Asset Liability Management in Banks

5 Asset and Liability Management (ALM) 29. There be different organizational and brass models that guide the charge of savings slang asset and obligation activities. The models chew over fundament ally different put on the line philosophies that tend to evolve with the growing worldliness and depth of financial markets together with the position and activities to a lower placetaken by a bank in the market. The marchess ALM unit of measurement and treasury unit, pile be confusing as they ar a good deal designd by organizations who offer different responsibilities to them this will be explained below. 5. 1 Key aspects that influence a banks tone-beginning 0. The evolution of models is driven by differing philosophies about the role of the treasury or the ALM unit and banks in markets at different stages of development often regard the treasury unit differently. 31. In emerging markets the treasury hold up is usually simplistic and a support function mainly focussed on runniness come throughment and basic foreign exchange activity. In these banks, it is not uncommon to have a prohibition on exponentiation in much than than sophisticated capital markets transactions much(prenominal) as derivatives due to lack of knowledge and suspicion about the instruments.Such markets give the gate suffer from poorly developed capital markets that provide little mental object to offset the jeopardizes fictive from the customer franchise. The issue is often that these banks argon impenetrable to evolve and run risks, without knowing it, which keep threaten their very survival. 32. In developing markets the treasury function usually begins to take on more than structure, more activities and a broader mandate. At the simpler end of the spectrum it bum assume liberal remnant rag season direction function, involving itself in more complex analytics and hedgerow activities.At the more complex end it can assume air and market making responsib ilities for a range of capital market produces that are utilize in hedging but overly are provided to customers. This can often be referred to as an integrated treasury function, with net profit making as well as hedge management the rally themes. 33. In developed markets the model usually evolves by separating out the employment and market making functions into a more customer centric unit such(prenominal) s a capital markets or institutional banking division, with a subsequent refocusing of the core ALM functions on more detailed outline, and management of the banks assets, liabilities and capital base. Treasury be behaves more of a service centre in these banks, providing assistance and support with set and analytics to customer facing divisions. The ALM or balance canvas tent can often be managed aggressively done the use of 11 P a g e derivative contracts. property transportation system pricing mechanisms are used extensively to take a shit stinting transparency a nd 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 day to day responsibility for the ALM core functions. Under all models it is important to leaven a overhear rationality of activities and risk thresholds in the Treasury function and ensure the risk framework is aligned to the operating structure and market realities. returning a governance structure within which the board of the bank is fully in contriveed and awake(predicate) 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 atomic number 53 independent point of oversight both internally and externally. 5. 2 Focus on some key ALM activities 36. Successful ALM units create a properly aligned risk and return management process. The recompense mix between skills and risk appetite must be identified, pass judgment outcomes of activities known and appropriate metrics established. The burn down adopted enquires 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 Measurement 37. A bank needs to decide whether it wants to take a relatively neutral approach to ALM risks or is prepared to take a more aggressive approach and target gameer long term earnings and an increase in economic think of. Irrespective of the choice made, a bank needs to figure that the right level of skills and resources need to be committed to support the function. trouble to do this can result in a poorly managed act characterised by volatility in core earnings/margin economic jimmy, and unpredictable economic results. 8. The mate position of the balance sheet represents the concern rate and runniness risk profile inherent. Assuming a single portfolio without hedges, a large and well diversified bank, with transact ions weighted broadly across all market segments, will find that its balance sheet will naturally take on countercyclical characteristics as the business surround consolidates through the economic cycle. This makes sense as the bank is foundively providing customers with solutions they are demanding as they operate in the external environment.The market itself will in any case provide limitations and one of the areas where this can manifest strongly is on the liability side of the balance sheet. Various techniques are used to examine the match in a banks balance sheet and it can be a difficult process if not supported with adapted systems. Depending on systems and analytical support the ALM process will undertake a number of analysis designed to identify static and dynamic mismatch sensitivity of net following income and, market value under quintuple scenarios -including under high stress. 39.The majority of banks set net interest income (NII) limits as a main measure of perf ormance with the more advanced banks in any case using market or economic value as a secondary measure. NII has become the industry benchmark simulation tool because it is relatively easy to understand and implement its a single stoppage measure that does not require many assumptions, and it is easy for investors to relate to because it is at one time linked to reported financial results. On the negative side, it is limited as it does not provide a full view of the risks run by a bank or reflect fully the economic shock absorber of interest rate movements.Market value or economic value simulations on the other hand, offer a more complete estimation of the risk being run but require significantly more 12 P a g e detailed analysis which is out of r all(prenominal) of many banks at this point. The process requires multiple assumptions that are difficult to form in some cases and is slight intuitive and more difficult to understand. Notwithstanding the difficulties of the latter, both metrics are important in the measurement and management of embedded risk in banks.In less developed ALM units, the time it takes to collect and analyse information can hit the hay much of it useless for active management as by the time it is available markets have moved making hedging ineffective. 40. Access to by the way and accurate data is critical in support of any form of ALM activity. 5. 2. 2 Funds Transfer Pricing (FTP) 41. The funds 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 basis for economic and product transparency. 42.The process of FTP is designed to identify interest margins and remove interest rate and funding or fluidity risk. Looking at it from the business unit perspective, it effectively locks in the margin on loans and deposits by delegate a transfer rate that reflects the repricing and cash flow 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 severalise metrics and facilitates the centralisation and management of interest rate mismatches.A byproduct 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 rates 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 certificate of the franchise. Similarly, in smaller and/or less developed banks it is of equal value as both a management and strategy tool. 4. The methods used by banks are generally consistent FTP rates are coordinate to include both interest rate and funding liquidity ris ks with the derived transfer yield curve constructed to include appropriate premiums. Such premiums should capture all elements associated with the banks funding cost. These should include the cost of items such as holding liquidity reserves optionality costs, where pre-payment rights exist term funding program costs and, items such as basis risk. 5. 2. 3 liquidness 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 transformation 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.B anks 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 recent crises that have brought its adjust importance into focus. Failure to manage effectively can have horrific results but the events of recent times have demonstrated that liquidity impacts can be cataclysmic to a bank. 47. Like all areas of risk management, it is inevitable to put a workable framework in place to manage liquidity risk.It needs to look at two 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 standard are shown in Table 2. Table 1 Selection of liquidity Measurement Tools Liquidity Management Tool Description / Aim Static Funding infract Defines the short fall in maturing liabilities required to service maturing assets it is usually mensural on a maturity bucket basis and is calculated as the net asset osition over total liabilities. Dynamic Cash come 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 defined to include items such as cash and cash equivalents, trading account securities, repos investments into government securities, etc absorption Ratios This is an important ratio that reassures the funding from a particular 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 doer a board needs to clearly articulate the risk leeway of the organization and subject the balance sheet to regular scrutiny. Guiding principles need to be included as part of this process. The following 5 principles are valuable 1. Diversify sources and term of funding concentration and contagion were the killers in the recent crisis. . Identify, measure, monitor and control it is still surprising 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 fundamental 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 strategic liquidity management platforms keep a focus on both the forest and the trees. 5. Establish detailed contingency plans and stress test under multiple scenarios regularly.