Topic 5: Commercial Banks' Asset-Liability Management (ALM)

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Topic 5: Commercial Banks' Asset-Liability Management (ALM)

  1. 1. Topic 5: Commercial Banks’ Asset-Liability Management (ALM) <ul><li>Asset-liability management strategies </li></ul><ul><li>Interest rate risk management and hedging </li></ul><ul><li>The concept of duration gap and its limitation </li></ul><ul><li>Using financial futures, options, swaps and other hedging tools </li></ul><ul><li>The use of derivatives </li></ul>
  2. 2. <ul><li>Asset-liability management (ALM) strategies </li></ul><ul><li>ALM is a series of management tools designed to minimise risk exposure of banks, hence, loss of profit and value of banks. </li></ul><ul><li>ALM comprises all areas related to banking operations – loans, deposit, portfolio investment, capital management etc. </li></ul><ul><li>ALM Strategies </li></ul><ul><ul><li>There are three ALM techniques </li></ul></ul><ul><ul><li>Asset Management Strategy (AMS) – this is a strategy concerns with control of incoming funds through the determination of loans/credits allocation and their interest rates. </li></ul></ul><ul><ul><li>Liability Management Strategy (LMS)– deals with controlling of sources of funds and monitoring of the mix and cost of deposit and nondeposit liabilities – by controlling price, interest rate. </li></ul></ul><ul><ul><li>Fund Management Strategy (FMS) – this a a more balanced approach of ALM that incorporates both AMS and LMS. The basic objectives of FMS are: </li></ul></ul>
  3. 3. <ul><li>- The control of volume, mix, and return or cost of both assets and liabilities for the purpose of achieving a bank’s goals. </li></ul><ul><li>- The coordination of asset and liability management as a means of achieving internal consistence and maximizing the spread between revenue and costs, and minimization of risk exposure. </li></ul><ul><li>- maximization of returns and minimization of costs from supplying services. </li></ul><ul><li>Interest rate risk management and hedging </li></ul><ul><ul><li>Interest rate risk is a major challenge being faced by banks in their ALM. </li></ul></ul><ul><ul><li>Interest rate is determined by market forces through the interaction of the forces of demand for and supply of loanable funds (credit). </li></ul></ul><ul><ul><li>Fluctuations in market interest rate leads to two types of risk in banks – Price risk and Reinvestment risks. </li></ul></ul>
  4. 4. <ul><li>Measurement of Interest rates </li></ul><ul><ul><li>Interest rate can be defined as price of credit or return to capital. Interest rate can be measured through: </li></ul></ul><ul><ul><li>Yield to Maturity (YTM ) – this equalizes current market value of a loan or security with the expected future income such loan could generate. The YTM is calculated as : </li></ul></ul>Where PV = current market value of asset CF = expected cash flow FV = Expected value of asset at maturity I = market interest rate YTM = the yield to maturity
  5. 5. <ul><li>II. Bank discount rate (DR) – the rate usually quoted on short- term loans and government securities. This calculated as: </li></ul><ul><li> </li></ul><ul><li> DR = 100 – Purchase price of loan or security </li></ul><ul><li> 100 </li></ul><ul><li>X 360 (2) </li></ul><ul><li> Number of days to maturity </li></ul><ul><li>III. YTM equivalent – this is a means of converting DR to YTM and it is calculated as: </li></ul><ul><li> YTM (100 – Purchase price) 365 </li></ul><ul><li> equivalent = Purchase price X Days to maturity </li></ul><ul><li> yield (3) </li></ul>
  6. 6. <ul><li>The Components of Interest rates </li></ul><ul><li>- Interest rate has two components – risk-free interest rate and risk premium. That is, </li></ul><ul><li> Market Risk-free real Risk premium to compensate </li></ul><ul><li>interest rate interest rate lenders who accept risky </li></ul><ul><li> on risky = (such as the + IOUs for their default (credit) </li></ul><ul><li> loan or inflation-adjusted risk, inflation risk, term or </li></ul><ul><li> security return on maturity risk, marketability </li></ul><ul><li> government bonds) risk, call risk, etc. (4) </li></ul><ul><li>Working Exercises </li></ul><ul><li>Determine the YTM for a bond purchased today at a price of $950 and promising an interest payment of $100 each over the next three years when it will be redeemed by the issuer for $1,000. </li></ul><ul><li>Suppose a money market security can be purchased for a price of $96 and has a face value of $100 to be paid at maturity. Using DR, calculate the interest on the security if it is expected to mature in 90 days. </li></ul><ul><li>What is the YTM equivalent for the security in question 2 above? </li></ul>
  7. 7. <ul><li>Risk Premiums – risk premiums are interest rates charged on loans or other instruments in order to compensate for certain risks – default-risk, inflation risk, liquidity risk, and call risk. </li></ul><ul><li>Yield Curve – graphical representation of variations in interest due to differences in maturity, maturity-premium – may be upward, downward or horizontal. </li></ul><ul><li>Interest Rate Hedging </li></ul><ul><ul><li>In response to interest rate risks, banks engage in interest rate hedging (IRH). </li></ul></ul><ul><ul><li>IRH aims at isolating profit from the damaging effects of interest rate fluctuations – concentrating on interest sensitive assets and liabilities – loans, investment, interest-bearing deposits, borrowings etc, thereby, protecting the NIM ratio. </li></ul></ul>
  8. 8. <ul><li>Interest Rate Hedging Strategies </li></ul><ul><li>- Interest-Sensitive Gap management (IS Gap) </li></ul><ul><li>- Duration Gap management </li></ul><ul><li>Interest-Sensitive Gap management (IS Gap) </li></ul><ul><li> - IS gap deals with analysis of maturity and repricing of interest-bearing assets with the aim of matching their values with the value of deposits and other liabilities. That is </li></ul><ul><li>Dollar amount of repriceable Dollar amount of repriceable </li></ul><ul><li> (interest – sensitive) = (interest – sensitive) (5) </li></ul><ul><li> Assets (ISA) Liabilities (ISL) </li></ul><ul><li>- A gap will occur if the repriceable ISA ≠ repriceable ISL. That is </li></ul><ul><li>ISG = ISA - ISL; >0, < 0 (6) </li></ul><ul><li> </li></ul>
  9. 9. <ul><li>- Relative IS Gap ratio </li></ul><ul><li> </li></ul><ul><li> IS Gap </li></ul><ul><li>Relative IS Gap = Size of Bank ; > 0, < 0 (7) </li></ul><ul><li> (total Assets) </li></ul><ul><li>- Also the ratio of ISA can be compared to that of ISL, in which case we have Interest-sensitive ratio (ISR) . </li></ul><ul><li>Interest-Sensitive Ratio (ISR) = ISA ; > 1, < 1 (8) </li></ul><ul><li> ISL </li></ul><ul><li>Importance of IS Gap </li></ul><ul><li> - It helps in the determination of time period when NIM is to be managed. </li></ul><ul><li>- Helps management to set target for the level of NIM – either to freeze it or increase it. </li></ul><ul><li>- Helps in the determination of ISA and ISL. </li></ul>
  10. 10. <ul><li>Managing IS Gap </li></ul><ul><ul><li>Management response to existence of IS GAP varies depending on ability of banks </li></ul></ul><ul><ul><li>Banks can either embark on aggressive or defensive gap management. </li></ul></ul><ul><ul><li>A defensive management response will seek to set IS GAP to as close to zero as possible to reduce expected income fluctuations. </li></ul></ul><ul><ul><li>Management response also depends on the nature of risk arising from the IS GAP </li></ul></ul>Expected  s in Best IS GAP Position Aggressive management Interest rates to be Action Rising interest rate Positive IS GAP Increase IS assets Decrease IS liabilities Falling interest rate Negative IS GAP Decrease IS assets Increase IS liabilities
  11. 11. Positive IS GAP Expected risk Possible management ISA > ISL Losses if interest rates fall 1. Do nothing 2. Extend asset maturities or shorten liability maturities. 3. Increase IS liabilities or reduce IS assets Negative IS GAP Expected risk Possible management ISA < ISL Losses if interest rate rise 1. Do nothing. 2. Shorten asset maturities or lengthen liability maturities. 3. Decrease IS liabilities or increase IS assets.
  12. 12. <ul><li>Duration Gap Management </li></ul><ul><li>- Duration gap deals with the effect of interest risk on the net worth of bank, value of its stock. </li></ul><ul><li>- Duration gap is a value- and time-weighted measure of maturity that considers the timing of all cash inflows and outflows. It is a measure of average time needed to recover the funds committed to an investment. </li></ul><ul><li>- Duration gap of a financial instrument is calculated as: </li></ul><ul><li>where D = time duration of instrument in years, CF = cash flow, YTM = yield to maturity of instrument,, and t = time period. </li></ul><ul><li>- Since the denominator is equivalent to current market value or price of asset/instrument, then the duration can be re-expressed as: </li></ul>
  13. 13. <ul><li>- Recall that Net Worth (NW) of a bank is the value of its assets less the value of its liabilities, that is </li></ul><ul><li>NW = A – L (11) </li></ul><ul><li>- This implies that </li></ul><ul><li> NW =  A -  L (12) </li></ul><ul><li>- Duration analysis can be used to stabilize or immunize the market value of a bank. </li></ul><ul><li>- Duration analysis measures the sensitivity of market value of financial instrument to changes in interest rate. That is </li></ul><ul><li>  P = - D x  i </li></ul><ul><li> P ( 1+i ) (13) </li></ul><ul><li>- Equation (13) implies that interest rate of a financial instrument is directly proportional to the duration of the instrument. </li></ul>
  14. 14. <ul><li>Using Duration to hedge against Interest rate risk </li></ul>

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