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Asset Liability Management


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Asset Liability Management

  1. 1. Asset Liability Management Vikram Singh Sankhala
  2. 2. Topics 1. The definition and implications of Liquidity Risk 2. The role of the ALCO 3. The concept of funding gaps 4. The concept and implications of duration gaps 5. Some measures of liquidity risk 6. The concept of funds transfer pricing
  3. 3. Reading Materials 1. ALCO (The Essentials of Risk Management, pp. 185-188) 2. Gap Analysis (The Essentials of Risk Management, pp. 188-195) 3. Earnings at Risk (The Essentials of Risk Management, pp. 195-199) 4. Duration Gap (The Essentials of Risk Management, pp. 199-203) 5. Liquidity Measures (The Essentials of Risk Management, pp. 203-205) 6. Funds Transfer Pricing (The Essentials of Risk Management, pp. 205-206)
  4. 4. Case Studies 1. Continental Illinois: A Case Study 2. Daiwa Bank
  5. 5. Example • Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years. • For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations.
  6. 6. • The net transaction appears profitable—the bank is earning a 20 basis point spread—but it entails considerable risk. • At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. • If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 3.20 it is earning on its loan.
  7. 7. • Suppose, at the end of a year, an applicable 4- year interest rate is 6.00%. • The bank is in serious trouble. • It is going to be earning 3.20% on its loan and paying 6.00% on its financing.
  8. 8. • The problem in this example was caused by a mismatch between assets and liabilities. • Prior to the 1970's, such mismatches tended not to be a significant problem. • Interest rates in developed countries experienced only modest fluctuations, • so losses due to asset-liability mismatches were small or trivial.
  9. 9. • Many firms intentionally mismatched their balance sheets. • Because yield curves were generally upward sloping, banks could earn a spread by borrowing short and lending long. • Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued into the early 1980s.
  10. 10. Some Concepts
  11. 11. Liquid Assets • Liquid assets are assets that can be turned quickly into cash – Low transaction costs – Little or no loss in principle value – Traded in large market (trading does not move the market)
  12. 12. Liquid Assets • Examples: T-bills, T-notes, T-bonds
  13. 13. • Ratio of liquid assets to anticipated short- term liability cash flows • Multiple time horizons might be considered Asset-Liability Management 13 Liquidity Ratios
  14. 14. • Measures the sensitivity of the value of a series of cash flows to changes in interest rates • Duration is approximately the average point at which the projected cash flows occur • For example, if a portfolio of assets has a duration of 4, a 1% increase in interest rates will cause a 4% decrease in its value Asset-Liability Management 14 Duration
  15. 15. • Measures the sensitivity of the duration of a series of cash flows to changes in interest rates • Convexity measures how rapidly duration changes as interest rates change Compare duration and convexity of assets with those of liabilities Asset-Liability Management 15 Convexity
  16. 16. Create portfolios with offsetting cash flows Uses ◦ Reduce systemic or non-diversifiable risk Scope ◦ For a business segment ◦ Across business segments Approaches ◦ Static or dynamic ◦ Rely on business cash flows or supplement with derivatives Asset-Liability Management 16 Hedging
  17. 17. • Cash flow matching – Structure portfolios to match asset and liability cash flows • Immunization – Structure portfolios so that the impact of a change in interest rates on the value of liabilities offsets the corresponding impact on asset values Asset-Liability Management 17 Hedging Techniques
  18. 18. • Cash flow testing – Project cash flows under various interest rate scenarios – Examine the adequacy of asset cash flows to meet liability cash flows under each scenario • Value at risk (VaR) – Probability-based boundary on losses – Used by banks to measure risk in trading portfolio • Economic capital – Assets required, in excess of liabilities, to avoid ruin at a given confidence level Asset-Liability Management 18 Other Measurement Techniques
  20. 20. LIQUIDITY RISK • What is liquidity risk? – Liquidity risk refers to the risk that the institution might not be able to generate sufficient cash flow to meet its financial obligations
  21. 21. WHAT ARE THE EFFECTS OF LIQUIDITY CRUNCH • Risk to bank’s earnings • Reputational risk • Contagion effect • Liquidity crisis can lead to runs on institutions – Bank / FI failures affect economy
  22. 22. LIQUIDITY RISK • Factors affecting liquidity risk – Over extension of credit – High level of NPAs – Poor asset quality – Mismanagement – Reliance on a few wholesale depositors – Large undrawn loan commitments – Lack of appropriate liquidity policy & contingent plan
  23. 23. TYPES OF LIQUIDITY RISKS Broadly of three types: • Funding Risk: Due to withdrawal/non-renewal of deposits • Time Risk: Non-receipt of inflows on account of assets(loan installments) • Call Risk: contingent liabilities and new demand for loans
  24. 24. TACKLING LIQUIDITY RISK • Tackling the liquidity problem – A sound liquidity policy – Funding strategies – Contingency funding strategies – Liquidity planning under alternate scenarios – Measurement of mismatches through gap statements
  25. 25. • Approaches
  26. 26. “Traditional” regulatory approach • Broadly, regulators have developed 2 approaches to liquidity regulation: – The first is to monitor banks’ mismatch between out-flows and inflows at short maturities (e.g. 1 day, week or month). Banks should measure the potential outflows over the period & ensure that they have sufficient liquidity to meet the funding requirement. – The second requires banks to hold, at all times, a stock of highly liquid assets that can be used in the event that they encounter problems raising liquidity.
  27. 27. “Traditional” regulatory approach • For authorities, ensuring that banks hold adequate liquid assets makes banks individually, and the system as a whole, more robust and better able to withstand shocks without recourse to central bank support • But there is an obvious public policy trade-off between risk and efficiency in the size of the buffer banks hold.
  28. 28. “Traditional” regulatory approach • This approach is fine as a starting point, but it has a number of limitations: – It is a broad-brush, “one size fits all” approach which is not tailored to the circumstances of particular banks; – It places insufficient emphasis on qualitative factors, particularly the adequacy of systems & controls for managing liquidity risk; & – It does not reflect the latest liquidity risk management practices of major banks.
  29. 29. LIQUIDITY RISK • METHODOLOGIES FOR MEASUREMENT – Liquidity index – Peer group comparison – Gap between sources and uses – Maturity ladder construction
  30. 30. 1. Liquidity index • Liquidity index: Weighted sum of “fire sale price” P to fair market price, P*, where the portfolio weights are the percent of the portfolio value formed by the individual assets. I = Σ wi(Pi/Pi*)
  31. 31. 2. Peer group comparisons : • Peer group comparisons: usual ratios include borrowed funds/total assets, loan commitments/assets etc.
  32. 32. Other Measures: • Peer group comparisons: usual ratios include: – borrowed funds/total assets, – loan commitments/assets – Loan Losses / Net loans – Total Deposits./ Total Assets – Reserve for Loan losses / Net Loans
  33. 33. 3. Sources and Uses • Net liquidity statement: shows sources and uses of liquidity. – Sources: incoming deposits, revenue from sale of non deposit services, Customer Loan repayments, Sale of bank Assets, Borrowing in money market – Uses include: Deposit Withdraws, Volume of Acceptable loan requests, repayments of bank borrowing, other operating expenses, dividend payments
  34. 34. 4. Maturity ladder Construction • Maturity ladder/Scenario Analysis – For each maturity, assess all cash inflows versus outflows – Daily and cumulative net funding requirements can be determined in this manner – Must also evaluate “what if” scenarios in this framework
  35. 35. For Liquidity Planning • Important to know which types of depositors are likely to withdraw first in a crisis. – Allow for seasonal effects. – Delineate managerial responsibilities clearly.
  36. 36. Liquidity Management • Liquidity can be managed from either the asset side of the balance sheet or the liability side. • Asset based management – Main goal is storing liquidity in the form of liquid assets. – Less risky and often used by smaller institutions – Costs • Opportunity cost of foregone earnings if sold • Opportunity cost of liquid assets • Transaction Costs • Weakened Balance Sheet
  37. 37. Liquidity Management • Raising funds via borrowing if needed –Advantages • Only borrow if funds are needed • Volume and composition of asset portfolio is unchanged • Can always attract funds (by increasing rate) –Disadvantages • Dependent upon market rate • Withdrawal risk (funding risk)
  38. 38. Balanced Liquidity Management • Combination of Asset and Liability Management • Borrow only for unanticipated (usually short term needs) • Plan for long term liquidity needs via asset management.
  39. 39. • Interest Rate Risk
  40. 40. Net Interest Income= Interest Income-Interest Expenses. Net Interest Margin= Net Interest Income/Average Total Assets Important Terms
  41. 41. Net Interest Margin AssetsEarningsTotal ExpensesInterest-IncomeInterest NIM =
  42. 42. Net interest margin (NIM) Example: $100 million 5-year fixed-rate loans at 8% = $8 million interest $90 million 30-day time deposits at 4% = $3.6 million interest $10 million equity Net interest income = $4.4 million Net interest margin (NIM) = ($8 - $3.6)/$100 = 4.4% If interest rates rise 2%, deposit costs will rise in next year but not loan interest. Now, NIM = ($8 - $5.4)/$100 = 2.6%.
  43. 43. Interest Rate Risk • Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM). • Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.
  44. 44. Sources of Interest Rate Risk • Interest rate risk mainly arises from: – Gap Risk – Basis Risk – Net Interest Position Risk – Embedded Option Risk – Price Risk – Reinvestment Risk
  45. 45. Interest rate risk is the volatility in net interest income(NII) or in variations in net interest margin(NIM). Gap:The gap is the difference between the amount of assets and liabilities on which the interest rates are reset during a given period. Basis risk:The risk that the interest rate of different assets and liabilities may change in different magnitudes is called basis risk. Embedded option:Prepayment of loans and bonds and/or premature withdrawal of deposits before their stated maturity dates.
  46. 46. • Price Risk –When Interest Rates Rise, the Market Value of the Bond or Asset Falls • Reinvestment Risk –When Interest Rates Fall, the Coupon Payments on the Bond are Reinvested at Lower Rates
  47. 47. Interest Rate Risk: GAP & Earnings Sensitivity • When a bank’s assets and liabilities do not reprice at the same time, the result is a change in net interest income. – The change in the value of assets and the change in the value of liabilities will also differ, causing a change in the value of stockholder’s equity
  48. 48. How to mitigate the effect • To mitigate interest rate risk, the structure of the balance sheet has to be managed in such a way • that the effect on assets of any movement in Interest rates • remains highly correlated with its effect on Liabilities, • even in Volatile interest rate environments.
  49. 49. Interest Rate Risk • Banks typically focus on either: – Net interest income or – The market value of stockholders' equity • GAP Analysis – A static measure of risk that is commonly associated with net interest income (margin) targeting • Earnings Sensitivity Analysis – Earnings sensitivity analysis extends GAP analysis by focusing on changes in bank earnings due to changes in interest rates and balance sheet composition
  50. 50. FUNDAMENTALS OF ALM How does it work? Asset-Liability Management 50
  51. 51. What is ALM • ALM or Asset Liability Management is the • structured decision making process • for matching the mix of Assets and Liabilities • on a firm’s Balance Sheet.
  52. 52. Asset-Liability Management The Purpose of Asset-Liability Management is to Control a Bank’s Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity
  53. 53. Techniques used by ALM to control Risk • Gap Analysis • Duration Gap Analysis • Long Term Var
  54. 54. • ALM Strategy is the responsibility of the treasurer of the company. • But the control of Risk in the Balance Sheet is typically the mandate of the risk management function.
  55. 55. • ALM is especially critical in the case of Financial Institutions such as commercial banks and Insurance Companies. • Financial Intermediation generates two types of imbalances.
  56. 56. First • An imbalance between the amount of funds collected and Lent.
  57. 57. Second • An imbalance between the maturities and interest rate sensitivities of the sources of funding and the loans extended to Clients.
  58. 58. • Deposits normally have lower maturities than loans. • The rate of interest normally increases with the term of the loan.
  59. 59. • Cash flows from both assets and liabilities must be projected • The timing and amount of some cash flows are highly predictable, but many are not Asset-Liability Management 59 ALM is built on cash flows…
  60. 60. ALCO • The asset liability management committee is the traditional name in the banking industry for what is often known today as the senior risk committee. • ALCO is typically chaired by the CEO and composed of senior executive team of the bank along with Senior executives of Risk and Treasury. • It is co-chaired by the Chief Risk Officer and the treasurer.
  61. 61. Asset-Liability Management 61 ALM must strike a balance…
  62. 62. An historical perspective • Before Oct. 1979, Fed monetary policy kept interest rates stable. • Due to the above factors, banks concentrated on asset management. • As loan demand increased in the 1960s during bouts of inflation associated with the Vietnam War, banks started to use liability management. • Under liability management, banks purchase funds from the financial markets when needed. Unlike core deposits that are not interest sensitive, purchased funds are highly interest elastic. – Purchased funds have availability risk -- that is, these funds can dry up quickly if the market perceives problems of bank safety and soundness.
  63. 63. Liquidity Planning • Important to know which types of depositors are likely to withdraw first in a crisis. • Composition of the depositor base will affect the severity of funding shortfalls. – Example: mutual funds/pension funds more likely to withdraw than correspondent banks and small businesses • Allow for seasonal effects. • Delineate managerial responsibilities clearly.
  64. 64. Causes of Liquidity Risk • Asset side – May be forced to liquidate assets too rapidly resulting n “fire sale prices” – May result from loan commitments • Traditional approach: reserve asset management • Alternative: liability management.
  65. 65. Asset Side Liquidity Risk • Risk from loan commitments and other credit lines: – met either by borrowing funds or – by running down reserves
  66. 66. Causes of Liquidity Risk • Liability side • Reliance on demand deposits – Core deposits (provide long term source of funds) – Need to be able to predict the distribution of net deposit drains.
  67. 67. Net Deposit Drains • Deposit withdraws are in part offset by the inflow of new funds and income generated by from both on and off balance sheet activities. • The amount by which the cash withdraws exceed the new cash inflows is the Net Deposit Drain. • Positive NDD implies withdraws are greater than inflows. Negative NDD implies that inflows are greater than withdraws
  68. 68. Using Cash • The most obvious asset side management technique is to use the cash reserves of the firm.
  69. 69. Gap Analysis • Gap is defined as the difference between the rate sensitive assets and rate sensitive liabilities maturing within a specific time period.
  70. 70. Gap Analysis • Gap Analysis- Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates. - If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII. - conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII.
  71. 71. Measuring Interest Rate Risk with GAP • Traditional Static GAP Analysis GAPt = RSAt-RSLt – RSAt • Rate Sensitive Assets – Those assets that will mature or reprice in a given time period (t) – RSLt • Rate Sensitive Liabilities – Those liabilities that will mature or reprice in a given time period (t)
  72. 72. MATURITY GAP METHOD (IRS) • THREE OPTIONS: • A) RSA>RSL= Positive Gap • B) RSL>RSA= Negative Gap • C) RSL=RSA= Zero Gap
  73. 73. What Determines Rate Sensitivity? • An asset or liability is considered rate sensitivity if during the time interval: – It matures – It represents and interim, or partial, principal payment – It can be repriced • The interest rate applied to the outstanding principal changes contractually during the interval • The outstanding principal can be repriced when some base rate of index changes and management expects the base rate / index to change during the interval
  74. 74. Interest-Sensitive Assets • Short-Term Securities Issued by the Government and Private Borrowers • Short-Term Loans Made by the Bank to Borrowing Customers • Variable-Rate Loans Made by the Bank to Borrowing Customers
  75. 75. Interest-Sensitive Liabilities • Borrowings from Money Markets • Short-Term Savings Accounts • Money-Market Deposits • Variable-Rate Deposits
  76. 76. Example – A bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The bank’s initial spread is 4%. – What is the bank’s one year gap? 4 year Car Loan 8.50% 1 Year CD 4.50% 4.00%
  77. 77. Example • Traditional Static GAP Analysis – What is the bank’s 1-year GAP with the auto loan? • RSA1yr = $0 • RSL1yr = $10,000 • GAP1yr = $0 - $10,000 = -$10,000 – The bank’s one year funding GAP is -10,000 – If interest rates rise (fall) in 1 year, the bank’s margin will fall (rise)
  78. 78. Measuring Interest Rate Risk with GAP • Traditional Static GAP Analysis – Funding GAP • Focuses on managing net interest income in the short- run • Assumes a ‘parallel shift in the yield curve,’ or that all rates change at the same time, in the same direction and by the same amount.
  79. 79. Asset-Sensitive Bank Has: • Positive Dollar Interest-Sensitive Gap • Positive Relative Interest-Sensitive Gap • Interest Sensitivity Ratio Greater Than One
  80. 80. Liability Sensitive Bank Has: • Negative Dollar Interest-Sensitive Gap • Negative Relative Interest-Sensitive Gap • Interest Sensitivity Ratio Less Than One
  81. 81. Aim is to stabilise the short-term profits,long- term earnings and long-term substance of the bank. The parameters that are selected for the purpose of stabilizing asset liability management of banks are: -Net Interest Income(NII) -Net Interest Margin(NIM) -Economic Equity Ratio
  82. 82. • Net Interest Income- Interest Income-Interest Expenses. • Net Interest Margin- Net Interest Income/Average Total Assets • Economic Equity Ratio- The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. The fact assesses the sustenance capacity of the bank.
  83. 83. Net Interest Margin AssetsEarningsTotal ExpensesInterest-IncomeInterest NIM =
  84. 84. Factors Affecting Net Interest Income • Changes in the level of interest rates • Changes in the composition of assets and liabilities • Changes in the volume of earning assets and interest-bearing liabilities outstanding • Changes in the relationship between the yields on earning assets and rates paid on interest-bearing liabilities
  85. 85. Example • Consider the following balance sheet: Assets Yield Liabilities Cost Rate sensitive 500$ 8.0% 600$ 4.0% Fixed rate 350$ 11.0% 220$ 6.0% Non earning 150$ 100$ 920$ Equity 80$ Total 1,000$ 1,000$ GAP = 500 - 600 = -100 NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220) NIM = 41.3 / 850 = 4.86% NII = 78.5 - 37.2 = 41.3 Expected Balance Sheet for Hypothetical Bank
  86. 86. Examine the impact of the following changes • A 1% increase in the level of all short-term rates? • A 1% decrease in the spread between assets yields and interest costs such that the rate on RSAs increases to 8.5% and the rate on RSLs increase to 5.5%? • Changes in the relationship between short-term asset yields and liability costs • A proportionate doubling in size of the bank?
  87. 87. 1% increase in short-term rates Assets Yield Liabilities Cost Rate sensitive 500$ 9.0% 600$ 5.0% Fixed rate 350$ 11.0% 220$ 6.0% Non earning 150$ 100$ 920$ Equity 80$ Total 1,000$ 1,000$ GAP = 500 - 600 = -100 NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220) NIM = 40.3 / 850 = 4.74% NII = 83.5 - 43.2 = 40.3 Expected Balance Sheet for Hypothetical Bank With a negative GAP, more liabilities than assets reprice higher; hence NII and NIM fall
  88. 88. 1% decrease in the spread Assets Yield Liabilities Cost Rate sensitive 500$ 8.5% 600$ 5.5% Fixed rate 350$ 11.0% 220$ 6.0% Non earning 150$ 100$ 920$ Equity 80$ Total 1,000$ 1,000$ GAP = 500 - 600 = -100 NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220) NIM = 34.8 / 850 = 4.09% NII = 81 - 46.2 = 34.8 Expected Balance Sheet for Hypothetical Bank NII and NIM fall (rise) with a decrease (increase) in the spread. Why the larger change?
  89. 89. Proportionate doubling in size Assets Yield Liabilities Cost Rate sensitive 1,000$ 8.0% 1,200$ 4.0% Fixed rate 700$ 11.0% 440$ 6.0% Non earning 300$ 200$ 1,840$ Equity 160$ Total 2,000$ 2,000$ GAP = 1000 - 1200 = -200 NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440) NIM = 82.6 / 1700 = 4.86% NII = 157 - 74.4 = 82.6 Expected Balance Sheet for Hypothetical Bank NII and GAP double, but NIM stays the same. What has happened to risk?
  90. 90. Changes in the Volume of Earning Assets and Interest-Bearing Liabilities • Net interest income varies directly with changes in the volume of earning assets and interest-bearing liabilities, regardless of the level of interest rates
  91. 91. RSAs increase to $540 while fixed-rate assets decrease to $310 and RSLs decrease to $560 while fixed-rate liabilities increase to $260 Assets Yield Liabilities Cost Rate sensitive 540$ 8.0% 560$ 4.0% Fixed rate 310$ 11.0% 260$ 6.0% Non earning 150$ 100$ 920$ Equity 80$ Total 1,000$ 1,000$ GAP = 540 - 560 = -20 NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260) NIM = 39.3 / 850 = 4.62% NII = 77.3 - 38 = 39.3 Expected Balance Sheet for Hypothetical Bank Although the bank’s GAP (and hence risk) is lower, NII is also lower.
  92. 92. Changes in Portfolio Composition and Risk • To reduce risk, a bank with a negative GAP would try to increase RSAs (variable rate loans or shorter maturities on loans and investments) and decrease RSLs (issue relatively more longer-term CDs and fewer fed funds purchased) • Changes in portfolio composition also raise or lower interest income and expense based on the type of change
  93. 93. Measuring interest rate sensitivity and the dollar gap • Dollar gap: – RSA($) - RSL($) (or dollars of rate-sensitive assets minus dollars of rate-sensitive liabilities, which normally are less than one-year maturity). – To compare 2 or more banks, or make track a bank over time, use the: Relative gap ratio = Gap$/Total Assets or Interest rate sensitivity ratio = RSA$/$RSL$. – Positive dollar gap occurs when RSA$>RSL$. If interest rates rise (fall), bank NIMs or profit will rise (fall). The reverse happens in the case of a negative dollar gap where RSA$<RSL$. A zero dollar gap would protect bank profits from changes in interest rates.
  94. 94. Measuring interest rate sensitivity and the dollar gap • Dollar Gap: – Interest rate forecasts can be important in earning bank profit. If interest rates are expected to increase in the near future, the bank could use a positive dollar gap as an aggressive approach to gap management. If interest rates are expected to decrease in the near future, the bank could use a negative dollar gap (so as rate declined, bank deposit costs would fall more than bank revenues, causing profit to rise). • Incremental and cumulative gaps – Incremental gaps measure the gaps for different maturity buckets (e.g., 0-30 days, 30-90 days, 90-180 days, and 180-365 days). – Cumulative gaps add up the incremental gaps from maturity bucket to bucket.
  95. 95. Measuring interest rate sensitivity and the dollar gap • Gap, interest rates, and profitability: – The change in the dollar amount of net interest income (∆NII) is: ∆NII = RSA$(∆ i) - RSL$(∆ i) = GAP$(∆ i) Example: Assume that interest rates rise from 8% to 10%. ∆NII = $55 million (0.02) - $35 million (0.02) = $20 million (0.02) = $400,000 expected change in NII • Defensive versus aggressive asset/liability management: – Defensively guard against changes in NII (e.g., near zero gap). – Aggressively seek to increase NII in conjunction with interest rate forecasts (e.g., positive or negative gaps). – Many times some gaps are driven by market demands (e.g., borrowers want long-term loans and depositors want short-term maturities).
  96. 96. Measuring interest rate sensitivity and the dollar gap • Three problems with dollar gap management: – Time horizon problems related to when assets and liabilities are repriced. Dollar gap assumes they are all repriced on the same day, which is not true. For example, a bank could have a zero 30-day gap, but with daily liabilities and 30-day assets NII would react to changes in interest rates over time. A solution is to divide the assets and liabilities into maturity buckets (i.e., incremental gap). – Correlation with the market rates on assets and liabilities is 1.0. Of course, it is possible that liabilities are less correlated with interest rate movements than assets, or vice versa. A solution is the Standardized gap. For example, assume GAP$ = RSA$ - RSL$ = $200 (com’l paper) - $500 (CDs) = - $300. Assume the CD rate is 105% as volatile as 90-day T-Bills, while the com’l paper rate is 30% as volatile. Now we calculate the Standardized Gap = 0.30($200) - 1.05($500) = $60 - $525 = -$460, which is much more negative!
  97. 97. Measuring interest rate sensitivity and the dollar gap • Three problems with dollar gap management: – Focus on net interest income rather than shareholder wealth. Dollar gap may be set to increase NIM if interest rates increase, but equity values may decrease if the value of assets fall more than liabilities fall (i.e., the duration of assets is greater than the duration of liabilities). – Financial derivatives could be used to hedge dollar gap effects on equity values. – While GAP$ can adjust NIM for changes in interest rates, it does not consider effects of such changes on asset, liability, and equity values.
  98. 98. Duration gap analysis • How do changes in interest rates affect asset, liability, and equity values? – Duration gap analysis: Ιn general, ∆V = -D x V x [∆i/(1 + i)] For assets: ∆Α = -D x A x [∆i/(1 + i)] For liabilities: ∆L = -D x L x [∆i/(1 + i)] Change in equity value is: ∆E = ∆A - ∆L DGAP (duration gap) = DA - W DL, where DA is the average duration of assets, DL is the average duration of liabilities, and W is the ratio of total liabilities to total assets. DGAP can be positive, negative, or zero. The change in net worth or equity value (or ∆E) here is different from the market value of a bank’s stock (which is based on future expectations of dividends). This new value is based on changes in the market values of assets and liabilities on the bank’s balance sheet.
  99. 99. Duration gap analysis EXAMPLE: Balance Sheet Duration Assets $ Duration (yrs) Liabilities $ Duration (yrs) Cash 100 0 CD, 1 year 600 1.0 Business loans 400 1.25 CD, 5 year 300 5.0 Total liabilities $900 2.33 Mortgage loans 500 7.0 Equity 100 $1,000 4.0 $1,000 DGAP = 4.0 - (.9)(2.33) = 1.90 years Suppose interest rates increase from 11% to 12%. Now, % ∆E = (-1.90)(1/1.11) = -1.7%. $ ∆E = -1.7% x total assets = 1.7% x $1,000 = -$17.
  100. 100. Duration gap analysis • Defensive and aggressive duration gap management: – If you think interest rates will decrease in the future, a positive duration gap is desirable -- as rates decline, asset values will increase more than liability values increase (a positive equity effect). – If you predict an increase in interest rates, a negative duration gap is desirable -- as rates rise, asset values will decline less than the decline in liability values (a positive equity effect). – Of course, zero gap protects equity from the valuation effects of interest rate changes -- defensive management. – Aggressive management adjusts duration gap in anticipation of interest rate movements.
  101. 101. Earnings at Risk • On a periodic basis • The potential impact of the firm’s various gap positions • On the income statement for the current quarter and full year.
  102. 102. Duration of equity • Net worth = Market Value of Assets – Market Value of Liabilities. • Duration of Equity = (Market Value of Assets * Duration of Assets– Market Value of Liabilities*Duration of Liabilities) divided by Net Worth
  103. 103. Long Term Var • Can be achieved only by the Monte Carlo Method. • Purpose is to generate statistical distributions of Earnings at Risk and Net worth at different time horizons • In order to produce the worst case EAR and NW at a given confidence level say 99%.
  104. 104. Input Parameters • Term structure of interest rates which will include a random component. • Implied Volatilities • Interest rate sensitive prepayments • Loan defaults etc. • Simulation conducted at the pool level. • Pricing models need to be developed at each stage of the simulation to assess the value of assets and liabilities at that point of time.
  105. 105. Complex Relationship Model • Since the EAR and NW is a function of the range of input parameters, one needs a complex pricing model to represent the function as well as assumptions about the dynamics of interest rates. • Inconsistent assumptions both on the relationships and the interest rate dynamics, can distort the results.
  106. 106. Liquidity Risk Measurement • Liquidity can be quantified by using a symmetrical scale. • There is a rank score for the dollar amount of the product. • The process is done both for liquidity suppliers and Liquidity users. • The amount is multiplied by the rank score. • The sum on both sides is netted out.
  107. 107. Funds Transfer Pricing • Here each business unit is taken separately. • If one business unit obtains funds and the other applies them, instead of taking the resultant profit margin, • We take an independent benchmark like the LIBOR for each business unit and arrive at the profit margin of each business unit independently. • The independent margins of Business units result in the overall margin of the Business.
  108. 108. Statements
  109. 109. OperationalCredit Income Corporate Banking Wealth Management Private Banking LiquidityInterest Rate V R@ Market Report OperationalCredit Income Liquidity V R@ Market OperationalCredit Liquidity V R@ Market Report Report BehaviorIncome LiquidityInterest Rate V R@ Market Report Report Report Report Report Report Report Risk Management Profile Operational Behavior Credit Income Asset Management Wealth Management Fund Managem ent Private Banking LiquidityInterest Rate V R@ Market Report Report Report Report ReportReport Report
  110. 110. STATEMENT OF STRUCTURAL LIQUIDITY • Placed all cash inflows and outflows in the maturity ladder as per residual maturity • Maturing Liability: cash outflow • Maturing Assets : Cash Inflow • Classified in to 8 time buckets • Mismatches in the first two buckets not to exceed 20% of outflows • Banks can fix higher tolerance level for other maturity buckets.
  111. 111. Statement of Structural Liquidity All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets: i. 1 to 14 days ii. 15 to 28 days iii. 29 days and up to 3 months iv. Over 3 months and up to 6 months v. Over 6 months and up to 1 year vi. Over 1 year and up to 3 years vii. Over 3 years and up to 5 years viii. Over 5 years
  112. 112. STATEMENT OF STRUCTURAL LIQUIDITY • Places all cash inflows and outflows in the maturity ladder as per residual maturity • Maturing Liability: cash outflow • Maturing Assets : Cash Inflow • Classified in to 8 time buckets • Mismatches in the first two buckets not to exceed 20% of outflows • Shows the structure as of a particular date • Banks can fix higher tolerance level for other maturity buckets.
  113. 113. An Example of Structural Liquidity Statement 1-14Days 15-28 Days 30 Days- 3 Month 3 Mths - 6 Mths 6 Mths - 1Year 1Year - 3 Years 3 Years - 5 Years Over 5 Years Total Capital 200 200 Liab-fixed Int 300 200 200 600 600 300 200 200 2600 Liab-floating Int 350 400 350 450 500 450 450 450 3400 Others 50 50 0 200 300 Total outflow 700 650 550 1050 1100 750 650 1050 6500 Investments 200 150 250 250 300 100 350 900 2500 Loans-fixed Int 50 50 0 100 150 50 100 100 600 Loans - floating 200 150 200 150 150 150 50 50 1100 Loans BPLR Linked 100 150 200 500 350 500 100 100 2000 Others 50 50 0 0 0 0 0 200 300 Total Inflow 600 550 650 1000 950 800 600 1350 6500 Gap -100 -100 100 -50 -150 50 -50 300 0 Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0 Gap % to Total Outflow-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
  114. 114. STRATEGIES… • To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.
  115. 115. • Risk Management procedures vary vastly from institution to institution as well as the available data and environments • This implies Integrated Risk Management will be both expensive and time consuming • Therefore, Integrated Risk Management MUST be custom made according to the institution’s requirements
  116. 116. Liquidity Risk in Banks
  117. 117. Cash versus liquid assets • Banks own four types of cash assets: 1. vault cash, 2. demand deposit balances at Federal Reserve Banks, 3. demand deposit balances at private financial institutions, and 4. cash items in the process of collection (CIPC). • Cash assets do not earn any interest, so the entire allocation of funds represents a substantial opportunity cost for banks. • Banks attempt to minimize the amount of cash assets held and hold only those required by law or for operational needs.
  118. 118. Why do banks hold cash assets? 1. Banks supply coin and currency to meet customers' regular transactions needs. 2. Regulatory agencies mandate legal reserve requirements that can only be met by holding qualifying cash assets. 3. Banks serve as a clearinghouse for the nation's check payment system. 4. Banks use cash balances to purchase services from correspondent banks.
  119. 119. Cash assets are liquid assets • …only to the extent that a bank holds more than the minimum required. • Liquid assets are generally considered to be: 1. cash and due from banks in excess of requirements, 2. federal funds sold and reverse repurchase agreements, 3. short-term Treasury and agency obligations, 4. high quality short-term corporate and municipal securities, and 5. some government-guaranteed loans that can be readily sold.
  120. 120. Liquidity versus profitability • There is a short-run trade-off between liquidity and profitability. – The more liquid a bank is, the lower its return on equity and return on assets, all other things being equal. • Both asset and liability liquidity contribute to this relationship. – Asset liquidity is influenced by the composition and maturity of funds. – In terms of liability liquidity, banks with the best asset quality and highest equity capital have greater access to purchased funds. (They also pay lower interest rates and generally report lower returns in the short run.)
  121. 121. Liquidity risk, credit risk, and interest rate risk • Liquidity management is a day-to-day responsibility. • Liquidity risk, for a poorly managed bank, closely follows credit and interest rate risk. – Banks that experience large deposit outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired. • Few banks can replace lost deposits independently if an outright run on the bank occurs.
  122. 122. Factors affecting certain liquidity needs: • New Loan Demand – Unused commercial credit lines outstanding – Consumer credit available on bank-issued cards – Business activity and growth in the bank’s trade area – The aggressiveness of the bank’s loan officer call programs • Potential deposit losses – The composition of liabilities – Insured versus uninsured deposits – Deposit ownership between: money fund traders, trust fund traders, public institutions, commercial banks by size, corporations by size, individuals, foreign investors, and Treasury tax and loan accounts – Large deposits held by any single entity – Seasonal or cyclical patterns in deposits – The sensitivity of deposits to changes in the level of interest rates
  123. 123. Asset liquidity measures • Asset liquidity …the ease of converting an asset to cash with a minimum loss. • The most liquid assets mature near term and are highly marketable. • Liquidity measures are normally expressed in percentage terms as a fraction of total assets. • Highly liquid assets include: • Cash and due from banks in excess of required holdings and due from banks- interest bearing, typically with short maturities • Federal funds sold and reverse RPs. • U.S. Treasury securities maturing within one year • U.S. agency obligations maturing within one year • Corporate obligations maturing within one year and rated Baa and above • Municipal securities maturing within one year and rated Baa and above • Loans that can be readily sold and/or securitized
  124. 124. Pledging requirements • Not all of a bank’s securities can be easily sold. • Like their credit customers, banks are required to pledge collateral against certain types of borrowings. • U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral.
  125. 125. What about loans? • Many banks and bank analysts monitor loan-to- deposit ratios as a general measure of liquidity. • Loans are presumably the least liquid of assets, while deposits are the primary sources of funds. • A high ratio indicates illiquidity because a bank is fully extended relative to its stable funding.
  126. 126. The Loan-to-Deposit Ratio, continued • The loan-to-deposit ratio is not as meaningful a measure of liquidity as it first appears. • Two banks with identical deposits and loan-to-deposit ratios may have substantially different liquidity if one bank has highly marketable loans while the other has risky, long-term loans. • An aggregate loan figure similarly ignores the timing of cash flows from interest and principal payments. • The same is true for a bank’s deposit base. • Some deposits, such as long-term nonnegotiable time deposits, are more stable than others, so there is less risk of withdrawal. • In summary, the best measures of asset liquidity identifies the dollar amounts of unpledged liquid assets as a fraction of total assets.
  127. 127. Purchased Liquidity and Asset Quality • A bank’s ability to borrow at reasonable rates of interest is closely linked to the market’s perception of asset quality. Banks with high quality assets and a large capital base can issue more debt at relatively low rates. • Banks with stable deposits generally have the same widespread access to borrowed funds at relatively low rates. • Those that rely heavily on purchased funds, in contrast, must pay higher rates and experience greater volatility in the composition and average cost of liabilities. • For this reason, most banks today compete aggressively for retail core deposits.
  128. 128. Funding Avenues To satisfy funding needs, a bank must perform one or a combination of the following: a. Dispose off liquid assets b. Increase short term borrowings c. Decrease holding of less liquid assets d. Increase liability of a term nature e. Increase Capital funds
  129. 129. Liquidity planning • Banks actively engage in liquidity planning at two levels. – The first relates to managing the required reserve position. – The second stage involves forecasting net funds needs derived, seasonal or cyclical phenomena and overall bank growth.
  130. 130. Liquidity planning: Monthly intervals • The second stage of liquidity planning involves projecting funds needs over the coming year and beyond, if necessary. • Projections are separated into three categories: 1. base trend, 2. short-term seasonal, and 3. cyclical values. • Management can supplement this analysis by including projected changes in purchased funds and in investments with specific loan and deposit flows.
  131. 131. Monthly liquidity needs • The bank’s monthly liquidity needs are estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits: Liquidity needs = Forecasted ∆loans + ∆required reserves - forecasted ∆deposits
  132. 132. Liquidity GAP measures • Management can supplement this information with projected changes in purchased funds and investments with specific loan and deposit flows. • The bank can calculate a liquidity GAP by classifying potential uses and sources of funds into separate time frames according to their cash flow characteristics. • The Liquidity GAP for each time interval equals the dollar value of uses of funds minus the dollar value of sources of funds.
  133. 133. Considerations in selecting liquidity sources • The previous analysis focuses on estimating the dollar magnitude of liquidity needs. • Implicit in the discussion is the assumption that the bank has adequate liquidity sources. • Banks with options in meeting liquidity needs evaluate the characteristics of various sources to minimize costs.
  134. 134. Evaluating Asset sales: • Brokerage fees • Securities gains or losses • Foregone interest income • Any increase or decrease in taxes • Any increase or decrease in interest receipts
  135. 135. Evaluating New borrowings: • Brokerage fees • Required reserves • FDIC insurance premiums • Servicing or promotion costs • Interest expense. • The costs should be evaluated in present value terms because interest income and expense may arise over time. • The choice of one source over another often involves an implicit interest rate forecast.
  136. 136. 136 LIQUIDITY RISK: Effects EFFECTS OF LIQUIDITY CRUNCH • Risk to bank’s earnings • Reputational risk • Contagion effect • Liquidity crisis can lead to runs on institutions – Bank and Financial Institutions failures affect economy
  137. 137. 137 LIQUIDITY RISK: Factors • Factors affecting liquidity risk – Over extension of credit – High level of NPAs – Poor asset quality – Mismanagement – Non recognition of embedded option risk – Reliance on a few wholesale depositors – Large undrawn loan commitments – Lack of appropriate liquidity policy & contingent plan
  138. 138. 138 LIQUIDITY RISK: Solutions • Tackling the liquidity problem – A sound liquidity policy – Funding strategies – Contingency funding strategies – Liquidity planning under alternate scenarios – Measurement of mismatches through gap statements
  139. 139. 139 What is a Liquidity Contingency Plan? • A documented process to ensure that your bank has the ability and means to obtain the necessary funds to manage through a liquidity crisis. • Creates a process to follow to utilize management talent to expedite access to the financial markets and to inform shareholders, customers and the regulatory authorities that you are taking the appropriate actions to mitigate a liquidity crisis.
  140. 140. 140 When could a liquidity crisis occur? • Intraday – fraud, large wire out, etc… • End of Day – Market crisis, etc… • Over several days. • Over a month. • Over several months. Stems from Market, Credit and/or Operational Risk Events Either Bank Specific or Systemic
  141. 141. 141 Liquidity Contingency Plan: Objectives • Ensure that a viable capability exists to respond to an event. • Accomplish the LCP in an efficient, documented and orderly way. • Minimize losses and reputational damage. • Protect the Balance Sheet and financial position, even if the Balance Sheet moves to a new structure. • Minimize the risk of legal liabilities. • Ensure compliance with all applicable laws and regulations. • Maintain the confidence and good relations with the shareholders, investment community, regulatory agencies, customers, service providers and other involved parties.
  142. 142. 142 How Do I know when the Liquidity Contingency Plan should be activated? • When a pre-determined set of parameters are exceeded. • When a pre-determined number of triggers are activated. – Note – Targets are difficult to assess without parameters • Example – A target rate of 2% - When is it way off?
  143. 143. 143 LCP Activation – When do I do this?• Level 1 Event – Indicated by minor infringement on the liquidity parameters and/or triggers. Handled in the normal course of business. • Level 2 Event – Indicated by additional triggers and parameter violations. Additional executives become involved in addressing the problem. Access to unsecured lines, pledging additional collateral, brokered CD’s, etc… • Level 3 Event – At level 3, the LCP is formally activated. A pre- determined set of parameters/triggers are exceeded. – Not handled during the normal course of business. – Scope and duration could have a strong adverse effect on the bank – Need to utilize multiple internal and external resources. – Could be as a result of a physical disaster (make sure this plan is referenced in your Business Continuity Plan)
  144. 144. 144 When should liquidity actions be taken? • Below is an activation table that indicates when liquidity actions should be taken. This table is a guidance table. To use this table, add the parameters and triggers together. However, the plan may be activated with fewer or no parameters or triggers exceeded, especially in the case of a sudden event. Level # of Parameters Exceeded Number of Triggers Exceeded Level I 2 2 Level II 4 4 Level III – Full Plan Activation 6 6
  145. 145. 145 Parameter Examples Liquidity and Funding Ratios Low High Gross Loans to Total Deposits 70% 140% Duration and Maturity Adjusted Liquidity 75% 90% Fixed Liability Ratio 25% 100% Pledgable Mortgage Loans to Total Residential Mortgage Loans 70% 80% Net Short Term Non-core Fund Dependence (Short term non core funding less short term investments divided by long term assets) 50% 80% Net Non-core Fund Dependence (Non core liabilities less short term investments divided by long term assets) 50% 85% Brokered Deposits to Deposits 0% 20%
  146. 146. 146 Triggers for different events Triggers are used as the basis for scenarios for review by the Bank. The triggers are used in order to ensure their relevance to the liquidity situation at the Bank. Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases of uncertainty about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy. Systemic risk events can be sudden and unexpected, or the likelihood of their occurrence can build up over time in the absence of appropriate policy responses. The adverse real economic effects from systemic problems are generally seen as arising from disruptions to payment systems, to credit flows, and from the disruption of asset values. This definition, from The Group of Ten: Report on Consolidation in the Financial Sector, captures both the timing and the scope of such an event. Systemic risk is diversifiable and the events that trigger the LCP should match the Bank’s exposures.
  147. 147. 147 Triggers - Examples Description Change/Cap/Floor Probability/Severity Strong shift from accommodative to restrictive monetary policy Qualitative Medium/Low Unemployment rate changes to indicate a recession 50% Change Medium/Medium Loss of confidence in a major capital markets participant by funds providers that may spill over to others Qualitative Low/Medium Indications of a potential asset bubble Qualitative Medium/High Agency MBS spreads to the 5 year Swap – 5 day moving average 150 bp increase Low/High 3 month LIBOR to 3 Month T-Bills – 5 day rolling average 100 bp increase Low/Medium Commercial Paper Issuance by Banks ($) year to year 50% decrease Low/Medium
  148. 148. 148 Parameters and Triggers • Parameters are established for overall management. • Triggers are identified for three types of situations – Normal to Non-Normal – Systemic – Normal to Non-Normal – Bank Specific – Non-Normal with Further Deterioration – Systemic and Bank Specific • The most difficult triggers to identify • Reports should be developed that contain this information and should be reviewed on a pre-identified schedule. In a crisis, critical reporting should be accelerated.
  149. 149. 149 Who Gets Involved? Liquidity Event Management Team (LEMT) LEMT Members Primary Responsibility Chief Executive Officer LEMT Leader Activate LCP Ensure necessary decisions are made by appropriate executives LEMT Leader role can be delegated to another executive Chief Risk Officer Activate LCP (if necessary) Ensure necessary decisions are made by appropriate executives (if necessary) Chief Financial Officer Coordinate all financial efforts related to the event Coordinate communication with regulatory agencies Chief Treasury Officer Alternate LEMT Leader Coordinate activities in Investments, Deposits and Lending Coordinate actions to access and secure funds for the financial institution LCP Coordinator Coordinate all actions related to enacting the LCP Coordinate communication up to the LEMT and down to the identified interested parties, including the BCP if required Treasury Operations/ALM Provide data and run models to manage the event. Coordinate scenario planning. Corporate Communications Coordinates all communications, with the exception of the Regulatory Agencies Serve as the point of contact for the media and other outside parties (except regulatory agencies) seeking information about the nature and status of the event and responses by the Bank
  150. 150. 150 Key individuals who support the LEMT Other Executives Primary Responsibility Chief Credit Officer Coordinate response for all lending area activities SVP Retail Banking Assist in coordination of response for all regional community bank activities Assistant Treasurer Coordinate all investment decisions Senior Trust Officer Coordinate response for all trust area activities Legal Counsel Identify legal issues as they arise and advise the LCP on liability issues Expedite review of contracts for procurement of necessary funds Coordinate insurance documentation and recordkeeping requirements for claims processing, if necessary Corporate Controller Balance sheet accounting and budget forecasting. Human Resources Director Ensure officers and employees who are deemed to need to be exited are exited and access to sensitive systems and information is discontinued. Work with recruiters if key personnel are required with specific skill sets.
  152. 152. 152 Stage 1 Declaration and Notification of Liquidity Crisis • Declaration of Formal Liquidity Crisis, based on pre-defined triggers. • Notification of interested and involved individuals through use of the Contact List. • Arranging the initial meeting to discuss actions to be taken to mitigate the Liquidity Crisis • The LEMT Leader assumes control of the response activities. • Corporate Communications prepares necessary employee notifications and news releases for media, regulators and counterparties.
  153. 153. 153 Stage 2 Initial Meeting of the Liquidity Event Management Team • Distribution of the LCP and the reasons for the declaration of the need for contingent liquidity. • Establish meeting schedule, information requirements and potential actions. • Arranging for full disclosure of issues to the LEMT. • Ensuring actionable items come out of the initial meeting, enabling early intervention. • Developing communication to the appropriate regulatory authorities regarding the reason for the activation and the intended actions.
  154. 154. 154 Stage 3 Subsequent Meetings and Actionable Items • Provide updates regarding liquidity status and projected needs. • Review updated information. • Determine how balance sheet, employees, customers, shareholders and counterparties are responding to draw downs of loan commitments, additional collateralizations, securitizations, sales and other actions. • Determine next steps, responsibilities and next meeting.
  155. 155. 155 Stage 4 Movement to Stabilized State of Liquidity • As liquidity stabilizes, determine methods to pay down loans, unwind positions and other steps to resume a stable liquidity state. • Reforecast upcoming months to develop strategy. • Identify communications requirements
  156. 156. 156 Stage 5 Forensic Review of Crisis • Conduct table top walk through of crisis. • Amend plan as appropriate. • Communicate forensic activities to appropriate personnel.
  157. 157. 157 LCP: The Goal • It is important to remember that the goal is to bridge the liquidity deficiency and not attempt to restructure the balance sheet for long term profitability. In fact, because of the liquidity issues, the profitability of the Bank should expect to suffer. The goal is to focus on short term solutions to enable the Bank to continue operating until longer term stability can be achieved.
  158. 158. 158 Actions to be taken during a Liquidity Crisis – In order of consideration • A liquidity crisis, whether a Level I, II, III, requires a concerted effort by the Bank to manage through. Because each liquidity crisis is somewhat unique, the actions outlined below are not specified as being required but are rather presented in menu form. 1. In general, a financial institution should consider tapping funds that are readily available, unsecured and can be termed longer than originally projected. These types of funds will be made unavailable or priced out of range more quickly than funds that require collateral to access. 2. Of secondary importance is the cost of these funds, as they are being used to deal with a crisis and should be expected to have a higher cost associated with them. 3. At the same time, some diversification is considered prudent because of the message that is being sent to the market. 4. It is important to keep in mind that the funds being accessed are to address the crisis until the Bank returns to a new level of stability, even if the new level is of a significantly riskier institution. In other words, the goal is to survive. • The LCP Coordinator should keep a list of available sources of funds and understand any covenants associated with their use. This list should be updated at least monthly or more frequently in case of a crisis.
  159. 159. 159 Examples of ActionsAction Impact Determine severity and duration of crisis through current observations and estimates of the short-term outlook. Creates platform from which to build recovery strategy. Have all Business Units that could have large outflows of cash contact Treasury prior to Outflow Provides ability to negotiate on deposits or alerts Treasury on wire activity. Reduces cash outflow. Move maturing less liquid securities into more liquid instruments. Typically reduces yield but provides pledgable collateral. Preferable to total liquidation because investments remain after liquidity crisis subsides. Acquire fed funds to cover liquidity shortfall. Very short term strategy to cover intraday or interday liquidity needs. Reduce correspondent balances and move to paying fees for services instead of compensating balances. Short term strategy to cover immediate cash needs. Access unsecured lines. Counterparties noted in Appendix I. Accessing unsecured lines should be an early stage activity and addresses short term needs. These funds will typically not be available as the crisis unfolds. Early use saves collateral for use at a later stage. However, a blended approach should be used (unsecured and secured). Access unsecured term loans. Counterparties noted in Appendix I. Accessing unsecured term loans should be an early stage activity and addresses the need to lengthen maturities. These funds will typically not be available as the crisis unfolds. Early use saves collateral for use at a later stage. Move customer repurchase agreements away from pledged securities. Pledged securities (repos) used for customer deposits may need to be redirected to access market funds. While there might be some flight from the bank because of this, alternatives can be offered to customers to retain deposits for a short period of time.
  160. 160. LIQUIDITY RISK • RBI GUIDELINES – Structural liquidity statement – Dynamic liquidity statement – Board / ALCO • ALM Information System • ALM organisation • ALM process (Risk Mgt process) – Mismatch limits in the gap statement – Assumptions / Behavioural study
  161. 161. ALM - Funds Transfer Pricing Rate Maturity LIBOR Curve Loan Deposit Credit Spread Funding Margin Maturity Mismatch
  162. 162. Questions for Revision • What are liquid assets ? What is a liquidity crisis ? What is its impact on an organization ? Illustrate with examples ? • What is meant by liquidity Risk ? Why is it so important ?
  163. 163. Define the following • Net Interest Income • Net Interest Margin • Static Gap Analysis in ALM.
  164. 164. Questions for Revision • What is Interest Rate Risk ? How does it affect a bank’s earnings ? • What is meant by Asset Liability Management ? What is ALCO ? What is the composition of ALCO ?
  165. 165. Questions for Revision • What are the traditional regulatory approaches towards Managing Liquidity Risk? • Discuss the methods that an organization can use to tackle liquidity risk ? What are the committees, contingency plans, triggers and actions that an organization put in place to tackle liquidity Risk ?
  166. 166. The End