Asset Liability Management(ALM) It is a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It defines management of all assets and liabilities (both off and on balance sheet items) of a bank. It requires assessment of various types of risks and altering the asset liability portfolio to manage risk. Also called surplus management.
Function of ALM To measure and control three levels of financial risk: Interest Rate Risk (the pricing difference between loans and deposits), Credit Risk (the probability of default), Liquidity Risk (occurring when loans and deposits have different maturities).
Primary Objective Managing Net Interest Margin that is, the net difference between interest earning assets (loans) and interest paying liabilities (deposits) to produce consistent growth in the loan portfolio and shareholder earnings, regardless of short-term movement in interest rates.
ALM Objectives Establish a comprehensive risk management system. Identify the sources of requisite information for ALM process. Identify and define the strategies for management of market risks. Develop new products as risk hedging techniques
ALM Models Gap Analysis Duration Gap Analysis VAR Simulation
Gap Analysis Simple to use Interest rate risk arises in bank operations because banks assets and liabilities generally have their interest rates reset at different times. The magnitude of interest rate risk depends on the degree of mismatch between the times when asset and liability interest rates are reset. A maturity gap is calculated for a given time period and includes all fixed-rate assets and liabilities that mature in that period and all floating-rate assets and liabilities that have interest rate reset dates in that period.
Gap Analysis A bank that has a positive gap will see its interest income rise if market interest rates rise, since more assets than liabilities will exhibit an increase in the interest rate. Drawbacks Not usable in conjunction with income statement analysis. Time value of money isn’t taken into account.
Duration Gap Analysis Measures the impact of changes in interest rates on the expected maturities of both assets and liabilities. Converts that information into present-value worth of deposits and loans, which is more meaningful in estimating maturities and the probability that either assets or liabilities will reprice during the period under review.
Value At Risk (VAR) It measures market or economic value risk. It is an overall indicator of loss likelihood that computes the maximum loss over a chosen horizon at a selected level of probability (confidence level). It’s major feature is that it takes portfolio diversification between risk factors into account.
Value At Risk (VAR) It simulates hundreds or thousands of times the next day value change in each instrument for each risk factor relative to the current risk factor values, classes the changes by order of magnitude, then determines the maximum expected loss. To integrate the correlation between risk factors, the variance/covariance matrix is used to convert the random risk factor changes to a set of correlated changes by pre-multiplying the vector of changes by the square root of the variance/covariance matrix.
Simulation This modeling is also referred to as a stochastic approach because the interest rate paths that it generates are based on a random-number generator. The method generates a large number of arbitrage- free interest rate paths, reevaluates the balance sheet and income value for each path and then presents the Asset & Liability Manager with a view of the values distribution and probability of occurrence. Useful for analysing mortgage prepayment options
Problems with Simulation Lack of historical data on customer behaviour still made modeling unreliable. Additionally, lack of on-going data storage made back testing the models difficult.
Hire-Purchase It is the legal term for a conditional sale contract Under a hire-purchase agreement you hire the goods unless and until you exercise the option to purchase them at the end of the agreement. This means that, as you dont own the goods, you cant sell them and must comply with the terms and conditions set out in the hire-purchase agreement.
Advantages When a sum equal to the original full price plus interest has been paid in equal installments, the buyer may then exercise an option to buy the goods at a predetermined price (usually a nominal sum) or return the goods to the owner. If the buyer defaults, the owner can repossess the goods (differentiation of HP from other unsecured consumer credit systems and benefits the economy because markets can expand while minimizing the sellers exposure to risk of default.)
Advantages HP is advantageous both To private consumers because it spreads the cost of expensive items over an extended time period. To certain business consumers in that the balance sheet and taxation treatment of hire purchased goods differs from outright capital purchases. The need for HP is reduced when consumers have collateral or other forms of credit are readily available.
HP Agreement A clear description of the goods The cash price for the goods The HP price, i.e., the total sum that must be paid to hire and then purchase the goods The deposit The monthly installments (most states regulate the rates and charges that can be applied in HP transactions) A reasonably comprehensive statement of the parties rights (including the right to cancel the agreement during a "cooling-off" period).
The seller and the owner If the seller has the resources and the legal right to sell the goods on credit (which usually depends on a licensing system in most countries), the seller and the owner will be the same person. The seller transfers ownership of the goods to a Finance Company, usually at a discounted price, and it is this company that hires and sells the goods to the buyer.
Implied warranties and conditions The hirer will be allowed to enjoy quiet possession of the goods. What is actually supplied must correspond with the description and the sample. If goods are misdescribed or faulty, you have a direct cause of action against the hire- purchase company (Supply of Goods (Implied Terms) Act 1973).
Implied warranties and conditions If, prior to signing the HP agreement, the dealer/shop made a false claim about the goods, you may be entitled to end the hire-purchase agreement and/or recover compensation from the HP company (section 56 Consumer Credit Act). If the dealer/shop gave you a false assurance about a financial-related matter under the HP agreement Youll have no cause for complaint if the written agreement which you signed sets out accurately the necessary financial details.
Implied warranties and conditions The hire-purchase company can always sue you for any arrears, but a prior notice of default is compulsory. If, with extra time, youll be able to make the repayments, apply to the court for a time order if, and when, youre served with a notice of default.
Hirer’s rights Buy the goods at any time by giving notice to the owner and paying the balance of the HP price less a rebate Return the goods to the buyer — this is subject to the payment of a penalty to reflect the owners loss of profit but subject to a maximum specified in each states law With the consent of the owner, to assign both the benefit and the burden of the contract to a third person.
Hirer’s obligation To pay the hire installments To take reasonable care of the goods (if the hirer damages the goods by using them in a non-standard way, he or she must continue to pay the installments and, if appropriate, compensate the owner for any loss in asset value) To inform the owner where the goods will be kept.
Owner’s rights To forfeit the deposit To retain the instalments already paid and recover the balance due To repossess the goods (which may have to be by application to a Court depending on the nature of the goods and the percentage of the total price paid) To claim damages for any loss suffered.