RMPG Learning Series ALM Workshop

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RMPG Learning Series ALM Workshop Handouts

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RMPG Learning Series ALM Workshop

  1. 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. 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 CONFIDENTIALAll the contents of the presentation are confidential and should not be published, reproduced or circulated without the writtenconsent of World Bank, Central Bank of Bangladesh and IMaCS © IMaCS 2010 Printed 26-May-11 2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. 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. 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. 5. Agenda for Day 2 Liquidity risk Continued Lunch Break Liquidity risk Continued Liquidity risk Continued © IMaCS 2010 Printed 26-May-11 5
  6. 6. Agenda for Day 3 Liquidity risk Continued Lunch Break Liquidity risk Continued Interest rate risk © IMaCS 2010 Printed 26-May-11 6
  7. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 30. In this session, we will understand what constitutes assets and liabilities in a Bank and why asset liability management is important
  31. 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. 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. 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. 34.  Liquidity  May lead to mismatch→ liquidation Interest rate  Affects mismatch → profitability
  35. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 53. Bank’s obligations under LCs, Contingent Guarantees, Acceptances on Liabilitybehalf of constituents and Bills accepted by the bank arereflected under this heads.
  54. 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. 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. 56.  1. Cash 2. Remittance in transit 3. Balances with banks (in India only) a) Current account b) Deposit accounts/short term deposits
  57. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 72. does does managementmanagement have procedureshave a strategy in place forfor handling a accessing funds in an emergency?crisis?
  73. 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. 74. Another major element in the planshould be a strategy for takingcertain actions toalter asset and liability behaviours.
  75. 75. Other components of the contingency plan involve maintaining customer relationships with liability-holders, borrowers, and trading and off-balance-sheet counterparties.
  76. 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. 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. 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. 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. 80. For banks, the ability to access“Lender of Last Resort” loans oruse discount window facilities atCentral Banks provide furtherpotential
  81. 81. new issues of short- and long-term debt instrumentsnew capital issues, the sale ofsubsidiaries or lines of businessasset securitisation
  82. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 104. Discounting curves Forward Curve ZCYC CurveYield Par Curve Time to Maturity © IMaCS 2009 Printed 26-May-11 156
  105. 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. 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
  107. 107. Yield curve structure-India –current scenario10.00%9.50%9.00%8.50%8.00%7.50%7.00% 0.25-0.5 0.5-1 1.0-2.0 2.0-3.0 3.0-4.0 4.0-5.0 5.0-6.0 6.0-8.0 8.0-10.0 >10.0 © IMaCS 2009 Printed 26-May-11 159
  108. 108. Pricing of bonds EXERCISE © IMaCS 2009 Printed 26-May-11 160
  109. 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. 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. 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
  112. 112. Example of yield curve risk10.00%9.00%8.00% 3M7.00% 6M 9M 12M6.00%5.00%4.00% 15-Feb-10 15-Mar-10 15-Apr-10 15-May-10 15-Jun-10 15-Jul-10 15-Aug-10 15-Sep-10 15-Oct-10 15-Nov-10 © IMaCS 2009 Printed 26-May-11 164
  113. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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

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