ADB Alm Guidelines 2004 rev.21
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ADB Alm Guidelines 2004 rev.21 ADB Alm Guidelines 2004 rev.21 Document Transcript

  • AFRICAN DEVELOPMENT BANK ASSET AND LIABILITY MANAGEMENT GUIDELINES October 2004 Rev. 21
  • TABLE OF CONTENTS Page I. INTRODUCTION 3 1.1 Scope and Authority 3 1.2 Objectives 3 1.3 Entry into Force 4 II. GUIDELINES 4 2.1 Interest Rate Risk Management 4 2.2 Currency Risk Management 11 2.3 Liquidity Risk Management 12 2.4 Counterparty Credit Risk Management 14 2.5 Authorized Transactions 17 2.6 Operational Risk Management 21 III. IMPLEMENTATION 24 3.1 Compliance 24 3.2 Exceptions 24 3.3 Reporting 25 Appendix 1: Asset and Liability Management Committee 27 Appendix 2: Benchmarks 28 Appendix 3: Valuation 29 Appendix 4: Debt Limits 31 Appendix 5: Debt Allocation 32 Appendix 6: Liquidity 33 Appendix 7: Master Agreements 34 Appendix 8: Exposure Limits 35 Appendix 9: Investment Guidelines Summary 36 2
  • I. INTRODUCTION 1.1 Scope and Authority 1.1.1 This document sets out the guidelines (the “Guidelines”) governing the asset and liability management activities of the African Development Bank (the “Bank” or the “ADB”) and the Nigeria Trust Fund (the “NTF”)1. It is intended to serve as a reference tool for all Staff involved in the Bank’s asset and liability management activities. For the purpose of the Guidelines, asset and liability management activities include all debt funding transactions, investment of liquid resources, managing the currency exposure of the administrative budget and the non-credit and operational aspects of the Bank’s lending and equity investment operations. Separate guidelines prescribe the rules governing the management of credit and operational risk for the Bank’s sovereign and non-sovereign loan and equity investment portfolios2. 1.1.2 On April 14, 1998, the Board approved a General Authority on Asset Liability Management (the “Authority”)3. In view of the Bank’s evolving operating environment, the Authority seeks to provide Management adequate flexibility, within prescribed limits, to efficiently manage the Bank’s assets and liabilities. Under the umbrella of the Authority framework, the President of the Bank (the “President”) is authorized to approve and amend the Guidelines as necessary. The President shall inform the Board of Directors of the Bank (the “Board”) of any substantive changes to the Guidelines. 1.1.3 Under the General Authority, the Asset-Liability Management Committee (ALCO) is responsible for the oversight of compliance with the Authority and the Guidelines. Matters of interpretation and proper implementation of the Guidelines shall be referred to ALCO, subject to the final authority of the President and consistent with ALCO’s Terms of Reference as stated in Paragraph II of Presidential Instruction P.I. 006/98 as amended. 1.2 Objectives 1.2.1 The principal objective of the Bank’s asset and liability management operations is to ensure that the Bank is able to provide flexible lending and investment products that meet client needs, while simultaneously reducing exposure to non-core risks such as market risk4, counterparty credit risk5 and operational risk in line with the Bank’s over-arching risk management philosophy6. 1.2.2 In evaluating the risks arising from the Bank’s asset and liability management operations, the possible non-financial consequences (reputational) shall be considered in addition to the potential financial losses. 1 In accordance with the Agreement establishing the Nigeria Trust Fund, the NTF investment management activities shall be governed by the ADB Asset and Liability Management Guidelines to the extent applicable. 2 Under the umbrella of the General Authority on the Bank’s Financial Products and Services, ref- ADB/BD/ WP/1999/164. 3 The Bank’s Asset and Liability Management Authority, ref - ADB/BD/WP/97/138/Rev.2 4 Market risk is the potential for losses due to fluctuations in the prevailing currency exchange or interest rates, or due to inadequate liquidity. 5 Counterparty credit risk means the credit risk arising from asset and liability management operations as opposed to the credit risks resulting from lending and equity investment operations. 6 The Bank’s over-arching risk management philosophy is to minimize exposure to non-core business risks in order to maximize its capacity to bear the core business risks arising from its sovereign and non-sovereign loan and equity investment portfolios. 3
  • 1.2.3 The Bank shall conduct its asset and liability management operations to ensure that: •it has sufficient liquidity to meet projected cash flow requirements for a 1-year horizon without recourse to additional borrowings from the capital markets7; •returns earned on its liquidity cover the cost of funding the liquidity to the extent possible; •the interest rate profiles of its assets and liabilities protect the Bank’s net interest margin from fluctuations in market interest rates8, leading to financial performance consistent with its long-term objectives; •the currency composition of its assets and liabilities minimizes the impact of exchange rate fluctuations on its risk capital and that fluctuating exchange rates do not lead to administrative cost over-runs9; •exposure to counterparty credit risk arising from asset and liability management operations is minimized; and •exposure to operational risks arising from asset and liability management operations is minimized. 1.2.4 The Bank’s Guidelines, as they pertain to the investment of liquid resources, also apply to the NTF. In some cases, specific guidelines have been articulated for the NTF10. In such cases, these specific guidelines shall take precedence. 1.3 Entry Into Force 1.3.1 These Guidelines shall enter into force on the date of their approval by the President and shall replace and supersede the Asset and Liability Management Guidelines of February 13, 2001 contained in Document ADB/BD/IF/2001/35 and any amendments thereto. II. GUIDELINES 2.1 Interest Rate Risk Management 2.1.1 Interest rate risk is the potential for loss due to adverse movements in market interest rates. To promote steady growth in its risk capital 11, the Bank’s principal interest rate risk management objective is to protect its net interest margin12 from fluctuations in market interest rates13. The Bank shall independently manage its own exposure to 7 The Bank’s Liquidity Policy, ref - ADB/BD/WP/2002/124 8 The Bank’s Interest rate Risk Management Framework, ref - ADB/BD/IF/2003/136 9 The Bank’s Currency Risk Management Policy, ref - ADB/BD/WP/99/61 and Managing the Currency Risks in the Bank Group’s Administrative Budget, ref – ADB/BD/IF/03/152 10 See para’s 3.1.23-25, 3.2.13, and 3.3.13. 11 Risk capital is the metric used by the Bank to measure its risk bearing capacity. As per the Bank’s capital adequacy policy, ref – ADB/BD/WP/2000/29, risk capital is composed of paid-in capital, reserves, and general provisions. 12 Net interest margin is the nominal difference between the interest earned on assets and the interest paid on liabilities. 13 Fluctuating market interest rates can affect interest rate sensitive assets and liabilities in two principal ways: the nominal interest rate or the economic (present) value of all future cash flows. In selecting stability of its 4
  • interest rates while giving its clients the flexibility to choose lending terms best suited to them. 2.1.2 To achieve the objective of protecting the Bank’s net interest margin from changes in market interest rates, the Bank shall match the interest rate sensitivity of both sides of its balance sheet. As a non-core business risk, it shall strive to maintain an interest rate risk profile that will lead to financial performance consistent with its long-term objectives. Within this framework, the Bank shall align the interest rate profile of its assets and liabilities to one of two principal benchmarks: 1) 6-month LIBOR14 or equivalent15 for the floating rate components16; and 2) a 10-year uniform re-pricing profile17 for the fixed rate components. (See appendix 2 on benchmarks) 2.1.3 To the extent possible, the Bank shall passively18 replicate the interest rate risk profile of the relevant benchmark at the level of each asset or liability group. Where purely passive management is not a practical alternative, the Bank shall actively manage19 its interest rate risk profile within tightly controlled risk parameters, such as duration 20 bands. 2.1.4 The Bank’s interest sensitive assets and liabilities can be divided into three broad groups of portfolios: 1) loan portfolios; 2) investment portfolios; and 3) funding portfolios. Loan Portfolios 2.1.5 The Bank offers clients three principal types of loan products : 1) pool-based loans21; 2) market-based loans22; and 3) risk management products. Pool-Based Loans 2.1.6 Pool-based loans are cost-pass through assets, whose interest rate periodically adjusts in line with the average cost of a designated pool of the Bank’s borrowings (see appendix 5 on debt allocation). Through proper structuring of the designated funding net interest margin as its principal interest rate risk management objective, the strategies undertaken by the Bank may increase the volatility of the economic value of its equity. 14 LIBOR – London Interbank Offered Rate is a standard market reference for short-term interest rates. 15 For instance, EURIBOR for Euro, JIBAR for South African Rand. 16 The interest rate on floating rate assets and liabilities resets periodically in line with a specified market interest rate reference or index before its final maturity as opposed to fixed rate assets and liabilites where the interest rate remains constant until maturity. 17 A financial instrument re-prices when its rate of interest adjusts periodically to market rates. A fixed rate instrument re-prices at maturity whereas a floating rate instrument re-prices at the next rate reset date. 18 Passive management implies a management style based on rules without taking any view on the future direction of market factors. 19 Active management implies a management style based on tactical trading of positions to benefit from the future direction of market factors, with a view to outperform the associated benchmark. 20 Duration is a metric for measuring the price sensitivity of an instrument or portfolio of instruments with respect to changes in market interest rates. The Bank uses Effective Duration for risk control purposes. Effective Duration is measured by averaging the impact of upward as well as downward changes in market interest rates on the trading portfolios; it is considered more suitable, given the composition of the Bank’s trading portfolios, than the main alternatives like Macaulay or Modified Duration. 21 Also referred to as variable lending rate (VLR) loans 22 Includes loans that may be created out of the obligation arising from a call on a guarantee provided by the Bank. 5
  • pools, pool-based loans can provide clients with some of the stability of a fixed rate loan together with some of the market tracking benefits of a floating rate loan. The Bank manages two types of pool-based loans: 1) single-currency loans; and 2) multi- currency loans. 2.1.7 The base interest rate on all single currency pool-based loans is reset every January 1 and July 1 based on the weighted average cost in the preceding semester of a designated single-currency pool of the Bank’s borrowings. Where applicable, the prepayment23 premium for single currency pool-based loans is the Bank’s redeployment cost24 at prevailing market interest rates. 2.1.8 The base interest rate on all multi-currency pool based loans is reset every January 1 and July 1 based on the multi-currency weighted average cost of the Bank’s designated single-currency pool-based loans. Multi-currency pool-based loans are no longer 25 offered to the Bank’s clients. 2.1.9 Subject to compliance with the Bank’s principal interest rate benchmarks, the Bank may use derivative transactions26 such as swaps27 or options28 to manage its prepayment risk or its run-off risk where there are insufficient pool-based loans to provide full cost pass-through of the designated pools of the Bank’s borrowings. Such risk management transactions shall be approved by the Vice President, Finance, subject to ALCO recommendations. Market-Based Loans 2.1.10 Market-based loans provide clients with the standard lending products found in the credit markets. The Bank offers clients two principal types of market-based loans: 1) floating rate loans; and 2) fixed rate loans. Floating Rate Loans 2.1.11 The base interest rate on all floating rate loans shall be periodically reset in relation to an agreed reference interest rate index in each currency. If a client requests floating rate terms that are different from the Bank’s standard 6-month Libor benchmark, the loan interest rate shall normally be swapped to replicate the Bank’s standard floating rate benchmark. For sovereign loans, the base interest rate may also include a spread that shall be determined each semester in line with the Bank’s estimated average funding margin29 in that currency (see appendix 5 on debt allocation). There is no prepayment premium for floating rate loans. 23 Prepayment means repayment by a borrower of all or part of its loan principal before the contractual due date. 24 Redeployment cost means the estimated present value of the difference between the cash flows on the loan being prepaid and current market swaps rates for similar maturities. 25 Following the introduction of the current range of loan products in 1997. 26 A derivative transaction is an instrument whose price fluctuates based on the value of an underlying instrument. In the context of the Bank’s asset and liability management operations, the principal derivative instruments include forwards, futures, swaps, and options. 27 A swap is an agreement between two parties to periodically exchange cashflows over an agreed period. 28 An option gives the owner the right (but not the obligation) to buy (or sell) an agreed underlying instrument at an agreed price within a specified period of time or on a specific date. 29 The Bank’s funding margin is the difference between the Bank’s actual cost of floating rate borrowings and the benchmark, expressed in basis points. 6
  • Fixed Rate Loans 2.1.12 The base rate of interest for fixed rate loans shall be determined at the time of rate fixing based on prevailing market swap rates in the currency of the loan. Clients may choose among various rate-fixing alternatives30. If rate fixing is not done at each disbursement, the loan interest rate shall be the floating interest rate in that currency until the rate is fixed. The prepayment premium for fixed rate loans shall be the Bank’s redeployment cost at prevailing market interest rates. 2.1.13 Fixed rate loans shall be the preferred source of fixed rate assets to replicate the Bank’s uniform re-pricing profile benchmark. Where client demand for fixed rate loans is insufficient to replicate the benchmark, the Bank may either swap outstanding floating rate loans to create synthetic31 fixed rate assets or it may purchase fixed rate investments for the equity-backed portfolio. Where demand for fixed rate loans may result in the net asset benchmark being exceeded, the Bank may swap incremental fixed rate loans to floating rate to remain aligned with the benchmark. Such swapping of floating or fixed rate loans shall be endorsed by ALCO based on IRWG recommendations. Following ALCO endorsement, FTRY shall determine the appropriate transactions to implement the recommendation and proceed to execute. Risk Management Products32 2.1.14 Risk management products enable clients to modify the terms of their outstanding ADB loans. The Bank will only provide risk management products requested by a client where the Bank is satisfied that there is a sound economic rationale for the proposed transaction. The Bank shall not purchase any kind of uncovered 33 option from a client through a risk management product. 2.1.15 The Bank intermediates risk management products such as swaps or options from the capital markets at prevailing market rates plus a transaction fee. 2.1.16 Where the Bank provides a client risk management product, an offsetting transaction shall be simultaneously executed with a counterparty in the capital markets such that the Bank has no residual market risk. The Bank may decide not to execute all or part of an off-setting transaction with a counterparty in the capital markets if a client risk management product reduces an existing exposure for the Bank. Such decision shall be approved by the Vice President, Finance, subject to ALCO recommendations. ADB Investment Portfolios 2.1.17 The Bank manages its investments in three principal portfolios: 1) an operational portfolio; 2) a prudential portfolio; and 3) an equity-backed investment portfolio. Investments in the operational and prudential portfolios, intended to meet the Bank’s 30 As approved by ALCO informed by the recommendations of the Financial Products Working Group. 31 In this context a synthetic fixed rate asset is a floating rate loan with an interest rate swap that creates a fixed rate stream of interest income for the Bank without affecting the floating rate cash flows paid by the client. 32 These guidelines seek to address only the ALM issues arising out of risk management products; a more complete set of guidelines, as required by the Financial Products General Authority, shall address the related credit and operational issues. 33 An uncovered option is an option that has been sold to another party where the seller does not own the underlying instrument or commodity. 7
  • liquidity policy objectives, shall be actively managed with the objective of achieving investment returns consistent with the reference benchmark for each portfolio. Generally, all investments in the operational and prudential portfolios are held-for- trading and are regularly marked to market34 whereas investments in the equity-backed portfolio shall in general be held-until-maturity35. (See appendix 3 on valuation). Operational Portfolio 2.1.18 The operational portfolio shall be managed to provide the most readily available source of liquidity to cover the Bank’s short-term cash flow needs. The operational portfolio shall be funded from floating rate or short-term fixed rate borrowings and actively managed against a 1-month LIBID36 reference benchmark in each currency. The average duration of the operational portfolio in each currency shall remain between 0 and 2 months. The maximum duration of any single investment/derivative purchased for the operational portfolio shall be 1 year. Prudential Portfolio 2.1.19 The prudential portfolio shall comprise investments held in addition to the operational portfolio to comply with the Bank’s liquidity policy but not immediately needed for operational purposes. The prudential portfolio shall be funded from floating rate borrowings and actively managed against the Bank’s standard 6-month LIBOR reference benchmark in each currency. The average duration of the prudential portfolio in each currency shall be maintained within a range of minus 6 months to plus 6 months of the average duration of the reference benchmark. The maximum duration of any single investment/derivative purchased for the prudential portfolio shall be 10 years37. 2.1.20 The Bank may appoint external managers38 to invest part of the funds held in the prudential portfolio. The Bank’s external managers shall be measured against the same benchmark as the Bank’s internal managers and unless otherwise specified, shall be generally39 subject to the same interest rate limitations. Equity-Backed Portfolio 34 Mark-to-market describes the process of determining the estimated fair value of an asset or liability in current market conditions. It is an estimate of the price at which an instrument could be traded. The price may be obtained from a trading counterparty based on prevailing market conditions or may be estimated using a pricing model, in which case the security is said to be “marked to model”. 35 Generally accepted accounting rules permit assets to be designated as “held-to-maturity” (HTM) when the owner has the intention and ability to hold the asset until its final maturity. The Bank’s assets designated as HTM are not marked-to-market but shall be held at amortized cost using the constant yield amortization method. 36 LIBID – London Interbank Bid Rate is the “bid-side” of LIBOR and generally equals LIBOR less 12.5 basis points. 37 For the purpose of this guideline, an asset swap shall be considered as a single composite investment. 38 External managers are companies contracted by the Bank to invest the Bank’s liquid resources under specific investment mandates. External managers may be appointed, subject to the approval of ALCO based on the recommendations of FTRY. 39 Any departures from these guidelines for the external managers shall be specified in their respective contracts. 8
  • 2.1.21 The equity-backed portfolio shall comprise fixed rate investments held specifically to align the Bank’s net interest sensitive assets 40 with the re-pricing profile benchmark in each of the special drawing right41 (SDR) currencies. Equity-backed investments may be used as one alternative to swapping floating rate loans if client demand for fixed rate loans is insufficient to meet the Bank’s requirement for fixed rate assets. The purchase of fixed rate investments for the equity-backed portfolio shall be endorsed by ALCO based on IRWG recommendations. Following ALCO endorsement, FTRY shall determine the appropriate transactions to implement the recommendation and proceed to execute. Nigeria Trust Fund Investments 2.1.22 In seeking to earn a stable and reasonable return on invested liquidity, the NTF’s principal interest rate risk management objective is to reduce the sensitivity of its investment returns to changes in market interest rates. To achieve this objective, NTF investments shall be managed in two portfolios: 1) an operational portfolio; and 2) an investment portfolio. 2.1.23 The NTF operational portfolio shall provide a readily available source of liquidity to cover both expected and unexpected disbursements as well as any other probable cash outflows. The operational portfolio shall be actively managed against a 3- month LIBOR reference benchmark. The average duration of the operational portfolio shall remain between 0 and 12 months. The maximum duration of any single investment purchased for the operational portfolio shall be 1 year. Generally, investments in the operational portfolio shall be held-for-trading and regularly marked to market. 2.1.24 The NTF investment portfolio shall consist of funds that are not immediately required for loan disbursements and therefore may be invested for a longer horizon than investments in the operational portfolio. The investment portfolio shall be aligned to a temporary fixed-maturity benchmark not exceeding the Sunset date of NTF. Generally, investments in the investment portfolio shall be purchased with the intention to hold them until their maturity and shall not be marked to market. Funding Portfolios 2.1.25 Pursuant to the provisions of the Agreement establishing the Bank and the Financial Regulations42, the Bank may borrow funds to supplement its capital resources. The principal objective of the Bank’s funding operations is to provide resources, on terms consistent with the risk management objectives and limitations specified in the Guidelines, at the lowest cost. In seeking to achieve the lowest overall cost of funds, due consideration shall be given to diversification of funding sources and increased investor awareness, to assure continuous access to the principal markets. 40 Net interest sensitive assets means all interest sensitive assets less all interest sensitive liabilities. Net interest sensitive assets is a proxy for the interest sensitivity of the Bank’s equity. 41 The special drawing right is a currency unit used by the IMF. The Bank’s reporting currency, the Unit of Account, is the equivalent of the SDR. 42 Chapter 9 of the Financial Regulations of the ADB, 2nd Edition, 2000 9
  • 2.1.26 Subject to the debt limits and the annual borrowing program approved by the Board, the Bank may borrow funds43 to finance: 1) lending operations; and 2) liquid investments (See appendix 4 on debt limits). 2.1.27 The interest rate sensitivity44 of resources borrowed to finance the Bank’s lending activities shall be matched to the target interest rate sensitivity of the related lending product. To achieve the desired balance between stability and market tracking characteristics, resources borrowed to finance the pool-based loans shall be predominantly fixed rate funds with maturities sufficiently spread out so as to permit regular sampling of market interest rates when refinanced. No more than 50% of the borrowings in any single-currency pool shall be floating rate borrowings (See appendix 5 on debt allocation). 2.1.28 The interest rate sensitivity of resources borrowed to finance market-based loans shall be aligned to the Bank’s standard floating rate benchmark in each currency. 2.1.29 The interest rate sensitivity of resources borrowed to finance the Bank’s portfolio of liquid investments shall be aligned to the Bank’s standard floating rate benchmark in each currency. Where the Bank borrows for maturities of less than 1 year, such borrowings shall be used to finance cash and liquid investments in the operational portfolio. 2.1.30 To reduce the risk of sharp fluctuations in the Bank’s average funding spread that could be caused by large refinancing of borrowings during a period of unfavorable market conditions, the Bank shall avoid excessive bunching of borrowing maturities or call dates. In order to ensure due consideration for refinancing risk, any borrowing transaction that may result in more than 25% of the Bank’s outstanding borrowings maturing in any given year45, shall be subject to ALCO endorsement. 2.2 Currency Risk Management 2.2.1 Currency risk is the potential loss due to adverse movements in market currency exchange rates46. To promote stable growth in its risk bearing capacity, the Bank’s principal currency risk management objective is to protect its risk capital from currency transaction and translation risks47 due to fluctuations in currency exchange rates. The Bank shall independently manage its own exposure to currency exchange rates while giving its clients the flexibility to choose the lending currencies best suited to them. 2.2.2 To achieve the objective of protecting the Bank’s risk capital from changes in currency exchange rates, the Bank shall match the currency composition of both sides of its balance sheet. As a non-core business risk, the Bank shall not seek 43 Borrowing activity may also be conducted with the purpose of capital market development in regional member countries. 44 Interest rate sensitivity refers to the extent to which the interest rate of a financial instrument varies with changes in market interest rates. 45 For the purposes of this guideline, callable debt shall be assumed to mature at the next call date. 46 The terms currency exchange rate and foreign exchange rate are used inter-changeably. 47 Currency translation risk is the potential loss in the value of an asset or liability denominated in one currency when its value is expressed in another currency. Currency transaction risk is the potential loss when an asset or liability in one currency is exchanged into another currency. 10
  • gains by anticipating the future direction of currency exchange rates, rather, it shall strive to maintain a currency risk profile that will lead to financial performance consistent with its long-term objectives. 2.2.3 To the extent possible, the Bank passively manages its currencies to align the currency profile of its net assets48 with its currency benchmark (See appendix 2 on benchmarks). The Bank’s currency benchmark is the currency composition of its reporting currency, the Unit of Account. Where purely passive management is not a practical alternative, the Bank actively manages its currency risk profile within tightly controlled risk parameters. 2.2.4 The Bank may conduct currency exchange transactions on its loan, investment, and funding portfolios for the purpose of maintaining the alignment of the currency composition of the Bank’s net asset with its currency benchmark. The Bank may also conduct currency exchange transactions for the purpose of hedging 49 the currency risks inherent in the annual administrative and capital expenditure budgets. Such currency risk management transactions shall be endorsed by ALCO based on CUWG recommendations. Following ALCO endorsement, FTRY shall determine the appropriate transactions to implement the recommendation and proceed to execute. Loan Portfolios 2.2.5 The Bank currently offers single-currency pool-based loans in three currencies50: USD; EUR; JPY and market-based loans in four currencies: USD; EUR; JPY; and ZAR. The Bank may offer market-based loans in any other currency where there is sufficient borrower demand and where it can efficiently fund itself51, subject to the President’s approval, informed by the recommendations of ALCO. 2.2.6 All loan charges and principal repayments shall be paid in the currency(ies) of the loan. 2.2.7 The Bank may intermediate a client risk management product, such as a currency swap, to convert the currency of a client’s outstanding ADB loan into another currency, where there is an appropriate swap market, or alternative mechanisms, to off-set the risk. 2.2.8 Where the Bank provides a guarantee for a loan denominated in a local currency, the guarantee shall be denominated in one of the Bank’s lending currencies for market-based loans52. 48 Net currency assets is the difference between the assets denominated in currencies and the liabilities denominated in the same currencies. Net currency assets is a proxy for the effective currency composition of the Bank’s equity. 49 Hedging describes the process whereby the risks inherent in an instrument or portfolio of instruments is mitigated with respect to a target risk profile. In this case, the target is the budget and the source of risk is fluctuating exchange rates and the impact on actual administrative expenditures. 50 Although multi-currency pool-based loans denominated in CHF remain outstanding, the Bank no longer offers new pool-based loans in CHF. However, the average cost of the CHF borrowing pool is included in the cost of multi-currency pool-based loans. 51 The concept of “efficient funding” means that the Bank would not incur undue costs in managing the resources after the funds have been mobilized and before and after a loan has been disbursed and repaid. 52 The amount payable in local currency in the event of a call on the guarantee is capped, using the spot exchange rate, at the lesser of (i) the maximum guaranteed amount in the Bank’s lending currency, or (ii) the 11
  • 2.2.9 The Bank may conduct currency purchases to fulfill client disbursement or repayment requests, where the Bank acts as an agent but takes no principal position in the transaction. All costs associated with currency purchases are borne by the client. ADB Investment Portfolios 2.2.10 The Bank may conduct cross-currency investment transactions53 provided that the Bank has no residual currency exposure54. 2.2.11 Where the Bank has appointed external managers to invest part of the Bank’s liquid resources, the external managers shall not conduct transactions that expose the Bank’s assets to currency exchange risks. Funding Portfolios 2.2.12 In addition to using swaps to maintain the alignment of the currency composition of the Bank’s net asset with its currency benchmark, the Bank may also conduct currency swaps to convert liabilities into another currency where resources in another currency are required for operational purposes provided that the Bank has no residual currency exposure. Nigeria Trust Fund Investments 2.2.13 The NTF’s principal currency risk management objective is to avoid exposure to fluctuations in currency exchange rates. To achieve this objective, the funds invested for the NTF shall be maintained in USD or fully hedged back into USD, the currency in which NTF resources are denominated. 2.3 Liquidity Risk Management 2.3.1 Liquidity risk is the potential for loss55 resulting from insufficient liquidity to meet cash flow needs in a timely manner. The Bank’s principal liquidity risk management objective is to hold sufficient liquid resources to enable it to meet all probable cash flow needs for a rolling 1-year horizon without additional financing from the capital markets. 2.3.2 To achieve this objective, the Bank’s liquidity policy prescribes a range for the volume of liquid assets. This range is calibrated to reflect the size of the Bank’s lending operations while providing adequate flexibility to implement a cost- effective borrowing program. The lower end of the range is defined by the prudential minimum level of liquidity (PML) and the normal upper end of the range is demarcated by the operating level of liquidity (OLL). 2.3.3 The PML shall be an estimate of the Bank’s probable net cash requirement for a 1- year horizon and shall be recomputed quarterly as the sum of four components: 1) amount, in local currency, that has been called. 53 A cross-currency investment transaction is an investment in one currency that is transformed into another currency using forward foreign exchange transactions. 54 Currency exposure caused by unwinding the transaction before maturity shall not constitute an exception to these guidelines. 55 Including the adverse impact on reputation caused by the inability to maintain normal lending operations. 12
  • 1-year debt service payments; 2) 1-year projected net loan disbursements56 if greater than zero; 3) loan equivalent value of committed guarantees; and 4) undisbursed equity investments. The level of liquidity shall always be maintained above the PML. 2.3.4 The OLL shall be computed quarterly as the PML plus 50% of the stock of committed undisbursed loans57. The OLL, as the upper end of the range for liquidity, is an operational guideline that may be periodically exceeded for justifiable operational reasons without material risk to the Bank. 2.3.5 Investments held in the Bank’s operational and prudential portfolios shall be considered as “eligible liquidity” 58. In addition, any investments held in the equity- backed portfolio with a remaining maturity less than 1-year shall also be considered as eligible liquidity. 2.3.6 Where the Bank has appointed external managers to invest part of its liquid assets, in determining the amount of externally managed liquidity, the Bank shall ensure that internally managed resources do not fall below 75% of the prudential minimum level of liquidity. The external managers shall be required to redeem the Bank’s liquid resources within 3059 calendar days of being given such notice by the Bank. Marketability of Investments 2.3.7 Liquidity risk is also the potential for loss resulting from the inability to sell an investment or buy-back a short position at a reasonable price within a reasonable period of time. The Bank’s principal investment liquidity objective is to ensure that the investments in the operational and prudential portfolios can be liquidated 60 promptly and without incurring undue transaction costs under normal market conditions61. To achieve this objective, a number of liquidity restrictions shall apply to the Bank’s investments. 2.3.8 In view of the potential cost of holding highly liquid investments 62, the size of the operational portfolio shall generally be linked to the estimated debt service flows over the following 3 months63. 2.3.9 All securities purchased shall meet the liquidity objectives of the targeted investment portfolio. Metrics such as the trading volume of a particular security, the number of brokers/dealers providing two-way markets in the security, typical bid/ask spreads64, and similar measures shall be used to gauge the overall liquidity of an investment at 56 Net loan disbursements means loan disbursements less loan repayments. It is an estimate of the net loan transfers to clients. 57 A committed undisbursed loan is a loan that has been signed, but has not fully disbursed. 58 Eligible liquidity is a term used to describe the liquid resources that shall be used to monitor compliance with the liquidity range. 59 The 30-day period includes the notice period plus the liquidation period. 60 Liquidated means to close-out a transaction for cash or the equivalent. 61 Liquidity cannot be precisely measured and may deteriorate sharply depending on various market factors. Such circumstance would be not considered normal market conditions. 62 Due to the normally upward sloping shape of the yield curve. 63 When monitoring the size of the operational portfolio vis-à-vis the 3 month debt service flows, a cushion of about UA 50-75 million to cover administrative expenses and unexpected outflows may be considered normal. 13
  • the time of purchase. All new investments shall be ranked at the time of purchase on the basis of estimated liquidity into one of two categories: 1) very liquid; and 2) moderately liquid (See appendix 6 on liquidity). 2.3.10 No security shall be purchased for the operational or prudential portfolios of the Bank, or the operational portfolio of NTF, if the total amount outstanding of the issue is less than USD 100 million65. Investments in a specific issue should not exceed 15% of the outstanding issue or tranche66 of an issue, as the case may be. 2.3.11 In order to restrict short sales67 to the most liquid investments, short-selling shall be permitted only for government securities, agency debt and agency mortgages including to-be-announced (TBA) issues. Further, short-sales may be conducted using futures68 or forwards for hedging the interest rate or currency risk of an underlying investment. Nigeria Trust Fund Investments 2.3.12 The NTF’s principal liquidity risk management objective is to ensure that it holds adequate liquid resources to meet its operational cash flow needs. To achieve this objective, 25% of the Fund’s investments shall be held in its Operational Portfolio. 2.4 Counterparty Credit Risk Management 2.4.1 Counterparty69 credit risk is the potential for loss due to failure of a counterparty to honor an obligation. The Guidelines prescribe the rules that govern counterparty credit risk for asset and liability management operations. Separate guidelines prescribe the rules governing credit risk management for the Bank’s sovereign and non-sovereign loan and equity investment portfolios. 2.4.2 As a non-core business risk, the Bank’s principal counterparty credit risk management objective is to minimize the likelihood of financial losses, business disruption, or reputational damage resulting from credit failures. To achieve this objective, the Bank’s asset and liability management operations shall be conducted within a prudential framework of: 1) approved counterparties; 2) minimum credit 64 Bid/ask spreads describes the difference between the price or yield at which an instrument may be bought/sold in the market. 65 An issue shall be considered to consist of the aggregate amount of a security or group of securities, which have characteristics permitting them to trade interchangeably in the market. 66 Asset and mortgage backed securities are generally issued as a large transaction with multiple tranches. A tranche of an issue is a special category of assets with similar risk characteristics. 67 Selling an investment “short” refers to the sale of a security without owning it. 68 A future is a standardized contract that is traded on a regulated exchange for the delivery of a prescribed instrument(s) at prescribed future points in time. Most futures contracts are closed-out for cash before delivery. 69 A counterparty means any party to an asset and liability management transaction excluding the Bank’s clients for loan or equity investments. 14
  • rating standards70; 3) counterparty exposure limits; and 4) counterparty credit risk mitigation measures. Approved Counterparties 2.4.3 There are three principal groups of counterparties: 1) investment counterparties 71; 2) derivative counterparties72; and 3) trading counterparties73. All counterparties shall be subject to the approval of Vice President, Finance. Asset and liability management transactions shall only be conducted with approved counterparties, which meet the Bank’s minimum credit standards and are located in or controlled by entities based in member countries of the Bank. 2.4.4 Swaps, forwards, options, other over-the-counter74 (OTC) derivative transactions and repurchase or reverse-repurchase agreements shall be only conducted with approved counterparties or clients for a risk management product where a standard agreement75 between the Bank and the relevant counterparty or client has been duly completed (See appendix 7 on trading agreements). Minimum Credit Rating 2.4.5 Subject to the transaction-specific credit limitations set forth in the section on authorized transactions, the minimum credit rating for any investment76 with a remaining final maturity longer than 1 year shall be AA-/Aa3. The minimum credit rating for any investment with a remaining final maturity of 1 year or less shall be A/A2 or the equivalent77. 2.4.6 The minimum credit rating for counterparties to any derivative transaction, regardless of the remaining final maturity, shall be AA-/Aa378. 70 The Bank’s credit standards are based on the ratings from approved credit rating agencies. These shall include Standard and Poors, Moody’s Investors Service, Fitch Ratings or any other rating agency approved by ALCO. All references to credit ratings in the Guidelines shall mean a credit rating by an approved rating agency. For purposes of eligibility, a counterparty’s credit rating means the lowest equivalent credit rating by an approved rating agency. 71 Investment counterparty means the issuer or guarantor of a security, obligation, or other debt instrument including banks that take time deposits etc. 72 Derivative counterparty means any institution that acts as the counterparty with the Bank in a derivative transaction. 73 Trading counterparty means brokers, dealers, securities companies, custodians, clearing houses, futures exchanges, etc. 74 An over-the-counter derivative transaction is conducted directly with a counterparty as opposed to an exchange-traded derivative transaction, which is traded on a regulated exchange. 75 A standard agreement is a standardized legal agreement defining matters such as the rights and obligations of the counterparties and standard market terminology. A standard agreement shall include provisions for netting of exposures. Examples of such agreements include ISDA (International Swaps and Derivatives Association) master agreements and ISMA (International Securities Market Association) master repurchase agreements. 76 Credit rating of investment refers to the rating applicable for the specific investment; ratings exclusively applicable for other investments by the same issuer shall not be used as a proxy rating. 77 Rating scales may differ between rating agencies and for different instruments. For the purpose of the Guidelines, any specified credit rating shall include any recognized equivalent rating by an approved rating agency. For investments with a money market rating, the minimum credit rating shall be A-1/P-2 or the equivalent, subject to the issuer’s long term unsecured rating being at least A/A2. 78 The Bank’s capacity to manage collateral is currently being established. Following the implementation of the collateral management system over a period of time, ALCO may, if it determines that the collateral 15
  • 2.4.7 The minimum credit rating for trading counterparties79 shall be A/A280. In exceptional cases the Bank may approve trading counterparties whose credit rating is below the minimum standard or are not rated. Non-rated counterparties shall be subject to the approval of Vice President, Finance, subject to the recommendation of ALCO after a thorough review of the counterparty’s creditworthiness. 2.4.8 If any credit rating81 of a counterparty to an asset and liability management transaction falls below the minimum level stated in the Guidelines, this shall be treated as an exception to the Guidelines. 2.4.9 No asset and liability management transactions shall be conducted where a counterparty is known to be under review for a credit rating downgrade that may bring it below the minimum rating allowed by the Guidelines. 2.4.10 While the minimum credit rating standards will be generally applicable for all asset and liability operations, the credit rating restrictions may be partially relaxed for local currency operations to enable adequate availability of investment avenues or/and derivative counterparties for implementing interest rate risk management strategies. Any such downward recasting of the minimum standards shall be subject to approval by ALCO. Counterparty Exposure Limits 2.4.11 Counterparty exposure82 limits shall be set and monitored by ALCO, informed by the recommendations of FFMA. Counterparty exposure limits shall be based on the credit rating of the counterparty and determined as a percentage of the lower of either the Bank’s risk capital or the counterparty’s net worth (See appendix 8 on exposure limits). 2.4.12 The counterparty exposure for asset and liability management transactions shall be measured in accordance with the methodologies83 approved by the Bank for International Settlements (BIS). Counterparty exposure shall be measured net of the current market value of any collateral84 posted to the Bank’s account by a counterparty. 2.4.13 Where the Bank has appointed external managers to invest part of its liquid assets, the counterparty exposures from the investments made by the external managers shall be aggregated at the end of each month with internal counterparty exposures to determine the Bank’s total counterparty exposures. management system is functioning satisfactorily, thereby effectively reducing counterparty risk, recommend to the President a lowering of the minimum credit rating for counterparties with whom the Bank has a collateral exchange agreement (CSA) to A-; this will enable the Bank to access a wider range of counterparties while keeping counterparty credit exposure under control. 79 Excluding authorized exchanges and clearing houses. 80 The risk of failure of a trading counterparty to complete a committed transaction is referred to as settlement risk. The maximum settlement period for any non-derivative asset and liability management transaction in the secondary market shall be 1 month. 81 When a counterparty’s credit ratings are not all equivalent, it is deemed to have a “split-rating”. 82 Counterparty exposure means an estimate of the Bank’s maximum current financial loss if a counterparty defaults. 83 Where netting agreements are applicable, exposures with the counterparty will be measured as the net exposure where all assets and liabilities with a counterparty are aggregated and off-set. 84 Collateral means any cash or authorized securities. 16
  • Counterparty Credit Risk Mitigation Measures 2.4.14 The Bank seeks to reduce counterparty credit exposures using collateral whenever feasible. The Bank shall seek to establish collateral exchange agreements with all derivative counterparties85 (See appendix 7 on trading agreements). 2.4.15 The threshold level of net credit exposure, which shall require the counterparty to post collateral, shall be based on the rating of the counterparty. 2.5 Authorized Asset and Liability Management Transactions 2.5.1 There are three principal groups of authorized asset and liability management transactions; 1) investment transactions; 2) funding transactions; and 3) derivative transactions. 2.5.2 Inclusion of new products under the authorized asset and liability transactions will be subject to approval by ALCO. 2.5.3 Where the Bank has appointed external managers to invest part of its liquid assets, the external managers shall undertake operations that are generally consistent with the transaction limitations in the Guidelines, unless specified otherwise. Investment Transactions 2.5.4 Authorized investment transactions are classified by type of investment counterparty, maturity, and/or type of fixed income instrument. Subject to the limitations set forth in the Guidelines, the Bank may invest in the following transactions: Governments 2.5.5 Debt obligations issued or unconditionally guaranteed by a government (government securities). The remaining final maturity86 for Government securities shall not exceed 30 years for AAA/Aaa rated securities, 15 years for securities with a minimum rating of AA-/Aa3, and 1 year for securities with a minimum rating of A/A2. Government Agencies and Supranationals87 2.5.6 Debt obligations issued or unconditionally guaranteed by an agency or instrumentality of a government or a supranational institution (agency and supranational securities). The remaining final maturity for agency and supranational securities shall not exceed 30 years for AAA/Aaa rated securities, 15 85 Collateral exchange agreements shall not be mandatory. However, all other things being equal, the Bank shall give preference to derivative counterparties where a collateral exchange agreement has been duly completed. 86 Remaining final maturity means the time until final maturity when a security is purchased (as opposed to the original final maturity when the security is issued). 87 Supranational means institutions with multi-national government shareholding and includes multilateral development banks. 17
  • years for securities with a minimum rating of AA-/Aa3, and 1 year for securities with a minimum rating of A/A2. Banks 2.5.7 Debt obligations issued or unconditionally guaranteed by a depository bank88 (bank obligations). The remaining final maturity for bank obligations shall not exceed 10 years for AAA/Aaa rated securities, 5 years for obligations with a minimum rating of AA-/Aa3, and 6 months for obligations with a minimum rating of A/A2. Corporations 2.5.8 Debt obligations issued or unconditionally guaranteed by a corporation including financial institutions89 (corporate securities). The remaining final maturity for corporate securities shall not exceed 10 years for AAA/Aaa rated securities, 5 years for securities with a minimum rating of AA-/Aa3, and 6 months for securities with a minimum rating of A/A2. 2.5.9 The total value of investments in corporate securities shall not exceed 35% of total investments in the combined operational and prudential portfolios and 25% of total investments in the equity-backed portfolio. Mortgage and Asset-Backed Securities 2.5.10 Mortgage-backed90 (MBS) or asset-backed securities91 (ABS) with a minimum rating of AAA/Aaa; for securities with only a short-term rating, the minimum rating shall be A-1+/P-1. The Bank shall only invest in MBS or ABS where repayment projections are available. 2.5.11 Due to their particular risk characteristics, the Bank shall not invest in the following types of MBS and ABS: where the underlying collateral is high-yield bonds92 or emerging market debt93; principal only securities94; and super floaters95. 2.5.12 The total value of investments in MBS96 and ABS shall not exceed 35% of total investments in the combined operational and prudential portfolios and 10% of total investments in the equity-backed portfolio. 88 Obligations of depository banks means all marketable securities as well as non-marketable instruments such as time deposits. Depository bank means deposit-taking banks supervised and regulated by the central bank. 89 Financial institutions means all non-bank finance corporations such as insurance companies and capital finance companies. 90 A mortgage-backed security is a debt obligation secured by the cash flows of a pool of mortgages. 91 An asset-backed security is a debt obligation secured by the cash flows of a pool of assets such as credit card receivables, auto loans, etc. A mortgage-backed security is a specific type of asset-backed security. 92 High-yield bonds are debt investments with a credit rating below BBB-/Baa3. 93 Emerging market debt is any sovereign debt obligation of a country rated below A- or obligation of a corporation located in a country rated below A-. 94 POs are structured securities where the holder is only entitled to the principal repayments of an underlying security(ies). 95 Super floaters are floating rate securities whose rate of interest moves faster than market interest rates. 96 Debt/securities issued or unconditionally guaranteed by agencies such as Fannie Mae, Ginnie Mae, Freddie Mac etc are excluded from this limit. 18
  • Securities Repurchase Agreements 2.5.13 Repurchase agreements (repo97) on authorized securities. For unrated counterparties, the remaining final maturity for such transactions shall not exceed 3 months. Mutual Funds 2.5.14 Money market mutual funds98 with a minimum rating of AA-/Aa3 or equivalent. Funding Transactions 2.5.15 Authorized funding transactions are classified by type of investor, maturity, and/or type of fixed income instruments issued. Subject to the limitations set forth in the Guidelines, the Bank may borrow using the following transactions: 2.5.16 Public99 or privately-placed100 debt instruments with a final maturity of less than 1 year for cash management purposes. Such debt issues are generally fixed rate and may be swapped to meet the Bank’s specific funding needs. 2.5.17 Public or privately-placed debt instruments with a final maturity of 1 year or longer to fund the loan and investment portfolios. Such debt issues may be either on a fixed or floating101 rate basis and may be swapped to meet the Bank’s specific funding needs. 2.5.18 The Annual Borrowing Program shall be approved by the Board of Directors. All borrowing transactions shall be subject to the approval of Vice President, Finance102. There shall be two exceptions: 1) borrowings whose final maturity is less than 1 year; and 2) privately-placed transactions pre-authorized by FNVP after consultation with FFMA under an “Open Mandate” 103. 2.5.19 The Bank may redeem any outstanding borrowing through the exercise of call options, or other debt buy-back or exchange strategies. Where the redemption of an outstanding borrowing would imply an up-front cost to the Bank, the transaction shall be approved by the Vice-President, Finance, subject to ALCO recommendations. 2.5.20 Where the Bank has appointed external managers to invest part of its liquid assets, the external managers shall not borrow funds, except as part of a repurchase agreement. 97 A repo is a transaction whereby the owner of a security temporarily lends it to a counterparty against cash collateral of equivalent market value. 98 A mutual fund is an investment vehicle with a prescribed investment mandate that pools resources for multiple investors. 99 A public issue is a borrowing issued to multiple investors on a public market. Examples include the Eurobond, Yankee, and Samurai public bond markets. 100 A privately-placed issue is a borrowing issued directly to a single investor or a limited number of investors. 101 For the purpose of this guideline, floating rate debt may include debt with structured coupons. 102 For all borrowings with new structures, FTRY shall send a copy of the proposed transaction to FFMA for review. FFMA shall confirm the proposed transaction’s compliance with the Guidelines, before the proposal is submitted to FNVP for approval. 103 An open-mandate is a temporary standing agreement with a counterparty to issue private placements for the Bank within prescribed limits. 19
  • Securities Reverse Repurchase Agreements 2.5.21 Reverse repurchase agreements (reverse repo104) on authorized securities. For unrated counterparties, the remaining final maturity for such transactions shall not exceed 3 months. Derivative Transactions 2.5.22 The Bank will only use derivative transactions whose risk characteristics can be clearly understood, measured, and valued internally by the Bank. The reason for using any derivative transaction shall be documented and all risk exposures related to derivative transactions shall be reported separately as well as in aggregate with the underlying transactions. All derivative transactions shall be regularly marked- to-market, regardless of whether intended to be held-for-trading or held-to- maturity. 2.5.23 Subject to the letter and intent of the interest rate and currency risk limitations set forth in the Guidelines, the Bank may use the following derivative transactions: Forwards and Futures 2.5.24 Foreign exchange forwards or futures in line with its currency risk management objectives and limits. Currency forwards or futures shall either be linked to specific underlying assets and liabilities or pools of assets and liabilities in the same currency. 2.5.25 Forward interest rate agreements105 (FRAs) or interest rate futures in line with its interest rate risk management objectives and limits. FRAs or interest rate futures shall either be linked to specific underlying assets and liabilities or pools of assets and liabilities in the same currency. Swaps 2.5.26 Currency and interest rate swaps in line with its interest rate or currency risk management objectives and limits. Currency swaps shall either be linked106 to specific underlying assets and liabilities or pools of assets and liabilities in the same currency. Interest rate swaps shall either be linked to specific underlying assets and liabilities or pools of assets and liabilities with homogeneous interest rate risk characteristics (macro-hedge or portfolio swaps). 2.5.27 Currency and interest rate swaps to offset an existing swap, where the underlying borrowing has been called, and where the cancellation of the original swap is uneconomical. The terms of such offsetting swaps should mirror the terms of the underlying issue. 104 A reverse repo is a transaction whereby the holder of cash temporarily lends the cash to a counterparty against security collateral of equivalent market value. 105 A forward rate agreement is a contract for a fixed rate deposit at a specified interest rate at a specified future point in time. 106 A swap is said to be “linked” to an underlying asset or liability if the risk characteristics of one side of the swap match the risk characteristics of the underlying asset or liability. 20
  • 2.5.28 Other types of swaps including commodity107 swaps to offer risk management products to clients, where the Bank is not exposed to any residual exposure to the underlying commodity or index. Options 2.5.29 Purchase of currency or interest rate options such as caps 108, floors109, and swaptions110 in line with its interest rate or currency risk management objectives and limits; the remaining life of purchased stand-alone options shall not exceed one year. 2.5.30 Purchase of other types of options including commodity options to offer risk management products to clients, where the Bank is not exposed to any residual exposure to the underlying commodity or index. 2.5.31 Sale of covered options111, such as embedded options. All sales of covered but stand-alone options112 for investment management purposes shall be subject to a maximum remaining maturity of 1 year and shall be communicated to ALCO for information. All sales of covered but stand-alone options113 for liability management purposes shall be approved by the Vice President, Finance subject to ALCO recommendations. 2.5.32 The Bank shall not sell any uncovered options directly or indirectly. 2.6 Operational Risk Management 2.6.1 Operational risk is the potential for loss due to failures of processes or systems114, exogenous events, or unenforceability of legal contracts. The Bank’s principal operational risk management objective is to minimize operational risk in the management of its assets and liabilities in a cost-effective manner. To achieve this objective, the Bank seeks to: 1) foster a professional work environment with the highest ethical standards; 2) hire and train sufficient and qualified staff in line with the nature and magnitude of the risks inherent in each activity; 3) establish adequate and documented processes and controls using the appropriate technology and systems; and 4) maintain adequate business continuity arrangements. Ethical Standards 2.6.2 Staff involved in the implementation of the Bank’s asset and liability management operations shall maintain professional standards consistent with Bank’s Code of Conduct and with such other standards as may be prescribed from time to time. 107 A commodity swap is a transaction where the interest rate on the swap is determined from a formula using the price of a specified commodity. 108 A cap is an option contract that is used to set the maximum rate of an underlying instrument. 109 A floor is an option contract that is used to set the minimum rate of an underlying instrument. 110 A swaption is an option where the underlying instrument is a swap. 111 A covered option refers to the possession of the underlying asset by the Bank. 112 Also referred to as ‘covered call writing’ 113 A stand-alone option is an option that is not embedded in an asset or liability. 114 Process failures could be due to process inadequacies, human error, or fraud. They could also be caused by break-down of a system or technology that supports the process. 21
  • Human Resources 2.6.3 The profiles of all positions created for the implementation of the Bank’s asset and liability management operations shall be consistent with the nature and risks of the required duties. All staff assigned to such positions shall be adequately trained and instructed to perform the required duties. Each critical function shall have an assigned staff (a back-up) that can competently substitute for the principal staff normally performing such critical duties. Processes 2.6.4 Processes shall be established that efficiently carry out the desired activities while providing adequate controls to reduce the risk of system failure, human error, or fraud. It is the responsibility of each individual involved in the Bank’s asset and liability management operations to understand the Bank’s processes and to continually strive to improve the control framework. 2.6.5 There are three principal groups of staff involved in the Bank’s asset and liability management transactions: 1) front-office staff; 2) middle-office staff; and 3) back- office staff. In addition, the Bank’s asset and liability management process are directly supported by IT, accounting, and legal staff. 2.6.6 Only front-office staff115 (traders) duly authorized by the Director, FTRY may carry out the Bank’s asset and liability management transactions. All asset and liability management transactions shall be carried out by a mechanism 116 approved by the Director, FTRY with a complete and reliable record. All transactions undertaken by telephone shall be subject to voice recording and shall be reported at the time of execution in a “trade-ticket”. Front-office staff executing any transaction shall be responsible for promptly entering the complete transaction into the Bank’s asset and liability management systems117 and for ensuring the integrity of the dynamic transaction data118 in the system. 2.6.7 Only middle-office staff119 duly authorized by the Director, FFMA may validate that transactions comply with the Guidelines for further back-office processing. The Director, FFMA may waive the requirement for middle-office validation for specified low-risk transactions. The middle-office shall be responsible for the valuation of all asset and liability transactions, and along with the back-office, for the integrity of all the static data120 and dynamic market data121 in the system. 115 Front-office staff means personnel who can commit the Bank in an asset and liability management transaction. 116 A mechanism in this context includes telephone, fax, telex, SWIFT message, Reuters, Bloomberg, EUCLID, or any other recognized method of committing the Bank in a transaction. 117 The Bank’s princpal asset and liability management system is SUMMIT. In addition, the Bank uses NUMERIX as a pricing engine integrated into SUMMIT for valuing certain complex transactions. 118 Dynamic transaction data includes data such as the price, amount, trading counterparty, settlement date, etc of a specific transaction. 119 Middle-office staff means personnel who validate transactions before they enter the Bank’s transaction database and are processed for payment. Middle-office staff provide an independent oversight function on all asset and liability management transactions. 120 Static data includes financial static data such as calendar codes, transaction static data such as booking codes, and post market static data such as settlement instructions. 121 Dynamic market data means all market rates such as interest rates, exchange rates, bond prices etc. 22
  • 2.6.8 Only back-office122 staff duly authorized by the Director, FTRY may settle123 asset and liability management transactions. Settlement of all transactions shall be subject to proper verification of trade confirmations from the counterparties by back-office staff. 2.6.9 FTRY and FFMA shall, in consultation with GECL, negotiate the required agreements with approved Bank counterparts to implement the permitted asset and liability management transactions. All such transactions shall be approved by the Vice-President and the relevant transaction contracts shall be signed by the authorized officer designated in the Delegation of Authority Matrix. Systems 2.6.10 Routine processes shall be automated by implementing systems that safeguard the integrity of the Bank’s financial data and enforce the Bank’s critical asset and liability management processes. 2.6.11 Only information systems staff duly authorized by the Director, Information Systems and Methods (CIMM) may establish access controls124 for the Bank’s asset and liability transaction and information systems, transaction database, and the transaction voice-recordings. Documentation 2.6.12 The Bank shall maintain appropriate procedure manuals for all asset and liability management processes. It shall be the responsibility of each business unit to ensure that the relevant procedure manuals are disseminated, understood, and complied with. It shall also be the responsibility of each business unit to ensure that the relevant procedure manuals are regularly updated as their processes evolve. Business Continuity 2.6.13 An implementation plan and adequate back-up arrangements to ensure business continuity for all critical asset and liability management operations shall be maintained in case of events that lead to temporary or sustained disruption of normal operations. Where appropriate, insurance shall be purchased to cover the financial losses due to such exogenous events. III. IMPLEMENTATION 3.1 Compliance 3.1.1 The Director, Treasury (FTRY), under the direct supervision of the Vice-President, Finance (FNVP), shall have primary responsibility for the implementation of the 122 Back-office staff means personnel who complete the process of payment and exchange in an asset and liability management transaction. 123 Settle or settlement refers to the process whereby a transaction is completed through the exchange of payment for the security or obligation between the buyer and the seller. 124 Access control means the ability of an individual to log-in, view, or change data in a system or database. 23
  • Bank’s asset and liability management operations125. The Director, Financial Management (FFMA), shall have primary responsibility for monitoring compliance with the Guidelines. 3.1.2 It shall be the responsibility of all Bank staff involved in the Bank’s asset and liability management operations to be familiar with the Guidelines. Each officer authorized to carry out asset and liability management transactions shall only enter into transactions that are consistent with the limitations set forth in the Guidelines. 3.1.3 Each limit set forth in the Guidelines that requires a calculation shall be applied as of the close of business, unless otherwise specified. In certain instances, the limitations set forth in the Guidelines cannot be monitored with precision, even on a close of business basis. In such cases, the applicable limits will be complied with on a best efforts basis. 3.2 Exceptions 3.2.1 FFMA shall have primary responsibility for coordinating the resolution of exceptions to the Guidelines. Any Bank officer that becomes aware of a breach of the Guidelines shall report such exceptions to their Division Manager by the close of business that day and simultaneously inform the Manager, FFMA.3. The Directors of FTRY and FFMA will be immediately informed of the exception and the Director, FTRY will inform the Director, FFMA of the proposed remedial action. 3.2.2 All exceptions shall be reported to ALCO at the next meeting. For significant exceptions the Director, FFMA will inform ALCO promptly of such exceptions being identified. FTRY and FFMA shall explain any exceptions and, if necessary, ALCO shall decide on any further actions to be taken. 3.2.3 If any officer is aware that a breach of the Guidelines has not been reasonably addressed in accordance with the previous paragraphs, such officer shall promptly act to ensure the required dissemination. 3.3 Reporting 3.3.1 FTRY shall be responsible for preparing various regular and ad-hoc reports to support the Bank’s asset and liability management process. • Monthly summary of asset and liability management operations and performance for the Board (to be cleared by ALCO). • Quarterly reports summarizing the Bank’s asset and liability management operations and strategy for the Board. 125 Where ALM trades are recommended by IRWG or CUWG, and endorsed by ALCO, FTRY shall examine the economic benefits of the alternative implementation strategies and execute the most financially attractive within the various limitations of the Guidelines. Such transactions shall be completed within twenty business days of the approval from ALCO and shall be described in the next monthly report from FTRY to ALCO. 24
  • • Execution reports on interest rate and currency risk management transactions undertaken to maintain alignment with the re-pricing profile and currency benchmarks. • FTRY shall maintain an up-to date list of all front-office staff authorized to conduct asset and liability management transactions and back-office staff authorized to settle asset and liability management transactions. Any changes in the authorized staff shall be subject to the approval of Director, FTRY and promptly communicated in writing to FFMA. FFMA shall communicate the updated list of the Bank’s authorized traders to all approved counterparties, at each instance of a change in the list. 3.3.2 FFMA shall be responsible for preparing various regular and ad-hoc reports to support the Bank’s asset and liability management process. • Monthly reports to ALCO on the Bank’s asset and liability management performance and compliance with the Guidelines126. • Monthly report to ALCO on any exceptions to the Guidelines and progress on any remedial actions. • Any changes to the lists of approved counterparties and the exposure limits127. • An annual report to the Board on the Bank’s exposure to market risk and compliance with the Guidelines. 3.3.3 The working groups under ALCO shall prepare periodic reports for the committee. • The IRWG shall submit a quarterly report to ALCO on the Bank’s interest rate risk profile and proposed corrective measures. It shall submit a semi-annual report on debt allocation, lending rates, and funding margins. • The CUWG shall submit a quarterly report to ALCO on the Bank’s currency risk profile and proposed corrective measures. • The PJWG shall submit a quarterly report to ALCO on the Bank’s medium-term financial projections, the liquidity risk profile and the proposed PML and OLL. 126 The monthly performance and compliance reports shall include the external managers. 127 Includes all investment, derivative, and trading counterparties. 25
  • APPENDIX 1 ASSET AND LIABILITY MANAGEMENT COMMITTEE ALCO was established in June 1998 by Presidential Instruction PL 006/98 as a successor to the Investment Committee. It has been subsequently modified by Presidential Instructions PL 004/02 and PL 001/03. ALCO is composed of a chairman, a non-voting secretary, plus six voting members. • Chairman: Vice President, Finance; • Member and alternate chairman: Director, Financial Control; • Member: Director, Financial Management; • Member: Director, Treasury; • Member: Director, Legal Services and General Counsel; • Member: Director, Operations Policy; • Member: Director, Strategic Planning and Budget • Secretary: Manager, Asset and Liability Management Division; ALCO’s role is to: • ensure sound integrated Bank-wide risk management; • monitor and report on overall Bank financial issues; • advise the President and provide guidance to the business units involved in the Bank’s asset and liability management operations; and • set broad guidelines in the areas of risk control, capital allocation, financial performance, and balance sheet structuring. ALCO may establish working groups to support the technical aspects of the Committee’s functions. Currently, seven standing working groups have been established: • interest rate risk working group; • currency risk working group; • projections working group; • financial products working group; • country risk working group; • credit risk working group; • operational risk working group. 26
  • APPENDIX 2 BENCHMARKS African Development Bank The Bank employs a number of reference benchmarks for performance measurement and risk control. The principal interest rate benchmarks are: • Net Assets – the standard reference benchmark is a uniform 10-year re-pricing profile in each of the SDR currencies. In this framework 10% of the Bank’s net interest sensitive assets re-price in each of the next 10 years. The tenth annual re-pricing bucket includes all assets re-pricing longer than 10 years. • Floating Rate Assets and Liabilities - the standard reference benchmark is the 6-month LIBOR rate in each currency resetting with a semi-annual frequency on the Bank’s standard reset dates of February 1st and August 1st. • Operational Portfolio - the reference benchmark is the 1-month LIBID rate (LIBOR minus 12.5 basis points) of the first business day of every month. • Prudential Portfolio - the reference benchmark is the Bank’s standard reference for floating rate assets and liabilities in each currency. The 6-month LIBOR rate is decompounded using an Actual/360 day basis to obtain the daily benchmark rate and re-compounded on an Actual/365 day basis to obtain the monthly benchmark rate. The principal currency benchmark is: • Net Assets – the standard reference is the currency composition of the SDR. The SDR is a basket currency composed of 0.5770 USD; 0.4220 EUR; 0.0984 GBP; and 21 JPY. The IMF adjusts the composition of the SDR every five years. The value of the SDR changes daily as the relative values of the component currencies fluctuate in the markets. FFMA is responsible for maintaining and computing the Bank’s benchmarks. Nigeria Trust Fund The NTF employs a number of reference benchmarks for investment performance measurement and risk control. The principal interest rate benchmarks are: • Investment Portfolio – pending the resolution of the Sunset Clause, the interim investment risk control benchmark is a single maturity repricing profile aligned to April 2006, when the Sunset Clause comes into force. • Operational Portfolio - the reference benchmark is the monthly average of daily 3-month LIBOR rates. 27
  • APPENDIX 3 VALUATION The Bank regularly revalues its investment and borrowing portfolios as well as all derivative transactions for the purpose of financial reporting and computing counterparty exposures. To the extent possible, all valuations should reflect the estimated price at which a transaction could be liquidated under prevailing market conditions. Investment Portfolios To the extent possible, all securities held in the Bank’s prudential and operational investment portfolios, and NTF’s operational portfolio, will be revalued daily using the closing bid prices or the futures exchange closing for the previous day. The Bank relies on three principal market pricing sources: Reuters; Bloomberg; and trading counterparties. For securities where a market price is not readily available, valuations will be estimated using the Bank’s internal treasury systems. At the time of purchase of each new security, front-office and middle-office staff will agree on the appropriate pricing model to be used. For securities that are valued internally, prices from a market source will be obtained at least monthly to validate and recalibrate the Bank’s pricing models. Middle-office staff will attempt to obtain prices from three different counterparts, including the underwriter of the security and the trading counterparty, which sold the security. The valuation price will be the average of the quotes received, excluding any quotes that significantly deviate from the mean. All investment valuations will be monitored for reasonableness. Security valuations exhibiting unusual volatility will receive closer scrutiny by middle-office and front-office staff. Securities held in the equity-backed portfolio (and the NTF investment portfolio) are intended to be held to maturity and are valued daily using the constant yield amortization methodology. For purposes of estimating counterparty exposures, and to measure the liquidity of the portfolio, market prices are obtained for the equity- backed portfolio at least monthly. Borrowing Portfolios Although the Bank generally does not “trade” the borrowings in its portfolio, all debt liabilities and the related derivatives are revalued at least monthly based on prevailing market conditions. Valuations will be estimated using the Bank’s treasury systems. At the time of issuance, front-office and middle-office staff will agree on the appropriate pricing model for each new borrowing. To ensure proper model calibration at inception, each new transaction will be priced using the Bank’s models and compared to the price of the lead manager. In addition, market prices for all new transactions will be obtained monthly for the first 6 months. For seasoned (older) transactions, prices from a derivative counterparty or an 28
  • independent market source will be obtained at least quarterly to validate and recalibrate the Bank’s pricing models. 29
  • APPENDIX 4 DEBT LIMITS The Bank operates its funding activities within a framework of debt limits. The three principal debt limits are: • Total debt shall not exceed 80% of the callable capital of member countries. • Total senior debt shall not exceed 80% of the callable capital of non-borrowing member countries. • Total debt shall not exceed 100% of the Bank’s usable capital128. 128 Usable capital is the sum of paid-in capital in convertible currencies, reserves, and callable capital of countries rated AA/Aa2 or better. 30
  • APPENDIX 5 DEBT ALLOCATION Each semester, the debt allocation exercise determines the composition of the USD, Euro, CHF and JPY borrowing pools funding the Bank’s pool-based loans as well as the Bank’s average funding margin for market-based loans in the lending currencies. The IRWG is responsible for proposing the debt allocation and computing the various lending rates and funding margins for ALCO’s approval. Pool-Based Loans The base interest rate charged to the borrowers of pool-based loans in any semester is the average cost of the underlying borrowing pool in the relevant currency, calculated over the previous semester. Pool-based loans are repriced every January 1 and July 1. Since the debt allocation exercise entails a degree of Management discretion in seeking to balance borrowers’ interest as well as shareholders’ interests, the following are used as guiding principles for pool-based loans: • Matching principle: The amount of borrowings in each pool will be within a band of 80% to 120% of the amount of pool-based loans outstanding in the currency. • Fixed-floating hybrid principle: At least 50% of the borrowings in each pool will be fixed rate debt. • Consistency principle: Debt allocations will not be reversed in future periods, unless the reversal is in order to conform to the first principle i.e. if declining loan balances require borrowings to be released from the pool. • Fairness principle: The debt allocation will seek, to the extent feasible, to equalize the interest costs of the different currency pools relative to the relevant market interest rates, to ensure fairness across various borrowers. Market-Based Loans At the option of the borrower, the lending rate charged to public sector borrowers of floating rate loans may include a spread to reflect the Bank’s funding margin in that currency. The Bank’s funding margin in each lending currency shall be estimated each semester as the difference between the Bank’s current cost of floating rate borrowings and the benchmark, expressed in basis points. 31
  • APPENDIX 6 LIQUIDITY To monitor the degree of the liquidity in the Bank’s trading portfolios, the Bank’s investments will be broadly classified according to marketability. The relevant front- office staff will classify all investments at the time of purchase into one of two liquidity classes: very liquid and moderately liquid. The liquidity classification of all securities in the trading portfolios will be reviewed by the middle-office at least monthly. In recognition of the inherently subjective nature of the liquidity assessment of specific securities, the criterion for classification will be the indicative time required to sell UA 25 million of the security, under normal business conditions, without a material impact on the market price. Liquidity Indicative Liquidation Valuation Classification Period Features Daily quotes on Very Liquid Within 3 business days Bloomberg, Reuters Counterparty Moderately Liquid Within 10 business days quotes at least once a month 32
  • APPENDIX 7 MASTER AGREEMENTS The Bank shall conclude ISDA Master Agreements with approved counterparties before undertaking any derivative transactions. It is expected that there will be collateral agreements with the Bank’s principal derivative counterparties. The threshold for transfer of collateral from the counterparty to the Bank shall be based on the credit rating of the counterparty. The table below sets out the indicative threshold levels currently applicable; these shall be subject to periodic review based on the Bank’s experience. Minimum Transfer Counterparty Rating Threshold* Amount* AAA** N/A N/A AA+ 25 5 AA 20 5 AA- 15 5 A+ 0 5 A 0 5 A- 0 5 • Thresholds and minimum transfer amounts expressed in USD Millions ** Excluding SPVs, for whom a threshold of USD 100 million will be applied The Bank shall conclude ISMA Agreements with all approved counterparties before undertaking any repo transactions. 33
  • APPENDIX 8 EXPOSURE LIMITS The counterparty exposure limits for the various Bank Group entities are based on the general principle of diversification and limiting the potential adverse impact of a failure by any single counterparty129 on the entity’s financial soundness. The Bank’s counterparty limits are linked to the credit rating of the counterparty and are expressed as a percentage of the lower of either the Bank’s networth (liquid assets for NTF) or the counterparty’s networth. The table below presents the current limit structure used to calculate the counterparty exposure limits for ADB and NTF. In order to cater to technical breaches of a non- material nature, exposures exceeding but within 105% of limit will not be treated as an exception, provided the limit is exceeded due to market interest or exchange rate movements. Percentage of Percentage of NTF’s Counterpart ADB’s/Counterpart’s Liquidity/Counterpart’s Net Credit rating Net Worth Worth AAA 8% 10% AA+ 6% 8% AA 6% 8% AA- 6% 8% A+ 4% 6% A 4% 6% A- 4% 6% AAA ABS/MBS 3% 6% 129 Each legally separate entity shall be considered as a distinct counterparty; aggregation of exposures across related entities (such as group companies, subsidiaries) shall be done only if implicit/explicit cross-guarantees can be established. 34
  • APPENDIX 9 INVESTMENT GUIDELINES SUMMARY Actively Managed Trading Portfolios Portfolio Parameter Limit ADB Operational Benchmark 1 month Libid reset each month Permitted Duration Band 0-2 months Individual Security/Derivative Plus or minus 1 year Duration ADB Prudential Benchmark 6 month Libor reset Feb 1 and Aug 1 Permitted Duration Band Plus or minus 6 months around benchmark duration Individual Security/Derivative Plus or minus 10 years Duration NTF Operational Benchmark 3 month Libor daily average Permitted Duration Band 0-12 months Individual security duration Maximum 12 months Passively Aligned HTM Portfolios Portfolio Benchmark ADB Equity-backed Portfolio Driven by 10-year uniform repricing profile for net assets NTF Investment Portfolio Constant maturity to Sunset date in April 2006. Counterparty Rating Restrictions Type Minimum Rating Additional limits/Remarks Trading counterparty A/A2 Maximum settlement period for non-derivative secondary market trade of 1 month Derivative Counterparty AA- 35
  • Investment counterparty A See Authorized Investments 36
  • Authorized Investments Investment Type Minimum Rating* Maturity Limit Long term Money Market Government AAA - 30 years AA- - 15 years A - 1 year Agency/Supranational AAA - 30 years AA - 15 years A A-1 1 year Depository Bank AAA - 10 years AA- A-1 5 years A A-1 6 months Corporations AAA 10 years including non-bank AA- A-1 5 years Financial Institutions A A-1 6 months MBS/ABS AAA A-1+ No maturity limit, but repayment projections mandatory. Money Market AA-m - Mutual Fund * Minimum rating may be either a long-term or a money-market rating; investments with only a money- market rating shall require a minimum issuer rating of A. Category Limits (percent of portfolio size) Category Portfolio Limit Corporations including ADB Operational+Prudential 35% non-bank Financial NTF Operational Institutions ADB Equity-backed 25% NTF Investment ABS/MBS ADB Operational+Prudential 35% NTF Operational ADB Equity-backed 10% NTF Investment 37