTOA BANK CONTINGENCY ACTION PLAN TO MANAGE STRESSEDLIQUIDITY QUANTIFICATION OF AMOUNT OF CONTINGENCY FUNDSFOREIGN CURRENCY

Sources of contingency funds during stressed liquidity Money Market (Marketable

Securities) Interbank Deposit Reserve

Formula/Parameters For basis of calculation

Estimated Maximum Available Funds

Cost to Korotoa

Libor+0.50bps 1 month Libor

USD 5 mio BDT 120 mio (USD 2 mio @60.0)

2.003.50% 1.25%1.75%

Signature Chief Executive Officer, Bangladesh Head of Corporate Banking Head of Treasury Head of Consumer Banking Head of Finance Senior Credit Officer Head of Operations

33




APPENDIX 4 A common formula for Value at Risk (VaR) calculation: Value at Risk = 2X Factor Sensitivity X Volatility Where, 2 relate to 2 standard deviations (97.5 %confidence level). For Interest Rates - using absolute volatility: Value at Risk = 2 XFactor Sensitivity X Volatility

Duration × Value at Risk = 2 × Net Present Value × (1+ Yieldt −1 ) Volatility

(d y ) × σ2 ( − C =2× × VAR Yt Yt −1 ,..........,Yn −1 − Yn ) d (1 + Yt −1 ) (1 + Yt −1 ) y

For Interest Rates - using relative volatility: Value at Risk = 2 × FactorSens itivity ×Volatility

Duration × × ( ) VAR= 2 × Net Present Value × (1+ Yieldt −1 ) Yield t VolatilityR

d y C Y Y− × VAR = 2 × × Yt × σ2 t Y − ,....., n 1 Y d t 1 n (1 + Yt −1 ) y (1 + Yt −1 )

Aggregation of UVAR from several positions: Zero correlation of losses: This approachassumes that the positions are independent and may or may not act as hedges.

34




VAR VAR

P ' folio

= VAR =

n

2 1

+ VAR 2 i

2+ + 2 ................. VAR

2 n

P ' folio

∑ VAR i =1

100% correlation of losses: This approach assumes that a loss is incurred on each andevery position.VAR VAR = Abs(VAR =n

P ' folio

1

) + Abs(VAR 2 )+ ............. ............+ Abs(VAR n )i

P ' folio

∑ Abs(VAR i =1

)

Perfect correlation between positions: This approach assumes that positions are perfecthedges for each other.VAR VAR P ' folio

= VAR =



n

1

+ VAR

i

2

+ .... ..... ...... ..... ..+VAR

n

P ' folio

∑ VAR

i =1

35




KOROTOA BANK A S S E T L IA B I L I T Y M A N A G E M E N T

ALCO PAPERS

FOR THE MONTH OF: FEBRUARY 2003

36




COMMENTARY

Date

28- Feb03

Liquidity LCY Month on Month Balance Sheet Movements `- Corporate BankingDeposits increased by BDT 100 mio; Mainly due to FDR by: (a) 'A' Company (BDT 50mio) (b) 'Z' Corporation (BDT 50 mio). `- Corporate Banking Advances decreased byBDT 150 mio; Mainly due to overdraft repayment by: (a) 'A' Company (BDT 50 mio) (b)'Z' Corporation (BDT 50 mio). `- Consumer Banking Deposits decreased by BDT 100mio; Mainly due to maturity of FDR of BDT 50 mio. `- Consumer Banking Advancesdecreased by BDT 100 mio; Mainly due to overdraft repayment of BDT 50 mio andmaturity of fixed loan of BDT 50 mio.

FCY Month on Month Balance Sheet Movements `- FCY balance sheet remained

relatively unchanged. Other Liquidity Issues `- Savings Deposit of corporate banking hasdecreased by 2%, whereas FDR has increased by 2.5%.

37




FINANCIAL ENVIRONMENT

Date

28- Feb03

1) TREASURY BILLS (a) Treasury Bills are auctioned at every Monday.

(b) Typical Rates TENOR 28 D 91 D 182 D 364 D 2Y 5Y Jan-03 7.80% 9.00% 7.80%10.10% 10.90% 11.50% Dec-02 8.00% 7.50% 7.80% 10.00% 10.70% 11.20% Nov-027.40% 7.50% 7.60% 9.50% 10.10% 10.90% Oct-02 6.70% 6.90% 7.20% 8.00% 9.00%10.60% Sep-02 6.30% 7.00% 6.40% 6.40% 6.90% 10.40% INTEREST RATES (%)Aug-02 Jul-02 Jun-02 5.90% 5.40% 4.60% 5.80% 5.80% 5.10% 5.80% 5.80% 5.00%6.30% 6.20% 5.80% 6.90% 7.00% 6.90% 9.30% 8.60% 8.60%

May-02 4.30% 5.00% 5.00% 5.90% 6.80% 8.70%

Apr-02 4.10% 5.10% 5.00% 5.80% 6.80% 8.80%

Mar-02 4.10% 5.20% 5.00% 5.80% 6.90% 9.40%

Feb-02 4.50% 4.90% 5.00% 5.20% 6.90% 9.40%

Jan-02 4.10% 4.90% 4.90% 5.20% 6.40% 9.50%

2) Overnight rates ranged between 5-7% for the month.

38




39




COMPETITIVE ENVIRONMENT

Date

28- Feb03

DEPOSIT SAVINGS STD 1 MNTH 3 MNTH 6 MNTH 12 MNTH 24 MNTH 36MNTH LENDING Agriculture Export Credit Small Cottage Ind. Term Loans WorkingCap

BANK 'A' 5.00 4.00 7.00 7.25 7.75 8.00 8.00

BANK 'B' 7.50 9.25 9.50 11.00 11.50 12.00

BANK 'C' 7.50 9.00 9.50 9.75 -

BANK 'D' 6.50 7.50 8.00 8.25 -

KOROTOA BANK 8.00 9.00 9.25 9.25 10.00 10.50

12.00-16.00 7.00-9.00 11.50-12.00 9.00-13.00 14.00

9.00-13.00 7.00 11.50-13.00 13.00-15.00 12.00-15.00

11.00-16.00 7.00 14.00-16.00 12.50-16.50 10.00-15.50

12.00 7.00-9.00 12.00 15.00 13.25-15.00

14.00 7.00 15.00 15.00 15.00

Commentary 1) FDR interest rates varies with amount and tenor for all banks. 2) Interestrate is fixed and nonnegotiable.

40




BALANCE SHEET SUMMARY

Currency:

BDT (Mio)

Date

28- Feb-03

ASSETS Reserve Assets Interbank Placings Corp. Custy Assets Cons. Custy AssetsOther Assets Total Assets

Current Month 1,000 750 2,500 1,500 500 6,250

Previous Month 900 900 2,350 1,400 600 6,150

LIABILITIES Interbank Deposits Corp. Custy Deposits Cons. Custy Deposits Capital &Reserves Other Liabilities Total Liabilities

Current Month (1,000) (1,500) (3,000) (500) (250) (6,250)

Previous Month (625) (1,400) (3,100) (625) (400) (6,150)

ASSET CATEGORIES

LIABILITY CATEGORIES Current Month (500) (400) (300) (300) Current Month (900)(600) (500) (1,000)

CORPORATE ASSETS Overdraft Fixed Loan Others

Current Month 750 1,000 750

Previous Month 700 1,100 550

CORPORATE LIABILITIES Savings Deposits Current Deposits FDR Others

Previous Month (550) (400) (350) (100)

CONSUMER ASSETS Overdraft Fixed Loan Others

Current Month 500 500 500

Previous Month 600 450 350

CONSUMER LIABILITIES Savings Deposits Current Deposits FDR Others



Previous Month (900) (650) (550) (1,000)

41




LIQUIDITY KEY INDICATORS 28- Feb03

Currency:

BDT (Mio)

Date

Key Management Indicators Wholesale Borrowing Guidelines Commitments LoanDeposit Ratio Medium Term Funding Ratio Swapped Funds Guideline MaximumCumulative Outflow (MCO) 1 Day 2-7 Day 8 Days to 1 Month

Current Month 1,000 1,500 89% 60% 750

Previous Month 625 1,800 83% 54% 700

Limits 2,000 2,250 100% 50% 1,000

Excess? NO NO NO NO NO

-1,250 -1,600 -1,350

-1,300 -1,500 -2,240

-1,500 -2,000 -3,000

NO NO NO

42




FORECAST LIQUIDITY SUMMARY BDT (Mio) TOTAL 1,000 750 4,000 500 6,250(1,000) (4,500) (500) (250) (6,250) (2,000) 250 (1,750) (1,750) (1,250) (1,250) (1,500)CALL 200 250 300 200 950 (750) (1,200) (250) (2,200) 2-7D 300 250 550

Currency:

Date 8D-1M 250 1,400 1,650 (250) (1,200)

28- Feb-03 1-3M 250 300 550 3M- 1Y 1-5Y 500 1,000 300 1,800 5Y+

Reserve Assets Interbank Placings Custy Assets Other Assets Total Assets Interbank Deposits Custy Deposits Capital & Reserves Other Liabilities Total Liabilities CustyCommitments Forward Contracts Total Off- B/S NET MISMATCH CUMULATIVE NET MISMATCH

250 250

500 500

(1,000)

(100)

(200) (100) (300) (1,850) (1,850) (1,900) (2,850)

(800) (400) (1,200)

(1,000)

(1,450)

(100) (150) 100 (50) 400 (950)

100 100 (350) (1,600) (2,000)

50 50 250 (1,350) (3,000)

600 (2,250)

500 (1,750)

LIMITS

43






LIQUIDITY STRESS

Currency

BDT (Mio)

Date

28- Feb03

Local CurrencyMarketable Assets Reserve Assets Stress Cash Flow Surplus/ Shortfall inReserve/Marketable Assets

Day 10 250 -25 225

Day 20 250 30 280

Day 30 250 45 295

Total Stress Net Cumulative Cashflow (Combined)

Day 1 250

Day 2 303

Day 3 328

Foreign CurrencyMarketable Assets Reserve Assets Stress Cash Flow Surplus/ Shortfall inReserve/Marketable Assets

Day 10 10 15 25

Day 20 11 12 23

Day 30 13 20 33

Other Sources of Liquidity



NONE

Day 1

Day 2

Day 3

Net Cumulative Cashflow (Combined)

250

303

328

USD CurrencySurplus/Shortfall in Reserve/Marketable Assets

Day 1

Day 2

Day 3 Stress Compliance3 Day Stress Compliance Yes

44




INTEREST RATE RISK

Currency

BDT (Mio)

Date

28- Feb03

TOTAL ASSETS TOTAL LIABILTIES Fwd Contracts Net Mismatch

Variable/1D 950 10.00% (2,200) 5.00% 0 (1,250)

2D-1M 2,200 11.00% (3,250) 5.50% 150 (900)

1-6M 650 (150) 100 600 10.00% 7.00%

6-12M 150 12.00% -250 10.00% 0 (100)

1-5Y 1,800 14.00% (400) 0.00% 0 1,400

5Y+ 500 0 0 500 14.50% 0.00%

45




LOCAL REGULATORY COMPLIANCE Date REGULATIONS COMPLIANCE 28-Feb-03 COMMENTS

(1) Cash Reserve Requirements (CRR) and Statutory Liquidity Ratio (SLR). The bank isrequired to place the following percentage of their customer deposits with the central

bank, interest free on a monthly basis and Govt. Securities and Treasury Bills. CRR-4%of average Time and Demand Deposits as at two months prior period SLR 16% of aaverage Time and Demand deposits as at two months prior period. (2) Fcy Balance heldwith Central Bank will not qualify for CRR (3) Advance to Deposit Ratio

Yes

Yes Bank is not to exceed a total (lcy + fcy) advances to deposit ratio of 120% as per statutory liquidity requirement. Central Bank does not have a set guideline but theyusually come back if the ratio is over 90% for a long time. (4) Bangladesh Central Bank Position Banks operating in Bangladesh are required to maintain credit balance with the

Central Bank minimum 4% of time and Demand Deposits as CRR and the accounts mustnot be overdrawn (5) Capital Adequacy Ratio Yes Banks operating in Bangladesh arerequired to maintain a minimum capital at 8% of total risk weighted assets (6) LargeExposures Yes Banks operating in Bangladesh are required to restrict their lending to anylarge single relationship to 15% of their capital and with the approval of Central Bank itcan be increased to 100% of their capital Note Regulatory changes * Banks operating inBangkadesh are required to maintain a minimum capital at 9% (core apital of whichminimum 4.5%) of total risk weighted assets. Yes

46




CONTRACTUAL LIQUIDITY SUMMARY

Currency

BDT (Mio)

Date

28- Feb03

Reserve Assets Interbank Placings Custy Assets Other Assets Total Assets Interbank Deposits Custy Deposits Capital & Reserves Other Liabilities Total Liabilities CustyCommitments Forward Contracts Total Off- B/S NET MISMATCH CUMULATIVE NET MISMATCH

TOTAL 1,000 750 4,000 500 6,250 (1,000) (4,500) (500) (250) (6,250) (2,000) 250

(1,750) (1,750)

CALL 200 250 1,250 500 2,200 (750) (1,200) (250) (2,200)

2-7D 300 100 400

8D-1M 250 600 850 (250) (1,200)

1-3M 250 300 550

3M- 1Y

1-5Y 500 1,000 1,500

5Y+

250 250

500 500

(1,000)

(100)

(200) (100) (300) (1,850) (1,850) (1,900) (2,550)

(800) (400) (1,200) 0

(1,000)



(1,450)

(100) (150) 100 (50) 400 (650)

0 0 0

100 100 (500) (500)

50 50 (550) (1,050)

300 (2,250)

500 (1,750)

47




YIELD BAROMETER

Date

28- Feb03

Overdraft Fixed Loan Others

Savings A/C Current A/C FDR Others

48




49




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Managing Core Risks in Banking

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