ALM PRESENTATION_MALIOUKIS_SOFIA_BG

''BANK ASSET AND LIABILITY
MANAGEMENT''
Financial Instruments and Applications
29 – 30 April, Sofia, Bulgaria
Ilias Malioukis

Agenda
Day 1
ALM concepts and tools
Day 2
Instruments and applications
17/03/2016 2Ilias Malioukis - Bank ALM

INTRODUCTION

Where We Are ?
Source: Zerohedge, Datastream

Where We Are ?
Source: The Banker, Feb. 2012

Where We Are ?
Source: The Banker, Feb 2012

Where We Are ?

Where We Are ?
• Low interest rates
• Volatility spikes in most asset classes
• Sovereign debt sustainability increasingly
questioned
• Banks facing funding difficulties, capital needs
• Banks deleveraging
• Slow economic growth
• Fail of trust (banks, rating agencies, “leaders”)

Case Study: Bank Deleveraging Plans
Source: Barclays Capital

Case Study: Bank Announced Job Cuts
17/03/2016 11Ilias Malioukis - Bank ALM Source: Bloomberg

Case Study: Central Bank Activity, ECB
Source: Citi Global Markets
US Data

Case Study: Central Bank Activity, FED
Source: Citi Global Markets
US Data

How We Arrived ?
Credit
Growth
Asset
Price
Growth
The
Growth
Triangle
Economic
Growth

How We Arrived ?
17/03/2016 15Ilias Malioukis - Bank ALM Source: Wikipedia

How We Arrived ?
• Illusion that a riskless risk was discovered (e.g.
CDO’s, CMO’s, CLO’s and other structures)
• Financial sector grow too big (risk was
misunderstood, policy makers encouraged
expansion)
• Persistence of global imbalances
• Accommodative monetary policy
• Lack of recognition of asset prices in policy
formulation

How We Arrived ?
• Financial innovations w/o adequate regulation
• Credit boom with lowering of credit standards
• Inadequate corporate governance
• Inappropriate financial sector incentives
• Overall lax oversight of the financial system
• Bypassed regulators (Conduits, SIVs)
• Rating agencies collusion
• Contagion

Case Study: Risk Management Failures
Risk management systems failed in many cases more due to
poor corporate governance than due to the adequacy of the
mathematical models used.
Source: Bloomberg

• Emphasis on income, mistreated risk
• Overlooked underlying asset quality
• Some aimed in enhancing their position on fixed
income league tables trading CDO’s
• Relied on flawed rating agency ratings ( e.g.
AAA on CDO’s)
• Bank culture promoted excessive risk taking
• Rewards not related to long term performance

• Partially hedged credit exposures
• VaR models could not adequately capture
asymmetric payoffs of structured products
• Poor collateral exchange and collateral
monitoring mechanisms
• Netting of positions hide risks not shown in VaR
models
• Poor risk controls

Where We Go?
• Risk re-pricing
• Deleveraging
• Structural changes
• Business refocusing
• Regulatory changes
• Slowdown of global economy

Where We Go ?
• Banks to report additional impairments on sovereign exposures
• Sovereign exposures to continue being reduced
• ECB 3y LTRO success contained peripheral spread widening (carry trades)
• Process of stabilizing EU banks is progressing
• “The New Normal” is lower growth and returns (commensurate with productivity)
• Leverage happens much more slowly than the past era of Great Leverage that
lasted 30 years.
• Selective sectors or countries can de-lever sharply
• Ability of investors to earn returns well in excess of inflation or nominal GDP is
limited.
• Inflation to pick-up
• From capitalism to “talentism” (e.g. Apple)

Where We Go ?
Assets to deliver the most return (Pimco Investment Outlook, April 2012)
 Real as opposed to financial assets – commodities, land,
buildings, machines
 Financial assets with shorter spread and interest rate durations
 Financial assets of entities with strong balance sheets exposed to
higher real growth, for which developing vs. developed nations
should dominate
 Financial assets that benefit from favorite policy thrusts form both
monetary and fiscal authorities
 Financial or real assets which are not burdened with excessive
debt and subject to future haircuts

Where We Go ? Banking In Context
17/03/2016 24Ilias Malioukis - Bank ALM Source: Foreign Policy Magazine, Sep-Oct 2011

“The financial memory should be assumed to last,
at a maximum, no more than 20 years. This is
normally the time it takes for the recollection of
one disaster to be erased and for some variant on
previous dementia to come forward to capture the
financial mind. It is also the time generally
required for a new generation to enter the scene,
impressed, as had been its predecessors, with its
own innovative genius.”
Kenneth Galbraith
Epilogue

BANKING CONCEPTS

What is a Bank ?
The term can be applied to a range of financial institutions:
 Thrifts or S&L’s (US) {housing loans and deposits}
 Building societies (UK) {customer held, mortgage specialized}
 Credit unions {members participation, business loans and
deposits}
 Merchant banks (UK) {provide capital for share ownership,
consult}
 Cooperative banks {customer held, cooperative principle, l&d}
 Central banks {monetary control, regulations, place
government debt}

What is a Bank ?
 Commercial banks {wholesale and retail intermediation,
payments}
 Investment banks {underwriting, m&a’s, trading, custody,
consulting, fund management}
 Universal banks {commercial and investment services,
insurance}, and....
 “Non banks” ( e.g. General Electric Capital, BMW Financial
Services, Marks & Spencer) {provide loans but w/o deposits}
 “Shadow banks” – represented ~30% of the total financial
system - (Conduits, SIVs, Hedge Funds, MM Funds)

What are the Main Banking Models ?

What is the Environment a Bank Operates?

Financial Sector Development Framework

What are the Key Functions of a Typical Bank ?
Bank
Financial
Institutions
Firms,
Households,
State,
Foreigners
Central Bank
Firms,
Households,
State,
Foreigners
Attract
Deposits
Provide
Loans
Lend money
at ASK
Borrow money
at BID
Firms and
Public
Institutions
Underwrite
and place
Asset
Management

1. Intermediation between depositors and borrowers
Factors to consider:
1. Intermediation costs
2. Cost of capital
3. Credit risk premia
4. Taxes and regulatory
costs
5. Profitability
6. Competition

2. Liquidity provision
 Deposits withdrawal
 Loan provisions
 Loan prepayments and extensions
 Trading liquidity, underwriting and placements
3. Asset transformation
 Short term deposits to loans
 Asset and liability pooling and diversification
 Asset management

4. Risk transformation
 Risk sharing (e.g. asset pools)
 Risk insurance (interest rate, inflation, liquidity
etc.)
5. Payment mechanism
 Transfers among individuals
 Debiting and crediting of accounts
6. Credit reference and information related services

What are the Key Business Lines of a U- Bank ?

Activities of a Bank: Directive 89/646/EEC
• Acceptance of deposits and other repayable funds
from the public
• Lending
• Financial leasing
• Money transmission services
• Issuing and administering means of payments ( e.g.
credit cards, travelers' cheques & bankers’ drafts)
• Guarantees and commitments

• Trading for own accounts or the account of
customers in
 Money market instruments (cheques, bills, CDs,
etc.)
 Foreign exchange
 Financial futures and options
 Exchange and interest rate instruments
 Transferable securities

• Participation in share issues and the provision of
services related to such issues
• Money broking
• Portfolio management and advice
• Safekeeping and administration of securities
• Credit reference service
• Safe custody service

Financial Statements

The Balance Sheet of a Bank: Assets
 Cash and deposits (CB, Interbank, Cash
collaterals)
 Financial Assets (Trading, AFS, HTM, DFV)
 Reverse Repos
 Derivatives
 Loans (Residential, Personal, Credit Cards,
Business and Government)
 Investments in associates, subsidiaries and JV’s
 Other (PP&E, Tax Assets, Goodwill etc.)

The Balance Sheet of a Bank: Liabilities
 Deposits (Customers, Banks, Cash
collaterals )
 Repos
 Financial liabilities (Trading, DFV, Debt
Issued)
 Derivatives
 Other (Acceptances, Securities Sold Short,
Tax Liabilities, etc.)

The Balance Sheet of a Bank: Equity
 Share capital (i.e. FV of shares issued)
 Share premium (paid in excess of FV)
 “OCI” (CTA, Pension liability adjustments,
unrealized gains/losses on CF hedging and AFS
securities)
 Retained earnings
 Treasury shares (i.e. repurchased shares)
 Minority interest (i.e. subs not owned 100%)

The Income Statement of a Bank: NII
• Interest Income
 Loans
 Securities (Trading, AFS, HTM, DFV)
 Reverse repo agreements
 Other (Deposits with banks etc.)
• Interest Expense
 Customer Deposits
 Securities issued
 Other liabilities

The Income Statement of a Bank
• Provisions for credit losses/ credit recoveries
• Non - Interest Income
 Fees (Capital Markets, Custodial and Investment
Management etc.)
 Commissions (Payments, Deposits etc.)
 Trading
 Other revenue (Credit Cards, Mutual Funds,
Securitization etc.)

Case Study: UBS

ALM CONCEPTS

What is ALM ?
ALM is the most important risk
management function of a bank and an
integral part of its financial
management.

ALM attempts to create an appropriate
risk – reward ratio commensurate with
the bank’s profile and its stakeholders
demands.
What is ALM ?

It is an attempt to match assets and
liabilities in terms of maturities and
interest rates sensitivities in order to
minimize the interest rate and liquidity
risks.
What is ALM ?

ALM can be termed as a risk management
technique designed to earn an adequate return
while maintaining a comfortable surplus of assets
beyond deposits (i.e. liquidity). It takes into
consideration interest rates, earning power, and
degree of willingness to take on debt and hence
is also known as “Surplus Management”.
What is ALM ?

“A planning procedure that accounts for all assets and
liabilities of a financial institution by rate, amount, and
maturity. Its intent is to qualify and control risk. It
focuses on the risk management of the net interest
margin for profit. ALM planning impacts directly on the
volume, mix, maturity, rate sensitivity, quality, and
liquidity of a bank’ s assets and liabilities.”
Encyclopedia of Banking & Finance, C.J. Woelfel, 1994
What is ALM ?

What is ALM ?

History of ALM
• Roots in the duration analysis proposed by
Macaulay in 1938 and Redington in 1952
• Developed further in the 1970’s as a hedging
reaction against the rising risks of financial
intermediation and markets deregulation
• Chain risks: Foreign exchange risk  Interest rate
risk  Liquidity risk  Credit risk  Equity risk

History of ALM
US Fed Funds Target Rate Evolution 1971-2012

History of ALM
USD/GBP Exchange Rate Evolution1971-2012

History of ALM
• Reasons for ALM
 Compliance  Risk management  Financial
planning  Funds management  Formation and
evaluation of financial targets  Strategy formation
 Maximize firm value
• ALM Techniques
 Cash flow gap  Duration gap  Scenarios
 Internal models (VaR, EaR, GARCH, EGARCH) 
CVAR  Simulations  Copula approaches

What are ALM’s Main Objectives ?
• Coordinate the balance sheet management
• Control risks
• Maximize NII
• Regulate cash flows
• Maintain adequate capital
• Design and implement high level b/s strategy
• Evaluate external factors and their impact

What Risk is Most Important for ALM ?
• Credit risk ?
• Counterparty risk ?
• FX risk ?
• Liquidity risk ?
• Cash flow risk ?
• Funding risk ?
• Capital adequacy risk ?
• Market risk ?
• Interest rate risk ?
• Equity risk ?
• Optionality risk ?
• Sovereign risk ?
• Pricing risk ?
• Product risk ?
• Commodities risk ?
• Collateral risk ?
• Basis risk ?

ALM Best Practices
• Understand the ALM Concept
• Have a comprehensive recognition of banking risks
• Develop an information system
• Design and implement the ALM decision making process
• Apply effective risk management procedures
• Have an ALM policy
• Secure senior management engagement and
understanding
• Establish the appropriate internal governance structure
(ALCO, Risk Committee, Audit Committee etc.)

ALM Best Practices
• Clearly define authorities
• Allocate internal limits
• Evaluate and monitor risks effectively
• Mange “Net” positions
• Evaluate the liquidity of hedged items as well as
unwinding risks
• Look return vs risk and not only the bottom line
• Judge when and how much to hedge
• Employ accurate and timely data

ALM Risks to Measure
• Current positions
• Re-investment risks
• Path risks
• Hedge unwind risks
• Event risks

ALM Summary
• What risk are mainly managed in ALM ?
 Interest rate risk
 Liquidity risk
 Other market risks (i.e. FX risk etc.)
 Counterparty, credit and operational risks
• Why ALM ?
 Maximize profits
 Minimize risks

BANKING RISKS:
MANAGEMENT’S PERSPECTIVE

What is Banking Risk ?
Definition 1:
Risk is the likelihood of losses taking
into account the magnitude of potential
recoveries.

What is Banking Risk ?
Definition 2:
It is the probability that the actual
return on a banking investment will
differ from its expected return due to
internal and/or external factors.

What is Risk Management’s Goal ?
The goal of risk management in banks
is to enhance the risk/return profiles of:
 Transactions
 Business lines
 Portfolios
...and therefore ultimately enhance the
entire bank’s portfolio risk/return profile

What are the Main Banking Risks ?

How Can We Classify Banking Risks ?

Financial Instrument Risks Examples

Level of Risk Management
Micro Level (decentralized)
• Interest Rate Risk (dealer, desk, BU level)
• Liquidity Risk (dealer, desk level)
• Market‐, Counterparty‐, Credit‐ and Operational Risk
(dealer, desk, BU level)
Macro Level (centralized)
• Interest Rate Risk (ALCO/RC)
• Liquidity Risk (ALCO/RC)
• Market‐, Counterparty‐, Credit‐ and Operational Risk
(ALCO/ORC/RC)

An Integrated Risk Management Framework

• Internal environment
Internal environment describes the work environment and
risk preferences of an organization and sets the framework
for how risk is viewed and addressed by its management and
employees. Internal environment includes risk management
philosophy, risk appetite, integrity and ethical values, and the
environment in which they operate.
• Objective setting
Objectives must be set up-front. Risk management
function should ensure that there is a process for corporate
management to set the objectives, that the chosen objectives
support and align with

• Event identification
Internal and external events affecting achievement
of an entity’s objectives must be identified, distinguishing between
risks and opportunities. Opportunities are channeled back to
management’s strategy or objective-setting processes.
• Risk assessment
Risks are analyzed, considering the likelihood of
occurrence and impact, as a basis for determining how they should
be managed. Risks are assessed on an inherent and a residual
basis.
• Risk response
Management selects risk responses—avoiding, accepting,
reducing, or sharing risk—developing a set of actions to align risks
with the entity’s risk tolerances and risk appetite.

• Control activities
Policies and procedures should be established and
implemented to help ensure the risk responses are
effectively carried out.
• Information and communication
Relevant information is identified, captured, and
communicated in a form and timeframe that enable people to
carry out their responsibilities. Effective communication also
occurs in a broader sense—flowing down, across, and up the
entity.
• Monitoring
The entirety of enterprise risk management must be
monitored and modifications made as necessary.

Management’s Risk Responsibilities
• Develop and recommend strategic plans and risk
management policies for board approval
• Implement strategic plans and policies after approval by
the board
• Establish an institutional culture promoting high ethical and
integrity standards
• Ensure development of manuals containing policies,
procedures, and standards for the bank’s key functions
and risks

Management’s Risk Responsibilities
• Implement an effective internal control system, including
continuous assessment of all material risks that could adversely
affect the achievement of the bank’s objectives
• Ensure the implementation of controls that enforce adherence
to established risk limits. Ensure immediate reporting of
noncompliance to management
• Ensure that the internal auditors review and assess the
adequacy of controls and compliance with limits and procedures.
• Develop and implement management reporting systems that
adequately reflect business risks

Case Study: Barclay’s Risk Organization

THE ALCO

What is the ALCO Committee?
The Asset and Liability Management Committee is
a permanent committee composed by members of
the General Management and Senior Managers,
actively involved in the management of the assets
and liabilities of the Bank. It is the most important
decision making body from the asset and liability
point of view.

What is the ALCO Committee?
CEO
Treasury CFO Risk
ALCO

What is the Objective of the ALCO ?
The Asset and Liability Management Committee’s objective is to
manage asset and liability composition (volume, diversification and
mix) and to ensure prudent balance sheet shape. It reviews market
exposures, particularly currency and interest rate exposures,
operational liquidity, pricing strategies, regulatory requirements and
developments and capital adequacy directives. It is responsible for the
prudent planning and management of the on - and off - balance sheet
of the Bank in order to optimize the Bank’s overall performance,
particularly the spread between funds raised and the interest earned
on the Bank’s assets while at the same time to ensure adequate
liquidity and to constrain risk to acceptable levels.

What is the Objective of the ALCO ?
It also ensures efficient use of capital within regulatory limits by
considering the potential consequences of the undertaken risks
due to balance sheet structure, interest-rate movements,
liquidity constraints, and exposure both to market risk ( foreign
exchange, derivatives, commodity and equity) and credit risk in
relation to the wholesale portfolios and the banking book.

What is the Composition of the ALCO ?
• Chief Executive Officer
• General Management (i.e. EXCO Members, Head of
Retail Unit, Head of Wholesale Unit)
• Head of Treasury
• Chief Risk Officer
• Chief Financial Officer
• Chief Accounting Officer
• Chief Economist

What are the Responsibilities of the ALCO ?
1. Analyze and monitor the Bank’s Balance Sheet in terms of :
• maturity match of assets and liabilities (duration and gap analysis)
• sensitivity/ scenario analysis and Earnings at Risk
• liquidity, liquidity ratios, liquidity gaps, liquid assets and relevant limits
• deposit structure and liability composition (evolution, market share,
competition, pricing)
• loan portfolio and asset structure (evolution, market share, competition,
pricing)
• trading portfolio performance and limits
• short and long term funding of balance sheet items
• capital adequacy
• interest rate gaps and relevant limits

2. Analyze and monitor the Bank’s market risks:
• interest rate risk of the banking book and the impact on Net
Interest Income as a result of interest rate fluctuations
• interest rate risk of the trading book and the impact on the books’
value as a result of interest rate fluctuations
• foreign exchange risk
• commodity risks
• equity risk
• credit spreads
• correlation risks

3. Review the appropriateness of the existing asset-liability strategy
and set measurable targets (e.g. efficiency ratios, management
action triggers) for its achievement.
4. Ensure that the investment portfolio has risk/return
characteristics consistent with the Bank’s current asset-liability
strategy.
5. Decide the level of interest rates paid and charged to all
categories and types of deposits for customers.
6. Develop headline framework for new products and services.

7. Explore and manage alternative pricing and hedging strategies.
8. Monitor the competition, the developments and the trends of the
financial markets where the Bank carries out its activity.
9. Analyze the quality of the assets and liabilities of the Bank and
propose to the Executive Committee solutions and measures to be
taken in order to improve it.
10. Analyze and monitor the Bank’s compliance with the internal
and external regulations related to the management of assets and
liabilities, and make appropriate recommendations.

11. Review performance and ratios versus internal and external or
regulatory ratios.
12. Approve liquidity measurement techniques.
13. Assess liquidity risks and perform cash flow planning.
14. Approve market risk guidelines, strategy and market risk
organizational structure in order to ensure that they remain in line with
the Bank’s risk appetite, activities and business objectives.
15. Oversee the implementation of the market risk management
strategy, policy and procedures, and ensure the appropriate
communication or escalation of market risk management issues.

16. Review on an annual basis the market risk management
policy, the proposed risk identification measures (including
the appropriateness of stress test scenarios) as well as other
internal or external indicators employed to identify potential
problems/crises (e.g. liquidity problems).
17. Approve the trading limits.
18. Approve amendments to the existing Asset and Liabilities
Management (ALM) Policy
19. Review and approve the Contingency Funding Plan.

20. Propose to the Executive Board policies and procedures for
market risk management and determine the criteria of
acceptable level of exposure to market risk.
20. Submit to the Executive Committee reports on position and
changes in assets and liabilities and propose measures and
activities for matching the maturity structure, maintaining
liquidity, managing risk and other reports.
21. Assist the Board of Directors in fulfilling any other duties
related to the management of the Bank’s assets and liabilities.

Decision Making Matrix Example

What are the Reports and Tools of the ALCO ?
1. Minutes of previous ALCO meeting
2. Overview of the current economic environment and projections, including:
• Economic outlook (including interest rate and exchange range forecasts)
• Political environment
• Regulatory developments
• Fiscal policy
3. Status of Bank’s current strategies, including:
• Asset growth
• Funding and liquidity
• Foreign exchange risk
• Interest rate risk
• Credit risk
• Target ratios (e.g. loans / deposits, gearing, capital adequacy, efficiency ratio,
non-interest income / total income, provisions

4. Evaluation and analysis of:
• Interest rate risk
• Liquidity risk
• Foreign-exchange risk
• Commodity risk
• Equity risk
• Credit risk
• Capital adequacy
5. Proposed Strategies/Plans, including:
• Funding strategies (savings deposits, time deposits)
• Investment strategies (liquid assets, overnight funds, loans, other investment
strategies)
• Hedging strategies (interest rate cycle, specific events)

6. VaR: Estimate of the maximum expected loss, under normal market
conditions, over a given time horizon and with a specified confidence level.
7. EaR: Measures the potential losses that could impact earnings before
tax over the next months.
8. Ratios: Liquidity, balance-sheet, interest rate, foreign exchange and
capital adequacy ratios.
9. Stress Testing: Sensitivity analysis on specific risk factors such as
interest rates and foreign exchange prices.
10. Management Action Triggers: Trigger levels which indicate
Management’s tolerance for accepting relevant risks.
11. Regulatory Reporting.

ALCO Ratios
General objectives:
1. A return on equity above ____ %
2. A return on assets above ____ %
3. An equity capital to assets ratio above ____ %
4. Cost to income ratio ____ %
5. Tier 1 Capital of ____ %
6. Capital adequacy ratio above ____ %
7. Risk weighted assets growth of ____ %

ALCO Ratios
Liquidity:
1. Liquidity Asset Ratio higher than ____ %
2. Loans/Deposits Less than ____ %
3. Investments/Deposits Less than ____ %
4. Debt/Capital less than ____ %
5. Retail/Wholesale funding not Less than ____ %
Profitability:
1. The minimum acceptable rate differential between average
liability cost and average asset yield on new business will
be ____ basis points.

ALCO Ratios
Risk:
1. Rate Sensitive Assets/Rate Sensitive Liabilities
____ to ____ %
2. Gap (RSA - RSL)/Total Assets Less than _____ %
3. Gap/Equity Less than _____ %

ALCO Reports Example

PROFITABILITY RATIOS

Profitability Ratios

Return on Equity (ROE)
• Shareholder value is created when the market
value of shares exceeds the equity invested.
• The cost of equity is the minimum return
demanded by shareholders.
• Cost of equity = risk-free rate on bonds + risk
premium. (CAPM)
• Value for shareholders is created when ROE
> cost of equity

Return on Equity (ROE)
ROE = PAT/ EQUITY

Return on Equity (ROE) Breakdown
ROE = PAT/ EQUITY

Example: ROE Calculation

Risk Adjusted Return on Capital (RAROC)
RAROC = Allocated Profit/Allocated Equity
Shareholder value creation  RAROC > C.E.

Economic Value Added (EVA)
EVA = Allocated profit after tax – cost of allocated
equity
Where cost of allocated equity = Allocated equity
amount * cost of equity
EVAA = 2 – (15% * 10) = 0.5
Shareholder value creation  EVA > 0

Exercise

Return on Assets (ROA)
ROA = PAT/ Total Assets
ROA = 10.8 / 1000 = 1.08%

REGULATORY ENVIROMENT

Corporate Governance of Banks

Bank Supervision

Basel Regulatory Standards Comparison
Basel I
• Single approach (rac)
• Arbitrary weights
• No reflect of individual
risks/ expertise
 Loan mix
 Concentrations
 Risk expertise
Basel II
• Three pillars
• Risk weights
• Rating agencies
• Permits internal
approaches reflecting
risks/ expertise
Basel III
• Stricter definition of capital and
additional capital buffers (capital
conservation buffer, discretionary
countercyclical buffer)
• Two new required liquidity ratios
(liquidity coverage ratio, net
stable funding ratio)
• Introduction of a minimum
leverage ratio (CT1/A>3%)
• Addition of CVA
• Incentives to move OTC
derivatives to central
counterparties
• Sovereign risks not risk free

Capital and Capital Adequacy
• Capital is required as a buffer against
unexpected losses (normal losses should be
covered by earnings).
• Capital cannot substitute for bad management
or for inadequate risk management policies and
practices.

Capital consists of a strong base of permanent
shareholders’ equity and disclosed reserves,
supplemented by other forms of qualifying
capital (for example, undisclosed reserves,
revaluation reserves, general provisions for loan
losses, hybrid instruments, and subordinated
debt).

International standards for minimum capital and
for assessment and measurement of capital
adequacy are set by the Basel Accord (Basel II),
which defines three tiers of capital. The first two
cover credit risk related to on- and off-balance-
sheet activities, derivatives, and operational risk;
the third tier partially covers market risk.

• Basel II set the total capital adequacy ratio at no
lower then 8 percent. The capital ratio is calculated
using the definition of regulatory capital and risk-
weighted assets.
• The 8-percent ratio must be seen as a minimum. In
transitional or volatile environments, a risk-weighted
capital adequacy requirement of substantially more
than 8 percent would be more appropriate.

In practice, capital adequacy is calculated
according to formulas prescribed by the
respective regulatory authorities (Pillar 1). It is
monitored by the bank’s supervisory authority
(Pillar 2). In addition, it is also subject to market
discipline (Pillar 3).

Basel II Conceptual Framework
• improved credit
risk metrics
• new measures for
operational risks
• risks not covered
by pillar I (banking
book Irr, business,
strategic, external)
• enhanced
disclosures
• enable external
assessment of risks

Basel II Conceptual Framework

What is Capital ?
Significant effect on profit margins and the bank’s
ability to bear risks.

The 8% Minimum Capital Requirement
(Tier 1 + Tier 2 + Tier 3) Capital
----------------------------------------------------------------------------------- = 8%
(Risk-weighted assets + (Market risk capital charge × 12.5) +
(Operational risk capital charge × 1.25))
• Tier 1 is the entire amount of the bank’s Tier 1 capital.
• Tier 2 is limited to 100 percent of Tier 1 capital,
subordinated debt included in Tier 2 is limited to 50 percent
of total Tier 2 capital.
• Tier 3 is limited to the amount that is eligible to support
market risk (that is, subject to the Tier 3 restrictions).

(Tier 1 + Tier 2 + Tier 3) Capital
----------------------------------------------------------------------------------- = 8%
(Risk-weighted assets + (Market risk capital charge × 12.5) +
(Operational risk capital charge × 1.25))
• Business loan weighted 100%
 Required capital = 8% * 1 = 8%
 For every EUR of capital 1/0.08 =12.5 EUR can be lent
• Mortgage loan weighted 50%
 Required capital = 8% * 0.5 = 4%
 For every EUR of capital 1/0.04 = 25 EUR can be lent
The 8% Minimum Capital Requirement

Tier 1 Capital (Core Capital)
Tier 1 capital is:
• permanent
• issued
• fully paid
• noncumulative
• able to absorb losses within the bank on a going-concern basis
• junior to depositors, general creditors, and subordinated debt of
the bank
• callable only after a minimum of five years with supervisory
approval and under the condition that it will be replaced with
capital of equal or better quality
• equity shares
• retained earnings
• nonredeemable, noncumulative
preference shares
• general provisions and
innovative capital instruments

Tier 1 Capital (Core Capital)
Tier 1 capital components:
• are regarded as core capital, or the primary capital of a bank
• allow a bank to absorb losses on an ongoing basis and are
permanently available for this purpose
• allow a bank to effectively conserve resources when under stress,
because common stock provides the bank with full discretion as to the
amount and timing of dividend payments are the basis on which most
market judgments of capital adequacy are made
• provide an important source of market discipline over a bank’s
management, through the voting rights attached to the common shares

Basel II: Components of Regulatory Capital
B-III 6%

Tier 3 to be eliminated in B-III

Basel II: Credit Risk (Standardized Approach)
• Many weightings (increased granularity)
• Dependent on external rating agencies rather
than arbitrary regulatory choices
• Still not perfect
 An unrated exposure is better than a B- rate
 Loans fully secured on residential property
retain 50% rating

With most derivatives (off balance sheet exposures)
banks are exposed to credit risk not for the full face
value of their contracts, but only to the potential cost
of restoring the cash flows if the counterparty
defaults. “Credit equivalent” amounts are established
to measure risk exposures. FX forwards, options etc.
factors are same as for the “Commodities”.

Basel II: Market Risk (Standardized Approach)
The capital requirement is calculated separately
for the following risks:
• trading book interest rate risk
• trading book equities risk
• trading and banking books currency risk
• trading and banking books commodities risk in

Basel II: Market Risk (Internal Model Approach)
• Capital charge is based on whichever is higher
from the previous day’s or the average VAR over
the last 60 business days

Basel II: Operational Risk
The risk of loss resulting from inadequate
or failed internal processes, people, and systems or
from external events
• basic indicator approach (15% of 3y gross income)
• standardized approach
• advanced measurement approach

Basel II: Summary

Case Study: Basel II Capital Calculation

Case Study: The UK Regulatory Structure

Basel III Implementation Timeline

FUNDING AND LIQUIDITY
MANAGEMENT

What is Liquidity ?
Liquidity is the ability of a bank to fund increases
in assets and meet obligations as they come
due, without incurring unacceptable losses.
BIS, Sept 2008, Principles for Sound Liquidity Risk Management
and Supervision

Liquidity and ALM
• Liquidity management is a key banking function and
an integral part of the ALM
• Virtually every financial transaction or commitment has
implications for a bank’s liquidity.
• Banks are particularly vulnerable to liquidity problems
• The source of deposits (who provides the bank’s
funding) adds to the volatility of funds (diversification)

Liquidity and ALM
• In day-to-day operations, the management of liquidity is
typically achieved through the management of a bank’s assets.
In the medium term, liquidity is also addressed through
management of the structure of a bank’s liabilities.
• Judgment of the adequacy of a liquidity position requires
analysis of a bank’s, its current liquidity position and its
anticipated future funding needs, the options it has for reducing
funding needs or attracting additional funds, and the source of
funding.

What is Liquidity Risk ?
There are two main types of liquidity risk, funding liquidity
risk and market liquidity risk. Funding liquidity risk is the
risk that the firm will not be able to meet efficiently both
expected and unexpected current and future cash flow and
collateral needs without affecting either daily operations or
the financial condition of the firm. Market liquidity risk is the
risk that a firm cannot easily offset or eliminate a position at
the market price because of inadequate market depth or
market disruption.

Funding Liquidity Risk
Within funding liquidity risk, banks address their practices related
to management of the following:
• Structural (over one year- long term, or strategic-gap, ratios and
funding mix, cash capital, survival horizon)
• Tactical (similar concept as long term but for shorter term,
operational, cash-flow), intraday (cash and collateral management)
• Contingency (Stress testing, sensitivity analysis and scenario
testing, special liquidity asset pool, contingency plans, ratios and
earmarked liquidity asset pool).

Sources of Liquidity Risk

Sources of Liquidity Risk, Continued

Measuring Assets Liquid Exposures
• Liquid assets could be diversified by using the following attributes:
Pledgeable assets (depending on central banks and industry criteria),
repoable assets, securitizable assets (retail consumer loans) with cash
structures or with synthetic structures (credit default swap).
• Securities need to be grouped by their liquidity value. High values, would
apply to eligible central bank holdings. Other criteria to be included in
considering liquidity values and categorization are rating and credit quality,
market price availability, maturity, type of security, reason for holding
(trading, investment, and hedge), access to secured funding for security,
issuer type/country, currency, size of position and time to settlement.

Firms having significant reliance on asset liquidity should evaluate
haircuts and the timing of cash flows from the sources:
- Encumbered assets should be excluded from incremental liquidity
value
- Haircuts should be evaluated in business as usual as well as in
stressed conditions
- Capacity of the markets for a particular asset class should be
evaluated and
- Operational capability to facilitate the transaction should be in place
and tested

• The bank could assess the ability to convert its unsecured funding to
secured basis. The loan (“collateral”) value of its unencumbered
portfolios is reviewed daily.
• The bank should practically categorize the assets based on their
liquidity. Liquidity categories can be high, medium and low or set up by
the likelihood of the action to be taken. Most firms use haircuts or
volatility analyses to determine the liquidity value of assets.

Liquidity Risk Management
• The fundamental role of banks in the maturity
transformation of short term deposits into long-term loans
makes banks inherently vulnerable to liquidity risk, both of an
institution-specific nature and that which affects markets as a
whole.
• Liquidity risk management is of paramount importance
because a liquidity shortfall at a single institution can have
system wide repercussions.

Liquidity Risk Management
• Liquidity management policies should comprise a risk
management (decision making) structure, a liquidity
management and funding strategy, a set of limits to liquidity
risk exposures, and a set of procedures for liquidity planning
under alternative scenarios, including crisis situations.
• Effective liquidity risk management helps ensure a bank’s
ability to meet cash flow obligations, which are uncertain as
they are affected by external events and other agents’
behavior.

Liquidity Management Techniques: Ratios

Liquidity Management Techniques: Cash Flow

Liquidity Management Techniques: Scenarios

Liquidity Risk Management: Early Warnings
Early warning indicators can be qualitative or quantitative in nature and may include
but are not limited to:
• 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
• 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
• negative publicity

Liquidity Risk Management: Early Warnings
• a credit rating downgrade
• stock price declines or rising debt costs
• widening debt or credit-default-swap spreads
• rising wholesale or retail funding costs
• counterparties that begin requesting or request additional collateral for credit
• exposures or that resist entering into new transactions
• 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 (e.g. commercial paper)
• embedded triggers (options etc)

Contingency Funding Plan
The Contingency plan addresses potential, early warning signals of risk.
Contingency planning should include establishing policies and procedure and clear
divisions of roles and responsibilities for liquidity events so as to avoid confusion or
lack of clarity of roles during crisis. This should include strategies and procedures for
timely, clear, consistent, and uninterrupted internal and external communication
flows to ensure timely decision to prevent undue escalation of issues and to provide
adequate assurance to market participants, employees, clients, creditors,
regulators, and shareholders. This could include the designation of a formal crisis
team that can be a contact point for senior management. The planning process
should include the designation of back ups for key functions and assurance that key
systems and processes have been considered in the firm’s business continuity
planning.

Organization: Contingency plans need to involve Treasury, Risk
and Business areas, IT, settlements, communication and finance
areas. Most firms have a liquidity crisis team in place that is chaired
by the Treasurer or CFO. A member of the Treasury or risk can be
the contingency coordinator to ensure that working groups
understand their tasks and those decisions and actions are logged
and communicated as appropriate. There are some banks, where
the crisis team meets on a regular basis to review stress scenarios
in business as usual conditions.

Action plans: Bank should have in place an asset reduction plan
and financing strategy for firm specific and market-related liquidity
events. Some firms define states of a crisis and define appropriate
measures to mitigate a crisis. During the disruption secured funding
asset liquidation would be possible for high-grade paper (in
particular, eligible central bank assets) but higher haircuts would be
applied based on liquidity quality. The bank can take attention the
unused credit facilities from the Central bank or other
counterparties, but the latest can be disappearing in the trouble.

Liquidity Planning
Information that management should consider in liquidity
planning includes:
- Economic forecasts
- Internal costs of funds
- Mismatches in the balance sheet
- Interest rate forecasts
- Anticipated funding needs
- New business opportunities
- Acquisitions
- Earnings decline
- Nonperforming asset increase etc.

Funding Tools

Case Study: A Medium Sized Bank

INTEREST RATE RISK
MANAGEMENT

Categories of ALM Interest Rates
• Administered Rates (internal)
e.g. prime rate for a housing loan
• Fixed Customer (external + spread)
e.g. fixed rate paid for a housing loan
• Fixed M/M Rates (external + spread)
e.g. usually par rates of the fixed leg of an IRS ‐ the swap
yield curve
• Central Bank Rates (external + spread)
e.g. ECB rate linked items (assets/liabilities)

Categories of ALM Interest Rates
• Adjustable Index Rates (external + spread)
e.g. financing a new loan which re‐prices quarterly with the
3M Euribor.
• Other Floating Rates (internal, external)
e.g. interest rate on a Nosto account paid by another bank.
• Fixed M/M Rates (external + spread)
e.g. usually par rates paid for the fixed leg of an IRS.

What is Interest Rates Risk ?
The interest rate risk is the exposure of a bank’s financial condition to adverse
movements in interest rates. Accepting this risk is a normal part of banking and can
be an important source of profitability and shareholder value. However, excessive
interest rate risk can pose a significant threat to a bank’s earning and capital base.
Changes in interest rates affect a bank's earnings by changing its net interest
income and the level of other interest sensitive income and operating expenses.
Changes in interest rates also affect the underlying value of the bank's assets,
liabilities, and off-balance sheet (OBS) instruments because the present value of
future cash flows (and in some cases, the cash flows themselves) change when
interest rates change. Accordingly, an effective risk management process that
maintains interest rate risk within prudent levels is essential to the safety and
soundness of the bank.

What are the Sources of Interest Rates Risk ?
1. Repricing risk: As financial intermediaries, banks encounter interest rate
risk in several ways. The primary and most often discussed form of interest
rate risk arises from timing differences in the maturity (for fixed-rate) and
repricing (for floating rate) of bank assets, liabilities, and OBS positions. While
such repricing mismatches are fundamental to the business of banking, they
can expose a bank's income and underlying economic value to unanticipated
fluctuations as interest rates vary. For instance, a bank that funded a long-term
fixed-rate loan with a short term deposit could face a decline in both the future
income arising from the position and its underlying value if interest rates
increase. These declines arise because the cash flows on the loan are fixed
over its lifetime, while the interest paid on the funding is variable, and
increases after the short-term deposit matures.

2. Yield curve risk: Repricing mismatches can also expose a bank
to changes in the slope and shape of the yield curve. Yield curve
risk arises when unanticipated shifts of the yield curve have
adverse effects on a bank's income or underlying economic value.
For instance, the underlying economic value of a long position in
10-year government bonds hedged by a short position in 5-year
government notes could decline sharply if the yield curve steepens,
even if the position is hedged against parallel movements in the
yield curve.

3. Basis risk: arises from imperfect correlation in the adjustment of the
rates earned and paid on different instruments with otherwise similar
repricing characteristics. When interest rates change, these
differences can give rise to unexpected changes in the cash flows and
earnings spread between assets, liabilities and OBS instruments of
similar maturities or repricing frequencies. For example, a strategy of
funding a one-year loan that reprices monthly based on the one-month
US Treasury bill rate, with a one-year deposit that reprices monthly
based on one-month LIBOR, exposes the institution to the risk that the
spread between the two index rates may change unexpectedly.

4. Optionallity: An additional and increasingly important source of interest
rate risk arises from the options embedded in many bank assets, liabilities,
and OBS portfolios. Formally, an option provides the holder the right, but
not the obligation, to buy, sell, or in some manner alter the cash flow of an
instrument or financial contract. Options may be stand-alone instruments
such as exchange-traded options and over-the-counter (OTC) contracts, or
they may be embedded within otherwise standard instruments. While
banks use exchange-traded and OTC options in both trading and non-
trading accounts, instruments with embedded options are generally more
important in non-trading activities.

Open position arises from the following transactions:
- Deposit collection, borrowing, issuing securities constituting loan
relationship, conducting repurchase agreement
- Providing loans, lending, investments in securities constituting
loan relationship
-Off-balance sheet transactions affecting interest rate risks (e.g.
interest rate and foreign exchange swaps, forward foreign
exchange and securities transactions, forward interest rate
agreements, foreign exchange option transactions)

How Interest Rates Risk is Measured?
• Repricing risk analysis for measuring yield curve risk
- Rate sensitivity gap
- Interest rate gap
- Static simulation
- Dynamic simulation
• Analyzing basis risks for measuring the effect of the interest
income
• Fund transfer pricing for measuring the effect of the interest
income
• Duration

NII Sensitivity Analysis

Equity Sensitivity Analysis

GAP ANALYSIS

Categories of Gaps
Marginal GAP
The marginal gap represents the net asset or liability amount
which re‐prices or matures a time period (time bucket).
Cumulative GAP
The net asset or liability amount which re‐prices or matures
within a time bucket, including the net positive or negative
liquidity or re‐pricing amounts of all previous time buckets.
The Cumulative gap gives you a better information about the
status of your maturity or re‐pricing structure.

Interest Rate Gap
• Detection of re-pricing gaps
• Evaluation of upside or downside IRR

Interest Rate Gap

Assumptions of the Interest Rate Gap Report
• Items are slotted according to their contractual re‐ pricing maturity with
their IFRS book value (includes accrued interest so far).
• Bonds are entered with their face value, i.e. the calculation basis of the
coupon rate.
• Items are supposed to re‐price in the middle of the time bucket they
belong.
• Every particular item (loan, deposit etc.) is supposed to be renewed at
maturity with the same conditions (amount, re‐pricing period).
• The simulation horizon for a Δ in N.I.I. is usually 12 months.
• Growth in the B/S is assumed.
• Limitation: behavioral model assumptions have to be proven statistically

Categories of Interest Rate Gaps
Static Gap
Basic Assumptions:
• Contractual re‐pricing structure is assumed to hold.
• No growth in the B/S is assumed.
• Any maturing items are assumed to be renewed on
maturity with the same conditions (same product,
amount, base rate and period).

Dynamic Gap
Basic Assumptions:
• Incorporation of future behavior of customers induced
by changes in interest rates such as prepayments, non
renewals, early withdrawals etc.
• Incorporation of bank’s behavior in re‐pricing
according the economic business cycle, e.g. delay in
passing rate increase to saving deposits.

Dynamic Gap
Basic Assumptions Continued:
• Optionalities are incorporated, e.g. the option of a
customer to choose the interest rate after a certain
period; embedded options in structured products etc.
• Growth in the B/S is assumed
• Limitation: behavioral model assumptions have to be
proven via statistical analysis

Limitations of the Interest Rate Gap Model
• The assumption of uniform changes of interest rates
of assets and liabilities and of rates for different
maturities.
• Treatment of demand loans and deposits.
• The effects of interest rate changes on the amount of
intermediated funds are disregarded.
• The effects of rate changes on market values are
disregarded.

Interest Rate Risk Types in Gap Context
Gap Risk
Financing a new loan which re‐prices quarterly,
e.g. the 3M Euribor, with newly attracted 12
month time deposits will result after 1 month to
less interest income in case the 1M Euribor
drops.

Basis Risk
Financing a new loan which re‐prices monthly
based on the ECB rate with an interbank deposit
which re‐prices also monthly based on the 1M
Euribor. Though there is no GAP the different
behavior of the uncorrelated change in the two
rates could cause a drop in N.I.I.

Change in Economic Value of Equity (E.V.E.)
• Consider a balance sheet with equity capital funding and
fixed rate mortgage loans @7%; an increase in yields
could cause a drop in asset value (like for a bond) and
hence in equity.
• Intuition: if the bank is going to securitize those loans the
attracted liquidity will be less than it would be before the
yield curve shift.

Optionality Risk
The risk which arises from the exercise of
embedded options in products by customers and
diverse counterparties or issuers, e.g. the option
of the customer to choose the interest rate of the
housing loan after a certain period; embedded
options in bonds etc.

Maturity (Liquidity) Gap
• Detection of liquidity gaps
• Liquidity planning

Assumptions of the Liquidity Gap Report
• Items are slotted according to their contractual
maturity with their IFRS book value (accrued
interest is included).
• For some items an expected maturity could be
assumed. Such items are slotted contractually.

Categories of Liquidity Gaps
Behavioral Gap
Basic Assumption:
• Diverse B/S items are slotted in the respective time bucket
according to their expected maturity, e.g. savings deposits
are slotted according to their expected maturity.
• Limitation: model assumptions have to be proven via
statistical analysis, e.g. maturity structure of saving deposits
(stickiness).

Categories of Liquidity Gaps
Contractual Gap
Basic Assumption:
• Items are slotted in the respective time bucket according to
their contractual maturity, e.g. demand or savings deposits
are considered to mature immediately.
• Limitation: very conservative approach, since some B/S
categories have in reality a different maturity structure, e.g.
high renewal rates for saving deposits, revolving loans etc.

GAP VS. DURATION MODELS

Gap vs. Duration Models
• One of the problems with the re-pricing gap model is that it
doesn’t take into account the effects that changes in market
rates have on the market values of a bank’s assets and
liabilities.
• As opposed to the re-pricing gap model, which uses an income-
based flow variable (NII, net interest income), the duration gap
model adopts an equity-based target variable.
• Banks are usually using mark-to-market to evaluate their assets
and liabilities.

Duration of a Financial Instrument

Estimating the Duration Gap

Estimating the Duration Gap with Convexity

Duration Gap Model Issues
• The dynamic nature of the B/S makes duration immunization
strategies last shortly.
• Duration changes with time.
• Assets duration sensitivity to time passage differs.
• Any interest rate change affects the duration gap.
• Balance sheet restructuring required to achieve immunization might
be costly. Usually IR derivatives are employed instead.
• Immunization is effective for small rate changes due to convexity
(no linear relation of IR changes and change in asset values).
• The model assumes parallel shift in the interest rates.

Duration Gap Example

FUNDS TRANSFER PRICING

Internal Transfer Rates in ALM
• A proper interest rate risk (i.e. gap risk)
management system requires banks to set up a
system of internal interest transfer rates (ITR).
• This comprises a series of virtual transactions
within the bank in order to centralize all the
decisions on the bank’s exposures to changes in
market rates.

Internal Transfer Rates in ALM
• Transfer interest rate risk from the various units of the bank that generate it
(for instance, branches that accept deposits and grant loans) to a central
unit. This would normally be the Treasury which can correctly evaluate and
manage this risk and, when necessary, apply hedging policies.
• Evaluate the actual profitability of this activity by assigning interest rate risk
management to a single centralized unit.
• Relieve the various operating units from the need to care about the funding
of their loans (or, conversely, the investment of deposits raised from
customers).
• Provide a more accurate assessment of the contribution each operating
unit gives to the bank’s overall profitability.

Internal Transfer Rates Example

Single Pool FTP (Net Flows)

Single Pool FTP (Gross Flows)

Double Pool FTP

Internal Transfer Rates Examples
Fixed Rate Transaction
Floating Rate Transaction

Off Market Rate Transaction

Floating Rate Loan With a Floor

FTP Best Practices
• FTP should ensure that changes in branch profitability are
due only to credit risk.
• Specifically, the FTP system must protect the branches from
the risk of changes in interest rates.
• The FTP system must protect the branches from the risks
associated with embedded options.
• The FTP system must allow for different interest rates
according to maturity (multipleITRs).
• The FTP system must operate on the basis of gross flows.

FTP Best Practices
• The sum of the profits of the individual operating units (including
the treasury) must be equal to the bank’s overall profit.
• The FTP system must be arbitrage-free, inasmuch as the
operating units must not be able to carry out arbitrage against the
treasury.
• As a general rule, ITRs must be market rates that the treasury
can negotiate effectively in the market. An exception could
possibly be allowed for non-market rate transactions (for instance,
loans issued at Repo rate), if one wants to isolate branches from
basis risk (which is centralized and managed by the treasury).

FOREIGN EXCHANGE RATE
RISK MANAGEMENT

What is Foreign Exchange Risk?
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What is Foreign Exchange Position ?
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How We Calculate FX Risk Exposures ?

CREDIT RISK MANAGEMENT

What is Credit Risk?
The term “credit risk” refers to the possibility that
an unexpected change in a counterparty’s
creditworthiness may generate a corresponding
unexpected change in the market value of the
associated credit exposure.

What is Credit Risk?
Credit or counterparty risk is the chance that a debtor or
issuer of a financial instrument - whether an individual,
a company, or a country will not repay principal and
other investment related cash flows according to the
terms specified in a credit agreement. Inherent to
banking, credit risk means that payments may be
delayed or not made at all, which can cause cash flow
problems and affect a bank’s liquidity.

Main Types of Credit Risk
• Default risk: this is the risk connected with a default by the
counterparty, which declares bankruptcy, goes into liquidation or
otherwise defaults on the loan. Such a risk leads to a loss equal
to the product of the exposure at default (EAD) and loss given
default (LGD).
• Migration risk: this is the risk connected with a deterioration in
the counterparty’s creditworthiness. It is also known as the
“downgrading risk” when the borrower has a public credit rating
and might be downgraded by the organization (e.g. rating
agency) that issued it.

• Spread risk: this is the risk associated with a rise in the spreads
required of borrowers (e.g. bond issuers) by the market. In the event of
increased risk aversion by investors, the spread associated with a given
probability of default (and therefore a given rating class) may increase.
In such a case the market value of the securities declines, without any
reduction in the issuer’s credit rating.
• Recovery risk: indicates the risk that the recovery rate actually
recorded after the liquidation of the insolvent counterparty’s assets will
be less than the amount originally estimated, because the liquidation
value was lower than estimated or simply because the recovery process
took longer than expected.

• Pre-settlement or substitution risk: indicates the risk that the
bank’s counterparty in an OTC (over-the-counter) derivative
will become insolvent before the maturity of the contract, thus
forcing the bank to “replace” it at new (and potentially less
favourable) market conditions.
• Country risk: indicates the risk that a non-resident
counterparty will be unable to meet its obligations due to
events of a political or legislative nature, such as the
introduction of foreign exchange constraints, which prevent it
from repaying its debt.

Credit Risk Models
• Credit Scoring Models: multivariate models which use the main
economic and financial indicators of a company as input, attributing
a weight to each of them, that reflects its relative importance in
forecasting default. The result is an index of creditworthiness
expressed as a numerical score, which indirectly measures the
borrower’s probability of default.
 Linear discriminant analysis.
 Regression models (linear, logit and probit).
 Heuristic inductive models such as neural networks and
genetic algorithms.

Credit Risk Models
• Capital Market Models: models based on asset
prices. Usually bond prices or, to be more precise,
on the term structure of spreads between corporate
bonds (which include an element of default risk),
and risk-free government bonds.
 Corporate bond spreads models.
 Structural models based on stock prices (e.g.
the KMV model).

Credit Risk Management
• Credit risk can be reduced by implementing policies to limit connected-
party lending and large exposures to related parties default (regulatory
requirements).
• Asset classification and provisioning against possible losses (affects the
value of the loan portfolio and the value of a bank’s capital).
• The profile of customers (who the bank has lent to) must be transparent.
• Risks associated with the key banking products (what the bank has lent)
must be understood and managed.
• The maturity profile of loan products (how long the loans are for)
interacts strongly with liquidity risk management.

Management Policies to Reduce Credit Risk
• Lending authority (centralized or not, approval limits,
meetings, reports)
• Type of loans and distribution by category (expertise,
limits)
• Appraisal process (L/D ratio, collateral)
• Loan pricing (credit risk charge, cost of funding, re-
valuation)
• Maturities (maximum tenors)
• Currency structure

Management Policies to Reduce Credit Risk
• Geographic areas (concentrations)
• Industry sectors exposure (concentrations)
• Use of current financial information
• Collections monitoring (develop procedures and
guidelines)
• Limit on total outstanding loans (demand, deposits
volatility)
• Proper, timely and conservative impairment recognition
• Loan renegotiation guidelines

Basel II: Credit Risk Assessment Options

BANKING BOOK
PRICING AND PROVISIONING
CONCEPTS

VAR

VaR Usage in ALM
• VaR is a market risk measuring instrument.
• It was initially used for dealing-room or treasury activities on
a time horizon of usually one day in order to assess the
market risk for that day.
• ALM is not concerned with this very short-term trading logic.
• If VaR is used, the VaR will be calculated on a longer
period, generally one month.
• VaR in ALM is usually used to assess the market risk for the
bank’s balance sheet as a whole and not just for market
activities in the narrow sense.

What is VaR ?
• VaR is a measure of market risk under “normal” conditions.
• VaR measures the potential loss in market value of a portfolio mainly
using estimated volatility and correlations .
• It is the maximum loss which can occur with X% confidence over a
holding period of t days.
• It is measured within a given confidence interval, typically 95% or 99%.
• For example, if a daily VaR is stated as 25,000 to a 95% level of
confidence, this means that during the day there is a only a 5% chance
that the loss will be greater than 25,000.
•The definition of normality is critical to the estimation of VaR and is a
statistical concept

How is VaR Calculated ?
General steps:
• Determine the time horizon over which the firm wishes to estimate a
potential loss.
• Select the degree of certainty required, which is the confidence level
that applies to the VaR estimate.
• Create a probability distribution of likely returns for the instrument or
portfolio under consideration.
• Calculate the VaR estimate

Correlation Method:
• Assumes the returns on risk factors are normally distributed, the
correlations between risk factors are constant and the delta (or price
sensitivity to changes in a risk factor) of each portfolio constituent is
constant.
• The volatility of each risk factor is extracted from the historical
observation period.
• Relevant risk factors volatilities or calculations are calculated either from
historical data or autoregressive models (Garch). Both methods rely on
the assumption that future volatilities can be predicted from historic
price movements.

Historical Simulation Method:
• The model calculates potential losses using actual historical
returns in the risk factors and so captures the non-normal
distribution of risk factor returns.
• Normal distribution assumption is not required (normally
distributed returns, constant correlations, constant deltas).
• Rare events and crashes can be included in the results.
• Risk factor returns and correlations in the calculation are also
actual past correlations.
• Is the most simple of all methods.

Monte Carlo Method:
• Monte Carlo simulation allows the risk manager to use actual historical
distributions for risk factor returns rather than having to assume normal
returns.
• A large number of randomly generated simulations are run forward in time
using volatility and correlation estimates chosen by the risk manager.
• Each simulation will be different, but in total the simulations will aggregate to
the chosen statistical parameters (i.e., historical distributions and volatility and
correlation estimates).
• This method is more realistic than the previous two models and, therefore,
is more likely to estimate VaR more accurately.
• Requires powerful computers and is more time consuming.

Comparison Between VaR Models

RAROC Calculation Using VaR

VaR Critisism
• VaR models disregard exceptional events.
• VaR models disregard customer relations.
• VaR models are based upon unrealistic
assumptions.
• VaR models generate diverging results.
• VaR models amplify market instability.
• VaR measures “come too late, when damage has
already been done”.

EAR

SIMULATION AND MONTE
CARLO ANALYSIS

How is Simulation Used in ALM ?
•The main aim of simulations in ALM is to explore the future
shapes of interest rate curves and their impact on interest
margins or interest income.
• Also they aim in optimizing liquidity and interest rate risk
management.
• There are four main analytical categories of simulations.
• For each type of simulation, one or more rate scenarios can be
used.
• the most frequently used method is a parallel shift of rates per
currency per 100 basis points.

Simulation Categories
The first category of simulation relates to the interest rate
curves with balance sheet volumes for each ALM product
renewed in the same way on transactional bases. The
effect of rate changes will be felt in existing contracts and in
new production, according to the transactional rollover
hypothesis. A contract with accounting value of 100 maturing
within two months will be renewed in the same way every
two months for the same accounting value. I.e. it will remain
in the same bucket (the two month bucket).

The second category of simulation relates to the rate curves
with balance sheet volumes for each ALM product renewed
in the same way according to the initial terms of each
contract. The effect of rate changes will be felt in existing
contracts and in new production, according to the contractual
rollover hypothesis. A contract with accounting value
of 100 maturing within two months will be renewed in the
same way within two months for the same accounting value,
with a term renewed as before (for example, one year).

The third category of simulation relates both to rates
and to balance sheet volumes of ALM products. This
simulation is both more complex and more realistic, as
volumes can be sensitive to changes in interest rates. In
this case a contract with 100 maturing within two
months will be renewed on a contractual basis with a
total of 100 + a % or 100 − a %.

The fourth category of simulation also uses the
previous simulation by introducing the commercial
and balance sheet development strategy. In this
case a contract with 100 maturing within two
months will be renewed on new or identical
contractual bases with a total of 100 + a % or 100 −
a %.

SECURITIZATION

What is Securitization ?
• It is the process by which financial assets (mortgage or consumer or
business) are pooled together and sold to a Special Purpose Vehicle
(SPV) that issues debt and equity tranches which are secured with the
financial assets.
• A number of loans payable by various obligors are put into a pool and
new securities are issued which payout according to the pool’s
collective performance.
• The new securities are divided into three or more levels of risk.
–The riskiest part (=the equity tranche) takes the first loss if any
companies in the pool default.
–If losses cannot be covered by the equity tranche, the next (=the
mezzanine tranche) level suffers.
–The most protected level (=the senior tranche) should still be
safe, unless the collective pool has severe losses.
• Depending on the nature of the underlying assets:
–Collateralised Loan Obligations (CLO)
–Collateralised Bond Obligations (CBO)
–Collateralised Synthetic (=swaps) Obligations (CSO)

What is Securitization ?

Securitization Parties and Their Role

Indicative Timetable

MONEY MARKET INSTRUMENTS

Depo
• Bilateral agreement for an interbank loan or deposit. The
price is the interest rate.

Depo Dealing Ticket
TO ALBB AB BULGARIA MMKT * 0932GMT 17/10/11*/1258
Our terminal : ALBB Our user : ILIAS MALIOUKIS
# RZBB DP EUR O/N
# NIKOLAI > HI HI FRD 0.25 – 0.50
# ILIAS > AT 0.25 I GIVE U 10 MIO EUR
MY EUR DIRECT VIA TARGET
VAL 17OCT2011 AND 18OCT2011
# NIKOLAI > ALL AGREED
AT 0.25 I TAKE 10 MIO EUR
MY EUR DVT
VAL 17OCT2008 AND 18OCT2008
MANY THANKS BIBI

FX Swap
• A transaction that involves the purchase and the simultaneous sale of the same
currency amount at foreign exchange rates that are both defined at the same
Transaction Date with the settlement for each of the transactions occurring at two
different dates, the Initial Settlement Date and the Final Settlement Date as defined
below. For the period between the two operations, interest is not calculated
(accrued) and transferred because it is effectively incorporated in the foreign
exchange rates agreed for the FX Swap.
• The price of an FX Swap is quoted as Swap Points (negative or positive). These
are basis points that are added to the FX Spot rate for determining the Final
Settlement FX Rate (Second Leg) of an FX Swap. They are typically based on the
difference between the interest rates of the currencies involved in the FX Swap
transaction and on the Period of the transaction.

FX Swap

FX Swap Dealing Ticket
TO ALBB AB BULGARIA MMKT * 0932GMT 06/10/11*/1258
Our terminal : ALBB Our user : ILIAS MALIOUKIS
# RZBB SW EUR 1M
# NIKOLAI > HI HI FRD 4.50 – 5.50
# ILIAS > AT 4.50 I B/S 10 MIO EUR
MY EUR DIRECT VIA TARGET
MY USD DEUTSCHE BANK NY
VAL 08OCT2011 AND 10NOV2011
# NIKOLAI > ALL AGREED
AT 4.50 I S/B 10 MIO EUR
MY EUR DVT
MY USD BOFA NY
VAL 08OCT2011 AND 10NOV2011
RATES ARE 1.3390 AG 1.33945
BIBI

Forward Rate Agreement (FRA)
A forward rate agreement (FRA) is a forward contract on an benchmark interest rate
(e.g. LIBOR for U.S. dollar deposits and Euribor for euro deposits). A long position in
a (FRA) allows us to borrow money at the agreed FRA rate (i.e. we are long the loan
with the FRA contract price being the interest rate on the loan). If the benchmark
rate at contract expiration is above the rate specified in the forward agreement, the
long position in the contract can be viewed as the right to borrow at below market
rates and the long will receive a payment. If the floating rate at the expiration date is
below the rate specified in the forward agreement, the short will receive a cash
payment from the long. (The right to lend at above market rates would have a
positive value.) FRA’s are settled in cash at the FRA contract expiration.

Example a 2 x 3 FRA

FRA Quotes

FRA Pricing Example

Valuing an FRA at Maturity (Settlement)

Valuing an FRA Before Maturity

FORWARD MARKETS AND
CONTRACTS

Forward Contracts

Forward Contracts Example

Forward Contracts Payoff

Forward Contracts Valuation

Forward Contracts Valuation Example

Equity Forward Contracts

Equity Forward Contracts Example

Equity Forward Contracts Valuation

Equity Forward Contracts Valuation Example

Equity Index Forward Contracts

Equity Index Forward Contracts Valuation

Bond Forward Contracts

Bond Forward Contracts Pricing Example

Bond Forward Contracts Valuation Example

Currency Forward Contracts

Currency Forward Contracts Examples

FUTURES MARKETS AND
CONTRACTS

Futures vs. Forwards
• Futures are marked to market at the end of every trading day. Forward
contracts are not marked to market.
• Forwards are private contracts and do not trade on organized exchanges.
• Futures contracts trade on organized exchanges.
• Forwards are customized contracts satisfying the needs of the parties
involved.
• Futures contracts are highly standardized.
• Forwards are contracts with the originating counterparty; a specialized entity
called a clearinghouse is the counterparty to all futures contracts.
• Forward contracts are usually not regulated. The government having legal
jurisdiction regulates futures markets.

Futures vs. Forwards Prices

Futures Carry Costs and Convenience Yield

Eurodollar Futures
Eurodollar futures are based on 90-day LIBOR ,
which is an add-on yield. By convention, however,
the price quotes are calculated as (100 –
annualized LIBOR in percent). These contracts
settle in cash, and the minimum price change is
one “tick,” which is a price change of 0.0001 =
0.01%, or $25 per $1 million contract.

Treasury Bond (T-Bond) Futures
T-bond futures are traded for T-bonds with a maturity of 15 years or more.
The contract is deliverable with a face value of $100,000. T-bond futures
are quoted as a percent and fractions of 1% (measured in 1/32nds) of face
value. The short in a T-bond futures contract has the option to deliver any
of several bonds, which will satisfy the delivery terms of the contract. This
is called a delivery option and is valuable to the short. Each bond is given
a conversion factor that is used to adjust the long’s payment at delivery so
the more valuable bonds receive a larger payment. These factors are
multipliers for the futures price at settlement. The long pays the futures
price at expiration multiplied by the conversion factor.

Stock Index Futures
Stock index futures are based on the level of an equity index.
The most popular stock index future is the S&P 500 Index
Future that trades in Chicago. Settlement is in cash and is
based on a multiplier of 250. The value of a contract is 250
times the level of the index stated in the contract. With an
index level of 1000, the value of each contract is $250,000.
Each index point in the futures price represents a gain or loss
of $250 per contract. A smaller contract on the same index
has a multiplier of 50.

Currency Futures
The currency futures market is smaller in volume
than the forward market described in the previous
topic review. In the United States, currency
contracts trade on the euro, Mexican peso, and
yen, among others. Contracts are set in units of
the foreign currency, and the price is stated in
U.S. dollars per unit of foreign currency.

T-Bill Futures
Treasury bill (T-bill) futures contracts are based on a $1 million face
value 90-day (13-week) T-bill, and they settle in cash. The price
quotes are 100 minus the annualized discount in percent on the T-
bills. For example, a price quote of 98.52 represents an annualized
discount of 1.48%, an actual discount from face of 0.0148(90 / 360)
= 0.0037, and a “delivery” price of (1 – 0.0037) × $1 million =
$996,300. Each change of 0.01 in the price of a T-bill futures
contract is worth $25. If you took a long position at 98.52 and the
price fell to 98.50, your loss is $50 per contract..

T-Bill Futures Pricing Example

ALM PRESENTATION_MALIOUKIS_SOFIA_BG

ALM PRESENTATION_MALIOUKIS_SOFIA_BG

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