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  1. 1. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ Risk and asset liability management (ALM in) a Pilot Bank (Ukreximbank) - Second Phase. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 1/42
  2. 2. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ Index 1. Objective of Risk Management and Asset/Liability Management Project 2. Definitions 3. Methodology 4. Conclusions and Recommendations: Strategy in Retail Banking and Mortgage Lending 5. The Ukraine Economy 6. The Banking Sector 7. Outline of Key Financial Aspects of Ukreximbank 8. Risk Management and Asset/Liability Management in Ukreximbank 9. Risk Management/ALM for Expanding Mortgage Lending 10. Role of Banking Sector in Mitigating the Risks of Mortgage Portfolios 11. Benchmarks Appendices Appendix 1: List of Meetings Appendix 2: Risk Management/ALM Topic List Appendix 3: Fully detailed Asset/Liability Management Policy Statement Appendix 4: Outline of Ukreximbank Presentation – 18 October 2006 Appendix 5: Office of the Controller of the Currency Regulatory Ratios Appendix 6: Interest Rate Risk Measures for US Banks 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 2/42
  3. 3. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 1. Objective of Risk Management (RM) and Asset/Liability Management (ALM) Project This RM/ALM appraisal was undertaken as part of the project to develop a ‘Blueprint” for Mortgage Risk Management in a Pilot Bank (Ukreximbank) - Second Phase. The goal of this Pilot project is twofold: 1. Assess the Risk Management and Asset/Liability Management capabilities of Ukreximbank 2. Identify those aspects of the Pilot study that can be seen as applicable to the retail banking and mortgage activities of the Ukrainian banking sector in general The initial version of this Report was focused on topic #1 above and this version addresses topic #2. In general, this Report is submitted in response to outline Terms of Reference (ToR) as follows: Objective: The EU Project of Support for Mortgage Market Development is working with the Ukreximbank to strengthen its risk management and introduce modern techniques adapted to the specific requirements of the bank for its retail banking and mortgage products. The first phase of this pilot exercise has been completed with the detailed assessment of the situation of the Bank. It is now essential to proceed with joint identification of the appropriate risk tools and their successive introduction into the bank. Tasks: The ALM Expert will support the bank in assessing and developing its ALM in mortgage and related areas. The specific tasks are: • Assess the degree of asset/liability management development in the bank, including liquidity risk, interest rate risk, and foreign exchange risk • Match asset/liability by duration, by interest rate type, by currency • Develop specific recommendations on improvement of asset/liability management • Regular participation in working group on the bank’s mortgage business development • Provide consulting support for the bank on ongoing basis • Expert team internal discussion on further steps in improving the bank’s mortgage lending system • Close cooperation with the local experts to ensure knowledge transfer • Regular meetings with the bank's top managers to discuss the project's further steps and milestones Additional guidance was provided by the project management - giving direction as follows: • Asset/liability risk management (liquidity risk, interest rate risk, foreign exchange risk). 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 3/42
  4. 4. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ • Assess the degree of asset/liability management development in the bank, including liquidity risk, interest rate risk, and foreign exchange risk • Assess the organizational / business process structure that supports the ALM within Ukreximbank • Develop specific recommendations on improvement of asset/liability management Workshops with Ukreximbank to improve the ALM Apart from participation in a number of discussions with Ukreximbank staff, the key documents produced by this Risk Management/ ALM study are: 1. PowerPoint presentation: Ukreximbank Risk Management and ALM – Focus on Retail Banking and Mortgage Business, delivered to a group of management on 18 October, 2006. 2. Two versions of this Report, prepared at the completion of the Mission to Kyiv. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 4/42
  5. 5. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 2. Definitions To a considerable degree the terms Risk Management and Asset/Liability Management cover similar ground. In effect RM covers a wider universe of possible areas of risk – with ALM focused on the management of balance sheet components. The following definitions are taken from well-known professional sources: Risk Management: Generally, risk management is the process of measuring, or assessing risk and then developing strategies to manage the risk. The strategies employed include transferring the risk to another party, avoiding the risk, reducing the negative affect of the risk, and accepting some or all of the consequences of a particular risk. Traditional risk management focuses on risks stemming from physical or legal causes Financial risk management, on the other hand, focuses on risks that can be managed using policies or available financial instruments (Source US Banking Industry). Asset/Liability Management: Asset-liability management is the formal management of risk to earnings emanating from changes in business conditions or financial markets that are caused by the specific mix of assets and liabilities of the bank. A typical example of such risk is reliance on fixed-rate deposits to fund a floating rate loan. (Source: Risk Managers’ Association Journal, 2001). Over the past couple of decades, these topics have come to dominate bank management thinking as well as that of regulatory bodies. In the mortgage sector the issues of ALM/RM are fundamental and (in the US) a number of mortgage banks have been downgraded by the regulators because of risk management concerns. Recently two major mortgage banks have suffered downgrades in their long-term credit ratings following discussions between the bank and its regulator to address asset/liability management risk issues from growth in businesses in longer-dated, fixed-rate mortgage loans. In this Report, we will consider issues raised by these definitions and concepts and view them both from the perspective of Ukreximbank and –more broadly – from the perspective of the Ukrainian mortgage banking sector. Note: The EU Working Paper No 1: Strengthening The Ukrainian Mortgage Structure, published by this project team in October 2005, includes an extensive coverage of Risk Management issues as well as discussion of the potential role of secondary mortgage markets (see PART II). This Report will attempt to avoid duplication of this material. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 5/42
  6. 6. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 3. Methodology The research and analysis for this study took place over a one-month timeframe in Kyiv. Appendix 1 presents a summary listing of the topics covered in meetings held with senior management in relevant areas of Ukreximbank. There was also significant input from (1) interviews held by other members of the consulting team (2) discussion following the Organization Workshop held by Ms Reavis Hilz-Ward on 28 September and (3) discussion following the Risk Management/ALM seminar on October 18. These interviews and discussions generated significant insight both into the bank’s processes and strategies in Risk Management and Retail Banking as well as indicators for the sector in general. In this context, a plan for the project was drawn up – based on an interview programme, data research and review of exiting project documentation. The topic list shown in Appendix 2 was used for each interview. With the bank’s co-operation, we were able to review the internal Risk Management Statements for both 2005 and 2006. Analytical Approach It is our view that the Risk Management criteria for any banking institution must be derived from an understanding of its economic and industry context. For the Ukraine this is particularly crucial as the country is enjoying a period of dramatic growth – both in the economy in general and specifically in the banking and real estate sectors. In this Report we briefly review the key features of the economic and banking environment in the Ukraine and then move on to data specific to Ukreximbank. • Economic Growth in Ukraine • Strength of the banking sector • Financial performance of Ukreximbank • Role of retail banking and mortgages • Risk Management and ALM factors Note: The data tables are taken from UNIA”s latest Report: Housing Mortgage Lending in Ukraine – analytical report for the first half of 2006. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 6/42
  7. 7. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 4. Conclusions and Recommendations The conclusions and recommendations presented below include issues raised by the RM/ALM study. Conclusions for the Ukraine Mortgage Market 1. The mortgage market in Ukraine is only a few years old and mortgages are still a relatively new financial instrument both for banks and for their clients 2. The Ukraine real estate market is clearly enjoying a period of strong growth, starting from a very small base with a highly limited historical context 3. Currently Ukraine is developing a traditional mortgage sector – namely one in which banks extend long term loans to clients on the basis of ability to pay the ongoing interest cost and ultimately to repay the mortgage. Loans are collateralized by the value of real estate 4. Given the limited data history, we doubt the ability of bankers and other participants to predict future growth and behavior patterns. 5. We commend UNIA on the quality, diversity and timeliness of its regular mortgage market reports – these are an invaluable contribution to gaining a greater understanding of key issues and trends in the sector Recommendations for Future Development of the Ukraine Mortgage Market 6. Our primary recommendation is that every effort should be made to encourage the widening and deepening of the Ukrainian mortgage market though the creation of a secondary market. 7. The simple mortgage model now being developed in the Ukraine, has changed significantly in US and Western European banking markets and Ukraine needs to develop a wider range of financial instruments to allow for securitizing of mortgage loans. 8. UNIA should enhance even further its provision of industry data for the mortgage industry as the lack of historical context clearly raises the possibility of over-commitment in the housing sector. 9. The mortgage sector in Ukraine currently consists of a number of relatively small participants. At some point, we would anticipate that many of these will disappear as the sector becomes more mature and economies of scale begin to change the industry characteristics (and international institutions with stronger capital bases focus on the opportunity). 10. Given the newness of the real estate market in the Ukraine, we believe this sector has a significant (but risky and administratively demanding) growth potential for the banking industry. 11. Banks need to move rapidly to organising along business lines in order to give adequate focus to the prospects of retail banking 12. For example, front, middle and back office functions are often performed by several departments with little clear division of labour, no clear segregation of customer categories or product types 13. We believe that there may be unclear separation of risk/management/credit analysis and business generation in corporate lending 14. Overall we see a lack of clearly defined and communicated strategy and this must be addressed to achieve long term success in this sector 15. On the risk side of the ledger, it should be noted that real estate is always very cyclical and major periods of price appreciation and also decline are to be expected. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 7/42
  8. 8. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 16. Specific concerns are: funding, legal, credit assessment and limited data on mortgage applicants. 17. In our view, the greatest management need in regard to RM/ALM in Ukraine is the lack of a medium term financial and business planning structure. It is unrealistic to develop a more detailed ALM decision format until an agreed set of business goals is in place. 18. We believe that Retail Banking and mortgage banking are specialized aspects of the banking industry and require the development of specific Risk Management expertise. This is discussed in Section 11 of this report. 19. Of course, lack of secondary market for securitizing mortgage loans implies that the portfolio is not at all liquid and this should be a major concern. 20. Experience in the US and UK strongly suggests that the real estate banking sector is highly scale driven. In the longer term, there is likely to be substantial consolidation in the this sector in the Ukraine and smaller players will either be absorbed into larger ones or will find it difficult to compete on a price and service basis. 21. We suggest that bank’s set up units in each branch to work solely with retail lending with other departments responsible for legal, collateral and risk management 22. Data for retail clients must be collected in highly manageable data bases in order to maximize information and account records. 23. There appears to be a need for specialised mortgage know-how among staff 24. Loan administration is apparently cumbersome, long and repetitive and will require proper technology support 25. We recommend that Ukrainian banks work towards the concept of Enterprise Risk Management- which calls for a totally integrated risk management approach on behalf of the consolidated goals of the institution. 26. Section 11 of this Report presents a detailed coverage of ALM benchmarks – created by the US Controller of the Currency – which are designed to indicate to reporting banks the issues which this agency sees as key in assessing the capabilities of individual institutions to deal effectively with the risks generated by operating practices and the pervading economic environment. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 8/42
  9. 9. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 5. Ukraine Economy The latest report from UNIA – Analytical Report for the first 6 months of 2006 – confirms that the underlying strength of the economy, and of the financial sector, is continuing. As the report states: “Developments in the money and credit sphere in the first half of the year reflected the situation in the real sector of the economy which was characterized by by the acceleration of economic growth, positive price dynamics, growth of investments and certain decrease of separate characteristics of the export oriented sector.” In summary: • real GDP was up 5% compared with same period of 2005 • nominal GDP rose 9.3% • growth was seen in virtually all sectors of the economy • CPI rose 2.9% - an improvement on the previous year’s 6.4% increase. • inflation expected to stay below 10% • the hryvna (UAH) was little changed versus the dollar but slipped 6% versus the Euro As can be seen in the following section, the recent extremely strong growth of banking indicators has continued. However, we caution that it is almost certain that excess investment will be made into this sector in the short-term, which may well create some instability as market momentum shifts. This will call for careful monitoring by the RM/ALM departments. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 9/42
  10. 10. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 6. The Banking Sector According to the UNIA Report quoted above - covering the first 6 months of 2006 - the following data summarize developments in the banking and mortgage sector: Issues are: • Non transparent construction permits and speculative buying were major factors behind the growth of the real estate sctor • Real estate prices expected to be up 25% by year end compared with 2005 • Interestingly, 60.4% of mortgages given to individuals are in FX – clearly indicating the possibility of currency depreciation leading to a sharp increase in average monthly payments • In Q2 2006, the mortgage interest rate rose 1.5-2% • A major concern for banks (though less so for Ukreximbank) is lack of long term funding sources • By the end of this year, UAH 20 billion expected in outstanding mortgage loans The following table summarizes some of the key data: Bank deposits Up by 12.0% Hyryna interest rate Eased to 10.1% from 10.9% Total Lending UAH 1.8billion Q2 of 2005, UAH 3.1 billion same period this year., Bank loans Up by 25.5% Foreign Currency loans Up by 32.3% Corporate loans Up 19% Loans to individuals Up 46.4% Housing construction Up 10.2% Kiev house prices Up 5% Outstanding mortgage loans 1/7: 15.6 billion UAH 1/1: 10.7 billion UAH Loans growing 2004: 41.5% 2005: 23.25% 2006 (6 months): 46% Mortgage loans as % of total 1/1: 7.5% loans 1/7: 8.5% Outstanding mortgage loans forecast to be up 90% by year end Personal Income Up 30.8% compared with same period 2005. Outstanding Debt 15.6 billion grms Growth in Jan-June 2006 46% Mortgage Credit as % of total 8.7% (7.5% end 2005) portfolio Foreign Currency Mortgages 83.9% (of which 95% USD) Average Mortgage 104,000 grms Bank Shares: Top 5 67% of market Top 15 86% of market Source: UNIA On an industry standing basis, retail credit has been very strong: 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 10/42
  11. 11. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ Retail Credit in Ukraine Banks Quantitative Changes Relative Changes (%) (millionUAH) Raiffaizenbank Aval 4821 110 Privatbank 3457 54 Ukrsibbank 2130 67 Ukrsotsbank 2233 75 Raiffaizenbank Ukraina 2142 127 Nadra 1392 83 Oschadbank 819 63 Brokbiznesbank -332 -45 Ukreximbank 141 145 PUMB 154 214 These data clearly indicate that the banking environment in the Ukraine is extremely buoyant and the banking industry as a whole – as well as Ukreximbank itself – are enjoying a period of strong growth and expansion. This is particularly true of the retail banking/mortgage sector which is seeing both a dramatic increase in real estate asset values as well as the impact of sharp growth I client demand - from a initially low business base. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 11/42
  12. 12. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 7. Outline of Key Financial Aspects of Ukreximbank Published financial reports indicate that Ukreximbank is enjoying a period of very strong growth. In the first half of 2006, the following data were reported: Interim Financials to June 30, 2006 (million UAH) 2006 2005 2004 Interest Income 649.7 318.2 Interest Expense (342.0) (162.8) NII 307.7 155.4 Net Fees and 97.7 72.9 Commissions Profit before income 265.9 59.2 taxes Loans to Customers 9553 6987 3460 Total Assets 12825.7 10187 5109.7 Loans to Customers as 74.5 68.6 67.9 % of Total Assets The following Table presents the Financial Summary included in the 2005 Annual Report: Selected Consolidated Figures (UAH million) Income 2006 Jan-June) 2005 2004 % change Statement 2004/2005 Net Interest 307.7 365.7 240.3 52.2 Income Non Interest 43.5 65.7 46.9 40.2 Income Net Fee and 97.7 183.4 144.6 26.8 Commission Non Interest (200.4) (328.5) (270.1) 21.7 expense Profit for period 191.0 184.9 59.4 211.2 Balance Sheet Total Assets 12825.7 10187.9 5109.7 99.4 Loans to 9553.1 6987.1 3460.4 101.9 Customers Equity 1137.4 946.4 461.5 105.1 Performance Indicators (%) Net Interest 5.15 6.18 Margin ROE 26.3 15.2 ROA 2.4 1.3 Cost/Income 53.4 62.4 Capital 14.5 11.4 Adequacy Loans to 68.6 67.7 Customers/Total Assets Equity/Total 9.3 9.0 Assets 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 12/42
  13. 13. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ In summary, Ukreximbank has a strong balance sheet and is well established in several business sectors. The bank is well regarded in international markets. However, some key changes are underway and new business areas are being sought. Organization Structure For the Ukraine banking sector, we see the following issues: • Need to set up clear business development and sales responsibilities with corresponding incentive and performance systems; • Given the potential growth of the retail banking sector in Ukraine, we suggest that It will be essential to give mortgage marketing teams the clearest scope to build business; • Similarly, the mortgage industry requires its own expertise, systems, technology and ongoing management and these must be identified clearly. • Based on conversations with bank management, there is no doubt that institutions will need to give much more clarity to Retail Banking and Mortgage divisions than is currently the case. Note: This topic was extensively addressed at the Workshop organized on 28 September by the TACIS project team (under the direction of Ms Reavis Hilz-Ward). Based on the example of Ukreximbank, we see the following goals as appropriate: • building a strong banking organization • support for the development of the Ukraine economy • develop the activities of the branch network • increase the bank’s capital an enhance the bank’s performance as a universal banking institution • maintaining capital adequacy to match top Ukrainian banks • improving risk management in line with Basle II requirements • develop the banking sector’s international reputation as reliable and profitable organizations • expand the range of and volume of banking services 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 13/42
  14. 14. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ 8. Risk Management and Asset/Liability Management in Ukreximbank. In reviewing the bank’s published and internal documents - and conducting detailed interviews with relevant management - we conclude that the Bank has a basically sound risk management system that covers most of major risks. However, we also believe that this system will need to become more detailed and specific – covering such topics as: interest rate gap analysis, funding strategy and a range of ALM performance criteria for the Retail Banking and mortgage business. Section 11 discusses these Benchmark issues in detail. Appendix 3 includes an ALM template – prepares for its members by the National Credit Union Administration (NCUA). NCUA is an independent federal agency that supervises and insures 7152 federal credit unions and insures 4240 state-chartered credit unions. These institutions are strongly focused on earning customer deposits and underwriting mortgage portfolios for its members. Ukreximbank’s key procedures are formalized and described in relevant policies and instructions. However, there are clear deficiencies (well understood by the bank’s specialists) it is still developing certain components or needs to improve some of existing ones. Some of these are: 1. Currently the Bank adheres to a very conservative policy in mortgage lending, which is not a competitive mass-market product. 2. Almost all of existing mortgage borrowers are personnel of banks corporate clients, and corporate employers guarantee all those mortgage loans. These are clearly a privileged (and limited) client group 3. No separate operational risk management policy currently exists. 4. Development of special operational regulations for mortgage lending will be very important. 5. A scoring evaluation system should be implemented as a part of modern mortgage loan underwriting procedure. 6. Certain improvements are needed for the legal and regulatory risk management that is currently decentralized and under responsibility of legal department; 7. Current IT components and modules responsible for risk monitoring and analysis should be assessed. It is clear that development of a more competitive mortgage product will require certain IT changes and implementation. 8. Currently, asset/liability long term mismatch risks are not a major concern and are well covered for the time being. However (as we outline in Section 11), some special recommendations may be needed in relation to mortgage lending procedures. Risk Management In overall terms, Ukreximbank is well set up in this area and regards RM as a key line of banking management. It adopts a prudent strategy in regard to risk taking. There is centralized management of financial risk (credit, liquidity, interest rate, currency and market) Most significantly the bank prepares an annual Risk Management Policy document (see Appendix 3). From our appraisal, it would seem that the Risk Management structure meets international standards with the Board, Assets and Liabilities Committee (ALCO), Credit Committee, Risk Management Division, Audit and Inspection Division and other departments all part of the ongoing management structure. The system is as follows: ALCO: Overall function is general risk management and Board liaison. The Committee decides what risks to accept and to what degree and relates expected profitability to risk exposure. Credit Committee: Manages the bank’s loan portfolio. Branch credit committees accept responsibility in line with authority delegated by the Head Office Committee. Divisions: Adhere to established policies and limits allocated to front-offices and back-offices and control the actual settlement of payments and agreements. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 14/42
  15. 15. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ Risk Management Division: identifies risks and makes qualitative and quantitative evaluation. Sets operating limits and reviews possible scenarios and supplies data to other risk bodies. Audit and Inspection Divison: Ensures adherence to internal rules and confirms that the Bank meets all policies laid down by the National Bank of The Ukraine. Credit Risk is managed by the following guidelines: • credit risk limits • asset classification – assigning an internal credit rating and loan review • loss provisioning • collateral monitoring – includes pledges, sureties etc. • ALCO reviews adherence to these guidelines and approves changes Risk Management Division Liquidity Risk Management: Liquidity is given preference over profitability and liquidity management is the top priority. Methods used are: GAP analysis, liquidity ratios, asset funding analysis, borrowed funds analysis. Stress testing is used to look at potential scenarios. The Bank looks at both short and medium timeframes and tends to be more conservative than the NBU standards. Interest Rate Risk: Some exposure through mismatches in maturity of assets and liabilities. Methods used are GAP analysis, simulations, assessment of vulnerability to interste rate moves and stress testing of scenarios. Management believes that there is very little to be concened about in GAP management. ALCO sets the maximum cumulative interest rate gap to total assets ratio (interest rate gap in each business divided by total earning assets). This is monitored by the RMD. Since there are no available hedging instruments, the goal is a a matched book. Any mismatch is monitored by RMD on a monthly basis for the ALCO discussion. Forecasts are made and assets and liabilities assessed by reference to perceived sensitivity to interest rate movements, repricing or maturity dates. Other performance measures include: net interest rate margin (NIM), with the policy indicating a minimum required. Operational Risk is managed by: • Maintaining an up to date system of rules and procedures • Segregation of duties • Audit and internal control over compliance • Management information system • Staff training • Developing crisis plans • Updating communications • Analysing areas of potential risk Interest Rate Risk The bank has a conservative position and tries to ensure that risks are maintained within prescribed limits. Methods include: GAP analysis, simulations, evaluation of potential impacts of movements, stress testing Foreign Exchange Risk The goal is to maintain risks within policy limits. Parameters used are: calculation of open currency positions, possible loss estimations under Value-at-Risk methods, co-variation calculations. Limits established are: total open position by transaction and category – possible loss estimates as exchange rates move – intra-day and closing limits – stop-loss limits and monitoring. Operational Risk Goal is to improve internal processes, flows and job descriptions – improving management information and training - effective risk assessment. Market Risk 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 15/42
  16. 16. Establishment of Mortgage Market Rules and Legislation in Ukraine EUROPEAID /115248/C/SV/UA ------------------------------------------------------------------------------------------------------------------------------------------------------------------ The main purpose of forex risk management is maintaining its level within the acceptable limits. Standard foreign exchange risks parameters are calculated: the amount of open currency position, possible amount of losses calculated in accordance with the Value-at-Risk (VAR) methodology using historic simulations and variation and covariation methods Management Information System TMIS (Treasury Management Information System), is used to manage capital efficiently and to evaluate branch performance with account of banking risks. In the TMIS system interest rate, forex and liquidity risks are transferred from branches to the Head Office for centralized management via transfer pricing of resources. Capital is allocated to assets according to the credit risk level with defined rate of return on allocated capital. ALM Planning As noted above, we are impressed by the quality of Ukreximbank’s annual document - Policy on Risk Management and the criteria it lays down for the year ahead. But this document limits itself to indicating target balance sheet percentages and then to monitoring actuals in the light of these target shares. While this approach is undoubtedly useful, it requires further elaboration in order to provide the full range of ALM guidance. A detailed example of an ALM structure designed explicitly for real estate banks is attached at Appendix 3. This document presents an example of a detailed ALM analysis produced for one sector of the key mortgage lending institutions in the US – credit unions. Credit unions have a relatively high percentage of their assets in the form of real estate mortgages (about 23% - and this can rise to around 30% if mortgage-related derivative instruments are included). One specific are of detail is the identification of target yields. As can be seen this will include criteria such as: 1. A return on assets above ____ %. 2. A return on equity above ____ %. 3. An equity capital-to-assets ratio above ____ %. 4. A risk-based capital ratio of ____ %. Criteria are also set for such key indicators as: • Interest rate gap analysis • Risk sensitive asset analysis • Risk limits The extremely detailed data requirements of this document are clear and are shown as a long term objective for Ukreximbank (and other participants in the Ukraine mortgage sector). Note: Gap Analysis is a tool used to judge a bank’s earnings exposure to interest rate movements. It is defined – by the Kansas City Federal Reserve Bank - as follows: A bank’s gap over a given time period is the difference between the value of its assets that mature or reprice during that period and the value of its liabilities that mature or reprice during that period. If this difference is large (in either a positive or negative direction), then interest rate changes will have large effects on net interest income. Rate sensitive assets and liabilities are an estimate of the amount of assets or liabilities whose interest rates will change during selected time intervals. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 16/42
  17. 17. 9. Risk Management/ALM for Expanding Mortgage Lending Enterprise Risk Management We suggest that the ultimate strategy for ALM/RM is Enterprise Risk Management (ERM), a structured and disciplined approach to managing risk. ERM attempts to align the organization's strategies, processes, technology and knowledge with the goal of improving its ability to evaluate and manage, enterprise-wide, the uncertainties it faces as it creates value. In this project, we have not been in a position to assess the full range of business opportunities and risks facing Ukreximabank and this is clearly a crucial requirement for a balanced review. ERM would demand such an ongoing approach and would force different areas of the bank to defend their business assumptions and then to compare each opportunity with others which maybe available. For example in this case, Retail Banking and Mortgage lending offer a range of opportunities, costs and potential risks which are significantly different from a bank’s existing primary revenue sources. An ERM approach will attempt to quantify the cost/benefit of each competeing sector. An enterprise-wide risk management capability increases the risk-sensitivity of the organization and reduces the inevitable functional, departmental and cultural barriers that exist in most organizations. ERM is an integrated, forward-looking and process-orientated approach to managing all key business risks and opportunities - not just financial ones - with the intent of maximizing value for the enterprise as a whole. The components are the processes, people, reports, methodologies, and technology that will integrate within the ERM solution to achieve the expected outcomes specified in the business case. There are eight categories of ERM element organized into three groups - foundation elements, process elements and enhancement elements: Using these elements, the organization takes the following steps: • Define needs and priorities, articulate industry points-of-view, draw initial ERM vision hypothesis, define preliminary ERM solution components to achieve vision and build a business case rationale. • Create the ERM Vision - Articulate ERM as the solution to your specific problem(s) and frame the ERM visioning process. Facilitate a management session to develop the organization's ERM vision and define the various components of the ERM solution. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 17/42
  18. 18. • Build the Business Case for ERM - Describe a compelling rationale for the organization to invest in the ERM program. • Manage the ERM Progam - Establish and deploy a program office to oversee the design, building, testing, and implementation of the ERM solution components, integrate the components with other priority client initiatives and enable the change process. • Continuously Improve ERM Capabilities - Review, monitor, assess, and improve risk management capabilities over time. Of the handful of leading money center banks in the world, JPMorganChase (JPM) has probably devoted more effort to the risk management and ALM areas. As a result, we believe it provides an interesting case-study on structuring this activity. The chart below presents JPM’s ALM structure. ALM at JPMorganChase The Central Pool of All Assets and Liabilities Market Sale of all uses of funds Purchase of Central pool all resources of all assets and Purchase Sale of of all liabilities all uses resources of funds Business Unit A Business Unit B Mortgage Risk Management The following comments are drafted on the basis of the possible long term goal of Ukreximbank to build a substantial mortgage business (say 10% to 25% of the loan portfolio). In such an institution, effective risk management requires that long-term implications on the earnings and net worth of the bank be properly addressed. Implicit to an effective and proper risk control process is establishing a reasonable risk tolerance amount and abiding by a prudent threshold. Such a process will enable banks to take appropriate and timely action to reduce excessive risk positions. While we do not prescribe a fixed, maximum percentage of mortgage loans in a lending portfolio that is applicable to all banks. Each bank must decide its own individual risk profile and risk tolerance level. However, no institution should continue an inherently high risk strategy when measures of fair value indicate net worth is approaching a dangerously low or even negative position as measured for plausible interest rate scenarios (e.g., in the USA, an upward movement in rates of 300 basis points). Given the relatively high (and somewhat unpredictable) interest rate structure of the Ukraine, we would expect that such plausible scenarios would cover a range of more like 500 basis points. . 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 18/42
  19. 19. In the future, exit alternatives may involve either management of the balance sheet itself, pricing strategies, off balance sheet measures, or a combination of these activities and can include, but are not limited to: • Sales/securitization of long-term assets. • Strategic pricing of credit union products. • Securing long-term, fixed-rate funding. • Purchasing interest rate swaps. The Ukraine financial sector should consider the real value offered to mortgage banks by the development of a secondary market. This would include: Securitization Securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a bank that has issued a large number of mortgage loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing loans, but there isn't a liquid secondary market for individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the pool to investors. For the financing company, this raises capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a diversified pool of auto loans, which may be an attractive alternative to a corporate bonds or other fixed income investment. Whole Loan Sales Whole loan sales are typically driven by increased investor demand for residential mortgage- backed securities and the entry of additional banks into the sector. Whole loan sales involve the sale of a pool of loans from a mortgage lender to another institution, usually at a premium. This means originators can realise an immediate profit by selling the pool of loans at higher than face value. At the same time, lenders are able to free their balance sheets, creating capacity for new lending. Whole loan sales also give lenders another way to manage risk. – the bank completely passes all the portfolio risk to the purchaser. Other Strategies include: Pricing and Product Strategies Banks typically approach pricing on a tactical basis, reviewing and changing rates to meet market competition. Pricing can also be used to promote long-term balance sheet goals when they are stated as part of a strategic business plan. On this basis, for example, a bank may set trigger limits permitting fixed-rate real estate products to comprise only a certain maximum percentage of originations, or may price its variable rate home equity line products to attract business from competitors. Trigger points can be set to initiate predetermined courses of action upon reaching specific levels. When using this type of strategy, there are several things to consider: • The trigger points should be based on sound ALM analysis. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 19/42
  20. 20. • Management must predetermine the appropriate action to be taken when the trigger point is reached. Examples could include selling mortgage loans at a predetermined interest rate threshold or volume threshold and, although less desirable, limiting originations to keep below predetermined trigger points. • Management must be committed to execute sales or take other predetermined steps based on the specified trigger point. Once management has determined appropriate risk tolerances, these should not be increased to accept more risk simply because the triggering point has been crossed. There should be a firm commitment by management to follow-through with the predetermined action. • If the action to be taken is or includes selling mortgages, relationships with purchasers should be established and tested. Waiting until the trigger point has been crossed to establish these relationships will likely be too late. In addition, a credit union that elects to wait to sell mortgage loans until rates have risen could be faced with a situation where there is more supply than demand for mortgage loans, which could adversely impact pricing. Traditionally (up to 20 years ago) a mortgage signified a long-term relationship. A home buyer found a property, approached the bank where he probably had his checking and savings accounts, his business loan or his safe deposit box. He filled out an application or sat down and chatted informally with the loan officer about his assets and liabilities. The loan officer then attended the monthly Board of Director's meeting to recommend the borrower as a regular and credit-worthy customer. The Board voted and the home buyer was suddenly a homeowner with a 20 year bond with the bank called a mortgage. The borrower paid his mortgage every month, and maybe even held a party to celebrate burning it at the end of its 20 year term. However, in the US and European mortgage markets a lot has changed. Banks have been increasingly outsourcing mortgage origination and loan processing to mortgage companies and third party brokers, and in fact are minor players today in the actual granting of mortgage loans. For another, mortgages, which are more likely to have a 30- than 20-year duration, are regarded as commodities that both borrower and lender treasure only so long as they are the best they can get. Operational Risk Operational risk is the risk that deficiencies in information systems or internal controls will result in unexpected loss. Sources of operating risk include inadequate procedures, human error, system failure, or fraud. Inaccurately assessing or controlling operating risks is one of the more likely sources of problems facing institutions involved in investment activities. Effective internal controls are the first line of defense in controlling the operating risks involved in an institution's investment activities. Of particular importance are internal controls that ensure the separation of duties and supervision of persons executing transactions from those responsible for processing contracts, confirming transactions, controlling various clearing accounts, preparing or posting the accounting entries, approving the accounting methodology or entries, and performing revaluations. Consistent with the operational support of other activities within the financial institution, securities operations should be as independent as practicable from business units. Adequate resources should be devoted, such that systems and capacity are commensurate with the size and complexity of the institution's investment activities. Effective risk management should also include, at least, the following: Valuation. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 20/42
  21. 21. Procedures should ensure independent portfolio pricing. For thinly traded or illiquid securities, completely independent pricing may be difficult to obtain. In such cases, operational units may need to use prices provided by the portfolio manager. For unique instruments where the pricing is being provided by a single source (e.g., the dealer providing the instrument), the institution should review and understand the assumptions used to price the instrument. Personnel. The increasingly complex nature of securities available in the marketplace makes it important that operational personnel have strong technical skills. This will enable them to better understand the complex financial structures of some investment instruments. Documentation. Institutions should clearly define documentation requirements for securities transactions, saving and safeguarding important documents, as well as maintaining possession and control of instruments purchased. An institution's policies should also provide guidelines for conflicts of interest for employees who are directly involved in purchasing and selling securities for the institution from securities dealers. These guidelines should ensure that all directors, officers, and employees act in the best interest of the institution. The board may wish to adopt policies prohibiting these employees from engaging in personal securities transactions with these same securities firms without specific prior board approval. The board may also wish to adopt a policy applicable to directors, officers, and employees restricting or prohibiting the receipt of gifts, gratuities, or travel expenses from approved securities dealer firms and their representatives. Legal Risk Legal risk is the risk that contracts are not legally enforceable or documented correctly. Institutions should adequately evaluate the enforceability of its agreements before individual transactions are consummated. Institutions should also ensure that the counterparty has authority to enter into the transaction and that the terms of the agreement are legally enforceable. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 21/42
  22. 22. 10. Role of Banking Sector in Mitigating the Risks of Mortgage Portfolios ALM and Interest Rate Risk For a mortgage bank, it is important to emphasize the role of interest rate risk management and its focus on mortgage-related assets because they are generally long-term assets and also have dynamic cash flow characteristics. While banks should meet clients’ real estate borrowing needs, they also need to manage the associated balance sheet risks. With the banking sector being new to real estate lending and seeing a rapid increase in real estate loans, it may not have adequate risk measurement knowledge, systems or methodologies in place to assess and manage balance sheet risk. This could impair their future earnings and capital positions as real estate lending involves a variety of inherent and interrelated risks. Three of the most substantial are interest rate risk, liquidity risk, and credit risk. The risk management process should assess risk relative to the amount of the credit union’s potential balance sheet risk and capacity to absorb such risk. Below, a brief description of the major balance sheet risks precedes an outline of the interest rate risk management process. Interest Rate Risk: The risk that changes in market rates will adversely affect a bank’s profitability and capital. Changes in interest rates will affect the fair value of their balance sheet. In a rapidly rising interest rate environment, a bank’s costs generally will increase faster than the return it receives on its loans. This can ultimately diminish the bank’s profitability. In addition, as higher yielding loans become readily available, the fair market value of the bank’s existing loans declines. This diminution in value could reduce the bank’s capital. As a bank adds to a concentration of long-term fixed-rate mortgages, there is an increased vulnerability to a rising interest rate scenario. Liquidity Risk: The risk that the bank will be unable to fund member loan demand and share withdrawals without adversely affecting profitability or capital. Banks engaging in real estate lending should evaluate and gain an understanding of the variability of mortgage cash flows and the corresponding impact on its balance sheet. When interest rates fall, mortgage cash flows increase. When interest rates rise, mortgage cash flows decrease. For example, as interest rates declined in the US some years ago, many fixed-rate and variable- rate mortgage holders paid the outstanding principal on their existing loans in advance of their contractual maturities. These prepayments greatly accelerated the cash flows. Banks either reinvested this money in securities or refinanced new loans at the lower prevailing rates. This phenomenon is called prepayment risk. Most borrowers have already refinanced at lower rates. As rates increase, proportionally fewer borrowers will have the market incentive to prepay their loans and refinance. Accordingly, credit unions likely will be amortizing their fixed-rate mortgage loans longer than expected. This will reduce the cash available to loan or reinvest at the higher rates. When the actual rate of prepayments becomes slower than the expected rate and average life therefore increases, it is termed extension risk. At the same time cash flows are getting smaller in the rising interest rate environment, the fair market value of the asset is also declining. This change in market conditions reduces the amount of cash the bank can raise through selling these assets or borrowing against them. To control risk, it is important that management understand the interrelationships of interest rates, mortgage cash flows, prepayment risk, extension risk, and the effect on the fair value of its assets. Credit Risk: The risk that a borrower will default or not repay the principal loan balance. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 22/42
  23. 23. Historically, bank regulators examiners have predicated the main thrust of their examination process on a comprehensive review of credit quality. The economic conditions that prevail in a high interest rate environment like the Ukraine, can further weaken some borrowers’ ability to repay. Banks can be subject to increased credit losses as well as reduced net interest margins. In addition, related credit quality difficulties can swiftly impair both a credit union’s balance sheet liquidity and solvency positions. Interest Rate Risk Management: The bank’s ALCO should evaluate the bank’s understanding and methodology for measuring interest rate risk relative to the balance sheet risk the institution has elected to acquire. An effective risk management process includes: • policies, procedures, and risk tolerance parameters; • identification, measurement and reporting of risk exposures; and • a sound system of internal controls. A bank should identify the risks associated with mortgage-related assets, increase their understanding of these risks and adequately measure them. Each department should establish a prudent exposure limit and then routinely evaluate whether its interest rate risk exposure is within policy. As with the Ukreximbank Risk Management Statement, prudent balance sheet limits based on a consolidated measure of the risk characteristics for both loans and investments. At a minimum, the policy should indicate how much interest rate risk the bank’s balance sheet can accommodate in relation to its capital position. It is sound business practice for banks to aggregate the interest rate risk measurements of assets that have similar exposures. These measures can be consolidate to obtain an overall risk profile. In short, this means combining the respective risk measures for mortgage-backed investment securities and mortgage loans to obtain an overall balance sheet risk profile. In order to sufficiently measure, evaluate and report interest rate risk exposure, management should utilize an adequate interest rate risk management system. However, the methodology should at least reflect the complexity of mortgage-related risks. The level of risk measurement sophistication and management understanding to increase proportional to the amount of balance sheet risk exposure. Risk management reports to senior management and the board should summarize the interest rate risk exposure. Management should use these reports to evaluate compliance with policy objectives for interest rate risk tolerance parameters. Interest Rate Risk Measurement Methodologies and Mortgage Assets Depending on its level of potential risk, banks should measure (1) the amount of net interest income at risk over future periods, and (2) the amount of Net Economic Value (discussed below) at risk. The bank should determine if it can remain profitable and adequately capitalized while holding its respective concentration of fixed-rate mortgages if interest rates increase suddenly by a large amount, such as 500 basis points.. Interest Rate Risk Measurement Techniques: GAP: A traditional GAP analysis alone is not adequate for evaluating mortgage-related risks. A repricing GAP is a measure of the mismatch between the amount of assets and liabilities repricing within a defined time period. It is a simplistic determination of the relative interest rate sensitivity of a balance sheet. GAP analysis is adequate for pinpointing large mismatches in assets and liabilities, but it is not a good tool for measuring the complex variables associated with mortgages. GAP does not consider changes in the shape of the yield curve, changes in the spread relationship between different market rates, or option risk (e.g., prepayments). In addition, it does not address the impact of an adverse increase in interest rates on net worth. Income simulation: 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 23/42
  24. 24. An income simulation model is one means available to simulate the impact on net interest income resulting from (positive and negative) changes in interest rates of 100, 200, 300 and 500 basis points. Typical models use rate shocks to measure the effect on earnings. purposes. As can be seen in Section 11 of this report, we believe that Income simulation offers the following improvements over GAP: • Plots all estimated cash flows; • Captures actual timing of cash flows; and • Can accommodate repricing assumptions, amortization assumptions, and yield curve assumptions. An income simulation model should be extended to five years, in order to estimate the impact of long term economic trends. In addition to measuring the short-term effect of interest rate changes on income, it is equally important to measure the long-term effect on capital. Just as changes in interest rates will cause stock and bond prices to fluctuate, changes in interest rates will also affect the fair value of the balance sheet. As noted earlier, an increase in interest rates will typically cause existing loans (and investments) to decline in value. The present value of a balance sheet represents an estimate of the fair value of future earnings over the life of the holdings (long-term measure). Banks should understand this relationship and the greater the risk the more sophisticated techniques are required to quantify this relationship on the balance sheet. Asset Valuation: For banks lacking advanced ALM models, there are additional methods for measuring interest- rate risk in mortgage loans. Banks can obtain estimates of risk exposure on their mortgages by calculating Net Economic Value (NEV). The components of NEV are as follows: A The value today (present value) of future amounts the bank will receive such as loan principal and interest payments, and investment principal and interest B (minus) The value today (present value) of future principal and interest amounts the credit union will pay for its funds. =C Net Economic Value. . While this assessment has focused on the risks associated with fixed-rate assets, banks should also should keep in mind that variable-rate assets are not free of interest rate risk. Variable-rate loans or securities may contain life-time and periodic “caps” that limit their ability to increase (reprice) loan rates. In addition, some interest rate coupon formulas on variable rate loans or securities are contractually tied to a reference rate that is subject to infrequent or unpredictable change. The modeling of such instruments requires more complex and robust analytical techniques. In all cases, it is important to employ an ALM methodology that is commensurate with the risk types and levels assumed. Balance sheet management • This key ALM concept requires tools that enable sophisticated, dynamic modeling and financial statement simulation using the latest financial techniques. T • To manage risk effectively, you need to model customer behavior, bank strategy, interest rate scenarios and a host of other economic variables quickly and accurately. • To measure risk effectively, you need the ability to transfer price all of your financial instruments – particularly the most complex 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 24/42
  25. 25. • Data accuracy is critical to predictive analysis, and effective risk management. • Sharing key market assumptions with your budgeting and planning team ensures more accurate analysis, and aligns planning with strategic goals. • ALM requires an evaluation of the impact of runoff and new business, either in combination or separately • Assessment of the effect of product and business decisions on your future balance sheet in multiple currencies • Assessment of changes in credit quality, defaults and delinquency • Integrate the gathering and vetting of planning assumptions directly into your ALM process • Manage and understand the impact of interest rate volatility on your balance sheet • Project net interest revenues more accurately, evaluate pricing strategies, and manage expectations • Narrow the variance between actual and projected interest rate margins • Mark-to-market current and forecast balance sheets, portfolios, or individual securities We recognize that many banks in the Ukraine will already be applying these standards and strongly urge the entire retail banking/mortgage sector to develop appropriate procedures. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 25/42
  26. 26. 11. Benchmarks In our view, the greatest management need in regard to RM/ALM in Ukreximbank - and other Ukrainian real estate lenders - is to address the apparent lack of a medium term financial and business planning structure. It is unrealistic to develop a more detailed ALM decision format until an agreed set of business goals is in place – in retail banking, mortgage business development, as well as all other key areas of the bank. ALM Overview Currently the Ukreximbank Risk Management Statement is focused entirely on maintaining target balance sheet ratios. We believe that this is overly rigid and static and should be augmented by adding additional performance measures. ALM and Risk Management must be seen within a comprehensive business planning context. Such a planning structure is an essential precursor to further progress in RM and ALM. With a focus on the Retail and Mortgage banking strategy, the planning requirements include: ALM Requirement Objective Maintain and enhance current RM Statement Develop into Enterprise Risk Management system Economic forecasts of Ukraine Anticipate economic and personal income trends and implications for banking and Ukreximbank. Also currency outlook. Real Estate construction and pricing forecasts Assess potential for gains in value of collateral and possible risks Interest rate forecasts Anticipate interest yield on gap between deposits and earnings Net Interest Earnings at Risk Assess the potential adverse change in net interest income arising from a change in interest rates, measured over a range of forecast horizons. Retail Bank Business Targets Forecasts of customer growth, deposits, mortgage demand and repayment Mortgage ALM targets Expected yield spreads and sensitivity analyses Branch business generation goals Assess impact of marketing strategy Cost forecasts Plan and monitor cost control planning Technology Investment Review and identify relevant technology systems to enhance operations ALM Benchmarks 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 26/42
  27. 27. In the USA, the Office of the Comptroller of the Currency (OCC) has identified nine risk categories, including strategic, credit, interest rate, liquidity, pricing, reputation, compliance, transaction and foreign exchange risk, which bankers should be aware of and manage. The Federal Reserve Bank has enumerated six risk categories, including credit, interest rate, liquidity, compliance, legal and reputation and operational risk. A few years ago,, the OCC introduced Project Canary, an early-warning system developed to identify banks with excessive risk. The goal of Project Canary was to develop a series of benchmark risk ratios that could be calculated from internal data and be used to evaluate credit, interest rate and liquidity risk at those banks regulated by the OCC. Since then the OCC has calculated 5 risk-related ratios for each bank and compared those ratios to the benchmark ratios. Those banks with high levels of risk, indicated by exceeding several benchmarks, will likely be targeted for early or additional examination work. The table below lists these categories and indicates the associated benchmark. The final column indicates that it is quite usual for banks to fail to meet an individual benchmark. These benchmarks are seen as “early warning signals” and any failure should not be seen as an automatic sign of a problem. The real focus is on deviations from these indicators over time to identify possible institutional problems. OCC ALM Benchmarks Benchmark National Banks Exceeding Benchmark (%) Credit Risk Loans/Equity > 8 times 32% Loan Yield >9.5% 28% Loan Growth > 20% 26% Adjusted reserves /adjusted < 0% 25% loans Changes in Portfolio mix >7% 23% Loans/Assets > 70% 23% Interest Rate Risk Residential Real Estate/Total >25% 44% Assets Asset Depreciation/TIER 1 >15% 40% Capital Long Term Assets/Total >25% 30% Assets Non-maturing Deposits/ Total <140% 21% Assets Liquidity Loans/Deposits >80% 29% Short Term Liabilities/Total >20% 24% Assets Non core Funding >20% 23% Dependence On hand Liquidity <8% 19% Reliance on Wholesale >15% 9% Funding As can be seen, the current set of benchmarks consists of 15 financial ratios and measures. Six relate to credit risk; four to interest rate risk; and five more to liquidity. By experience, it has been possible to indicate a threshold in each case that represents the point at which risk tends to rise. For example, credit quality problems often increase when a bank's loan-to-asset ratio exceeds 70 percent. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 27/42
  28. 28. The benchmark is simply designed to alert when a bank is seen to have a pronounced risk appetite in that area. It's important to note that the number of benchmarks, their distribution among risk categories, and the established thresholds can change over time. The benchmarks are meant to be a dynamic system that will constantly evolve to reflect changing circumstances and improvements in the understanding of risk. The Federal Reserve Bank, FDIC, Office of Thrift Supervision, and Credit Union regulatory authorities have developed similar monitoring tools. A current example of these benchmarks and the current levels exhibited in a broad sample of banks can be seen at Appendix 5. In its member communications, the OCC suggests the following steps to developing an effective risk-management program include: 1. Measure the inherent risk in the bank and determine the risk trend. 2. By virtue of the types of business being done, a bank chooses to be in, is there greater or lesser credit, interest rate, pricing liquidity, strategic and other risks? Is the level of such risks increasing, stable or decreasing? 3. Review management policies and ensure that they incorporate appropriate risk exposure limits. Do credit policies specify guidelines for concentrations of credit, in particular loan types, industries, collateral types or geographic areas? Do investment policies set guidelines for the quality and maturities of investments? 4. Evaluate the management information reporting system. What comprises the management information system at the bank, and is it providing directors and senior managers with meaningful information about the risk position of the bank? 5. Are current risk positions presented in comparison with approved risk guidelines? For example, do senior managers and directors receive periodic reports that compare concentrations of credit to the limits in the credit policy? Are risk trends provided, and are their potential affects on future earnings, credit quality, capital and liquidity clearly understood? For example, is information about the effect on earnings, equity and liquidity of 100, 200 and 300 basis point shifts in interest rates provided regularly to management and directors? Are current positions compared to risk guidelines established in the interest-rate risk and asset/liability management policies? 6. Prepare an inventory of risk and exposures. Identify those risk issues that threaten the achievement of your bank’s strategic business objectives. Using the nine categories of risk established by regulators, review each of the major business cycles in the bank and identify the risk events and related levels of exposure, which might damage credit quality, earnings, equity or the reputation of the bank. Clearly identify how these groups of risks are identified, measured, monitored and controlled. 7. Evaluate risk-management strategies. At the end of the day, there are only four methods to manage risk: Control it, avoid it, retain it, or transfer it. Most banks are over-controlled and do not take advantage of effective risk-transfer methods beyond insurance. 8. Evaluate the bank’s risk controls. If you’ve chosen to control a particular risk event, because it cannot be avoided or transferred, and the exposure is too great to retain, ensure that the control implemented is effective in reducing the frequency of the risks and severity of the exposures identified. In a complex financial services environment, a risk-management plan is a critical element of any responsible business planning and management structure. Banks that pursue proven risk-management techniques deliver higher and more stable returns over a prolonged period of time. Moreover they are prepared to deal with adverse economic changes and unexpected operational problems. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 28/42
  29. 29. For ALM, the key issue is yield management. Appendix 6 presents an example of a detailed interest rate risk monitoring format – prepared each quarter by Olson Research Associates for its bank client base.. The table presents indications of the potential impact on the various indices quoted of interest rate volatility. 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 29/42
  30. 30. APPENDICES Appendix 1: Summary List of Meetings The following Ukreximbank executives were interviewed as part of the RM/ALM project: 1. Mr Volodymyr Giris, Member of Board, Retail Banking - 26 September and 12 October 2. Vitaliy Lisovenko, Member of Board and Corporate Business 3. Ms Vera Voloshchenko, Member of the Board and Risk Management 4. Sergiy Sokyrko, Head of Risk Management 5. Michola Udovychenko, Deputy Chairman of the Board and Head of Treasury 6. Ms Olga Demchenko, Head of Department, Credit Operations Methodology Department 7. A. A.Martynov, Deputy Head of Division, Risk Control and Monitoring 8. Oleg Tyshchenko, Deputy Head Retail Banking Division 9. Ms Inna Romanenko, Deputy Head Risk Management Division 10. Members of the Organization Workshop 11. Members of the Risk Management Seminar 22/11/2006 Risk and Asset Liability Management in the pilot bank Page 30/42
  31. 31. Appendix 2: Risk Management/ALM Question List General Risk Management/ALM 1. Is there an updated Risk Management System document? 2. How effective is the Risk Management organization? 3. What key risk/ALM problems have been identified and are any improvements planned? 4. Is the ALM system working as expected? 5. Outline the ALM strategy in regard to duration, currency, liquidity and interest rate risks. 6. The desirable structure of balance sheet for 2005 and possible deviations were listed in the following table. Please comment on issues with any of these targets. (Note: Table taken from Ukreximbank Risk Management Report, 2005) Desirable figure Possible deviation Total assets 100% Liquid assets 16,3% 12,5 – 20,9% Credits to clients and banks 67,16% 64 – 70,7% Securities of CB 4,8 2,4-6,9 Other securities 3,8 2,6-5,0 Fixed assets 6,3 4,8-7,9 Other assets Total liabilities 100 CB deposits and short term deposits of banks 2,6 1,4 – 4,0 Deposits of International financial organizations 23,4 20,2 – 27,2 Term deposits of clients 35,3 32,5 – 37,6 On-demand deposits of clients 34,0 32,7 – 35,3 Subordinate debt 1,8 0,0 – 4,2 Other liabilities 3,0 2,0 – 4,0 7. Have other ALM target indicators been developed – particularly in reference to mortgage business? 8. What are seen as major risks in the mortgage business? 9. Please indicate Chairman and members of ALM Committee. 10. Can we see ALM Committee reports? 11. Can you provide any further specific numbers and performance data? 12. Develop specific recommendations on improvement of asset/liability management 13. Specific areas in which we can provide consulting support for the bank on an on going basis Retail/Mortgage Business 14. We understand that the Mortgage lending business is a relatively new direction for the bank. What is experience to date and what issues need to be addressed in connection with future expansion? 15. What costing/profitability goals are reasonable? 16. Do you have profit performance criteria? 17. Can you give quantitative measures? 18. Does the bank wish to remain focused on corporate customers or offer mass market products? For the retail business we understand that a new direction in risk management is being defined focusing more on "mass" products then on corporate loans. Please explain. 19. What business plan targets are established for these areas? 20. Is the current organization structure appropriate for the business strategy? 21. We understand that a manager will be responsible for developing the risk management system for mortgage business and focusing on all retail products, limit taking, underwriting, approval process and scoring procedures. Where does this stand?
  32. 32. 22. What are the next steps for Ukrexim Bank in regard to (a) organizational restructuring of the bank (b) building up the retail business/mortgages and (c) establishing effective structures and business processes. 23. Possible participation in working group on the bank’s mortgage business development 24. Possible internal discussion on further steps in improving the bank’s mortgage lending system
  33. 33. Appendix 3: Detailed Asset/Liability Management Policy Statement Source: National Credit Union Administration (an American Government agency working with Federally Insured credit unions) I. GOAL A. The assets and liabilities of _______________________ Bank of ______________________ shall be managed in order to maximize shareholder value, to enhance profitability and increase capital, to serve customer and community needs, and to protect the institution from any disastrous financial consequences arising from changes in interest rate risk. These objectives shall be pursued within the framework of written loan, capital, and investment policies. The Board of Directors believes that accepting some level of interest rate risk is necessary in order to achieve realistic profit goals. The responsibility of managing the asset/liability management procedures will be directed by the Asset/Liability Management Committee (ALCO). II. ALCO ORGANIZATION AND RESPONSIBILITY A. The composition of the ALCO Committee of____________________ Bank of _______________________ shall consist of the following individuals and Mr/Ms X shall serve as Chairman of the Committee. The Committee shall meet once a month or more frequently when necessary to discuss asset/liability management issues. The ALCO is responsible for recommending to the Board of Directors prudent asset/liability management policies and procedures that enable the bank to achieve its goals while operating in full compliance with all state and federal laws, rules, and regulations. The Board of Directors will review reports and procedures to ensure adherence with this policy statement. As necessary, the Board will modify or grant exceptions to the policy for recommended action that are in the best interest of the institution. III. OBJECTIVES A. The assets and liabilities shall be managed to attempt to achieve the following minimum objectives: 1. A return on assets above ____ %. 2. A return on equity above ____ %. 3. An equity capital-to-assets ratio above ____ %. 4. A risk-based capital ratio of ____ %. IV. DUTIES A. At its quarterly meeting the ALCO shall review the following: 1. Local and national economic forecasts 2. Interest rate forecasts and spreads including a consensus interest rate forecast for the Bank developed by Bank management 3. Internal cost of funds (recent pricing) 4. Mismatches in the balance sheet 5. Year-to-date operating results 6. Anticipated funding needs 7. Anticipated loan demands 8. Liquidity position 9. Maturity distribution of certificates of deposit of $100,000 10. (GAP) Rate Sensitivity measures 11. Net Interest Margin/Interest Rate Risk Measures 12. Simulation 13. Capital Positions
  34. 34. 14. Ratio of loan loss reserves to outstanding risk loans 15. Tax position 16. Fed funds position 17. Investment portfolio 18. Current loan investment and funding strategies 19. An explanation of any known exceptions to this policy as well as an action plan and timetable to bring the bank into compliance with such policy limits. V. REPORTING REQUIREMENTS A. The ALCO shall provide the following to the Board of Directors on a quarterly basis: 1. Average daily balance sheet 2. Interest income and interest expense statements 3. Non-interest income and non-interest expense statements 4. Interest spread statement and GAP Report 5. Relevant ratios (detailed above) 6. Net interest change analysis attributable to dollar volumes, earning, paying and market rates as well as time (simulation) compared to policy limits. 7. Investment portfolio and loan activity report 8. A summary approximating investment portfolio values 9. Duration analysis to approximate investment portfolio values for different rate scenarios (annual) 10. Projected flow of funds analysis 11. Recommended Asset/Liability Management plan including a quarterly strategy for the management of interest rate risk and liquidity risk 12. Assessment of performance against the prior quarter's strategy 13. An explanation of any known exceptions to this policy as well as an action plan and timetable to bring the bank into compliance with such policy limits. VI. LIQUIDITY A. Liquidity is measured by our ability to accommodate decreases in deposits and other purchased liabilities, and fund increases in assets. In assessing the bank's liquidity position, consideration shall be given to: (1) present and anticipated asset quality (2) present and future earnings capacity (3) historical funding requirements (4) current liquidity position (5) anticipated future funding needs, and (6) sources of funds. The committee will monitor the Bank's liquidity position by reviewing the following measures: 1. Loans/Deposits Less than ______ % 2. Investments/Deposits Less than ______ % 3. Net Fed Funds Purchased/Capital Not Greater than ______ % 4. Loans/capital Less than ______ % 5. Net Fed Funds Purchased/Loans Less than ______ % 6. Dependency ratio Less than ______ % (% long term assets versus volatile liabilities) B. The Bank must perform one or a combination of the following to meet liquidity and lending needs of our customers: 1. Dispose of liquid assets 2. Increase short-term borrowing (Fed Funds, Federal Home Loan Bank or Discount Window) 3. Decrease holdings of non-liquid assets 4. Increase liabilities of a term nature 5. Increase capital funds VII. FUNDING A. The Bank will not depend on Fed Fund purchases to be a part of its permanent pool of funds, but does realize that a line of credit is necessary as a secondary funding source. The amount of net Fed Funds purchased should normally not total more than ______ % of total capital.
  35. 35. B. Another source of short-term funds to be used is Government or Agency security repurchase agreements with upstream banks. C. The Bank will not rely on purchased or brokered money or public funds as a source of permanent funding. This will not preclude the use of Federal Home Loan Bank advances to provide matched-funding opportunities. Such advances will be limited to ________% of total capital. The use of FHLB borrowing shall be addressed in the Bank's quarterly strategy as to the market, interest rate, price, and liquidity risks as well as earnings and capital volatility resulting from new risk positions. D. The Bank will offer a full array of money market, savings, and NOW accounts, and certificates of time deposits to customers of our Bank with interest rates paid subject to market conditions. E. Maturities of both greater than $100,000 and less than $100,000 certificates of deposit will normally average ______ months in the aggregate with the majority of new deposits written for ______ months with a minimum ________ month(s) and a maximum of ________ months. As interest rate forecasts dictate, maturities on liabilities will be lengthened or shortened to maximize the net interest margin while complying with the ranges detailed above. F. The minimum acceptable rate differential between average liability cost and average asset yield on new business will be ______ basis points. VIII. LOANS A. Loan commitments will be consistent with separate written loan policies. The maximum amount of loans outstanding shall not exceed ________ times the gross capital funds (capital, surplus, undivided profits reserves for loan losses, and capital debentures). The maximum amount of loans outstanding shall be limited to ________ % of deposit levels. B. Loan relationships will be pursued if management can demonstrate that such loans will produce a minimum of a ________ basis point spread over current funding costs. C. The Board of Directors seeks to keep the amount of assets classified as substandard, doubtful, or loss by the regulatory authorities at less than ________ % of gross capital funds. Furthermore, loan loss reserves shall amount to at least ________ % of the non-government guaranteed loans outstanding. IX. INVESTMENTS A. Security purchases will be consistent with separate written investment policies and strategies. The objectives of the investment portfolio are to (1) provide liquidity (2) provide for interest rate risk management, and (3) provide additional profit. X. INTEREST RATE RISK A. It is the policy of the Bank to measure and manage its rate sensitivity position to ensure the longrun earning power of the bank. In addressing this challenge, the ratios of rate sensitive assets (RSA) to rate sensitive liabilities (RSL) and gap (RSA minus RSL) to equity, as well as gap to total assets will be reviewed based on 30, 60, 90, 180, and 365-day, 1-2 year, and greater than 2 year definitions. More importantly, however, special emphasis is to be placed on the change in net interest income that will result from possible fluctuations in interest rates, changing account volumes, and time. In particular, changes in interest income resulting from increasing (+100 b.p. to +300 b.p.), decreasing (-100 b.p. to -300 b.p.) and constant rate scenarios will be evaluated via simulation. B. In an effort to measure risk to market value of equity, the Bank will review all long-term fixed rate assets. The Bank will review price volatility of the investment portfolio using duration analysis and specifically look at the estimated depreciation in market value if interest rates rise 300 b.p. in comparison to the Bank's equity capital. In addition, the Bank will compare long term assets to short term volatile liabilities. XI. RATE SENSITIVE ASSETS
  36. 36. A. Rate sensitive assets (RSA) are any loans or investments that can be repriced either up or down in interest rate within a given time frame. The following represent some examples of assets that would be considered rate sensitive: 1. Federal Funds sold 2. Securities purchased under agreement to resell 3. All loans maturing within a given time frame 4. All securities maturing within a given time frame 5. Principal payments on all securities that are to be received using current prepayment speed assumptions 6. Principal payments on all loans that are to be received (including the impact of expected prepayments if deemed to be significant) 7. All loans with floating interest rates, and when the floating rate can change (with respect to caps and floors) as well as the repricing characteristics of the underlying index 8. All securities with floating interest rates, and when the floating rate can change (with respect to caps and floors) as well as the repricing characteristics of the underlying index. 9. Special attention shall be paid to any assets having embedded options (calls, prepayments, repricing, etc) XII. RATE SENSITIVE LIABILITIES A. Rate sensitive liabilities (RSL) are interest paying deposits or other liabilities that can be repriced (as dictated historically) either up or down in interest rates within a given time frame. The following represent some examples of rate sensitive liabilities: 1. Fed Funds purchased 2. Securities sold under agreement to repurchase 3. Certificates of deposits or other liabilities that are maturing a. A portion of a portion of demand deposits and MMDA accounts are not considered core deposits. Bank's management believes that 60% of interest bearing deposit accounts should normally be considered rate sensitive and 40% should normally be considered core or fixed rate. b. A portion of savings and NOW accounts are not considered core deposits. Bank's management believes that 60% of interest bearing deposit accounts should normally be considered rate sensitive and 40% should normally be considered core or fixed rate. Items Section 3 (a) and (b) refer to FDICIA Section 305 (Core Deposit Reporting). 4. Other liabilities such as debentures, term loans, and other floating rate deposits that can be repriced 5. Deposit accounts will be rate sensitive only if historical trends dictate XIII. GAP MANAGEMENT A. The Bank's gap and interest rate exposure is compiled and reviewed on a _________ basis. The GAP reports will be used to measure risk to net interest income arising from the repricing of assets and liabilities over time. The Bank will focus on net repricing imbalances (RSA - RSL) in the 90, 180, and 365-day cumulative time frames, while measuring the risk based upon the size of the repricing balances, how long the repricing imbalances remain open, and potential movements in interest rates. While the GAP reports will be used to indicate the timing and sources of interest rate risk, it is understood that maintaining a balanced position for all time periods in a GAP report does not ensure immunity from interest rate risk. The Bank will take into account the following limitations of GAP reporting: 1. Interest rates on assets and liabilities do not always move in the same magnitude or velocity 2. Significant risk may be hidden in the repricing time frames of the GAP report 3. Option features of many deposit instruments and loans are not readily determinable 4. Exposures arising from new business generally are not captured. 5. Repriceable investments/funds may roll off at rates significantly different from current rates