Learning Outcomes

• Define the meaning and the general concepts of ALM

• Describe the impact of main risk factors on the asset and the liability side of the
balance sheet: Impact of Interest Rate Risk, Currency Risk, Liquidity Risk and
Credit Risk

• Understand the importance of an efficient and reliable organizational

infrastructure delivering the necessary data with accuracy and frequency in order
to manage ALM Risks

• Describe the organisational and infrastructure set up of ALM in a bank:

− ALM information systems (Management Information System, Information availability
and accuracy)
Principals of Asset & Liability − ALM organisation (Structure and responsibilities, ALM Committee, Role of Controlling,
Level of top management involvement)
Management − ALM process (Risk parameters, Risk identification, Risk measurement, Risk
management, Risk tolerance levels)

• Understand the use of Gap management: interest and duration mismatches

Learning Outcomes (Continued) Learning Outcomes (Continued)

• Explain Asset and liability management techniques: Cash Flow • Describe the interaction between bank capital and leverage and the role
Management, Duration Management, Gap Limits of economic and regulatory capital

• Describe the use of different types of interest rate and FX derivatives • Describe the formulation of Liquidity Stress Test Scenarios and the use
for implementing hedging techniques against ALM risks in ALM

• Describe the use of Credit Risk Transfer Instruments for Balance Sheet
Management: Credit Derivatives and Asset Securitizations
Source: www.aciforex.org
• Explain the impact of Basel III (Liquidity Coverage Ratio, Net Stable
Funding Ratio, Leverage Ratio) on the structure of a bank’s balance
sheet

• Explain the concept of funds transfer pricing as a means to ensure that

funding and liquidity costs & benefits are transparently allocated to
respective businesses and products

What Is ALM? What Is The Function Of The Alm Team

• ALM Incorporates the modern techniques used in profitability and risk

management of commercial banks. These involve the following: Banks have 3 main Banks invest in 5 main assets:
– Creating shareholder wealth sources of funds: 1. Reserves with the central bank
– Profit center management 1. Deposits from clients 2. Loans
– Risk-adjusted performance management 2. Interbank deposits 3. Interbank loans
– Pricing of credit risk and loan provision 3. Shareholders equity 4. Bonds
– The management of interest rate and liquidity risks 5. Fixed assets

• As competition is reducing bank margins, the need for more precise • The ALCO comprises the CEO and heads of business units in Credit,
information and a complete asset and liability management system is retail, corporate and Treasury.
becoming an absolute necessity.
• The ALM team or ALCO (asset and Liability Committee) controls profit
and risk. They primarily consider the Interest rate risk created by the
mismatch of the asset and liability maturities of the banks balance
sheet.
Question Answer
Which of the following is a function of asset and liability Which of the following is a function of asset and liability
management (ALM)? management (ALM)?

a. Co-ordinated limit management of a financial institution’s credit a. Co-ordinated limit management of a financial institution’s credit
portfolio portfolio

b. Running a matched trading book b. Running a matched trading book

c. Monitoring credit quality of assets and establishing a early warning c. Monitoring credit quality of assets and establishing a early warning
system system

d. Managing the financial risk of the bank by protecting it from the d. Managing the financial risk of the bank by protecting it from the
adverse effects of changing interest rates adverse effects of changing interest rates

GAP Analysis

Gap analysis is the maturity

distribution and re-pricing schedule for
a group of assets and liabilities.

When either is exposed to more re-

pricing (with a shift in interest rates), or
reaches maturity earlier a gap exists
Managing Assets & Liabilities

425

Traditional Treasury Risk Models Duration Analysis

• Take on liabilities (Deposits, Insurance policies and annuities) • Doing business is a non-dynamic process

• Make investments (loans, bonds or real estate)

• Successful treasuries are those that understand the
nuances of bridging the gap between asset and liability
• Intentional mismatch as a result of the structure of the yield curve
profiles
• Gap and duration analysis works well for fixed cash flows, optionality
poses problems (e.g. callable debt, which arguably duration analysis • Value weighted measure of maturity of a security or income
could fix) generating asset.

• Lead to scenario analysis

• Takes into account the amount and timing of cash flows
expected

426 427
Maturity Profile of Assets and Varying Maturities – Difficult to
Liabilities Manage

Just looking at the time-bucket

Amount

distribution of Assets & Liabilities

makes it virtually impossible to
manage the risk adequately.

6 month 1yr 2yr 3yr 4yr 5yr

Assets

Liabilities

428 429

Establishing the Average Duration of

Maturity profile of Assets on book
the Pool of Assets
Amount

6 month 1yr 2yr 3yr 4yr 5yr

Assets

Assets
430

Determining the Duration Maturity profile of Liabilities on book

Amount

6 month 1yr 2yr 3yr 4yr 6 months 1yr 2yr 3yr 4yr 5yr
5yr
Liabilities

Assets
Establishing the Average Duration of
Determining the Duration
the Pool of Liabilities

6 month 1yr 2yr 3yr 4yr 5yr

Liabilities Liabilities

Managing A & L profiles (Duration Gap

Analysis) Question
You have a short position of 50 EURODOLLAR futures
contracts. How could you hedge this position?
Amount

a. By selling a FRA for a similar notional amount

b. By buying a FRA for a similar notional amount

c. By selling a call option on the contract

d. By selling a put option on the contract

6 month 1yr 2yr 3yr 4yr 5yr
Assets

Liabilities

Workings Answer
Futures prices are expressed as 100 – i You have a short position of 50 EURODOLLAR futures
Thus : contracts. How could you hedge this position?

a. By selling a FRA for a similar notional amount

i Goes up = Price goes down
i Goes down = Price goes up a. By buying a FRA for a similar notional amount

b. By selling a call option on the contract

So by shorting the futures, am I banking on rates rising or
c. By selling a put option on the contract
falling?
By shorting – Need price to go lower i.e. rates to go up

My risk lies with rates going down..

Question Answer
If a dealer has a 6-month USD asset and a 3-month USD If a dealer has a 6-month USD asset and a 3-month USD
liability, how could he hedge his balance sheet exposure in liability, how could he hedge his balance sheet exposure in
the FRA market? the FRA market?

a. Buy 3x6 a. Buy 3x6

b. Sell 3x6 b. Sell 3x6
c. Buy 0x6 c. Buy 0x6
d. Sell 6x9 d. Sell 6x9

Question Answer
What is a ‘duration gap’? What is a ‘duration gap’?

a. The average maturity of liabilities on a balance sheet a. The average maturity of liabilities on a balance sheet

b. The difference between the duration of assets and liabilities b. The difference between the duration of assets and liabilities

c. The difference between the duration of the longest-held and shortest- c. The difference between the duration of the longest-held and shortest-
held liabilities on the balance sheet held liabilities on the balance sheet

d. The average maturity of the portfolio on the asset side of a balance d. The average maturity of the portfolio on the asset side of a balance
sheet sheet

Principals Of The Basel Committee Return On Equity

1. Board and senior management oversight of interest rate risk • There are five key variables driving ROE

2. Adequate risk management policies and procedures

3. Risk measurement and monitoring

Earnings on assets (EOA)
4. Internal controls
Margin (EOA – COD)
5. Information for supervisory authorities ROE Operating expenses (OE)
Leverage (debt/equity)
6. Capital adequacy
Tax (t)
7. Disclosure of interest rate risk

8. Supervisory treatment of interest rate risk in the banking book

Return On Equity Capital Adequacy
• Leverage (debt/equity) can have a major impact on the • The Basel accord is the main capital adequacy structure that bank
supervisors use.
ROE of a bank

• Basel covers aspects of:

• Banks could be tempted to increase debt while leaving – Capital,
equity unchanged. – Risk weighting of assets
– Required capital ratio to meet the banks product mix.
• Central banks are aware of this danger and therefore
control the level of debt to equity through the imposition of The basic Capital Adequacy Directive - CAD - sets the minimum capital required at
capital adequacy regulations. 8% of total risk-weighted assets. (This is known as the Cooke Ratio)

Capital Adequacy Capital Adequacy Under Basel III

The three pillars of the BASEL Accord: • Refers to the adequacy of a banks capital in relation to risk arising
from:
1. Minimum Capital Requirements - measurement – Assets (loans, negotiable paper)
– Dealing operations
2. The Supervisory Process – no measurement – Off-balance sheet transactions
– Other business risk
3. Market Discipline - no measurement

• Equity Capital enables a bank to bear risk and absorb unexpected

losses

Capital Adequacy Under Basel III Question

• Regulatory Capital – Prescribed by the regulatory Under Basel rules, what is the meaning of EEPE?
authorities in the country. This is split into two main
categories namely: a. Effective Expected Potential Exposure
– Tier 1 (core) b. Effective Expected Positive Exposure
– Tier 2. c. Effective Expected Price Earning
d. Effective Expected Payment Exposure
• Economic capital – this is the amount of capital needed to
cover the risk being faced by a bank. (usually in excess of
Regulatory Capital).
– This is the capital specifically allocated to a branch of a bank.
– It can also be defined as capital at risk (CaR)
– Can be measured using VaR
Answer Types Of Capital
Under Basel rules, what is the meaning of EEPE? • Three tiers of capital:

– Tier 1 (going concern capital) common equity capital, declared reserves,

a. Effective Expected Potential Exposure current years audited profits.
• Under BASEL III there are new targets for capital.
b. Effective Expected Positive Exposure • The common equity in Tier 1 must be a minimum of 4.50% with a 2.50%
c. Effective Expected Price Earning conservation buffer making a total of 7.00%
d. Effective Expected Payment Exposure • Tier 1 capital must be a minimum of 6.0% with a conservation buffer of 2.50%
making Tier 1 total 8.50%. Total capital must be 8% with a 2.50% conservation
buffer making a total of 10.50%

– Tier 2 (gone concern capital) comprises undisclosed reserves of the bank

and subordinated term debt with a maturity of 5 years or longer , certain
reserves and general provisions. Tier 2 capital can NEVER be more than
100% of tier 1 capital.

– Tier 3 – Bonds issued to support the trading book of a bank and no longer
used.

Types Of Capital Capital Adequacy

• NOTE:
Credit Risk

– Under BASEL III certain Tier 2 capital will go from being bonds to
Risk weighted assets Trading Risk

common equity if the banks capital ratio falls below a certain level. Operational Risk

Credit Risk Weighting

– These are referred to as CoCos (contingent convertibles).
Two approaches:

– Going concern capital is where the Tier 2 bonds lose their status • Standardized approach which relies on external ratings; that is ratings
and become common stock if the bank goes into liquidation. given by rating agencies such as moody’s and standard and poor or
fitch-ibca

• The second approach which has received the most attention all over the
world is the internal rating –based (IRB) approach (available under two
options: foundation or advanced)

Credit Risk Weighting – Approach 1 Credit Risk Weighting – Approach 2

• The Standardized approach • In the Internal Rating Based approach (IRB):

– where a weighting will be related to the riskiness of the transaction – banks have to calculate the probability of default
– as identified by the rating of external rating agencies. – of a corporate client
– over a 1-year time horizon.
• EXAMPLE:
• To apply the IRB approach you need two pieces of
AAA - AA- A+ - A- BBB+ - BBB- and below information:
Corporate 20% 50% 100% – the Probability of Default (PD) and
– the maturity of the loan.
A loan made to a A+ would be rated at 50% therefore a loan
of $100 would attract capital of ≥ 8% x ($100 x 50%) = $4 • With retail loans (small amounts), a similar PD can be
calculated for a portfolio of loans.
Credit Risk Mitigation - Securitization Credit Risk Mitigation - Securitization

• Securitization is a process used for generating funding (or freeing up

Removes assets
cash tied up in assets)
Issuing Bank
Balance sheet
• Typically an SPV or Trust will be created as owner of the income
Frees up capital
producing asset.
Assets against which the
bonds are issued
• Bonds are then issued against the SPV or trust

• These bonds as backed by the asset in the SPV (e.g. mortgages or

Trust or SPV Bond Market
short-term debt instruments, such as credit card receipts)
Issues bonds of differing
classes based on the
• This is a popular way of freeing up capital and transferring credit risk. underlying credit

• Different classes of bonds can be issued in a single securitization

based on the credit of the underlying securitized asset.

Credit Risk Mitigation – Credit

Derivatives Credit Derivative Trigger
• A credit derivative is a privately negotiated contract whose value is • The standard ISDA documentation for credit swaps defines
derived from the credit risk of a bond, bank loan, or some other credit a set of credit events which trigger the Credit Derivative.
instrument.
• A credit event could be one of the following:
• Credit derivatives allow the market participant to separate default risk
– Payment default on an agreed-upon public or private debt issue
from the other forms of risk, such as interest rate and currency risk
(the reference asset)
Three basic structures
– Debt rescheduling
– Credit Default Swap – CDS this bases the payoff on a specific
credit event, such as a bond down grading or default. .
– A filing for bankruptcy
– A total return swap - Links a stream of payments to the total return
– Or some other specified event to which the two parties agree.
on a specific asset.

– Credit spread options - Ties the payoff to the credit spread on a

specific bank loan or bond.

Credit Derivative Trigger Liquidity Risk Under Basel III

• The credit event must be an objectively measurable event involving • Liquidity Coverage Ratio - LCR
real financial distress; technical defaults are usually excluded. – The Basel rules insist that a bank maintains a high liquidity coverage ratio.
This rule requires banks to have enough cash or near-cash to survive a
• The reference credit is usually a corporation, a government, or some 30-day market crisis.
other debt issuer or borrower to which the credit protection buyer has
some credit exposure. • Net Stable Funding Ratio – NSFR (1 year time horizon)
– This ratio is applied to reduce the banks dependency on short-term
funding and is longer term in nature to limit over-reliance on short-term
• The contract will contain a materiality clause which will:
wholesale funding.
– Call for a significant move of the reference credit’s underlying stock or
bond price
• Leverage ratio
– Ensure that the market recognizes the credit event for what is
– This ratio refers to the amount of regulatory capital and the nominal
– Prevent an unnecessary trigger due to a default caused by legal questions
amount of on and off balance sheet exposures and derivatives. This is
recommended to be a minimum Tier 1 leverage ratio of 3%
Liquidity Risk Under Basel III

• Stress testing
– These are tools used to identify and manage situations which can
cause extra-ordinary losses. They can be based on the following:
1. Replication of the strongest market shocks which occurred in the past
2. Statistical measures with extreme multiple of historical volatility
3. Subjective assumptions such as a 100BP move up or down in the Yield
Curve