asset and liability management

 

  • o Limits on the mix of balance sheet liabilities such as deposits and other types of funding (all sources of funding are expressed as a % of total assets with the objective
    to offer comparability and correlate by term and pricing to the mix of assets held) considering the differential costs and volatility of these types of funds o Policy limits have to be realistic :based on historical trend analysis and comparable
    to the peers or the market • Correlating maturities and terms • Controlling liquidity position and set limits in terms of ratios and projected net cash-flows, analyse and test alternative sources of liquidity • Controlling interest rate risk
    and establishing interest rate risk measurement techniques • Controlling currency risk • Controlling the use of derivatives as well as defining management analysis and expert contribution for derivative transactions • Frequency and content
    for board reporting • But also practical decision such as : o Who is responsible for monitoring the ALM position of the bank o What tools to use to monitor the ALM framework Note that the ALM policy has not the objective to skip out the institution
    from elaborating a liquidity policy.

  • It has the central purpose of attaining goals defined by the short- and long-term strategic plans: • To ensure adequate liquidity while managing the bank’s spread between
    the interest income and interest expense • To approve a contingency plan • To review and approve the liquidity and funds management policy at least annually • To link the funding policy with needs and sources via mix of liabilities or sale
    of assets (fixed vs. floating rate funds, wholesale vs. retail deposit, money market vs. capital market funding, domestic vs. foreign currency funding…) Legislative summary[edit] Relevant ALM legislation deals mainly with the management
    of interest rate risk and liquidity risk: • Most global banks have benchmarked their ALM framework to the Basel Committee on Banking Supervision (BCBS) guidance ‘Principles for the management and supervision of interest rate risk’.

  • Liquidity risk management The role of the bank in the context of the maturity transformation that occurs in the banking book (as traditional activity of the bank is to borrow
    short and lend long) lets inherently the institution vulnerable to liquidity risk and can even conduct to the so-call risk of ‘run of the bank’ as depositors, investors or insurance policy holders can withdraw their funds/ seek for cash in
    their financial claims and thus impacting current and future cash-flow and collateral needs of the bank (risk appeared if the bank is unable to meet in good conditions these obligations as they come due).

  • Measuring liquidity risk[edit] The liquidity measurement process consists of evaluating : • Liquidity consumption (as the bank is consumed by illiquid assets and volatile
    liabilities) • Liquidity provision (as the bank is provided by stable funds and by liquid assets) 2 essential factors are to take into account : • Speed: the speed of market deterioration in 2008 fosters the need to daily measurement of liquidity
    figures and quick data availability • Integrity But daily completeness of data for an internationally operating bank should not represent the forefront of its procupation as the seek for daily consolidation is a lengthy process that may put
    away the vital concern of quick availability of liquidity figures.

  • In fact, reasons for banking cash inflows are : • when counterparties repay their debts (loan repayments): indirect connection due to the borrower’s dependence on market liquidity
    to obtain the funds • when clients place a deposit: indirect connection due to the depositor’s dependence on market liquidity to obtain the funds • when the bank purchases assets to hold on its own account: direct connection with market liquidity
    (security’s market liquidity as the ease of trading it and thus potential rise in price) • when the bank sells debts it has held on its own account: direct connection Liquidity gap analysis[edit] Liq gap report 2 Measuring liquidity position
    via liquidity gap analysis is still one of the most common tool used and represents the foundation for scenario analysis and stress-testing.

  • ALM concepts Building an ALM policy[edit] Illustrative example of a balance sheet mix limits mechanism As in all operational areas, ALM must be guided by a formal policy and
    must address: • Limits on the maximum size of major asset/ liability categories • Balance sheet mix : in order to follow the old adage ‘Don’t put all your eggs in one basket’ o Limits on the mix of balance sheet assets (loans by credit category,
    financial instruments…) considering levels of risk and return and thus guided by annual planning targets, lending licence constraints and regulatory restrictions on investments.

  • The traditional ALM programs focus on interest rate risk and liquidity risk because they represent the most prominent risks affecting the organization balance-sheet (as they
    require coordination between assets and liabilities).

  • • Slotting every asset, liability and off-balance sheet items into corresponding time bucket based on effective or liquidity duration maturity In dealing with the liquidity
    gap, the bank main concern is to deal with a surplus of long-term assets over short-term liabilities and thus continuously to finance the assets with the risk that required funds will not be available or into prohibitive level.

  • So the main focus will be on material entities and business as well as off-balance sheet position (commitments given, movements of collateral posted…) For the purposes of
    quantitative analysis, since no single indicator can define adequate liquidity, several financial ratios can assist in assessing the level of liquidity risk.

  • Setting limits[edit] Setting risk limits still remain a key control tool in managing liquidity as they provide : • A clear and easily understandable communication tool for
    risk managers to top management of the adequacy of the level of liquidity to the bank’s current exposure but also a good alert system to enhance conditions where the liquidity demands may disrupt the normal course of business • One of the
    easiest control framework to implement

  • In addition, ALM deals with aspects related to credit risk as this function is also to manage the impact of the entire credit portfolio (including cash, investments, and loans)
    on the balance sheet.

  • The 2007 crisis however has evidence fiercely that the withdrawal of client deposits is driven by two major factors (level of sophistication of the counterparty: high-net-worth
    clients withdraw their funds quicker than retail ones, the absolute deposit size: large corporate clients are leaving faster than SMEs) enhancing simplification in the new deposit run-off models.

  • a negative mismatch that can be financed o By long-term borrowings (typically costlier) : long-term debt, preferred stock, equity or demand deposit o By short-term borrowings
    (cheaper but with higher uncertainty level in term of availability and cost) : collateralized borrowings (repo), money market o By asset sales : distressed sales (at loss) but sales induce drastic changes in the bank’s strategy • A surplus
    of liabilities over assets creates the need to find efficient uses for those funds, i.e.

  • Due to the large number of areas within the bank’s business giving rise to liquidity risk, these ratios present the simpler measures covering the major institution concern.

  • This new coming ratio will ensure that banks will have sufficient adequacy transformation level between their stock of unencumbered high-quality assets (HQLA) and their conversion
    into cash to meet their liquidity requirements for a 30-calendar-day liquidity stress scenario (and thus hoping to cure shortcoming from Basel II that was not addressing liquidity management).

  • Put limits for each time bucket and monitor to stay within a comfortable level around these limits (mainly expressed as a ratio where mismatch may not exceed X% of the total
    cash outflows for a given time interval) Non-maturing liabilities specificity[edit] As these instruments do not have a contractual maturity, the bank needs to dispose of a clear understanding of their duration level within the banking books.

  • Financial strength (leverage) Liquidity risk oriented ratios: Cash and short term investment to total assets ratio; Operating cash flow ratio; Current ratio; Quick ratio (acid
    test ratio); Non core funding dependence ratio; Core deposits to total assets; Loans to deposit ratio; Loans to asset ratio.

  • Even if market liquidity risk is not covered into the conventional techniques of ALM (market liquidity risk as the risk to not easily offset or eliminate a position at the
    prevailing market price because of inadequate market depth or market disruption), these 2 liquidity risk types are closely interconnected.

  • For banking institutions, treasury and ALM are strictly interrelated with each other and collaborate in managing both liquidity, interest rate, and currency risk at solo and
    group level: Where ALM focuses more on risk analysis and medium- and long-term financing needs, treasury manages short-term funding (mainly up to one year) including intra-day liquidity management and cash clearing, crisis liquidity monitoring.

  • a positive mismatch that is not a wrong signal (generally a rare scenario in a bank as the bank always has a target return on capital to achieve and so requires funds to be
    put to work by acquiring assets) but only means that the bank is sacrificing profits unnecessarily to achieve a liquidity position that is too liquid.

  • The credit risk, specifically in the loan portfolio, is handled by a separate risk management function and represents one of the main data contributors to the ALM team.

  • ALM includes the allocation and management of assets, equity, interest rate and credit risk management including risk overlays, and the calibration of company-wide tools within
    these risk frameworks for optimisation and management in the local regulatory and capital environment.

  • Depending on deal-stage and likelihood, analysts will incorporate expected capital investments and their required funding under either approach, as appropriate.

  • It is focused on a long-term perspective rather than mitigating immediate risks and is a process of maximising assets to meet complex liabilities that may increase profitability.

  • “Dynamic gap analysis” enlarges the scope by including “what if” scenarios, testing potential changes in business activity (new volumes, additional prepayment transactions,
    potential hedging transactions), and considering unusual interest rate scenarios, with their associated shape of the yield curve and resultant changes in pricing.

  • From an ALM perspective, the focus is on the funding liquidity risk of the bank, meaning its ability to meet its current and future cash-flow obligations and collateral needs,
    both expected and unexpected.

  • ALM intervenes in these issues of current business activities but is also consulted to organic development and external acquisition to analyse and validate the funding terms
    options, conditions of the projects and any risks (i.e., funding issues in local currencies).

  • Liquidity risk: the current and prospective risk arising when the bank is unable to meet its obligations as they come due without adversely affecting the bank’s financial
    conditions.

  • Hold a significant productions of high liquid assets (favorable conversion rate into cash in case distressed liquidity conditions) 4.

  • For non maturity assets (such as overdrafts, credit card balances, drawn and undrawn lines of credit or any other off-balance sheet commitments), their movements as well as
    volume can be predict by making assumptions derived from examining historic data on client’s behaviour.

  • The ALM function scope covers both a prudential component (management of all possible risks and rules and regulation) and an optimization role (management of funding costs,
    generating results on balance sheet position), within the limits of compliance (implementation and monitoring with internal rules and regulatory set of rules).

  • Actions to perform[edit] • Determining the number or the length of each relevant time interval (time bucket) • Defining the relevant maturities of the assets and liabilities
    where a maturing liability will be a cash outflow while a maturing asset will be a cash inflow (based on effective maturities or the ‘liquidity duration’: estimated time to dispose of the instruments in a crisis situation such as withdrawal
    from the business).

  • Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part
    of an investment strategy in financial accounting.

  • Issued in July 2004, this paper has the objective to support the Pillar 2 approach to interest rate risk in the banking book within the Basel II capital framework.

  • This excess of liquidity can be deployed in money market instruments or risk-free assets such as government T-bills or bank certificate of deposit (CDs) if this liability
    excess belongs to bank’s capital (the ALM desk will not take the risk of putting capital in a credit-risk investment).

  • Capital markets risk: The risk from movements in equity and/or credit on the balance sheet.

  • On the other hand, ALM is a discipline relevant to banks and financial institutions whose balance sheets present different challenges and who must meet regulatory standards.

  • Calculation to define (example): • Average opening of the accounts : a retail deposit portfolio has been open for an average of 8.3 years • Retention rate : the given retention
    rate is 74.3% • Duration level : translation into a duration of 6.2 years Various assessment approaches may be used: 1.

  • One of the primary causes are mismatches in terms of bank deposits and loans.

  • Interest rate risk: The risk of losses resulting from movements in interest rates and their impact on future cash-flows.

  • It is a dynamic and ongoing process considering both short- and longer-term capital needs and is coordinated with a bank’s overall strategy and planning cycles (usually a
    prospective time-horizon of 2 years).

  • • managing the spread between interest rate sensitive assets and interest rate sensitive liabilities; see Corporate bond § Risk analysis and Yield spread § Yield spread analysis.

  • This strategy includes : Assessment of possible funding sources[edit] Funding requirement-liability sensitivity table Main characteristics : • Concentrations level between
    funding sources • Sensitivity to interest-rate and credit risk volatility • Ability and speed to renew or replace the funding source at favorable terms (evaluation of the possibility to lengthening its maturity for liability source) • For
    borrowed funds, documentation of a plan defining repayment of the funds and terms including call features, prepayment penalties, debt covenants… • Possible early redemption option of the source • Diversification of sources, tenors, investors
    base and types, currencies and to collateralization requirements (with limits by counterparty, secured versus unsecured level of the market funding, instrument types, securitization vehicles, geographic market and investor types) • Costs :
    a bank can privilegiate interest bearing deposit products for retail clients as it is still considered as a cheap form of stable funding but the fierce competition between banks to attract a big market share has increased the acquisition and
    operational costs generated to manage large volume treatment (personnel, advertising…) Dependencies to endogenous (bank specific events such as formulas, asset allocation, funding methods…) / exogenous (investment returns, market volatility,
    inflation, bank ratings…) factors that will influence the bank ability to access one particular source.

  • They can represent : o Additional unsecured or secured funding (possible use of securities lending and borrowing) o Access to central bank reserves o Reduction plan of assets
    o Additional sale plan of unencumbered assets Determination of the contingent funding sources value according to stressed scenario events[edit] • Stressed haircut applied • Variation around cash-flow projection • Erosion level of the funding
    resources • Confidence level to gain access to the funding markets (tested market access) • Monetization possibility of less liquid assets such as real-estate or mortgage loans with linked operational procedures and legal structure to put
    in place if any (as well as investor base, prices applied, transfer of servicing rights, recourse debt or not) Setting of an administrative structure and crisis-management team[edit] The last key aspect of an effective Contingency Funding
    Plan relates to the management of potential crisis with a dedicated team in charge to provide : • Action plan to take during a given level of stress • Communication scheme with counterparties, large investors, Central Bank and regulators involved
    • Reports and escalation process • Link with other contingent activities such as the Business Continuity Planning of the bank Managing the ALM profile generated by the funding requirements[edit] ALM funding report requirement ALM funding report
    requirement – Liabilities and gap profile The objective is to settle an approach of the asset-liability profile of the bank in accordance with its funding requirement.

  • In fact, how effectively balancing the funding sources and uses with regard to liquidity, interest rate management, funding diversification and the type of business-model
    the bank is conducting (for example business based on a majority of short-term movements with high frequency changement of the asset profile) or the type of activities of the respective business lines (market making business is requiring more
    flexible liquidity profile than traditional bank activities) ALM report[edit] Funding report summarises the total funding needs and sources with the objective to dispose of a global view where the forward funding requirement lies at the time
    of the snapshot.

  • Gaining cushion of high liquid assets (refers to the bank’s management of its asset funding sources) Today, banking institutions within industrialized countries are facing
    structural challenges and remain still vulnerable to new market shocks or setbacks: • New regulations from Basel III requirements on new capital buffers and liquidity ratios are increasing the pressure on bank’s balance sheet • Prolonged period
    of low rates has compressed margins and creates incentives to expand the assets hold in order to cover yields and thus growing exposures (rise in credit and liquidity risks) • Long-term secured funding has fallen half since 2007 with decrease
    of the average maturity from 10 to 7 years • Unsecured funding markets are no longer available for many banks (mostly banks located in southern European countries) with cut access to cheap funding • Client deposits as the reliable source of
    stable funding is no more under a growth period as depositors shifting away their funds into safer institutions or non-banks institutions as well as following the economic slowdown trends • The banking system needs to deal with fierce competition
    of the shadow banking system : entities or activities structured outside the regular banking mechanism that perform bank-like functions such as credit intermediation or funding sources (with bank corporate clients with refinancing rates lower
    or similar to the banks themselves and of course without financial regulatory restrictions and risk control).

  • These aspects can be expressed as the inability : • To fund asset growth • To renew or replace maturing liabilities • To use off-balance sheet commitments given • To hold
    back unexpected large deposit withdrawals External events : • Changes in economic conditions o Changes in price volatility of securities o Negative press coverage o Disruption in the markets from which the bank obtains funds Estimation of
    the severity levels, occurrence and duration of those stress events on the bank funding structure[edit] Examples of Contingent Funding Plan stress events This assessment is realised in accordance with the bank current funding structure to
    establish a clear view on their impacts on the ‘normal’ funding plan and therefore evaluate the need for extra funding.

  • The bank need, in accordance, to develop a monitoring process to : • Detect early sign of events that could degenerate into crisis situation through set of warning indicators
    or triggers • Build an escalation scheme via reporting and action plan in order to provide precautionary measure before any material risk materialized Overview of potential and viable contingent funding sources and build up of a central inventory[edit]
    Such inventory includes : • The dedicated liquidity reserve (stock of highly liquid assets that can follow the Basel III new liquidity ratios LCR/ NSFR strict liquid asset definition) • Other unencumbered liquid assets (i.e.,those contained
    in the trading book) and in relation to economic liquidity reserve view.

  • • Marginal gap : difference between change in assets and change in liabilities for a given time period to the next (known also as incremental gap) • Gap as % of total gap
    : to prevent an excessive forward gap developing in one time period Funding cost allocation or Fund Transfer Pricing concept[edit] The effect of terming out funding is to produce a cost of funds, the objective is to : • Set an internal price
    estimation of the cost of financing needed for the coming periods • Assign it to users of funds This is the concept of Fund Transfer Pricing (FTP) a process within ALM context to ensure that business lines are funded with adequate tenors and
    that are charged and accountable in adequation to their current or future estimated situation.

  • This negative carry of this high liquid portfolio assets will be then allocated to the respective business lines that are creating the need for such liquidity reserve Contingency
    funding plan[edit] As the bank should not assume that business will always continue as it is the current business process, the institution needs to explore emergency sources of funds and formalise a contingency plan.

  • Maintenance of a constant relation with funding market as market access is critical and affects the ability to both raise new funds and liquid assets.

  • Such as Long Term Refinancing Operations (LTRO) in the Eurozone where the ECB provides financing to Eurozone banks (on 29 February 2012, the last LTRO has contained €529,5
    billion 36-months maturity low-interest loans with 800 banks participants) Equity funds or raising capital[edit] • Common stock • Preferred stock • Retained earnings Putting an operative plan for the normal daily operations and ongoing business
    activities[edit] This plan needs to embrace all available funding sources and requires an integrated approach with the strategic business planning process.

  • This quantitative estimation of additional funding resources under stress events is declined for: • Each relevant level of the bank (consolidated level to solo and business
    lines ones) • Within the 3 main time categories horizon : short-term (focus on intraday, daily, weekly operations), medium to long-term In addition, analysis are conducted to evaluate the threat of those stress events on the bank earnings,
    capital level, business activities as well as the balance sheet composition.

  • Principal sources of funding[edit] After 2007, financial groups have further improved the diversification of funding sources as the crisis has proven that limited mix of funds
    may turn out to be risky if these sources run dry all of a sudden.

  • If the bank has never experienced to sold loans in the past or securitization program, it should not anticipate using such funding strategies as a primary source of liquidity
    Liquidity reserve or highly liquid assets stock[edit] This reserve can also referred to liquidity buffer and represents as the first line of defense in a liquidity crisis before intervention of any measures of the contingency funding plan.

  • It consists of a stock of highly liquid assets without legal, regulatory constraints (the assets need to be readily available and not pledged to payments or clearing houses,
    we call them cashlike assets).

  • Setting for each source an action plan and assessment of the bank’s exposure to changes[edit] Once the bank has established a list of potential sources based on their characteristics
    and risk/ reward analysis, it should monitor the link between its funding strategy and market conditions or systemic events.

  • In light of the stricter LCR eligible assets definition, the economic approach could include a larger bulk of other liquid assets (in particular in the trading book) 4.

  • Monitoring of the bank capacity to raise each funds quickly and without bad cost effects as well as the monitoring of the dependence factors affecting its capacity to raise
    them 4.

  • 2 forms to obtain funding for banks : Asset-based funding sources[edit] The asset contribution to funding requirement depends on the bank ability to convert easily its assets
    to cash without loss.

  • Explanation of the objective, purpose and strategy behind each funding source chosen : a bank may borrow on a long-term basis to fund real estate loans 3.

  • To evaluate the cost of maintening dedicated stock of liquid assets portfolio as the negative carry between the yield of this portfolio and its penalty rate (cost of funding
    or rate at which the bank may obtain funding on the financial markets or the interbank market).

  • This practice induces a close management of these assets hold as collateral • Liquidation of assets or sale of subsidiaries or lines of business (other form of shortening
    of assets can be also to reduce new loans origination) • Securitization of assets as the bank originates loans with the intent to transform into pools of loans and selling them to investors Liability and equity funding sources[edit] Retail
    funding[edit] From customers and small businesses and seen as stable sources with poor sensitivity level to market interest rates and bank’s financial conditions.

  • To apply, if possible (smaller banks may suffer from a lack of internal model intelligence), both an economic and regulatory liquidity assets holding position.

  • It identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute
    30-days stress scenario specified by supervisors.

  • As an example, a bank may decide to use high liquid sovereign debt instruments in entering into repurchase transaction in response to one severe stress scenario 5.

  • They can include : • High grade collateral received under repo • Collateral pledged to the central bank for emergency situation • Trading assets if they are freely disposable
    (not used as collateral) Key actions to undertake : 1.

  • This access to market is expressed first by identification and building of strong relationships with current and potential key providers of funding (even if the bank is soliciting
    also brokers or third parties to raise funds) 5.

  • Funding management As an echo to the deficit of funds resulting from gaps between assets and liabilities the bank has also to address its funding requirement through an effective,
    robust and stable funding model.

  • To adapt (scalability approach) the stock of the cushion of liquid assets according to stress scenarios (scenarios including estimation on loss or impairment of unsecured/
    secured funding sources, contractual or non contractual cash-flows as well as among others withdrawal stickiness measures).

  • To do so, the bank needs to perform the hereafter tasks : Identification of plausible stress events[edit] Bank specific events : generally linked to bank’s business activities
    and arising from credit, market, operational, reputation or strategic risk.

  • • Cash-flows : as the primary source of asset side funding, occur when investments mature or through amortization of loans (periodic principal and interest cash-flows) and
    mortgage-backed securities • Pledging of assets: in order to secure borrowings or line commitments.

  • For simplification, the diversify available sources are divided into 3 main time categories: • Short-term • Medium-term • Long-term period Key aspects to take into account
    : 1.

  • If that collaterals become less liquid or difficult to evaluate, wholesale funds providers may arbitrate no more funding extension maturity 2.

  • Assessment of the likehood of funding deficiencies or cost increase across time periods.

  • To invest in liquid assets for purely precautionary motives during normal time of business and not during first signs of market turbulence 3.

  • In case for example, position on the wholesale funding, providers often require liquid assets as collateral.

 

Works Cited

[‘1. “Asset-Liability Management – an overview | ScienceDirect Topics”. www.sciencedirect.com. Retrieved 2023-04-05.
• Crockford, Neil (1986). An Introduction to Risk Management (2nd ed.). Woodhead-Faulkner. 0-85941-332-2.
• Van Deventer, Imai and
Mesler (2004), chapter 2
• Moorad Choudhry (2007). Bank Asset and Liability Management – Strategy, Trading, Analysis. Wiley Finance.
Photo credit: https://www.flickr.com/photos/seven_of9/4279989256/’]