Asset Liability Management in Banks
There are different organizational and governance models that guide the management of bank asset and liability activities. The models reflect fundamentally different risk philosophies that tend to evolve with the growing sophistication and depth of financial markets together with the position and activities undertaken by a bank in the market. The terms ‘ALM unit’ and ‘treasury unit’, can be confusing as they are often used by organizations who assign different responsibilities to them - this will be explained below. Key aspects that influence a banks approach . The evolution of models is driven by differing philosophies about the role of the treasury or the ALM unit and banks in markets at different stages of development often regard the treasury unit differently. In emerging markets the treasury function is usually simplistic and a support function mainly focused on liquidity management and basic foreign exchange activity. In these banks, it is not uncommon to have a prohibition on involvement in more sophisticated capital markets transactions such as derivatives due to lack of knowledge and suspicion about the instruments.
Such markets can suffer from poorly developed capital markets that provide little capacity to offset the risks assumed from the customer franchise. The result is often that these banks are slow to evolve and run risks, without knowing it, which can threaten their very survival. In developing markets the treasury function usually begins to take on more structure, more activities and a broader mandate. At the simpler end of the spectrum it can assume full balance sheet management responsibility, involving itself in more complex analytics and hedging activities.
At the more complex end it can assume trading and market making responsibilities for a range of capital market products that are used in hedging but also are provided to customers. This can often be referred to as an ‘integrated treasury function’, with profit making as well as hedge management the central themes. In developed markets the model usually evolves by separating out the trading and market making functions into a more customer centric unit such s a capital markets or institutional banking division, with a subsequent refocusing of the core ALM functions on more detailed analysis, and management of the banks’ assets, liabilities and capital base. Treasury becomes more of a service centre in these banks, providing assistance and support with pricing and analytics to customer facing divisions. The ALM or balance sheet can often be managed aggressively through the use of derivative contracts. Funds transfer pricing mechanisms are used extensively to create economic transparency and to immunize business units to risk. In all models the ALM function reports to either the CEO / CFO with the CFO generally having the day to day responsibility for the ALM core functions. Under all models it is important to establish a clear understanding of activities and risk thresholds in the Treasury function and ensure the risk framework is aligned to the operating structure and market realities. Establishing a governance structure within which the board of the bank is fully informed and cognisant of the risks being run is a critical and mandatory component.
Order custom essay Asset Liability Management in Banks with free plagiarism report
450+ experts on 30 subjects
Starting from 3 hours delivery
It is in the more developed markets that the Chief Risk Officer function has developed and come to represent the single independent point of oversight both internally and externally. Focus on some key ALM activities 36. Successful ALM units create a properly aligned risk and return management process. The right mix between skills and risk appetite must be identified, expected outcomes of activities known and appropriate metrics established. The approach adopted needs to be aligned to the realities of the market the bank is operating within and to its desired risk appetite. A bank needs to decide whether it wants to take a relatively neutral approach to ALM risks or is prepared to take a more aggressive approach and target higher long term earnings and an increase in economic value. Irrespective of the choice made, a bank needs to realise that the right level of skills and resources need to be committed to support the function. Failure to do this can result in a poorly managed operation characterised by volatility in; core earnings/margin; economic value, and; unpredictable economic results. The mismatch position of the balance sheet represents the interest rate and liquidity risk profile inherent. Assuming a single portfolio without hedges, a large and well diversified bank, with transactions weighted broadly across all market segments, will find that its balance sheet will naturally take on countercyclical characteristics as the business environment consolidates through the economic cycle. This makes sense as the bank is effectively providing customers with solutions they are demanding as they operate in the external environment.
The market itself will also provide limitations and one of the areas where this can manifest strongly is on the liability side of the balance sheet. Various techniques are used to examine the mismatch in a bank’s balance sheet and it can be a difficult process if not supported with adequate systems. Depending on systems and analytical support the ALM process will undertake a number of analysis designed to identify; static and dynamic mismatch; sensitivity of net interest income; and, market value under multiple scenarios -including under high stress.
The majority of banks set net interest income (NII) limits as a main measure of performance with the more advanced banks also using market or economic value as a secondary measure. NII has become the industry benchmark simulation tool because; it is relatively easy to understand and implement; it’s a single period measure that does not require many assumptions, and; it is easy for investors to relate to because it is directly linked to reported financial results. On the negative side, it is limited as it does not provide a full view of the risks run by a bank or reflect fully the economic impact of interest rate movements.
Market value or economic value simulations on the other hand, offer a more complete assessment of the risk being run but require significantly more detailed analysis which is out of reach of many banks at this point. The process requires multiple assumptions that are difficult to form in some cases and is less intuitive and more difficult to understand. Notwithstanding the difficulties of the latter, both metrics are important in the measurement and management of embedded risk in banks.
In less developed ALM units, the time it takes to collect and analyse information can render much of it useless for active management as by the time it is available markets have moved making hedging ineffective. 40. Access to timely and accurate data is critical in support of any form of ALM activity. The funds transfer pricing system has become a fundamental ALM tool in a bank. It creates the ability to immunize business units from risk and provides the basis for economic and product transparency.
The process of FTP is designed to identify interest margins and remove interest rate and funding or liquidity risk. Looking at it from the business unit perspective, it effectively locks in the margin on loans and deposits by assigning a transfer rate that reflects the repricing and cash flow profile of each balance sheet item – it is applied to both assets and liabilities. From the ALM unit’s perspective, it isolates business performance into discrete portfolios that can be assigned individualised metrics and facilitates the centralisation and management of interest rate mismatches.
A by-product is that it effectively allocates responsibilities between the organizational business units and the treasury department. In more developed banks, the FTP mechanism can also be used as a tool to assist with management of the balance sheet structure with FTP rates adjusted to either encourage or discourage product and customer flows. The associated analytical process leads to greater understanding of a bank’s competitive advantage, assisting with asset allocation and protection of the franchise. Similarly, in smaller and/or less developed banks it is of equal value as both a management and strategy tool. The methods used by banks are generally consistent - FTP rates are structured to include both interest rate and funding liquidity risks with the derived transfer yield curve constructed to include appropriate premiums. Such premiums should capture all elements associated with the banks funding cost. These should include the cost of items such as; holding liquidity reserves; optionality costs, where pre-payment rights exist; term funding program costs; and, items such as basis risk.
Liquidity Management
The main liquidity concern of the ALM unit is the funding liquidity risk embedded in the balance sheet. The funding of long term mortgages and other securitised assets with short term liabilities (the maturity transformation process), has moved to centre stage with the contagion effect of the sub-prime debacle. Both industry and regulators failed to recognise the importance of funding and liquidity as contributors to the crisis and the dependence on short term funding created intrinsic flaws in the business model. Banks must assess the buoyancy of funding and liquidity sources through the ALM process.
Banks are in the business of maturity transformation to meet their customers’ requirements and these result in liquidity, interest rate and currency mismatches which need to be managed. ALM units have traditionally analysed and ‘managed’ liquidity within pre set limits; however it is only the recent crises that have brought its true importance into focus. Failure to manage effectively can have dire results but the events of recent times have demonstrated that liquidity impacts can be cataclysmic to a bank. Like all areas of risk management, it is necessary to put a workable framework in place to manage liquidity risk.
It needs to look at two aspects: Managing liquidity under the business as usual scenario, and Managing liquidity under stress conditions. It also needs to include a number of liquidity measurement tools and establish limits against them. Some of the tools that have become industry standard are shown in Table 2.
Dynamic Cash Flow Gap
This includes a measurement based on maturing assets and liabilities plus assumed marketable asset liquidation over a given period. Liquidity Asset Ratios This is the ratio of liquid assets to total liabilities with liquids defined to include items such as cash and cash equivalents, trading account securities, repos investments into government securities, etc Concentration Ratios This is an important ratio that reassures the funding from a particular source compared to assets /liabilities or capital.
Liquidity Stress Measurement
A number of ratios can be examined here looking at multiple low stress and high stress scenarios Source: Modified from GARP 2008 Best Practices presentation. At the governance level, boards need to recognise liquidity risk as the ultimate killer. This means a board needs to clearly articulate the risk tolerance of the organization and subject the balance sheet to regular scrutiny. Guiding principles need to be included as part of this process. The following 5 principles are valuable: Diversify sources and term of funding – concentration and contagion were the killers in the recent crisis. Identify, measure, monitor and control – it is still surprising that many banks do not fully understand the composition of their balance sheet to a sufficient level of detail to allow for management of the risks. Understand the interaction between liquidity and other risks – e. g. basis risk – the flow on impact of an event in one area can be devastating to others. Establish both tactical and strategic liquidity management platforms – keep a focus on both the forest and the trees. Establish detailed contingency plans and stress test under multiple scenarios regularly.
Cite this Page
Asset Liability Management in Banks. (2018, Jan 14). Retrieved from https://phdessay.com/asset-liability-management-in-banks/
Run a free check or have your essay done for you
