Diapositive 1

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ADNEOM Benelux Training
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ALM
Different businesses - Commercial Bank making
loans to customers and hoping to earn a return
because the cost of the funds borrowed is less
than the interest earned on the funds lent
out. - Investment bank institutions are paid
a fee for their services, and acts as agent
rather than principal - Trading
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Different risks Interest rate risk There
should be a positive difference between the
interest paid on money borrowed (the liability),
and that received on money lent (the asset).
However, typically the interest rates payable on
assets and liabilities will be subject to change
over the life of transactions. Liquidity risk
a bank may make a 5-year loan, and raise the cash
through a 6-month deposit that it hopes to
refinance. Risk exists because, in six months'
time, the bank may not be able to raise cash
easily at reasonable rate, or even at
all. Credit risk In the case of a loan, will a
counterparty be able to repay borrowings? In the
case of trading markets, will a counterparty be
able to pay for any securities that might have
been purchased? Other risks Market risks,
foreign exchange risks, etc.
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ALM
Risks ALM Bank risk factory The ALM
function of a financial organization focuses on
interest rate risk and liquidity risk. A bank
might raise money through the deposits of a
current account. Although a retail customer
typically leaves money on deposit at the bank for
a long period, the customer has the right to
withdraw money on demand. If the money has
already been lent out for a long period of time,
then liquidity risk (the classic 'run on the
bank') must be taken into account.
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ALM

• ALM Scope
• When using funds to generate assets (making
  loans, investing in securities, and so on) or
  raising funds and generating liabilities, the
  individual transactions will differ as to
• Rate type (fixed, variable)
• Maturity the values of long-term fixed rate
  instruments become more volatile as maturities
  lengthen.
• A current account has no maturity the money
  can be withdrawn by a depositor at any time.
• Credit lines - the bank has no precise way of
  knowing when or how much a counterparty will need
  to withdraw under an agreement.
• Mortgages a borrower may choose to refinance
  a mortgage as rates fall just when the mortgage
  is becoming more profitable it gets repaid.

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- Liquidity If a bank adopts the 'traditional
posture' of lending long term funds and
borrowings in the short-term, then the borrowings
will need to be repaid or refinanced before the
asset becomes payable.
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ALM
Liquidity Central Banks Most central banks
impose or recommend prudential liquidity
requirements that oblige banks to keep some
amount of cash on hand, or on deposit with the
central bank, or both. Furthermore, central
banks operate as 'lenders of last resort'
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• Risk Measurement
• Sensitivities How much will a given value, such
  as the market value of an investment, change
  given a particular movement of a market variable?
  
• Volatilities How likely is it that the market
  will move by certain amounts such as to change
  target values?
• Scenarios The central form of scenario analysis
  is to take the distribution above and analyze the
  'worst cases' at the relevant tail of the
  distribution. This is fundamentally the value at
  risk (VaR) approach

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Some sources of interest rate risk - Repricing
risk
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• Yield Curve Risk
• Normal Yield Curve

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• Basis Risk that instruments which reference
  different indices will experience different sized
  rate shifts at different times.
• Options many financial instruments contain
  embedded options, such as the call or put
  provisions contained in certain securities. These
  allow bonds issuers or bonds investors to change
  the final maturity of an instrument.
• In the case of variable rate loans, 'caps'
  may exist which state a maximum value for a rate,
  irrespective of that which is observed.
• Asymmetry of fixed rate mortgages due to
  optionality of refunding when interest rates are
  decreasing.

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Sources of liquidity - Funding Risk Can the
institution borrow at an appropriate market rate?
If the perceived creditworthiness of an
institution declines, then it may be forced to
borrow at increasingly higher rates. Perceptions
will tend to deteriorate if the institution
persistently borrows more and more funds. -
Funding alternatives Where can the institution
borrow money? A retail-oriented operation may
rely on depositors, and it may not be easy to
quickly change the size of flows from this
source. Alternatively, a large international
operation may be able to borrow money form a
greater variety of markets than those open to
small operations. - Market/Asset liquidity risk
There may be a general deterioration in market
conditions and it may not be possible to raise
the funds required easily if conditions are
'tight'. Furthermore, if an institution was
hoping to raise funds through the sale of assets,
the liquidity of such assets may be impaired.
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• GAP Reporting
• All of the individual interest rate sensitive
  assets and liabilities are collected together and
  separated out into individual 'time buckets'.
• Each bucket represents a collection of
  asset/liabilities that have similar repricing
  dates. For instance, a floating rate loan that
  had 6-month Libor resets, and where the next
  reset was due in four months' time, would appear
  as an asset in the relevant bucket covering four
  months.
• The sum of repricing assets is compared with the
  sum of repricing liabilities in a particular
  bucket.
• A positive gap therefore should represent an
  increase in interest income if rates rise.

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ALM

• Liquidity/maturity Gaps
• Another gap analysis which focuses on the
  maturity of outstanding assets/liabilities is
  needed to manage the risk of refinancing assets.
• Problems with GAP Analysis
• The simplification process of gap reports means
  that certain issues may be hidden
• If 2 instruments with different maturities
  exists in the same bucket.
• for instruments where maturity is unstated a
  statistical analysis should be made.

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ALM

Risk reward In financial markets risk and
reward are positively correlated. The objectives
of ALM units thus differ widely between banks
because they will not have the same risk
appetite. There is no single dominant risk-reward
strategy that applies to all financial
institutions. ALM Objectives Tactical Existing
or projected interest rate and liquidity risks
need to be identified and hedged in accordance
with an institution's guidelines. The tactical
components of ALM are typically the
responsibilities of a central treasury. Strategic
It may be necessary to adjust long-term
business decisions so that the overall business
mix of an institution reflects a desired risk
profile. Strategic decisions are more likely to
be taken by some senior management forum.
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ALM
Tactical ALM Hedging in the treasury The job
of a central treasury is to manage any interest
rate or liquidity risks that have been
identified. It will often be looking to
neutralize, or immunize, outstanding risks in the
portfolio.
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ALM
Managing the repricing risk may increase
liquidity risk. the liability would need to be
continuously refinanced every six months until
the maturity of the loan. To avoid the risk, the
treasury might be offered the opportunity to
issue a fixed rate 5-year bond. However, although
the liquidity risk would be largely eliminated
(ignoring the minor issue of coupon cash
mismatches), interest rate risk would be
increased.
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ALM

• Risk Management with derivatives
• With Interest rate swaps
• With options for example, the income on a
  variable rate capped loan will be restricted by
  the 'cap' rate of the loan, even if rates rise.

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ALM

• Issues with derivatives
• Market limitations the relevant derivatives
  may not exist in all markets, or there may only
  be limited liquidity for certain maturities.
• Liquidity risk the more customized agreement
  will probably have a higher cost and lower
  liquidity.
• - Contractual restrictions The use of
  derivatives is thus usually accompanied by a
  significant documentary burden, and requires that
  a counterparty is of sufficient creditworthiness
  to enter into the trade. Access to the market is
  limited.
• - Other factors For example, mortgage
  prepayments may be due to economic factors, which
  can generally only be estimated.

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ALM
ALM Funds Transfer Pricing (FTP) It is the
role of ALM to consider the funding risks of the
whole bank across its different business
lines. While the FX department may be responsible
for managing currency risks, they will require
funding in order to carry out business. This
money will generally be delivered from a central
source - the treasury. Similarly, while a
syndicated loan department might be responsible
for pricing and executing term loans for clients,
the treasury will generally arrange for actual
funds to be transferred to the loan desk - at a
particular price.
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ALM

• Asset/Liability Committee (ALCO)
• Determine the relevant risk targets
• Outline guidelines for the management of current
  and future risks and the range of actions
  permitted to the treasury function.
• Define policy for key internal issues such as
  FTP
• Guide to the future business mix of the bank
  (level of mortgages, shorter or longer-dates
  loans, etc.). This have an impact on the pricing
  for different products.

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ALM
Who is the ALCO The decisions made by the ALCO
are fundamental to the viability of an
institution, and will determine the positioning
of the institution within a market. Consequently
the membership of the committee will tend to
include senior executives such as the CEO. Since
the decisions affect most business lines within
an organization, the committee will also tend to
include the key executives from individual
business lines. There will also be input from
independent risk management or governance
executives.
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