Asset Liability Management in Banks

5 Asset and Liability instruction (ALM) 29. There be unlike organizational and governance models that guide the worry of savings fix summation and liability activities. The models reflect fundament tot eitheryy different lay on the line philosophies that tend to uprise with the growing sophistication and depth of financial food commercializes together with the position and activities down the stairs bearn by a bank in the market. The terms ALM building block and treasury unit, nates be confusing as they ar lots utilize by organizations who assign different responsibilities to them this pass on be explained be baseborn. 5. 1 strike aspects that influence a banks approach 0. The evolution of models is driven by differing philosophies intimately the role of the treasury or the ALM unit and banks in markets at different forms of development often regard the treasury unit differently. 31. In emergent markets the treasury swear out is usually simplistic and a hold in lean mainly foc utilize on fluidness prudence and basic contrasted exchange activity. In these banks, it is not uncommon to establish a rampart on involvement in much(prenominal) sophisticated ceiling markets minutes such as derivatives due to lack of knowledge and suspicion astir(predicate) the instruments. such markets chamberpot suffer from poorly true capital markets that exit little capacity to offset the assays assumed from the guest franchise. The result is often that these banks are slow to evolve and run risks, without knowing it, which buttocks peril their very survival. 32. In developing markets the treasury figure out usually begins to take on much structure, more activities and a broader mandate. At the simpler end of the spectrum it can assume full equilibrise sheet management responsibility, involving itself in more complex analytics and hedging activities.At the more complex end it can assume trading and market making responsibilities for a range of capital market products that are used in hedging but alike are provided to customers. This can often be referred to as an integ localized treasury function, with profit making as well as elude management the central themes. 33. In developed markets the model usually evolves by separating out the trading and market making functions into a more customer centric unit such s a capital markets or institutional banking division, with a subsequent refocusing of the core ALM functions on more detailed analysis, and management of the banks assets, liabilities and capital base. Treasury becomes more of a supporter centre in these banks, providing assistance and support with pricing and analytics to customer liner divisions. The ALM or oddment sheet can often be managed sharp through the use of 11 P a g e derivative contracts. Funds transfer pricing mechanisms are used extensively to create economic transparency and to immunize business units to risk. 4. In all models the ALM function reports to every the CEO / CFO with the CFO generally having the daytime to day responsibility for the ALM core functions. Under all models it is important to represent a clear down the stairsstanding of activities and risk thresholds in the Treasury function and ensure the risk framework is aligned to the operating structure and market realities. Establishing a governance structure indoors which the board of the bank is to the full informed and cognisant of the risks being run is a critical and mandatory component. 35.It is in the more developed markets that the Chief Risk Officer function has developed and come to represent the single independent point of concern twain internally and externally. 5. 2 Focus on some key ALM activities 36. Successful ALM units create a properly aligned risk and go along management mathematical operation. The right mix between skills and risk appetite must(prenominal) be identified, expected outcomes of activities known and approp riate metrics established. The approach follow motives to be aligned to the realities of the market the bank is operating within and to its desired risk appetite. 5. . 1 Mismatch Management and Performance touchstone 37. A bank needs to decide whether it wants to take a comparatively neutral approach to ALM risks or is prepared to take a more aggressive approach and target higher long term wampum and an increase in economic valuate. Irrespective of the choice made, a bank needs to realise that the right level of skills and resources need to be perpetrate to support the function. Failure to do this can result in a poorly managed operation characterised by volatility in core profit/margin economic tax, and unpredictable economic results. 8. The mismatch position of the relaxation sheet represents the sideline rate and liquidity risk profile inherent. assuming a single portfolio without hedges, a large and well diversified bank, with proceedings weighted broadly across all market segments, will examine that its balance sheet will naturally take on countercyclical characteristics as the business environment consolidates through the economic cycle. This makes sense as the bank is effectively providing customers with solutions they are demanding as they operate in the external environment.The market itself will withal provide limitations and one of the field of battles where this can manifest potently is on the liability side of the balance sheet. Various techniques are used to examine the mismatch in a banks balance sheet and it can be a difficult operate if not supported with adequate systems. Depending on systems and analytical support the ALM process will undertake a pattern of analysis designed to identify silent and dynamic mismatch sensitivity of solve interest income and, market value under multiple scenarios -including under high stress. 39.The majority of banks set net interest income (NII) limits as a main measure of performance with t he more advanced banks also using market or economic value as a secondary measure. NII has become the industry benchmark color dickhead because it is relatively simple to understand and implement its a single period measure that does not involve many assumptions, and it is easy for investors to relate to because it is directly linked to reported financial results. On the interdict side, it is limited as it does not provide a full legal opinion of the risks run by a bank or reflect fully the economic impact of interest rate movements.Market value or economic value simulations on the former(a) hand, offer a more complete assessment of the risk being run but require significantly more 12 P a g e detailed analysis which is out of reach of many banks at this point. The process requires multiple assumptions that are difficult to form in some cases and is little intuitive and more difficult to understand. Notwithstanding the difficulties of the latter, two metrics are important i n the measurement and management of embedded risk in banks.In less developed ALM units, the time it takes to collect and analyse development can render much of it useless for active management as by the time it is available markets have moved making hedging ineffective. 40. Access to timely and accurate data is critical in support of any form of ALM activity. 5. 2. 2 Funds Transfer Pricing (FTP) 41. The coin transfer pricing system has become a fundamental ALM tool in a bank. It creates the ability to immunize business units from risk and provides the initiation for economic and product transparency. 42.The process of FTP is designed to identify interest margins and remove interest rate and sustenance or liquidity risk. tone at it from the business unit perspective, it effectively locks in the margin on loans and deposits by assigning a transfer rate that reflects the repricing and cash fertilize profile of each balance sheet item it is applied to both assets and liabilities. From the ALM units perspective, it isolates business performance into discrete portfolios that can be assigned individualised metrics and facilitates the centralisation and management of interest rate mismatches.A by-product is that it effectively allocates responsibilities between the organizational business units and the treasury department. 43. In more developed banks, the FTP mechanism can also be used as a tool to assist with management of the balance sheet structure with FTP range adjusted to either encourage or discourage product and customer flows. The associated analytical process leads to greater understanding of a banks competitive advantage, assisting with asset allocation and protection of the franchise. Similarly, in smaller and/or less developed banks it is of equal value as both a management and outline tool. 4. The methods used by banks are generally consistent FTP rates are structured to include both interest rate and championship liquidity risks with the deri ved transfer yield curve constructed to include appropriate premiums. Such premiums should capture all elements associated with the banks bread and butter cost. These should include the cost of items such as holding liquidity reserves optionality costs, where pre-payment rights exist term supporting syllabus costs and, items such as al-Qaida risk. 5. 2. 3 liquid Management 45.The main liquidity concern of the ALM unit is the funding liquidity risk embedded in the balance sheet. The funding of long term mortgages and other securitised assets with short term liabilities (the maturity innovation process), has moved to centre stage with the contagion effect of the sub-prime debacle. Both industry and regulators failed to recognise the importance of funding and liquidity as contributors to the crisis and the dependence on short term funding created intrinsic flaws in the business model. Banks must assess the buoyancy of funding and liquidity sources through the ALM process. 46.Bank s are in the business of maturity transformation to meet their customers requirements and these result in liquidity, interest rate and currency mismatches which need to be managed. ALM 13 P a g e units have traditionally analysed and managed liquidity within pre set limits however it is only the upstart crises that have brought its true importance into focus. Failure to manage effectively can have dire results but the events of recent times have show that liquidity impacts can be cataclysmic to a bank. 47. Like all areas of risk management, it is necessary to put a workable framework in place to manage liquidity risk.It needs to look at dickens aspects 1) Managing liquidity under the business as usual scenario, and 2) Managing liquidity under stress conditions. It also needs to include a number of liquidity measurement tools and establish limits against them. Some of the tools that have become industry meter are shown in Table 2. Table 1 Selection of Liquidity Measurement Tools Liquidity Management Tool Description / Aim nonoperational Funding Gap Defines the short fall in maturing liabilities required to portion maturing assets it is usually calculated on a maturity bucket basis and is calculated as the net asset osition over total liabilities. self-propelled Cash Flow Gap This includes a measurement based on maturing assets and liabilities plus assumed marketable asset liquidation over a given period. Liquidity Asset Ratios This is the ratio of liquid assets to total liabilities with liquids delineate to include items such as cash and cash equivalents, trading name securities, repos investments into government securities, etc Concentration Ratios This is an important ratio that reassures the funding from a item source compared to assets /liabilities or capital.Liquidity Stress Measurement A number of ratios can be examined here looking at multiple low stress and high stress scenarios Source Modified from GARP 2008 Best Practices presentation. 5 48 . At the governance level, boards need to recognise liquidity risk as the ultimate killer. This means a board needs to clearly articulated the risk tolerance of the organization and subject the balance sheet to rhythmical scrutiny. Guiding principles need to be included as part of this process. The following(a) 5 principles are valuable 1. Diversify sources and term of funding tightfistedness and contagion were the killers in the recent crisis. . Identify, measure, monitor and control it is still surprise that many banks do not fully understand the composition of their balance sheet to a sufficient level of detail to allow for management of the risks. 3. Understand the interaction between liquidity and other risks e. g. basis risk the flow on impact of an event in one area can be devastating to others. 4. Establish both tactical and strategical liquidity management platforms keep a focus on both the forest and the trees. 5. Establish detailed contingency plans and stress te st under multiple scenarios regularly.