Financial Markets & Institutions-Unit3

8/7/2019 Financial Markets & Institutions-Unit3

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Asset Liability Management

Dr. P. K. Gupta


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Foc us Areas f o r a FI

N et interest in co me

Market value o f st oc kh o lders' equity


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B uilding B loc ks ALM

Risk Drivers

Risk Exp o sures

Standal o ne Risk

Co rrelati o ns

P o rtf o lio Risk

Eco n o mi c Capital


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W hat is ALM?

Managing a bank's entire balan c e sheet as a

dynami c system o f interrelated a cco unts and

transa c tio ns.ALM tend t o stru c ture the time s c hedule o f assets

and liabilities l o ans and dep o sits t o c lo se the

defi c it o r ex c ess liquidity gaps.

F uture defi c it require funding triggering interest

rate risks


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Reas o ns f o r ALM imp o rtan c e

VolatilityFinancial innovations

Regulatory PressuresManagement Recognition


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Asset and liability management co mmittee(ALCO)

A bank's asset and liability management co mmittee

(ALCO) coo rdinates all p o lic y de c isi o ns and

strategies that determine a bank's risk pr o fit and

pr o fit o bje c tives.

Interest rate risk management is the primary

resp o nsibility o f this co mmittee .


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Illustrati o n Pri c e & Maturity Mat c hing


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Maturity Mat c hing


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Interest Rate Risk is the p o tential variability in

a bank's net interest in co me and market value

o f equity due t o c hanges in the level o f

market interest rates.

Interest rate risk


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Interest Rate Risk Subtypes

Prepayment RiskCall/Put Risk

Volatility RiskRate Level RiskReinvestment Risk

Basis Risk(short run)Real interest rate risk


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W hat determines rate sensitivity?

In general, an asset o r liability is n o rmallyc lassified as rate-sensitive with a time frame if:

It matures

It represents and interim, o r partial, prin c ipalpaymentThe interest rate applied t o o utstanding prin c ipalc hanges co ntra c tually during the intervalThe o utstanding prin c ipal c an be repri c ed when

s o me base rate o f index c hanges and managementexpe c ts the base rate / index t o c hange during theinterval


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Interest Rate Gaps

Fixed Interest Rate Gap = Fixed Rate Assets-Fixed Rate Liabilities

Variable Interest Rate Gap = InterestSensitive Assets- Interest Sensitive LiabilitiesInterest Rate Gap=Average Reset Dates of

Assets - liabilities


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P o sitive and negative gaps

Positive GAPimplies a bank has m o re rate sensitive assetsthan liabilities, and that net interest in co me willgenerally rise (fall) when interest rates rise (fall).

N egative GAPimplies a bank has m o re rate sensitive liabilities

than rate sensitive assets, and that net interestin co me will generally fall (rise) when interest ratesrise (fall).


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Maturity Gap Analysis

Rate Sensitive Gap = Rate Sensitive Assets-

Rate Sensitive Liabilities


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Illustrati o n o f Gaps

Rate Sensitive Gap = RSA-RSL


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Rate Adjusted Gap

T he above percentages are movements in the value of assets andliabilities


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F a c to rs affe c ting NIIChanges in the level o f i-rates .

( NII = (GAP) * ( ( iexp .)

assumes a parallel shift in the yield c urve whi c h rarely

occ urs

Changes in the sl o pe o f the yield c urve o r the relati o nship

between asset yields and liability co st o f funds

Changes in the v o lume o f assets and liabilities

Change in the co mp o siti o n o f assets and liabilities


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Interest rate risk

Example: Rs. 50,000 l o an4 year l o an at 8.5%1 year debt at 4.5%

Spread 4.0%F unding GAP

GAP = RSA - RSL,GAP = 50,000This is a negative GAP.


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F unding GAP

Foc uses o n managing NII in the sh o rt run.

Gr o up assets and liabilities int o time"bu c kets a cco rding t o when they mature o r are expe c ted t o re-pri c eCal c ulate GAP f o r ea c h time bu c ketF unding GAP at per the bu c ket


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Traditi o nal stati c GAP analysis

Fo re c asting the interest rateSele c ting a series o f time bu c kets (intervals) f o r determining when assets and liabilities are rate-sensitiveGr o uping assets and liabilities int o time "bu c kets"

a cco rding t o when they mature o r re-pri c eThe effe c ts o f any o ff-balan c e sheet p o siti o ns(swaps, futures, et c .) are added t o the balan c esheet p o siti o nCal c ulate GAP f o r ea c h time bu c ketF

unding GAP t = Value RSA t - Valueo

r RSL twhere t = time bu c ket; e.g., 0-3 m o nthsManagement f o re c asts NII given the interest rateenvir o nment


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Expe c ted balan c e sheet f o r hyp o theti c al bank

Expe c ted Balan c e heet f o r Hyp o theti c al Bankssets Yield iabilities o st

ate sensiti e 6Fixed rate 22 6No n earnin

92E ity

o tal

6

NII x + x x 6 + 6 x 22

NI 6NII 7 7 2


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F a c to rs affe c ting net interest in co me

Change in the level of all short-term rates

Change in spread between assets yields and

interest cost (non-parallel shift in yield curve)Proportionate doubling in size .

Increase in RSAs and decrease in RSLs

RSA = 540, fixed rate = 310RSL = 560, fixed rate = 260 .


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In co me Sensitivity

Changes in NII are dire c tly pr o p o rti o nal t o the size o f the GAP( NII exp = (GAP) * ( ( iexp )

The larger is the GAP, the greater is the d o llar c hange in NII .*This applies o nly in the c ase o f a parallel shift in theyield c urve, whi c h is rare.

If rates d o n o t c hange by the same am o unt, thenthe GAP may c hange by m o re o r less.


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Advantages / disadvantages o f GAP

T he primary advantage of GAP analysis is itssimplicity . T he primary weakness is that it ignores thetime value of money . GAP further ignores the impact of embeddedoptions . For this reason, most banks conduct earningssensitivity analysis, or pro forma analysis, toproject earnings and the variation in earningsunder different interest rate environments .


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Embedded o pti o nsCustomers have different types of options,both explicit and implicit:

Option to refinance a loanCall option on a federal agency bond the bankownsDepositors option to withdraw funds prior to

maturity


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The impli c ati o ns o f embedded o pti o ns

Is the bank the buyer o r seller o f the o pti o nDo es the bank o r the c ust o mer determine whenthe o pti o n is exer c ised?

o w and by what am o unt is the bank being

co mpensated f o r selling the o pti o n, o r h o w mu c hmust it pay t o buy the o pti o n?W hen will the o pti o n be exer c ised?

Often determined by the e co n o mi c and interest

rate envir o

nmentStati c GAP analysis ign o res these embeddedo pti o ns


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Interest rate risk management measures

Cal c ulate peri o di c GAPs o ver sh o rt timeintervals.Mat c h fund repri c eable assets with similar repri c eable liabilities s o that peri o di c GAPsappr o a c h zer o .Mat c h fund l o ng-term assets with n o n interest-bearing liabilities.Use o ff-balan c e sheet transa c tio ns, su c h asinterest rate swaps and finan c ial futures, t ohedge.


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Vari o us ways t o adjust the effe c tive rate sensitivity o f abanks assets and liabilities o n-balan c e sheet.

Obje c tive Appr o a c hes

Redu c e assetsensitivity

B uy l o nger-term se c urities.Lengthen the maturities o f lo ans.Mo ve fr o m fl o ating-rate l o ans t o term l o ans.

In c rease assetsensitivity

Buy sh

ort-term se

curities.Sh o rten l o an maturities.

Make m o re l o ans o n a fl o ating-rate basis.

Redu c e liabilitysensitivity

Pay premiums t o attra c t l o nger-term dep o sitinstruments.Issue l o ng-term sub o rdinated debt.

In c rease liabilitysensitivity

Pay premiums t o attra c t sh o rt-term dep o sitinstruments.B o rr o w m o re via n o n- co re pur c hasedliabilities.


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Liquidity Risk

Arises due to mismatch of assets andliabilities with respect to size and maturity

Makes banks vulnerable to market liquidityriskT ime profile of gaps results from projected

assets and liabilities at different future timepoints .


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Gap Stru c ture

Rate Assets = 95Fixed Assets = 15

Liabilities = 50Equity = 30Liquidity Gap = 30

- ive value indicates deficits


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LG and LR

If L > A , it indicates excessIF A>L , it indicates deficit

Related aspects- N eed for funds/investments

- Maturity Mismatch


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Cash Mat c hing

Matching the time profile of the amortizationof assets and liabilitiesT

his makes liquidity gap = 0Fixed Rate vs . Floating Rate Matching


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Gap CalculationDate 1 3 4 5

A 150 140 130 1 0 110

L 150 130 1 0 100 105

G 0 10 0 0 0

A-Am o rtizati o n -10 -10 -10 -10

L- Am o rtizati o n - 0 -10 -10 -5

Marginal G 10 0 0 -5

Cum. Marginal G 10 10 10 5

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Financial Markets & Institutions-Unit3