Topic 5: Commercial Banks AssetLiability Management ALM

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Topic 5 Commercial Banks Asset-Liability
Management (ALM)

• Asset-liability management strategies
• Interest rate risk management and hedging
• The concept of duration gap and its limitation
• Using financial futures, options, swaps and
  other hedging tools
• The use of derivatives

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• Asset-liability management (ALM) strategies
• ALM is a series of management tools designed to
  minimise risk exposure of banks, hence, loss of
  profit and value of banks.
• ALM comprises all areas related to banking
  operations loans, deposit, portfolio
  investment, capital management etc.
• ALM Strategies
• There are three ALM techniques
• Asset Management Strategy (AMS) this is a
  strategy concerns with control of incoming funds
  through the determination of loans/credits
  allocation and their interest rates.
• Liability Management Strategy (LMS) deals with
  controlling of sources of funds and monitoring of
  the mix and cost of deposit and nondeposit
  liabilities by controlling price, interest
  rate.
• Fund Management Strategy (FMS) this a a more
  balanced approach of ALM that incorporates both
  AMS and LMS. The basic objectives of FMS are

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• - The control of volume, mix, and return or
  cost of both assets and liabilities for the
  purpose of achieving a banks goals.
• - The coordination of asset and liability
  management as a means of achieving internal
  consistence and maximizing the spread between
  revenue and costs, and minimization of risk
  exposure.
• - maximization of returns and minimization of
  costs from supplying services.
• Interest rate risk management and hedging
• Interest rate risk is a major challenge being
  faced by banks in their ALM.
• Interest rate is determined by market forces
  through the interaction of the forces of demand
  for and supply of loanable funds (credit).
• Fluctuations in market interest rate leads to two
  types of risk in banks Price risk and
  Reinvestment risks.

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• Measurement of Interest rates
• Interest rate can be defined as price of credit
  or return to capital. Interest rate can be
  measured through
• Yield to Maturity (YTM) this equalizes current
  market value of a loan or security with the
  expected future income such loan could generate.
  The YTM is calculated as

Where PV current market value of asset CF
expected cash flow FV Expected value of asset
at maturity I market interest rate YTM the
yield to maturity
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• II. Bank discount rate (DR) the rate
  usually quoted on short- term loans and
  government securities. This calculated as
• DR 100 Purchase price of loan or security
• 100
• X 360 (2)
• Number of days to maturity
• III. YTM equivalent this is a means of
  converting DR to YTM and it is calculated
  as
• YTM (100 Purchase price)
  365
• equivalent Purchase price
  X Days to maturity
• yield (3)

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• The Components of Interest rates
• - Interest rate has two components risk-free
  interest rate and risk premium. That is,
• Market Risk-free real Risk premium to
  compensate
• interest rate interest rate
  lenders who accept risky
• on risky (such as the IOUs
  for their default (credit)
• loan or inflation-adjusted
  risk, inflation risk, term or
• security return on
  maturity risk, marketability
• government bonds) risk, call
  risk, etc. (4)
• Working Exercises
• Determine the YTM for a bond purchased today at a
  price of 950 and promising an interest payment
  of 100 each over the next three years when it
  will be redeemed by the issuer for 1,000.
• Suppose a money market security can be purchased
  for a price of 96 and has a face value of 100
  to be paid at maturity. Using DR, calculate the
  interest on the security if it is expected to
  mature in 90 days.
• What is the YTM equivalent for the security in
  question 2 above?

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• Risk Premiums risk premiums are interest rates
  charged on loans or other instruments in order to
  compensate for certain risks default-risk,
  inflation risk, liquidity risk, and call risk.
• Yield Curve graphical representation of
  variations in interest due to differences in
  maturity, maturity-premium may be upward,
  downward or horizontal.
• Interest Rate Hedging
• In response to interest rate risks, banks engage
  in interest rate hedging (IRH).
• IRH aims at isolating profit from the damaging
  effects of interest rate fluctuations
  concentrating on interest sensitive assets and
  liabilities loans, investment, interest-bearing
  deposits, borrowings etc, thereby, protecting the
  NIM ratio.

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• Interest Rate Hedging Strategies
• - Interest-Sensitive Gap management (IS Gap)
• - Duration Gap management
• Interest-Sensitive Gap management (IS Gap)
• - IS gap deals with analysis of maturity and
  repricing of interest-bearing assets with the aim
  of matching their values with the value of
  deposits and other liabilities. That is
• Dollar amount of repriceable Dollar amount
  of repriceable
• (interest sensitive) (interest
  sensitive) (5)
• Assets (ISA) Liabilities (ISL)
• - A gap will occur if the repriceable ISA ?
  repriceable ISL. That is
• ISG ISA - ISL gt0, lt 0 (6)

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• - Relative IS Gap ratio
• IS Gap
• Relative IS Gap Size of Bank gt 0, lt
  0 (7)
• (total Assets)
• - Also the ratio of ISA can be compared to that
  of ISL, in which case we have Interest-sensitive
  ratio (ISR).
• Interest-Sensitive Ratio (ISR) ISA gt
  1, lt 1 (8)
• ISL
• Importance of IS Gap
• - It helps in the determination of time period
  when NIM is to be managed.
• - Helps management to set target for the level
  of NIM either to freeze it or increase
  it.
• - Helps in the determination of ISA and ISL.

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• Managing IS Gap
• Management response to existence of IS GAP varies
  depending on ability of banks
• Banks can either embark on aggressive or
  defensive gap management.
• A defensive management response will seek to set
  IS GAP to as close to zero as possible to reduce
  expected income fluctuations.
• Management response also depends on the nature of
  risk arising from the IS GAP

Expected ?s in Best IS GAP Position
Aggressive management Interest rates
to be Action Rising interest rate
Positive IS GAP Increase IS assets Decreas
e IS liabilities Falling interest rate Negative
IS GAP Decrease IS assets Increase IS
liabilities
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Positive IS GAP Expected risk
Possible management ISA gt ISL
Losses if interest rates fall
1. Do nothing 2. Extend asset
maturities or shorten liability
maturities. 3. Increase IS
liabilities or reduce IS
assets Negative IS GAP Expected risk Possible
management ISA lt ISL Losses if
interest rate rise 1. Do nothing.
2. Shorten asset maturities
or lengthen liability maturities. 3.
Decrease IS liabilities or
increase IS assets.
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• Duration Gap Management
• - Duration gap deals with the effect of interest
  risk on the net worth of bank, value of its
  stock.
• - Duration gap is a value- and time-weighted
  measure of maturity that considers the timing of
  all cash inflows and outflows. It is a measure of
  average time needed to recover the funds
  committed to an investment.
• - Duration gap of a financial instrument is
  calculated as
• where D time duration of instrument in years,
  CF cash flow, YTM yield to maturity of
  instrument,, and t time period.
• - Since the denominator is equivalent to
  current market value or price of
  asset/instrument, then the duration can be
  re-expressed as

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• - Recall that Net Worth (NW) of a bank is the
  value of its assets less the value of its
  liabilities, that is
• NW A L (11)
• - This implies that
• ?NW ?A - ?L (12)
• - Duration analysis can be used to stabilize or
  immunize the market value of a bank.
• - Duration analysis measures the sensitivity of
  market value of financial instrument to changes
  in interest rate. That is
• ? P -D x ? i
• P (1i) (13)
• - Equation (13) implies that interest rate of a
  financial instrument is directly proportional to
  the duration of the instrument.

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• Using Duration to hedge against Interest rate
  risk

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