1. TRAINING ON CORE RISKMANAGEMENT FOR BANGLADESH BANK Training Session 2: Asset Liability Management May 2011 Dhaka ICRA Management Consulting Services Limited © IMaCS 2010 Printed 26-May-11 1
2. CONFIDENTIALAll the contents of the presentation are confidential and should not be published, reproduced or circulated without the writtenconsent of World Bank, Central Bank of Bangladesh and IMaCS © IMaCS 2010 Printed 26-May-11 2
3. Agenda of the presentation  Understanding requirement for training on Asset Liability Management  Introducing key concepts and tools for Asset Liability Management  Outlining the current guidelines issued by Bangladesh Bank and suggesting improvements, if any © IMaCS 2010 Printed 26-May-11 3
4. Agenda for Day 1 Introduction to Asset Liability Management ALM basic concepts Lunch Break Liquidity Risk © IMaCS 2010 Printed 26-May-11 4
5. Agenda for Day 2 Liquidity risk Continued Lunch Break Liquidity risk Continued Liquidity risk Continued © IMaCS 2010 Printed 26-May-11 5
6. Agenda for Day 3 Liquidity risk Continued Lunch Break Liquidity risk Continued Interest rate risk © IMaCS 2010 Printed 26-May-11 6
7. Agenda for Day 4 Interest rate risk Lunch Break Interest rate risk continued Interest rate risk continued © IMaCS 2010 Printed 26-May-11 7
8. Agenda for Day 5 Interest Rate risk Continued Lunch Break Interest Rate risk Continued Basel Guidelines, current guidelines in Bangladesh and wrap up session © IMaCS 2010 Printed 26-May-11 8
9. In this session, we will understand what constitutes assets andliabilities in a Bank and why asset liability management is important © IMaCS 2010 Printed 26-May-11 9
10. Components of Balance Sheet Balance Sheet of a Bank Liabilities AssetsCapital Cash and Balances at Central BankReserves and Surplus Balance w ith banks and money at callDeposits and short noticeBorrow ings InvestmentsOther Liabilities and Provisions AdvancesContingent Liabilities Fixed Assets Other Assets © IMaCS 2009 Printed 26-May-11 10
11. Components of Liabilities … 11. Capital: Capital represents owner‟s contribution/stake in the bank. - It serves as a cushion for depositors and creditors. - It is considered to be a long term sources for the bank. © IMaCS 2009 Printed 26-May-11 11
12. Components of Liabilities … 22. Reserves & SurplusComponents under this head includes:I. Statutory ReservesII. Capital ReservesIII. Investment Fluctuation ReserveIV. Revenue and Other ReservesV. Balance in Profit and Loss Account © IMaCS 2009 Printed 26-May-11 12
13. Components of Liabilities … 33. Deposits This is the main source of bank‟s funds. The deposits are classified as deposits payable on „demand‟ and „time‟. They are reflected in balance sheet as under:I. Demand DepositsII. Savings Bank DepositsIII. Term Deposits © IMaCS 2009 Printed 26-May-11 13
14. Components of Liabilities … 44. Borrowings (Borrowings include Refinance / Borrowings from central bank, Inter-bank & other institutions)I. Borrowings in Bangladesh i) Bangladesh Bank ii) Other Banks iii) Other Institutions & AgenciesII. Borrowings outside Bangladesh © IMaCS 2009 Printed 26-May-11 14
15. Components of Liabilities … 55. Other Liabilities & Provisions It is grouped as under:I. Bills PayableII. Inter Office Adjustments (Net)III. Interest AccruedIV. Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital)V. Others(including provisions) © IMaCS 2009 Printed 26-May-11 15
16. Components of Assets … 11. Cash & Bank BalancesI. Cash in hand (including foreign currency notes)II. Balances with Bangladesh Bank In Current Accounts In Other Accounts © IMaCS 2009 Printed 26-May-11 16
17. Components of Assets … 22. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICEI. In Bangladesh i) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks b) With Other InstitutionsII. Outside Bangladesh a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice © IMaCS 2009 Printed 26-May-11 17
18. Components of Assets … 33. Investments A major asset item in the bank‟s balance sheet. Reflected under 6 buckets as under: I. Investments in Bangladesh in: i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (Commercial Papers, COD & Mutual Fund Units etc.)II. Investments outside Bangladesh in Subsidiaries and/or Associates abroad © IMaCS 2009 Printed 26-May-11 18
19. Components of Assets … 44. AdvancesThe most important assets for a bank.A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term LoansB. Particulars of Advances : i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured © IMaCS 2009 Printed 26-May-11 19
20. Components of Assets … 55. Fixed Asset I. Premises II. Other Fixed Assets (Including furniture and fixtures)6. Other Assets I. Interest accrued II. Tax paid in advance/tax deducted at source (Net of Provisions) III. Stationery and Stamps IV. Non-banking assets acquired in satisfaction of claims V. Deferred Tax Asset (Net) VI. Others © IMaCS 2009 Printed 26-May-11 20
21. Contingent Liability Bank‟s obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. © IMaCS 2009 Printed 26-May-11 21
22. Banks Profit & Loss Account A bank’s profit & Loss Account has the following components:I. Income: This includes Interest Income and Other Income.II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies. © IMaCS 2009 Printed 26-May-11 22
23. Components of Income … 11. INTEREST EARNEDI. Interest/Discount on Advances / BillsII. Income on InvestmentsIII. Interest on balances Central Bank and other inter-bank fundsIV. Others © IMaCS 2009 Printed 26-May-11 23
24. Components of Income … 22. OTHER INCOMEI. Commission and BrokerageII. Profit on sale of Investments (Net)III. Profit/(Loss) on Revaluation of InvestmentsIV. Profit on sale of land, buildings and other assets (Net)V. Profit on exchange transactions (Net)VI. Income earned by way of dividends etc. from subsidiaries and Associates abroad/in BangladeshVII. Miscellaneous Income © IMaCS 2009 Printed 26-May-11 24
25. Components of Expenses … 1 1. INTEREST EXPENDED I. Interest on Deposits II. Interest on Central Bank of Bangladesh/ Inter-Bank borrowings III. Others © IMaCS 2009 Printed 26-May-11 25
26. Components of Expenses … 22. OPERATING EXPENSESI. Payments to and Provisions for employeesII. Rent, Taxes and LightingIII. Printing and StationeryIV. Advertisement and PublicityV. Depreciation on Banks propertyVI. Directors Fees, Allowances and ExpensesVII. Auditors Fees and Expenses (including Branch Auditors)VIII. Law Charges IX. Postages, Telegrams, Telephones etc. X. Repairs and Maintenance XI. InsuranceXII. Other Expenditure © IMaCS 2009 Printed 26-May-11 26
27. Reclassification of liabilitiesLiabilities/outflows1&2. Capital fundsa) Equity capital, Non-redeemable or perpetual preference capital, Reserves, Funds and Surplusb) Preference capital - redeemable/non-perpetual3. Grants, donations and benefactions4. Bonds and debenturesa) Plain vanilla bonds/debenturesb) Bonds/debentures with embedded call/put options (including zero-coupon/deep discount bonds)5. Inter Corporate Deposits:6. Borrowingsa) Short Term borrowingsb) Long Term Borrowings7. Current liabilities and provisions:a) Sundry creditorsb) Expenses payable (other than interest)c) Advance income received, receipts from borrowers pending adjustmentd) Interest payable on bonds/depositse) Provisions for NPAsf) Provision for Investments portfoliog) Other provisions © IMaCS 2009 Printed 26-May-11 27
28. Reclassification of Assets … 1Inflows1. Cash2. Remittance in transit3. Balances with banks (in Bangladesh only)a) Current accountb) Deposit accounts/short term deposits4. Investments (net of provisions)a) Approved Trustee securities, government securities, bonds, debentures and other instrumentsb) Unlisted securities (e.g. shares, etc.)c) Unlisted securities having a fixed term maturityd) Venture capital unitse) Equity shares, convertible preference shares, non-redeemable/perpetual preference shares, shares ofsubsidiaries/joint ventures and units in open ended mutual funds and other investments.5. Advances (performing)a) Bill of Exchange and promissory notes discounted and rediscountedb) Term loans (rupee loans only)c) Corporate loans/short term loans © IMaCS 2009 Printed 26-May-11 28
29. Reclassification of Assets … 26. Non-performing loans(May be shown net of the provisions, interest suspense held )a) Sub-standardi) All overdues and instalments of principal falling due during the next three yearsii) Entire principal amount due beyond the next three yearsb) Doubtful and loss i) All instalments of principal falling due during the next five years as also all overduesii) Entire principal amount due beyond the next five years7. Assets on lease8. Fixed assets (excluding leased assets)9. Other assets(a) Intangible assets and items not representing cash inflows.(b)Other items (such as accrued income, other receivables, staff loans, etc.)C. Contingent liabilities(a) Letters of credit/guarantees (outflow through devolvement)(b) Loan commitments pending disbursal (outflow)(c) Lines of credit committed to/by other Institutions (outflow/inflow)Overdue for less than one month.Interest overdue for more than one month but less than seven months (i.e. before the relative amountbecomes NPA)Principal installments overdue for 7 months but less than one year © IMaCS 2009 Printed 26-May-11 29
30. In this session, we will understand what constitutes assets and liabilities in a Bank and why asset liability management is important
31.  Asset Liability  Asset liability management is a Management is strategic management tool to measure and concerned with manage liquidity risk, strategic balance interest rate risk and interest rate risk faced sheet management by Banks and Financial Institutions. ALM is involving risks about matching of the caused by changes assets and liabilities of the balance sheet based in interest rates, on maturity or re-pricing for liquidity risk and exchange rate and interest rate risk the liquidity respectively position of bank
32.  ALM is the process  It is a dynamic involving decision process of Planning, making about the Organizing & composition of assets Controlling of Assets and liabilities & Liabilities- their including off balance volumes, mixes, sheet items of the maturities, yields and bank / FI and costs in order to conducting the risk maintain liquidity assessment and NII
33. Globalization of financial markets. _ Deregulation of Interest Rates. _ Multi-currency Balance Sheet. _ Prevalence of Basis Risk and Embedded Option Risk. _ Integration of Markets – Money Market, FOREX Market, Government Securities Market. _ Narrowing NII / NIM_ Mismatches in the maturity profile of assets and liabilities _ Banks borrow short term and lend long term-basis of profitability _ Mismatches in interest rates
34.  Liquidity  May lead to mismatch→ liquidation Interest rate  Affects mismatch → profitability
35.  An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
36.  An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
37.  An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
38.  An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
39.  It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are:  Net Interest Income (NII)  Net Interest Margin (NIM)  Economic Equity Ratio
40. Liquidity ManagementBank’s liquidity management is theprocess of generating funds to meetcontractual or relationship obligationsat reasonable prices at all times.New loan demands, existingcommitments, and deposit withdrawalsare the basic contractual or relationshipobligations that a bank must meet.
41. FLOW APPROACH STOCK APPROACHMeasuring & Based on the level of Managing net Assets & Liabilities as funding requirement well as Off balance Sheet exposures on aManaging market particular date and access calculating certain ratios to assess theContingency planning liquidity position
42. COMPONENTS OF BALANCE SHEET Liabilities  Assets Capital  Cash and Balances Reserves and at Central Bank Surplus  Investments Deposits  Advances Borrowings  Fixed Assets Other Liabilities and Provisions  Other Assets Contingent Liabilities
43. Components of Liabilities … 1 1. Capital: Capital represents owner’s contribution/stake in the bank. - It serves as a cushion for depositors and creditors.- It is considered to be a long term sources for the bank.
44. Components of Liabilities … 2 2. Reserves & Surplus Components under this head includes: I. Statutory Reserves II. Capital ReservesIII. Investment Fluctuation Reserve IV. Revenue and Other Reserves V. Balance in Profit and Loss Account
45. Components of Liabilities … 3 3. DepositsThis is the main source of bank’sfunds. The deposits areclassified as deposits payable on‘demand’ and ‘time’. Theyare reflected in balance sheet asunder:I. Demand DepositsII. Savings Bank DepositsIII. Term Deposits
46. Components of Liabilities … 4 4. Borrowings(Borrowings include Refinance / Borrowings from RBI, Inter-bank& other institutions) I. Borrowings in India i) Bangladesh Bank ii) Other Banks iii) Other Institutions & Agencies II. Borrowings outside India
47.  5. Other Liabilities & Provisions  It is grouped as under:  I. Bills Payable  II. Inter Office Adjustments (Net)  III. Interest Accrued  IV. Unsecured Redeemable Bonds  (Subordinated Debt for Tier-II Capital)  V. Others(including provisions)
48. Components of Assets … 1 1. Cash & Bank Balances I. Cash in hand (including foreign currency notes)II. Balances with Bangladesh Bank In Current Accounts In Other Accounts
49. Components of Assets … 2 2. BALANCES WITH BANKS ANDMONEY AT CALL & SHORT NOTICE I. In Bangladesh i) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks b) With Other Institutions II. Outside Bangladesh a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice
50. Components of Assets … 3 3. Investments A major asset item in the bank’s balance sheet. Reflected under 6 buckets as under: I. Investments in Bangladesh in: i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutionsvi) Others (Commercial Papers, COD & Mutual Fund Units etc.) II. Investments outside Bangladesh in Subsidiaries and/or Associates abroad
51. Components of Assets … 4 4. Advances The most important assets for a bank. A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term Loans B. Particulars of Advances :i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured
52. Components of Assets … 5 5. Fixed Asset I. PremisesII. Other Fixed Assets (Including furniture and fixtures) 6. Other Assets I. Interest accrued II. Tax paid in advance/tax deducted at source (Net of Provisions) III. Stationery and Stamps IV. Non-banking assets acquired in satisfaction of claims V. Deferred Tax Asset (Net) VI. Others
53. Bank’s obligations under LCs, Contingent Guarantees, Acceptances on Liabilitybehalf of constituents and Bills accepted by the bank arereflected under this heads.
54.  1&2. Capital funds a) Equity capital, Non-  4. Bonds and redeemable or debentures perpetual preference  a) Plain vanilla capital, Reserves, bonds/debentures Funds and Surplus  b) Bonds/debentures b) Preference capital - with embedded redeemable/non- call/put options perpetual (including zero- 3. Grants, donations coupon/deep discount and benefactions bonds)  5. Inter Corporate Deposits:
55.  6. Borrowings  c) Advance income a) Short Term received, receipts borrowings from borrowers b) Long Term pending Borrowings adjustment 7. Current  d) Interest payable liabilities and on bonds/deposits provisions:  e) Provisions for a) Sundry creditors NPAs b) Expenses  f) Provision for payable (other than Investments interest) portfolio  g) Other provisions
56.  1. Cash 2. Remittance in transit 3. Balances with banks (in India only) a) Current account b) Deposit accounts/short term deposits
57.  4. Investments (net of provisions) a) Approved Trustee securities, governmentsecurities, bonds, debentures and otherinstruments b) Unlisted securities (e.g. shares, etc.) c) Unlisted securities having a fixed termmaturity d) Venture capital units e) Equity shares, convertible preferenceshares, non-redeemable/perpetual preferenceshares, shares of subsidiaries/joint ventures and units in openended mutual funds and other investments.
58. 5. Advances (performing) a) Bill of Exchange andpromissory notes discounted and rediscountedb) Term loans (rupee loans only) c) Corporate loans/short term loans
59.  6. Non-performing loans (May be shown net of the provisions, interest suspense held ) a) Sub-standard i) All overdues and instalments of principal falling due during the next three years ii) Entire principal amount due beyond the next three years b) Doubtful and loss i) All instalments of principal falling due during the next five years as also all overdues ii) Entire principal amount due beyond the next five years
60.  7. Assets on lease  8. Fixed assets (excluding leased assets)  9. Other assets (a) Intangible assets and items not representing cash inflows.  (b)Other items (such as accrued income, other receivables, staff loans, etc.)
61. C. Contingent liabilities(a) Letters of credit/guarantees (outflow through devolvement)(b) Loan commitments pending disbursal (outflow)(c) Lines of credit committed to/by other Institutions (outflow/inflow)Overdue for less than one month.Interest overdue for more than one month but less than seven months (i.e. before the relative amountbecomes NPA)Principal installments overdue for 7 months but less than one year
62. Managing Currency risk is one moredimension of Asset - LiabilityManagement. Mismatched currencyposition besides exposing thebalance sheet to movements inexchange rate also exposes it tocountry risk and settlement risk.
63. It is the current or prospective risk to earnings andcapital arising from adverse movements in currencyexchange rates.It refers to the impact of adverse movement incurrency exchange rates on the value of open foreigncurrency.The banks are also exposed to interest rate risk,which arises from the maturity mismatching of foreigncurrency positions. Even in cases where spot andforward positions in individual currencies arebalanced, the maturity pattern of forward transactionsmay produce mismatches. As a result, banks maysuffer losses due to changes in discounts of thecurrencies concerned
64. Banks also face another risk calledtime-zone risk, which arises out of timelags in settlement of one currency inone center and the settlement ofanother currency in another time zone.The forex transactions with counterparties situated outside Bangladeshalso involve sovereign or country risk.
65. LIQUIDITY NET STABLE COVERAGE RATIO FUNDING RATIOObjective is to examine Objective is to ensureshort term resiliency of longer term resiliencyliquidity risk profile to by funding activitiesensure they have with more stablesufficient high quality funding on an on goingresources to survive structural basisone month in acutestress condition
66. The liquidity coverage ratio identifies theamount of unencumbered, high quality liquidassets an institution holds that can be used tooffset the net cash outflows it would encounterunder an acute short-term stress scenariospecified by supervisors. The specified scenarioentails both institution-specific and systemicshocks built upon actual circumstancesexperienced in the global financial crisis
67. The scenario entails: • a significant downgrade of the institution’s public credit rating; • a partial loss of deposits; • a loss of unsecured wholesale funding; • a significant increase in secured funding haircuts; and • increases in derivative collateral calls and substantial calls on contractual and noncontractual off-balance sheet exposures, including committed credit and liquidity facilities.
68. The net stable funding (NSF) ratio measures theamount of longer-term, stable sources of fundingemployed by an institution relative to the liquidityprofiles of the assets funded and the potential forcontingent calls on funding liquidity arising from off-balance sheet commitments and obligations.The NSF ratio is intended to promote longer-termstructural funding of banks’ balance sheets, off-balance sheet exposures and capital marketsactivities.
69. Throughout the global financial crisiswhich began in mid-2007, many banksstruggled to maintain adequate liquidity.Unprecedented levels of liquidity supportwere required from central banks in orderto sustain the financial system and evenwith such extensive support a number ofbanks failed, were forced into mergers orrequired resolution.
70. These circumstances and events werepreceded by several years of ample liquidityin the financial system, during whichliquidity risk and its management did notreceive the same level of scrutiny andpriority as other risk areas. The crisisillustrated how quickly and severelyliquidity risks can crystallise and certainsources of funding can evaporate,compounding concerns related to thevaluation of assets and capital adequacy.
71. Banks should have in placecontingency and businesscontinuity plans to ensure theirability to operate as goingconcerns and minimize lossesin the event of severe businessdisruption.
72. does does managementmanagement have procedureshave a strategy in place forfor handling a accessing funds in an emergency?crisis?
73. A contingency plan needs to spellout procedures to ensure thatinformation flows remain timelyand uninterrupted, and that theyprovide senior management withthe precise information it needs inorder to make quick decisions.
74. Another major element in the planshould be a strategy for takingcertain actions toalter asset and liability behaviours.
75. Other components of the contingency plan involve maintaining customer relationships with liability-holders, borrowers, and trading and off-balance-sheet counterparties.
76. Contingency plans should also includeprocedures for making up cash flowshortfalls in adverse situations. Banks haveavailable to them several sources of suchfunds, including previously unused creditfacilities. The plan should spell out asclearly as possible the amount of funds abank has available from these sources, andunder what scenarios a bank could usethem.
77.  The plan should spell out as clearly aspossible the amount of funds a bank hasavailable from these sources, and underwhat scenarios a bank could use them. Holding readily marketable securities(financial assets). The sub-prime crisis hasexposed the shortcomings in such a strategyfor coping with market wide liquidity crises.
78. Holding securities which can bepledged as collateral for short termborrowings. The repurchase (repo)market has become an important tool forliquidity management of this sort. Having in place lines of credit or otherarranged borrowing facilities. The Havingin place lines of credit or other arrangedborrowing facilities.
79. Having at-call or short term loansoutstanding to other entities which can becalled to provide cash when needed. Therisk here is that such loans involvecounterparty risk – and calling such loansmay increase the likelihood of default ifthere is widespread stress in the financialmarket.
80. For banks, the ability to access“Lender of Last Resort” loans oruse discount window facilities atCentral Banks provide furtherpotential
81. new issues of short- and long-term debt instrumentsnew capital issues, the sale ofsubsidiaries or lines of businessasset securitisation
82.  rapid asset growth, especially when funded with potentially volatile liabilities • growing concentrations in assets or liabilities • increases in currency mismatches • a decrease of weighted average maturity of liabilities
83.  • repeated incidents of positions approaching or breaching internal or regulatory limits • negative trends or heightened risk associated with a particular product line, such as rising delinquencies • significant deterioration in the bank’s earnings, asset quality, and overall financial condition
84.  • negative publicity • a credit rating downgrade • stock price declines or rising debt costs • widening debt or credit-default-swap spreads • rising wholesale or retail funding costs
85.  • correspondent banks that eliminate or decrease their credit lines • increasing retail deposit outflows • increasing redemptions of CDs before maturity • difficulty accessing longer-term funding • difficulty placing short-term liabilities (eg commercial paper)
86. All banks are CFP are liquidityrequired to stress tests designed to quantify the likelyproduce a impact of an event onContingency the balance sheetFunding Plan and the net potential(CFP). These cumulative gap over aplans are to be 3-month period.approved byALCO
87.  The banks CFP  If a CFP results in should reflect the a funding gap within funding needs of a 3-month time the bank frame, the ALCO must establish an Reports of CFPs action plan to should be address this prepared at least situation. The Risk quarterly and Management reported to ALCO Committee should approve the action
88.  CFPs under each  Balance sheetscenario must actions andconsider the impact incremental sourcesof accelerated run off of funding should beof large funds dimensioned withproviders. sources, time frame The plans must and incrementalconsider the impactof a progressive, marginal cost andtiered deterioration, included in the CFPsas well as sudden, for each scenario.drastic events.
89.  Assumptions  The ALCO willunderlying the CFPs, implement the CFP,consistent with each amending it necessary,scenario, must be to meet changingreviewed and approved conditions dailyby ALCO. reports are to be The Chief submitted to theExecutive/Chairman Treasury Head,must be advised as comparing actual cashsoon as a decision has flows with thebeen made to activate assumptions of theor implement a CFP. CFP.
90. Risks• Various sources of risk that investors are exposed to when investing in fixed income securities– Interest Rate Risk: Sensitivity of bond prices to changes in interest rates– Yield Curve Risk: Changes in the shape of the yield curve will negatively impact bond values– Call Risk: Bond redeemed (called) before maturity & have to reinvest at lower yields– Prepayment Risk: Principal on amortizing securities is prepaid, and have to reinvest at lower yields– Reinvestment Risk: Risk of reinvesting in new security with lower yields– Credit Risk: The risk of default and the risk of decrease in bond value due to a downgrade– Liquidity Risk: immediate sale of security will result in a price below fair value– Exchange-Rate Risk: Foreign exchange value of the currency that a foreign bond is denominated in will fall relative to the home currency of the investor.– Inflation Risk: Higher inflation erodes the purchasing power of the cash flows from a fixed income security.– Event Risk: Decrease in a securitys value from disasters, corporate restructurings, or regulatory changes that negatively impact the firm.– Sovereign Risk: Govt. may repudiate debt, prohibit debt repayment by private borrowers, or impose general restrictions on currency flows– Credit spread risk: The default risk premium required in the market for a given rating can increase, even while the yield on Treasury securities of similar maturity remains unchanged © IMaCS 2009 Printed 26-May-11 142
91. Basic Concepts-Bonds Fixed Income Securities (FIS): An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. Eg. Bonds Bond Indenture: Contract that specifies all rights and obligations of issuer and owners of FIS. Covenants: are the contracts provisions including both affirmative and negative covenants  Affirmative Covenants: (actions that borrower promises to perform) 1. Maintenance of certain financial ratios. 2. Timely payments of principal & interests.  Negative Covenants: (prohibitions on the borrower) 1. Restrictions on assets sales 2. Negative pledge of collateral 3. Restrictions on additional borrowings © IMaCS 2009 Printed 26-May-11 143
92. Key terminologies  Interest/coupon: The charge for the privilege of borrowing money, typically expressed as an annual percentage rate.  Frequency: The coupon frequency  Principal: The original amount invested, separate from earnings.  Maturity: The length of time until the principal amount of a bond must be repaid.  YTM: Yield to maturity is defined as the one discount rate at which all the coupons needs to be discounted to arrive at the market price of the bond  Day count: The number of days to be taken in a year for computation of interest.  Face Value: Value of bond stated in indenture (denominated in currency in which payments will be made).  Issue Price: Price at which security is issued in the market.  Market Price: Price at which bond is traded in the market. © IMaCS 2009 Printed 26-May-11 144
93. Bonds Bonds: A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Types of bonds: 1. Zero Coupon Bonds -no periodic interest payments 2. Accrual bonds - interest payments at maturity 3. Step up notes -coupon rate increase over time at specified rate 4. Deferred coupon bonds- coupon payments starts after some specified period 5. Floating Rate Securities- coupon payments varies based on specified interest rate or index. 1. Inflation indexed bond 2. Caps, floors, collar © IMaCS 2009 Printed 26-May-11 145
94. Redemption Provisions Redemption Provisions: Refers to how, when, and under what circumstances the principal will be repaid.  Non Amortizing: Pay only interest until maturity, at which time the entire par or face value is repaid  Amortizing securities: Make periodic interest and principal payments over the life of the bond.  Prepayment options: Give the issuer/borrower the right to accelerate the principal repayment on a loan.  Call provisions: Give the issuer the right (but not the obligation) to retire all or a part of an issue prior to maturity.  Nonrefundable bonds: Prohibit the call of an issue using the proceeds from a lower coupon bond issue.  Sinking fund provisions: Provide for the repayment of principal through a series of payments over the life of the issue © IMaCS 2009 Printed 26-May-11 146
95. Embedded Options Security owner options: gives additional value to the security, compared to an otherwise-identical straight (option free) security.  A conversion option: Right to convert the bond into a fixed number of common shares of the issuer.  Put provisions: Right to sell (put) the bond to the issuer at a specified price prior to maturity.  Floors: Set a minimum on the coupon rate for a floating-rate bond. Security issuer options: will be priced less (or with a higher coupon) than otherwise identical option free securities.  Call provisions: Right to redeem (payoff) the issue prior to maturity.  Prepayment option: Right to prepay the loan balance prior to maturity, in whole or in part, without penalty.  Accelerated sinking fund provisions: Allow the issuer to (annually) retire a larger proportion of the issue than is required by the sinking fund provision, up to a specified limit.  Caps: Set a maximum on the coupon rate for a floating-rate bond. © IMaCS 2009 Printed 26-May-11 147
96. Treasury SecuritiesType Maturity Coupon paymentsT bills Less than 1 yr Similar to Zero (usually 4 weeks, 3, 6 months) coupon bondsT Notes 2,3,5,10 yrs Semiannual couponsBonds 20 or 30 years Semiannual couponsTreasury Inflation 5,10 year notes, 20 year bonds Semiannual couponsProtected Securities (TIPS)•TIPS : The par value is adjusted semiannually for changes in the Consumer Price Index. •If there is deflation, the adjusted par value is reduced for that period. •The fixed coupon rate is paid semiannually as a % of the inflation adjusted par value. •TIPS coupon payment = (Inflation adjusted coupon value)*(stated coupon rate/2)•On-the-run issues are the most recently auctioned Treasury issues.•Off-the-run issues are older issues replaced by a more recently auctioned issue.•STRIPS: Strip the coupons from the principal, repackage the cash flows, and sell themseparately as zero-coupon bonds, at discounts to par value. •Coupon Strips: Created from coupon payments stripped from the original security © IMaCS 2009 •Principal Strips: Bond and note principal payments with the coupons stripped off Printed 26-May-11 148
97. Contd. Medium-term notes (MTN):  Issued periodically by corporations under a shelf registration  Sold by agents on a best efforts basis  Have maturities ranging from 9 months to over 30 years. Commercial paper :  Short-term corporate financing vehicle  Does not require registration with the SEC if its maturity is less than 270 days. • Directly-placed paper-sold directly by the issuer • Dealer-placed paper-sold to investors through agents/brokers. Negotiable CDs  Issued in a wide range of maturities by banks  Trade in a secondary market  Are backed by bank assets. Bankers acceptances:  Issued by banks to guarantee a future payment for goods shipped  Sold at a discount to the future payment they promise  Short term, and have limited liquidity Asset-backed securities :  Debt that is supported by an underlying pool of mortgages, auto loans, credit card receivables Collateralized debt obligations (CDOs)  Backed by an underlying pool of debt securities like corporate bonds, loans etc © IMaCS 2009 Printed 26-May-11 149
98. Yield Curve Yield Curve: curve depicting relation between yield on bonds of same credit quality but different maturities. 4 types of yield curves © IMaCS 2009 Printed 26-May-11 150
99. Theories of the Yield Curve The pure expectations theory  Rates at longer maturities depend only on expectations of future short-term rates  Consistent with any yield curve shape. The liquidity preference theory  Longer term rates reflect investors expectations about future short-term rates as well as a liquidity premium  Consistent with a downward sloping curve if an expected decrease in short-term rates outweighs the term premium. The market segmentation theory  Lenders and borrowers have preferred maturity ranges  Shape of the yield curve is determined by the supply and demand for securities within each maturity range, independent of the yield in other maturity ranges.  Consistent with any yield curve shape © IMaCS 2009 Printed 26-May-11 151
100. Bonds Valuation 3 major steps in bonds valuations are  Estimate the cash flows over the life of the security. 1. The coupon payments 2. The return of principal Arbitrage-free valuation approach: discount each cash flow using spot rates.  Determine the appropriate discount rate based on the risk of the receipt of the estimated cash flows. 3 main kinds of discount rates used are 1. Yield to maturity: The rate of return anticipated on a bond if it is held until the maturity 2. Spot rates : appropriate discount rates for individual future payments 3. Forward rates: current lending rates for loans to be made in future periods  Calculate the present value of the estimated cash flows by multiplying the bond„s expected cash flows by the appropriate discount factors. © IMaCS 2009 Printed 26-May-11 152
101. Price Volatility Characteristics of FIS Price/Yield relationship for option-free bonds Price of bond changes inversely to the change in yield Yield % 8%/ 5-year 6 108.9826 7 104.3760 7.5 102.16 7.9 100.4276 7.99 100.0427 8 100 8.01 99.9574 8.1 99.57462 8.5 97.8944 9 95.8417 © IMaCS 2009 Printed 26-May-11 153
102. Observation from graphs Relationship is not linear (its convex). Slope gives measure of sensitivity of price for variation in yield (Duration) Higher the market yield, lower the interest rate risk (curve less steep at higher yields). As yield increases, price of option-free bond decreases. For discount and premium bonds, the price changes even if the yield remains the same as we move towards maturity. Price of discount (premium) bond increases (decreases) as it moves towards maturity, reaching at par value at maturity. Absolute dollar price change and absolute % price change are different for an equal increase and decrease in yields Volatility can be measured in terms of dollar price change and percentage price change . It depends on maturity, coupon rate, YTM © IMaCS 2009 Printed 26-May-11 154
103. Bonds with options Negative convexity in putable and callable bonds Price of callable bond can not exceed the call price (negative convexity). Value of callable bond = (value of option free bond - call premium) (Value of callable bond) < (value of option free bond) Value of putable bond cannot decline more than put price (negative convexity). Value of putable bond= (value of option free bond+ value of put) Value of putable bond > value of option free bond © IMaCS 2009 Printed 26-May-11 155
104. Discounting curves Forward Curve ZCYC CurveYield Par Curve Time to Maturity © IMaCS 2009 Printed 26-May-11 156
105. Debt Market in India Distribution of securities Distribution of number of trades 1% 0% 1% 1% 2% 1% 1% 8% 14% A A 10% 3% A- A- A+ A+ AA 17% AA62% AA- AA- AA+ 79% AA+ AAA AAA 60% of AAA securities accounted for 80% of the total trade in past 2 years © IMaCS 2009 Printed 26-May-11 157
106. Interest rate movement in India10.00%9.00%8.00%7.00% 3M 6M6.00% 9M 12M5.00%4.00% © IMaCS 2009 Printed 26-May-11 158
109. Introduction to Interest rate risk Risk due to variation in financial condition of the Bank due to variation in interest rates  Reprising risk  Yield curve risk  Option risk  Basis risk The immediate impact of variation in interest rates is on the earning of the Bank A long term impact of change in interest rates is on the net worth, since the economic value of assets and liabilities get affected © IMaCS 2009 Printed 26-May-11 161
110. Types of interest rate risk … 1 Re-pricing risk  Risk due to timing difference in the maturity (for fixed rate) and repricing (for floating rate) of assets and liabilities and off balance sheet (OBS) position  Banks usually have assets deployed at fixed rates (pre-determined at the time of contract) and also at variable rates (changes with change in benchmark interest rates), which get run down in the EMI structures regularly.  On the other hand the liabilities have varying structures that include repayment in installments and bullets. This leads to reprising risk © IMaCS 2009 Printed 26-May-11 162
111. Types of interest rate risk … 2 Yield curve risk  Yield curve risk is the risk of change in the shape or slope of the yield curve  Usually banks borrow short term and lend long term, thus flattening of the yield curve increases the cost of funds, whereas the interest earned does not increase proportionately. Thereby leading to pressure on the profitability of the Bank © IMaCS 2009 Printed 26-May-11 163
113. Types of interest rate risk … 3 Basis risk  Assets and liabilities are linked to different benchmark yield curves  Movement in the benchmark yield curves are seldom same in direction and magnitude  Any variance in the direction and magnitude of different benchmark yield curves would lead to volatility in the profitability of the bank  The risk that value of assets and liabilities change by the same magnitude by change in interest rates is termed as basis risk © IMaCS 2009 Printed 26-May-11 165
114. Types of interest rate risk … 4 Option risk  Change in interest rate that could lead to funds being withdrawn by the exercise of the option embedded with the product  Also change in interest rate could lead to cash flows being received earlier than expected as a result of options being exercised  Thus option risk is the risk that a change in prevailing interest rates will lead to an adverse impact on the earnings or capital by change in timing of the cash-flows of assets or liabilities © IMaCS 2009 Printed 26-May-11 166
115. Reasons for interest rate risk On account of asset transformation  Many deposits are used for one big loan Non-periodical review of assets and liabilities Due to mismatches between maturity / reprising dates as well as maturity amounts between assets and liabilities Depositors and borrowers may pre-close their accounts © IMaCS 2009 Printed 26-May-11 167
116. Earnings vs. economic value Earnings perspective: It involves the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in NII and NIM Economic value perspective: It involves the impact of interest rates on the expected cash-flows on assets minus the expected cash-flows on liabilities. It focuses on the risk to net worth arising from all reprising mismatches and other interest rate sensitive positions. It identifies the risk arising from long term interest rate gaps © IMaCS 2009 Printed 26-May-11 168
117. Factors Affecting NII. Changes in the level of interest rates. Changes in the volume of assets and liabilities. Change in the composition of assets and liabilities. Changes in the relationship between asset yields and liabilities. cost of funds. © IMaCS 2009 Printed 26-May-11 169
118. Example-impact of interest rate on profitability Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities CostRate sensitive 500 8.0% 600 4.0%Fixed rate 350 11.0% 220 6.0%Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.08x500+0.11x350) - (0.04x600+0.06x220) 78.5 - 37.2 = 41.3 NIM = 41.3 / 850 = 4.86% GAP = 500 - 600 = -100 © IMaCS 2009 Printed 26-May-11 170
119. Exhibit 1 1% increase in the level of all short-term rates. 1% decrease in spread between assets yields and interest cost.  RSA increase to 8.5%  RSL increase to 5.5% Proportionate doubling in size. Increase in RSAs and decrease in RSL‟s  RSA = 540, fixed rate = 310  RSL = 560, fixed rate = 260. © IMaCS 2009 Printed 26-May-11 171
120. 1% Increase in Short-Term Rates Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities CostRate sensitive 500 9.0% 600 5.0%Fixed rate 350 11.0% 220 6.0%Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.09x500+0.11x350) - (0.05x600+0.06x220) 83.5 - 43.2 = 40.3 NIM = 40.3 / 850 = 4.74% GAP = 500 - 600 = -100 © IMaCS 2009 Printed 26-May-11 172
121. 1% Decrease in Spread Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities CostRate sensitive 500 8.5% 600 5.5%Fixed rate 350 11.0% 220 6.0%Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.085x500+0.11x350) - (0.055x600+0.06x220) 81 - 46.2 = 34.8 NIM = 34.8 / 850 = 4.09% GAP = 500 - 600 = -100 © IMaCS 2009 Printed 26-May-11 173
122. Proportionate Doubling in Size Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities CostRate sensitive 1000 8.0% 1200 4.0%Fixed rate 700 11.0% 440 6.0%Non earning 300 200 1840 Equity 160 Total 2000 2000 NII = (0.08x1000+0.11x700) - (0.04x1200+0.06x440) 157 - 74.4 = 82.6 NIM = 82.6 / 1700 = 4.86% GAP = 1000 - 1200 = -200 © IMaCS 2009 Printed 26-May-11 174
123. Increase in RSAs and Decrease in RSLs Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities CostRate sensitive 540 8.0% 560 4.0%Fixed rate 310 11.0% 260 6.0%Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.08x540+0.11x310) - (0.04x560+0.06x260) 77.3 - 38 = 39.3 NIM = 39.3 / 850 = 4.62% GAP = 540 - 560 = -20 © IMaCS 2009 Printed 26-May-11 175
124. There are four methods for measuring InterestRate Risk Gap Analysis method Duration and Convexity method Simulation and Scenario analysis method Value at Risk method Each method has its advantages, disadvantages and complexities which is explained subsequently. For this workshop, we will limit our discussions to Gap method and duration method. © IMaCS 2009 Printed 26-May-11 176
125. What is a Gap? Gap = Risk Sensitive Assets (RSA) - Risk Sensitive Liabilities (RSL) 1. Risk Sensitive Assets and Liabilities are those whose values are affected by interest rate movement 2. For interest risk analysis, gap is calculated for each bucket according to repricing or residual maturity, whichever earlier 3. If they do not have contractual maturity, behaviourial maturities to be used 4. Gap analysis, though simple, forms the basis of calculations based on which Asset-Liability Mismatch limits are set © IMaCS 2009 Printed 26-May-11 177
126. Gap Report: Key concepts A gap report calculates the gap over different time intervals and the cumulative gap of a period  Gap report based on reprising maturities is used for analysis of Interest Rate Risk  Gap report based on actual maturities is used for analysis of Liquidity Risk Gap reports can be Static or Dynamic:  Static Gap report is based on actual data on assets, liabilities and hedges on a particular day  Dynamic Gap report is based on projections of assets, liabilities and hedges on a particular day taking into account bank‟s business plans © IMaCS 2009 Printed 26-May-11 178
127. Bucketing 1 to 14 days 15 day to 30 / 31 days (one month) Over one month and up to 2 months Over 2 months and up to 3 months Over 3 months and up to 6 months Over 6 months and up to 1 year Over 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years © IMaCS 2009 Printed 26-May-11 179
128. Bucketing of assets and liabilitiesLiabilities1. Capital Non-sensitivea) Equity and perpetual preferenceshares Non-sensitiveb) Non-perpetual preference shares Non-sensitive2. Reserves & surplus Non-sensitive3. Gifts, grants, donations &benefactions Non-sensitive4. Notes, bonds & debentures Sensitive; reprice on the roll- over/repricing date should be slotted in respective time buckets as per thea) Plain vanilla bonds/debentures repricing dates. Sensitive; could reprice on the exercise date of the option particularly in rising interest rate scenario. To beb) Bonds Debunture with placed in respective time buckets as per the nextembedded options exercise date. Sensitive; reprice on maturity. To be placed in respective time buckets as per the residual maturity ofc) Fixed rate notes such instruments. © IMaCS 2009 Printed 26-May-11 180
129. Bucketing of assets and liabilities(contd.)5. Deposits Sensitive: could reprice on the repricing date in case ofa) Term deposits from public floating or reprice on maturity if fixed Sensitive; reprice on maturity. To be placed in respective time buckets as per the residual maturity of suchb) ICDs instruments. Sensitive; reprice on maturity. To be placed in respective time buckets as per the residual maturity of suchc) Certificate of Deposit instruments.6.Borrowings Sensitive; reprice on maturity. To be placed in respective a) Term money borrowings from time buckets as per the residual maturity of such Banks instruments. b) From Bangladesh Bank, Govt., & Sensitive: could reprice on the repricing date in case of others floating or reprice on maturity if fixed c) Bank Borrowings in the nature of Sensitive: could reprise on the reprising date in case of WCDL, CC etc floating or reprise on maturity if fixed © IMaCS 2009 Printed 26-May-11 181
130. Bucketing of assets and liabilities(contd.)7. Current Liabilities & provisions: a) Sundry creditors Non-sensitive b) Expenses payable (other than interest) Non-sensitive c) Advance income received, receipts from borrowers pending adjustment Non-sensitive d) Interest payable on bonds/deposits Non-sensitive e) Provisions (other than for NPAs) Non-sensitive8. Contingent Liabilities a) Letters of credit/guarantees Non-sensitive b) Loan commitments pending disbursal (outflows) NA c) Lines of credit committed to other institutions (outflows) NA d) Outflows on account of forward Sensitive: should be bucketed according to the maturity of exchange contracts, rupee/dollar swap the contract Sensitive: could reprice on the repricing date in case of9. Commercial Paper floating or reprice on maturity if fixed Sensitive: could reprice on the repricing date in case of10. Others (Subordinate Debt) floating or reprice on maturity if fixed © IMaCS 2009 Printed 26-May-11 182
131. Bucketing of assets and liabilities(contd.)Assets1. Cash Non-sensitive2. Remittance in transit NA3. Balances with banks a) Current account Non-sensitive Sensitive; reprice on maturity. To be placed in respective time buckets as per the residual maturity of such b) Deposit /short-term deposits instruments. Sensitive: could reprice on the repricing date in case of4. Investments (net of provisions) floating or reprice on maturity if fixed5. Advances (performing) Sensitive; reprice on maturity. To be placed in respective a)Bills of exchange and promissory time buckets as per the residual maturity of such notes discounted & rediscounted instruments. Sensitive: could reprice on the repricing date in case of b) Term loans (only rupee loans) floating or reprice on maturity if fixed Sensitive: could reprice on the repricing date in case of c) Corporate loans/short term loans floating or reprice on maturity if fixed © IMaCS 2009 Printed 26-May-11 183
132. Bucketing of assets and liabilities(contd.)6. Non-performing loans Same as Bucketing criteria of SLG Sensitive on cash flows. The amounts should be distributed to the respective maturity buckets7. Inflows from assets on lease corresponding to the cash flow dates.8. Fixed assets (excluding assets onlease) Non-sensitive9. Other assets : a) Intangible assets & other non-cash flow items Non-sensitive Sensitive: could reprice on the repricing date in case of b) Interest and other income receivable floating or reprice on maturity if fixed In respective maturity buckets as per the timing of the c) Others cashflows.10. Lines of credit committed byother institutions (inflows) 1-14 day time bucket Sensitive: could reprice on the repricing date in case of11. Bills rediscounted (inflow) floating or reprice on maturity if fixed12. Inflows on account of forwardexchange contracts, dollar/rupee In the respective time buckets as per the residual maturityswaps of the underlying bills/transactions.13. Others NA © IMaCS 2009 Printed 26-May-11 184
133. Important points to be considered while auditing GapStatements for measuring interest rate risk Number of time buckets  Choosing too few may not give meaningful results  Choosing too many will be difficult to interpret  5 to 12 time buckets may be ideal Length of time buckets may depend on maturity mix of assets and liabilities  Length of bucket depends on the type of institution  It depends on the how developed the market for asset and liabilities are across maturities  The first few buckets are generally shorter Buckets should not be too heavy or light under “normal” conditions  A bucket having 30% or more of assets or liabilities should be split into two buckets  Buckets containing less than 5% of the assets or liabilities are considered light and should be combined © IMaCS 2009 Printed 26-May-11 185
134. Important points to be considered while auditing slottingof assets and liabilities for measuring interest rate risk  On and off- Balance sheet items are slotted into appropriate buckets as per maturities. Maturities can be classified into three types:  Repricing  Contractual  Remaining For estimating interest rate risk repricing maturities may be used.  For example: 5 year variable rate bond with a coupon of 6-months LIBOR will be slotted in the 6-month bucket as the bond will reprice according to movements in 6-month LIBOR.  Non-interest sensitive items like capital are slotted into the last time bucket. © IMaCS 2009 Printed 26-May-11 186
135. Group Exercise : Slotting of cash flows The bonds with following maturity details should be classified under which time bucket. Options are: (a) Less than 1 month, (b) 1 to 3 months, (c) 3 to 6 months, (d) 6 months to 1 year, (e) 1 to 3 years and (f) 3 to 5 years i. Today: 1st February, 2005 ii. Issue Date: 1st January, 2000 iii. Maturity Date: 30th June, 2005 iv. Bond reprices on 1st January © IMaCS 2009 Printed 26-May-11 187
136. Other important points to be considered while auditing slotting ofassets and liabilities for estimating interest rate risk Principal vs. The principal to be slotted in the contractual Cash Flows maturity Accrued interest, if shown in balance sheet, should be slotted in the bucket it will be actually received Amortizing Loans Calculate payments and segregate the principal and interest components Slot only the principal in the bucket Liabilities Liabilities with non-contractual maturities • Core vs. Volatile • Trend, seasonal and cyclical components © IMaCS 2009 Printed 26-May-11 188
137. Gap report Residual Impact of 1%Time Buckets RSA RSL GAP Period change in (Mid Point) Interest Rate A B C=A-B D 1%*C*D/121 to 14 days 797 390 407 0.25 0.0814 days to 30 / 31 days (one 297 349 -52 0.75 -0.03month)Over one month to 2 months 202 168 34 1.50 0.04Over 2 months to 3 months 1309 1240 69 2.50 0.14Over 3 months and up to 6 618 1051 -433 4.50 -1.63monthsOver 6 months and up to 1 year 1381 900 481 9.00 3.61Total 4604 4098 506 2.22 © IMaCS 2009 Printed 26-May-11 189
138. Different types of GapPeriodic Gap Gap for each time bucket Measures the income effects from interest rate changesCumulative Gap – Sum of periodic Gaps – Measures aggregate interest rate risk over the entire period © IMaCS 2009 Printed 26-May-11 190
139. Types of Gap: Positive Gap & Negative GapA negative gap for a particular time A positive gap for a particular timebucket is when the Rate Sensitive bucket is when the Rate Sensitive AssetsLiabilities exceed Rate Sensitive Assets exceed Rate Sensitive LiabilitiesLiabilities reprice faster than assets Assets reprice faster than liabilitiesLong term assets funded with shorter Short term assets funded with Long termterm liabilities LiabilitiesAn increase in interest rate leads to an An increase in interest rate leads to adecrease in NII increase in NII © IMaCS 2009 Printed 26-May-11 191
140. Illustration: A liability sensitive gap Gap and Cumulative Gap 1.Since there are more liabilities at the 150 shorter end, the institution is 100 50 borrowing short and lending long. 0 -50 -100 2. Therefore liabilities reprise faster -150 -200 than assets -250 1 2 3 4 5 6 7 3. Increase in interest rates leads to aPeriod 1 2 3 4 5 6 7 decrease in the Net interest income.Assets 20 50 60 40 80 100 150Liabilities 90 160 70 60 50 40 30 4. This is called a negative gap.Gap -70 -110 -10 -20 30 60 120Cum. Gap -70 -180 -190 -210 -180 -120 0 © IMaCS 2009 Printed 26-May-11 192
141. Illustration: An asset sensitive gap Gap and Cumulative Gap 1.Since there are more assets at the 250 200 shorter end, the institution is 150 100 borrowing long and lending short 50 0 -50 2. Therefore assets reprice faster than-100-150 liabilities 1 2 3 4 5 6 7 3. Increase in interest rates leads to anPeriod 1 2 3 4 5 6 7 increase in the Net interest income.Assets 100 150 70 60 50 50 30Liabilities 30 50 60 40 80 100 150 4. This is called a positive gapGap 70 100 10 20 -30 -50 -120Cum. Gap 70 170 180 200 170 120 0 © IMaCS 2009 Printed 26-May-11 193
142. Management of gaps Management should cap the gap for each time bucket and the cumulative gap based on  Regulatory requirement  Risk appetite of the Bank The gap can be adjusted to positive or negative based on the interest rate perception of the bank  Should have more rate sensitive assets in case of interest rates are perceived to go up  Should have more rate sensitive liabilities in case interest rates are perceived to go down © IMaCS 2009 Printed 26-May-11 194
143. Group ExerciseBank’s asset liability maturity profile is given below: Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 monthsTotal assets 97967 502495 71691 11519 44840 18937Total liabilities 203567 285347 285302 30967 4513 30701. Does the Bank have a positive gap or a negative gap?2. Find the interest rate sensitivity of the bank‟s NII to a 5% increase in interest rates for (a) Quarter (b) Half year (c) Year Assume all assets and liabilities as fixed rate. Hint: If interest rates change and we are noticing the impact for a quarter, only the cash flows relevant up to the quarter will be effected and for a quarter only © IMaCS 2009 Printed 26-May-11 195
144. Help guide for Exercise Step 1: Calculate the Net Gap Step 2: Calculate duration for repricing Step 3: Calculate the impact of 5% rise in interest rate on the NII by using the following formula: [(Net Gap) * (duration for repricing) * (period/12) * (change in interest rate)] © IMaCS 2009 Printed 26-May-11 196
145. Solution : Impact of 5% increase in interest rate for one Quarter Step 1: Calculate the Net Gap Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months Total assets 97967 502495 71691 11519 44840 18937 Total liabilities 203567 285347 285302 30967 4513 3070 Gap -105600 217148 -213611 -19448 40327 15867 Step 2: Calculate duration for reprising = [(3 months/ 12) – (Reprising after how much time)] 0.000 0.042 0.167 0.375 0.625 0.875 Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months Step 3: Calculate the impact of 5% rise in interest rate on the NII by using the following formula:= [(.25*-105600*.25*5%) + (.208*217148*.25*5%) + (.083*- 213611*.25*5%) ]= 12.98 © IMaCS 2009 Printed 26-May-11 197
146. Solution: Impact of 5% increase in interestrate for half year and full year For a quarter- 12.98 For half year- 0.500 0.458 0.333 0.125 x x 0. 5 x 5%= -672.7 -105600 217148 -213611 -19448 For whole year- 1.000 0.958 0.833 0.625 0.375 0.125 x x 1 x 5%= -3528 -105600 217148 -213611 -19448 40327 15867 © IMaCS 2009 Printed 26-May-11 198
147. Solution : Diagrammatic representation of the solutionImpact of a 5% upward shock on interest rate will be as follows: 500 2.0% 13 0 0.0% Quarter Half-year Full-year -500 0.0% -673 -2.0%-1000 -2.0%-1500 -4.0% NII % of PBT-2000 -6.0%-2500 -8.0%-3000 -10.0%-3500 -10.7% -3528-4000 -12.0% © IMaCS 2009 Printed 26-May-11 199
148. Relation between NII and interest rates NII Asset Sensitive Interest rates NII Liability Sensitive Interest rates NII Fully Hedged Interest rates © IMaCS 2009 Printed 26-May-11 200
149. Stress testing  Analyse the impact of change in interest rate due to parallel and non parallel shift in yield curve Impact of Residual Non-Parallel change inTime Buckets RSA RSL GAP Period Shift Interest (Mid Point) Rate A B C=A-B D E E*C*D/121 to 14 days 797 390 407 0.25 1% 0.0814 days to 30 / 31 days (one 297 349 -52 0.75 1% -0.03month)Over one month to 2 months 202 168 34 1.5 0.75% 0.03Over 2 months to 3 months 1309 1240 69 2.5 0.75% 0.11Over 3 months and up to 6 months 618 1051 -433 4.5 0.50% -0.81Over 6 months and up to 1 year 1381 900 481 9 0.50% 1.80Total 4604 4098 506 1.18 © IMaCS 2009 Printed 26-May-11 201
150. While Gap method is simple for estimating theinterest rate risk, it has a few limitations Gap method does not capture the impact of non parallel shift in yield curves, volatility, basis risk, mismatches within a time bucket, dynamic positions and change in timing differences Implications • Could lead to errors in risk quantification • Limits the ability to do sensitivity analysis © IMaCS 2009 Printed 26-May-11 202
151. There are four methods for measuring InterestRate Risk Gap Analysis method Duration and Convexity method Simulation and Scenario analysis method Value at Risk method Each method has its advantages, disadvantages and complexities which is explained subsequently. For this workshop, we will limit our discussions to Gap method and duration method. © IMaCS 2009 Printed 26-May-11 203
152. What is Duration? Duration is a quantitative technique to measure the “first order” interest rate sensitivity of assets and liabilities It is the weighted average maturity of a bond where the present value of cash flows is used as weights (Macaulay Duration) Duration is also a interpreted as a measure of the price elasticity of a bond (Modified Duration) The concept of duration can be used for: all assets, liabilities and off-balance sheet items, single asset, a portfolio of assets, or the entire balance sheet. © IMaCS 2009 Printed 26-May-11 204
153. How to calculate Macaulay Duration? Macaulay Duration can be measured as follows: N t 1 t PV (t ) D N t 1 PV (t ) Where t=Period, and PV(t)=PV of cash flows in period t Macaulay duration is a “time -weighted ” present value. © IMaCS 2009 Printed 26-May-11 205
154. How to calculate Modified Duration? Modified Duration can be measured as follows: dP D MD P di 1 i Where P = Price of the bond, and I = prevailing yield It can be shown that: D MD Change in Price ≈ MD x Change in Yield 1 i The Macaulay duration is easy to understand as an „average” maturity of an instrument. However, the more important use of duration is to predict “first order” price sensivity due to changes in the interest rate. Modified duration, elasticity to interest changes, is the measure for this. © IMaCS 2009 Printed 26-May-11 206
155. Mathematically duration is defined as follows Duration Convexity 1. Taylor series is a mathematical expression of the extent to which price changes with the change in interest rates 2. Mathematically duration is the first term of Taylor series 3. Convexity, is the rate of change of price owing to change in interest rates and contributes to the non-linear shape of the price-yield relationship © IMaCS 2009 Printed 26-May-11 207
156. Five steps in calculating duration of an asset orportfolioStep 1 Define timing and magnitude of cash flowsStep 2 Calculate PV (t). Sum Present Value of all cash flowsStep 3 Calculate t PV (t). Sum time –weighted Present Value of all cash flowsStep 4 Divide t PV (t) by PV (t)Step 5 Calculate Modified Duration © IMaCS 2009 Printed 26-May-11 208
157. Assumptions for Duration framework Duration measures the “first order” approximation of price sensitivity to interest changes and works exactly under the following assumptions: Change in • Change in interest rates must be “small”. interest rates • Cash flows do not change with interest rates. Exceptions: Cash flows Collateralised Mortgage Obligations (CMOs), Callable Bonds Yield change • Yield changes are assumed to be instantaneous Shift in curve • Parallel shift in the yield curve is assumed. © IMaCS 2009 Printed 26-May-11 209
160. Weighted average duration Weighted Avg.Serial No. Home Equity Loan Amount Duration Duration 1 A 100000.00 2.00 200000.00 2 B 200000.00 2.30 460000.00 3 C 300000.00 5.00 1500000.00 4 D 400000.00 3.20 1280000.00 5 E 500000.00 2.10 1050000.00 6 F 600000.00 2.20 1320000.00 7 G 700000.00 2.30 1610000.00 8 H 800000.00 1.50 1200000.00 9 I 900000.00 1.80 1620000.00 10 J 1000000.00 2.00 2000000.00 Total 5500000.00 12240000.00 (a) (b) Weighted Avg. Duration (b)/(a) 2.23 © IMaCS 2009 Printed 26-May-11 212
161. Duration Gap analysis Modified duration gap (DGAP) is derived as: DGAP = Modified DA-W*Modified DL Where W = RSL/RSA DA = Weighted average MD of Assets DL = Weighted average MD of Liabilities MD of equity = DGAP*Leverage Where Leverage = RSA/Net worth Net Worth = Equity + reserves and surplus © IMaCS 2009 Printed 26-May-11 213
163. Contd. RSA 4885.45 RSL 6001.52 DA 3.709696 DL 1.999689 Net worth 708.43 Equity + reserves and surplus W 1.228447738 RSL/RSA DGAP 1.253182572 DA-DL*W Leverage 6.896164759 RSA/Net-worthDuration of equity 8.642153489 Leverage*DGAP Duration of Equity of 8.64 means that an increase of interest rate by 1% would result in a decrease in equity by 8.64% © IMaCS 2009 Printed 26-May-11 215
164. Duration Ratio Duration ratio is defined as the ratio of the duration of assets to that of the liabilities. The impact on Net Interest Income (profitability) is as follows: Duration Ratio Net Sensitivity Interest rate ↑ Interest rate ↓ Less than 1 Liability Sensitive Adverse Favorable Impact on NII Impact on NII Equal to 1 Matched Insulated * Insulated* Greater than 1 Asset Sensitive Favorable impact Adverse Impact on on NII NII * Assuming parallel shift © IMaCS 2009 Printed 26-May-11 216
165. MATURITY GAP METHOD(IRS) THREE OPTIONS: A) RSA>RSL= Positive Gap B) RSL>RSA= Negative Gap C) RSL=RSA= Zero Gap © IMaCS 2009 Printed 26-May-11 217
166. Management of gaps Each bank to set its prudential limits on individual gaps with approval of Board Prudential limits set with respect to bearing on Total Assets, Earning Assets or Equity Bank‟s may work out their Earnings at Risk – 20-30% of last year‟s NII or NIM © IMaCS 2009 Printed 26-May-11 218
168. Business Strategy…Impact on NEV must be assessed Risk Mitigation Product mix Product Pricing•How much long term/short •Charging a premium forterm? products not offered by•Advance portfolio competitors?composition © IMaCS 2009 Printed 26-May-11 220
169. Investment Strategy…Impact on NEV must be assessed Risk Mitigation Maturity mix Rate profile of investments•How much long term/short •High risk-high return?term •Additional risk such as currency risk? © IMaCS 2009 Printed 26-May-11 221
170. Exercise : Estimate duration of a bond Face value of bond: Amount 100,000 Annual coupon rate: 12% Remaining maturity: 4 years Yield curve is flat at 11%Find the duration and modified duration of the bond. © IMaCS 2009 Printed 26-May-11 222
171. Exercise : Help guide for measuring duration andmodified duration of a bondStep 1 Define timing and magnitude of cash flowsStep 2 Calculate PV (t). Sum Present Value of all cash flowsStep 3 Calculate t PV (t). Sum time –weighted Present Value of all cash flowsStep 4 Divide t PV (t) by PV (t)Step 5 Calculate Modified Duration © IMaCS 2009 Printed 26-May-11 223
172. Solution : Estimating duration of a bond 1. The present value of cash flows A B C D (column C) is obtained by discounting Present the cash flows in column B with a Period Cashflow A*C Value discount rate of 11%. 1 12000 10811 10811 2 12000 9739 19479 2. Last column (column D) is the product 3 12000 8774 26323 of the discounted cash flows and time 4 112000 73778 295111 periods. Yield 11% 103102 351724 3. Duration is calculated by dividing the total of column D by that of column C 4. Duration divided by the discounting gives Modified duration. Sum of Col. D 3.411 Duration 3.411 M .Duration 3.073 Sum of Col. C 1 0.111. Modified Duration is an approximate measure of the price elasticity of a bond.2. A more exact measure can be calculated by using both duration and convexity © IMaCS 2009 Printed 26-May-11 224
173. Exercise: Estimate the impact of change ininterest rate and coupon on duration Consider the following 3 bonds Duration 3.411 M. Duration Maturity Coupon Yield 3.073 A 4 12% 11% B 4 11% 11% C 4 11% 10% 1. What is the impact on duration if coupon changes ? (Bond B) 2. What is the impact on duration if yield changes ? (Bond C) © IMaCS 2009 Printed 26-May-11 225
174. Solution: Impact of duration if couponchanges Consider the following 3 bonds Maturity Coupon Yield D=3.411 MD=3.073 A 4 12% 11% D=3.444 MD=3.102 B 4 11% 11% C 4 11% 10% 1. What is the impact on duration if coupon changes ? (Bond B) If the coupon decreases, the duration increases. In fact the duration of a zero coupon bond is equal to its maturity © IMaCS 2009 Printed 26-May-11 226
175. Exercise : Impact on duration if yield changes Consider the following 3 bonds Maturity Coupon Yield A 4 12% 11% D=3.444 MD=3.102 B 4 11% 11% D=3.453 MD=3.139 C 4 11% 10% 2. What is the impact on duration if yield changes ? (Bond C) If the yield decreases, the duration increases. © IMaCS 2009 Printed 26-May-11 227
176. Exercise: What is the duration of an portfolio Assume there is an investment portfolio of 3 assets:  Mark-to-market valuation: Amount 90, Amount 125 and Amount 65 respectively  Book values of the assets: Amount 80, Amount 130 and Amount 40 respectively  The duration of these assets are 2, 3.5 and 6 respectively. What is the duration of the portfolio? Hint: The Duration of a portfolio is the weighted average of the Mark-to-Market value of the portfolio. © IMaCS 2009 Printed 26-May-11 228
177. Solution: Duration of investment portfolio Mark-to-market value of the investment portfolio is :  (90 + 125 + 65)= 280 Average duration of the portfolio is (in years) : 90 2 125 3.5 65 6 3.598 280 Duration of a portfolio of assets (for assets or liabilities) n i 1 d i vi DP V © IMaCS 2009 Printed 26-May-11 229
178. Exercises (1): Rapid fire questionsQ 1 Modified duration is a more accurate measure of interest rate sensitivity than duration.1 True2 FalseQ 2 Duration of a bond generally increases with an increase in:1 Coupon2 Yield3 Term to maturity4 Frequency of coupon paymentsQ 3 Assuming the following bonds has the same yield, which one has the shortest duration?1 Zero coupon, 30-year maturity2 10% coupon, 30-year maturity3 Zero coupon, 5-year maturity4 10% coupon, 5-year maturity © IMaCS 2009 Printed 26-May-11 230
179. Exercises (2): Rapid fire questionsQ 4 With a zero coupon bond, duration is1 Less than maturity2 Greater than maturity3 Depends on yield4 Equal to maturityQ 5 Duration is a measure of1 Length of time until a bond matures2 Timing of cash flows weighted by the proportionate present value of cash flows3 Timing of cash flows weighted by the magnitude of cash flows4 Original maturity of the bondQ 6 An investment is made in a bond. The credit rating of the bond has been upgraded by the ratingagency. How would duration of the bond react? 1 Increase 2 Decrease 3 Does not change © IMaCS 2009 Printed 26-May-11 231
180. Exercises (3): Rapid fire questionsQ 7 A bonds modified duration is 3.7. Its value is Rupees 100,000. If interest rates increase by 20basis points, the price will:1 Decrease by Rupees 7402 Increase by Rupees7403 Increase by Rupees 74004 Decrease by Rupees7400Q 8 For regular coupon paying bonds (with no structured features), duration is:1 Equal to maturity2 Less than maturity3 Greater than maturity4 None of the aboveQ 9 Assuming the following bonds has the same yield, which has the shortest duration?1 10-year, 10% coupon2 10-year, 8% coupon3 10-year, 6% coupon4 10-year, zero coupon © IMaCS 2009 Printed 26-May-11 232
181. RISK MANAGEMENT FRAMEWORK ALM ORGANISATION
182. RISK MANAGEMENT FRAMEWORKA risk management framework encompasses the scope of risks to be managed, the process/systems and procedures to manage risk and the roles and responsibilities ofindividuals involved in the risk management.
183. Risk Management Framework• It includesA well constituted organisational structure defining clearly roles & resposibilities of individuals involved in risk taking & managing itAn effective Management Information SystemMechanism to ensure ongoing review of systems policies and procedures to adopt changes
184. BUSINESSLINE ACCOUNTABILITYIn every banking organization there arepeople who are dedicated to riskmanagement activities, such as risk review,internal audit etc. It must not be construedthat risk management is something to beperformed by a few individuals or adepartment. Business lines are equallyresponsible for the risks they are taking.Because line personnel, more than anyonee lse, understand the risks of the business,such a lack of accountability can lead toproblems.
185. Risk Evaluation/MeasurementTo adequately capture institutions riskexposure, risk measurement should representaggregate exposure of institution both risk typeand business line and encompass short run aswell as long run impact on institution.To the maximum possible extent institutionsshould establish systems / models that quantifytheir risk profile
186. Independent review.One of the most important aspects in riskmanagement philosophy is to make sure thatthose who take or accept risk on behalf of theinstitution are not the ones who measure, monitorand evaluate the risks.To be effective the review functions should havesufficient authority, expertise and corporatestature so that the identification and reporting oftheir findings could be accomplished without anyhindrance.
187. Contingency planningInstitutions should have a mechanism toidentify stress situations ahead of timeand plans to deal with such unusualsituations in a timely and effectivemanner.
188. Board and Senior Management OversightTo be effective, the concern and tone for riskmanagement must start at the top. While theoverall responsibility of risk management restswith the BOD, it is the duty of seniormanagement to transform strategic direction setby board in the shape of policies and proceduresand to institute an effective hierarchy to executeand implement those policies.
189. Board and Senior Management OversightThe formulation of policies relating to risk management onlywould not solve the purpose unless these are clear andcommunicated down the line. Senior management has toensure that these policies are embedded in the culture oforganization. Risk tolerances relating to quantifiable risks aregenerally communicated as limits or sub-limits to those whoaccept risks on behalf of organization. However not all risksare quantifiable. Qualitative risk measures could becommunicated as guidelines and inferred from managementbusiness decisions.
190. Board and Senior Management OversightTo ensure that risk taking remains within limitsset by senior management/BOD, any materialexception to the risk management policiesIntroduction and tolerances should be reportedto the senior management/board who in turnmust trigger appropriate corrective measures.
191. Board and Senior Management OversightTo keep these policies in line withsignificant changes in internal andexternal environment, BOD is expected toreview these policies and makeappropriate changes as and when deemednecessary.
192. BANGLADESH BANK RECOMMENDATION1. The Asset Liability Committee (ALCO) is responsible for balance sheet (asset liability) risk management.2. The responsibility of Asset Liability management is on the Treasury Department of the bank.3. Specifically, the Asset liability Management (ALM) desk of the Treasury Department manages the balance sheet.
193. BANGLADESH BANK RECOMMENDATION4. The results of balance sheet analysis along with recommendation is placed in the ALCO meeting by the Treasurer where important decisions are made to minimise risk and maximize returns.
194. BANGLADESH BANK RECOMMENDATION
195. BANGLADESH BANK RECOMMENDATION
196. BANGLADESH BANK RECOMMENDATION
197. BANGLADESH BANK RECOMMENDATION
198. BANGLADESH BANK RECOMMENDATION – POLICY STATEMENT
199. BANGLADESH BANK RECOMMENDATION – POLICY STATEMENT
200. Basel I Basel I was published in 1988 to set out a minimum capital requirement for Banks Basel I primarily focused on credit risk when published first, though in subsequent issue in 1996 the minimum capital requirement for market risk was introduced Under Basel I assets were classified under 5 risk categories as 0%, 10%, 20%, 50% and upto 100% based on the risk profile of the assets Banks with international presence were required to maintain capital of 8%. Basel I is now outmoded and a more comprehensive guidelines in the form of Basel II has been introduced © IMaCS 2009 Printed 26-May-11 255
201. Basel II Basel II was intended to cover risk in a more comprehensive manner as compared to Basel I Basel II is a three pillar system  Minimum capital requirement • Credit risk • Market risk • Operational risk  Supervisory review process • Regulatory framework for banks • Supervisory framework  Market discipline • Disclosure requirements for banks © IMaCS 2009 Printed 26-May-11 256
202. Menu for estimating capital as per Basel II Accord For Measuring Credit Risk  Standardized Approach  Foundation Internal Ratings-based Approach  Advanced Internal Ratings-based Approach For Measuring Market Risk  Standardized Approach  Internal VaR Models For Measuring Operational Risk  Basic Indicator Approach  Standardized Business Line Approach  Internal Measurement Approach © IMaCS 2009 Printed 26-May-11 257
203. Amendment to the Basel Accord to incorporate Market Risk In 1996, the Basel Committee amended the Basel Capital Accord to incorporate market risks. The Amendment separated the banks assets into: Trading Book Banking Book  This is the bank portfolio  This consists of other containing financial instruments, mainly instruments that are loans. internationally held for short-term resale and are marked-to-market.Amendment required institutions to hold capital to cover their exposure to market risks,associated with foreign exchange, commodity positions, debt and equity positions in thetrading account. © IMaCS 2009 Printed 26-May-11 258
204. To cover the capital charge for Market Risk, Baselsuggested “Tier III” capital1. To cover market risks as well as credit risks, Basel suggested another tier of eligible capital titled "Tier 3" capital.2. Tier 3 capital can only be used to support the market risk capital charge and will be limited to 250% of a banks Tier 1 capital.3. Only short-term subordinated debt with an original maturity of greater than two years.This implies that at least 28.5% of original Tier I capital has to be set aside forsupporting market risk © IMaCS 2009 Printed 26-May-11 259
205. Basel II approaches to measuring Market risk Market Risk InternalApproaches Standardise Models d Based Yield curve sensitivity VaR based- Bank‟s own (Duration) based. models stress- tested by Decided by the Regulator regulator Covering General Market + Specific *Amendment to the Basel Accord to Incorporate Market Risk (1996/8) © IMaCS 2009 Printed 26-May-11 260
207. Standardised Approach - Capital Charge for GeneralMarket Risk General Market Maturity Duration Or Method Method Risk weights specified by Basel 1. Yield curve shift specified, II, where Bank unable to and its impact on portfolio calculate duration calculated 2. Minor adjustments for non- parallel shifts in yield curve1.Time slotting of cash flows (on and off-balance sheet) into 15 categories.2.The change in portfolio value as a result of yield changes in Duration method“roughly” corresponds to the risk weights assumed © IMaCS 2009 Printed 26-May-11 262
208. Standardised Approach: Capital charge for General Market risk by Maturity MethodRisk Weights Low Coupon Normal Coupon 1 2 3 15 Residual Maturity buckets 1.In the maturity method, the cash flows are slotted into time buckets as per their residual maturities 2. Risk weights are applied as indicated in the table. © IMaCS 2009 Printed 26-May-11 263
209. Standardised Approach: Capital charge for General Market risk by Duration Method Assumed yield Zone 3 No. Mod. Duration change Zone 2 Changed Zone 1 1 1 month or less 1% Zone 1 2 1 to 3 months 1% Yield 0.6% 0.75% Current 3 3 to 6 months 1% 4 6 to 12 months 1% Zone 2 5 1.0 to 1.9 years 0.90% 6 1.9 to 2.8 years 0.80% 7 2.8 to 3.6 years 0.75% 1% Zone 3 8 3.6 to 4.3 years 0.75% 9 4.3 to 5.7 years 0.70% 10 5.7 to 7.3 years 0.65% 11 7.3 to 9.3 years 0.60% 12 9.3 to 10.6 years 0.60% 1 2 .. 13 10.6 to 12 years 0.60% 4 8 15 14 12 to 20 years 0.60% Residual Duration buckets 15 over 20 years 0.60%1. In duration method, instruments are slotted into time buckets as per their residualduration and their sensitivities calculated. This is summed across to determine capitalcharge2. Minor adjustments to capture basis risk (vertical disallowance) and between “Zones”(horizontal disallowance) are added to modify capital charge © IMaCS 2009 Printed 26-May-11 264
210. Standardised Approach: Capital Charge for Specific Risk 8.0% 1.Govt. Securities •T-Bills •Govt. Securities Capital Charge 2.Qualifying Category 1.60% •Public Sector Entities •Multilateral Development Banks •Investment Grade Securities 0% 3.Other 1.0% •Private Sector Entities 0.25% Specific Risk measures price changes of Govt. Other individual securitiesSecurities Qualifying Category Categories owing to the factors Maturity- Maturity - Maturity- 6m or less 6m - 24m greater than 24 related to individual m issuer. No offsetting of positions © IMaCS 2009 Printed 26-May-11 265
212. Basel market capital charge using VaR method(Internal Models Approach)1. Internally measured VaR with 99% confidence interval2. A horizon of 10 days or two calendar weeks3. An observation period of at least a year of historical data and updated at once a quarterCapital requirements will be the maximum of:1. Previous day‟s 10 day 99% VaR2. Average of daily VaR for the previous 60 days multiplied by a multiplication factor (3+ where (0,1)The alpha factor depends on the stress test of the VaR model and the discretion ofthe national supervisor © IMaCS 2009 Printed 26-May-11 267
213. Use of the discretionary plus factor forcalculating capital requirements for Market risk Less than 3 3- 6 6- 9 More than 9 Number of instances of breach of the daily VaR as stated by model 0 0.5 1 Reject VaR model This is the penalty component added to the multiplicative factor k, if backtesting reveals that the internal model incorrectly forecasts risks. It gives incentives to banks to improve predictive accuracy of models Specific Risk Specific risk is either the by the Standardized approach or that from internal models (not to be less than 50% of the Standardized amount) © IMaCS 2009 Printed 26-May-11 268
214. Basel III Basel III remains the same as Basel II with the major difference as given below:  Tier I capital has been increased from 4% to 6%  Core tier I capital is increased from 2% to 4.5% • Core tier I capital is common equity minus deductions  Capital conservation buffer is introduced in Basel III • A buffer of 2.5% of core capital needs to be plugged in addition to 4.5% to withstand future periods of stress bringing the total common equity requirements to 7%. This is to be implemented by 2019 • The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. © IMaCS 2009 Printed 26-May-11 269
215. Contd.  Countercyclical capital buffer • A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. • Banks that have a capital ratio that is less than 2.5%, will face restrictions on payouts of dividends, share buybacks and bonuses. The buffer will be phased in from January 2016 and will be fully effective in January 2019. • Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 1st January 2017 = 1.25%, 1st January 2018 = 1.875%, 1st January 2019 = 2.5% © IMaCS 2009 Printed 26-May-11 270
216. Current guidelines on ALM The current guidelines looks at the following parameters to be monitored  Loan to deposit ratio • Loan to deposit ratio should not increase more than 80% • Banks can also lend more than 80% by lending from capital or raise funds from interbank market, but excessive lending could put the bank under tremendous liquidity crisis in case liquidity in the market tightens  Wholesale borrowing guidelines • Set up guidelines for borrowing from the wholesale market • Reduce dependency on wholesale market for funding • Alternative products to borrow from the market • Set limits to borrow from the wholesale market © IMaCS 2009 Printed 26-May-11 271
217. Contd. • Number of parameters needs to be analyzed to determine the limit of borrowing from the wholesale market - Balance sheet size of the bank - Historical trend of the market liquidity - Credit rating of the bank - Stability of liquidity and interest rates in the market  Commitments • These are undrawn parts of the overdraft limit given to the customers, which may be withdrawn at any point in time • There should be limit to the undrawn part of the commitment • The limit should be visa-a-via the undrawn part from the wholesale borrowing limit © IMaCS 2009 Printed 26-May-11 272
218. Contd.  Medium term funding ratio • Banks borrow sort term and lend long term, thereby there are mismatches. • Thus the Bank needs to have medium term sources of funds • Medium term funding ratio is calculated as the ration of liabilities with maturity more than 1 year to that of assets maturing in more than 1 year • This ratio shows the extent to which the bank is dependent on roll over to fund medium term assets  Maximum cumulative outflow • This can be calculated for different tenors, for example a month or a year. • The MCO should be limited to the maximum amount that could be raised from the wholesale market and the amount of liquid assets held by the bank © IMaCS 2009 Printed 26-May-11 273
219. Contd.  Swapped fund guidelines • There should be cap on the maximum amount in absolute terms that can be swapped from foreign currency liabilities in order to fund domestic currency assets or vice-versa. • This is to prevent excessive dependence on the foreign exchange market  Local regulatory compliance • Maintain CRR, SLR and capital adequacy ratios  Liquidity contingency plan • Prepare a liquidity contingency plan to manage liquidity crisis • Maintain liquid assets in the form of reserve assets, t-bills, specific Government securities, open foreign currency position and specific FDR’s © IMaCS 2009 Printed 26-May-11 274
220. Contd. Maturity profile mismatches for liquidity risk and interest rate risk  Classification of the balance sheet into different time buckets based on the maturity profile and behavioral pattern for liquidity risk and based on re-pricing or maturity for interest rate risk  Calculation of mismatches between inflows and outflows for every bucket and also the cumulative outflow Based on the mismatches the ALCO takes the following action points  Deposit mobilization or growth in assets in the appropriate time buckets  Cash-flow plan (long/short) based on market interest rates and liquidity  Change in FTP or customer rates  Address to the breach in limit and also provide plan to bridge the gap  Address all regulatory compliance © IMaCS 2009 Printed 26-May-11 275
221. Contd. VaR  Calculation of expected loss at a confidence interval of 97.5% as to loss due to change in market rates Factor sensitivity  To estimate the change in value of the instruments with move in interest rates by 1 bps (PV01) Management action trigger (MAT)  Is equal to the current VaR + latest rolling monthly P/L (21 working days)  It is a trigger point of a persistent loss making position © IMaCS 2009 Printed 26-May-11 276
222. Contd. Other analysis done  Overall assessment of the market interest rates and liquidity  Peer group comparison on deposit and lending rates  Balance sheet performance as compared to the lat month  Three day liquidity stress, wherein it is assumed that more outflows are there as compared to normal days for the next three days © IMaCS 2009 Printed 26-May-11 277
223. Organization structure The responsibility of ALM is on the treasury department  Managed by the ALM desk of the treasury department  The roles and responsibilities of the ALM desk are as follows • Assume overall responsibility of the money market activities • Manage liquidity and interest rate risk of the Bank • Comply with statutory requirement • Understanding market dynamics, i.e. competition, potential target markets, etc. • Deal with dealer authorization limits • Provide market views to the treasurer  The analysis and recommendation is presented to ALCO ALCO is set up and is responsible for the overall management of the balance sheet risk © IMaCS 2009 Printed 26-May-11 278
224. Recommendations … 1 Organization structure to be decided Roles and responsibilities to be defined Process flow has to be put in place for proper and smooth functioning of the ALM MIS  Define systems  Data flow © IMaCS 2009 Printed 26-May-11 279
225. Recommendations … 2 Liquidity risk management  Bucketing criteria to be defined  Set limits for each bucket as the tolerance limit (both positive and negative gaps)  Set limit for cumulative gap  Analysis of detailed ratio analysis (some are covered but there are other that also need to be monitored)  Dynamic liquidity statement to be done on a fortnightly basis  Resource planning to be done  Stress testing and models  Back testing © IMaCS 2009 Printed 26-May-11 280
226. Recommendations … 3 Interest rate risk  Define bucketing criteria  Define limits for gaps  Implement the entire process for NEV method for interest rate risk management  Stress testing In case of FOREX exposure the Banks should also implement the ALM in managing Currency risk using the net open position method © IMaCS 2009 Printed 26-May-11 281
227. DISCLAIMERIMaCS does not assume any liability, financial or otherwise, for any loss or injury that the user of therecommendations in this report may experience in any transaction. All information contained herein isobtained by IMaCS from sources believed by it to be accurate and reliable. Although reasonable carehas been taken to ensure that any information herein is true, such information is provided „as-is‟ withoutany warranty of any kind and IMaCS, in particular, makes no representation or warranty, express orimplied, to the accuracy, timeliness or completeness of any such information. The analysis andrecommendations should not be construed to be a credit rating assigned by ICRA‟s rating division forany of the company‟s debt instruments. © IMaCS 2009 Printed 26-May-11 282