Workshop AFGAP-ALMA

Professional training in ALM

11 May 2012

ALM Professional training in France

As of now, only in-house ALM training programs do exist in France

For example, Société Générale and BNPP have developed their in-house programs exclusively dedicated to their own employees

As far as we are aware, there is no academic-based training specifically oriented toward asset-liability management

Nevertheless, many academic programs on asset management, risk management, mathematical finance, actuarial sciences etc. do actually exist

AFGAP has been working on a comprehensive training program in ALM under the following guidelines:

mostly oriented towards banks (versus insurance companies)

sponsored by AFGAP and its stakeholders

anchored in one (or more) academic institution, for example ENSAE which is one of the leading graduate school in economics, finance and quantitative analysis

delivering both academic and professional certification

ALM Professional training in France: An example

Level 1 (2-3 days)

• Intoduction to banking book risks

• Definition, economic and regulatory context, main challenges about Liquidity Risk

• Definition, economic and regulatory context, main challenges about Interest Rate Risk

• Definition, economic and regulatory context, main challenges about Currency Risk

• Organisation, gouvernance and risk policies

Level 2 (2-3 days)

• Focus on balance-sheet / off balance sheet main exposures

• Modeling of maturing / non maturing products

• Liquidity gap, interest rate gap, risk measurement

• Main risk indicators: gaps, duration analysis, interest rate margin sensitivity, present value, Earnings-at-Risk

• Static liquidity gap and on-going concern gaps

• Hedging and Funding Transfer Prices

• Regulatory context: ratios, accountancy rand prudential requirements

Level 3 (2-3 days)

• Option modelling in ALM: interest-rate-capped loans, fixed/variable rate loans, early repayment/termination etc.

• Off-balance sheet and non-plain vanilla hedging products: swaptions

• Non-linear risk modeling

• Advanced hedging

• Economic capital and capital management

ALM Professional training in France: An example

Employees targeted :

• ALCO members

• ALM employees in F/O and B/O departments

• Risk managers

• Internal auditors / Accountants

• Quants

• Budgeting and Capital planning executives

• All employees in Finance divisions, Retail and Corporate management units etc.

ALM Professional training in France: AFGAP objectives

AFGAP Objectives Extending in-house program to set up a 80-hour program aimed at training any employee from AFGAP stakeholders

Providing trainees with a common and unified package of skills and core competences

Enhancing ALM culture in France to strengthen banks position when discussing with French and foreign regulators

Developing an international english-based training program in the coming years

Enrolling supervisory bodies’ and regulators’ employees in the program

Connecting ALM with academic curriculum in order to develop academic research in this field

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Example of a training program - 4 modules

1. Fundamentals of structural risks management E-learning of 80 slides.

2. Level 1 - Introduction to structural risks management 2-day training in a classroom with exercices

3. Level 2 – Advanced practice for the management of structural risks 2-day training in a classroom with exercices and a case study

4. Level 3 – Management of implicit and explicit options in ALM 2-day training in a classroom with exercices

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I. Fundamentals of structural risks management

• Introduction.• The yield curve.• Intermediation activity and the ALM perimeter.• The schedule and gap principles.• Liquidity, interest rate and foreign exchange risks.• Fund transfer pricing.• ALM function regulation and organization.

Summary

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2011 2012 2013 2014 2015 2016 2017 2018

II. Level 1 - Introduction to structural risks management

• Introduction to structural risks and their management– Banking intermediation– The bank balance sheet– Origins and impact of structural risks– Principles and tools for structural risks management

• Liquidity risk and its management– Origins and impact of liquidity risk– Liquidity spread– Illustration: the 2007-2008 and 2009-2011 financial crises– Measuring liquidity risk: indicators– Managing liquidity risk– Regulatory guidelines regarding liquidity risk

Summary – 1st Part

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2011 2012 2013 2014 2015 2016 2017 2018

• Interest rate risk and its management– Origins and impact of interest rate risk– Interest rate risk illustrations– First interest rate risk measurement: the interest rate gap– Building the interest rate gap: illustrations– Second interest rate risk measurement: sensitivity.– Managing interest rate risk– Fund transfer pricing– Regulatory guidelines regarding interest rate risk

• Currency risk and its management– Origins and impact of currency risk– Scope and measurement of currency risk– Managing currency risk

• How risk management is organised in a bank– Regulatory guidelines and their transposition to banks– The role of ALM within a bank– The parties involved in risk management

Summary – 2nd Part

II. Level 1 - Introduction to structural risks management

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2011 2012 2013 2014 2015 2016 2017

III. Level 2 - Advanced practice for the management of structural risks

• Reminders about the basics – Reminders on structural risk– Reminders about the yield curve

• Scheduling of balance sheet items– Contract Maturities and modeling principle– Prepayments– Non scheduled deposits and modeling principles– Off Balance sheet commitments– Reserve requirements– Overdrafts

Summary – 1st Part

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2011 2012 2013 2014 2015 2016 2017 2018

• Indicators and hedging of structural risks– Interest rate risk– Liquidity risk– Fund Transfer Price

• External Regulation

• Special Cases: the shareholders' equity in the management of structural risks – Definitions – Group Principles on the reinvestment (re-investment) of Shareholders’ Equity

Case study: preparing and conducting of the ALM Committee

Summary – 2nd Part

III. Level 2 - Advanced practice for the management of structural risks

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2011 2012 2013 2014 2015 2016 2017 2018

IV. Level 3 - Management of implicit and explicit options in ALM

• Part 1 - Modeling prepayments• Part 2 - Modeling of home-buyer's savings plan • Part 3 - Review of the notions of convexity, duration and sensitivity• Part 4 - Pricing of a cap• Part 5 - Calculation of optional ITR• Part 6 - Value at Risk

• Part 7 - Economic Capital required for the interest rate risk

Summary

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Illustrations

deposits

Banking intermediation

• The fundamental role of a commercial bank is to:– Raise funds from its customers (resources);– Grant loans to various customers (uses).– Examples:

• This is a bank's intermediation role.

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salaries

loans

The bank balance sheet

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ASSETS LIABILITIES

CUSTOMERUSES

MARKETS

FINANCING

FIXED ASSETS

CUSTOMERRESOURCES

SHORT-TERMFINANCING

LONG-TERMFINANCING

SHAREHOLDERS’ EQUITY

COMMITMENTSGIVEN

MARKET TRANSACTIONS

COMMITMENTS RECEIVED

MARKET TRANSACTIONS

Off-Balance sheet

Balance sheet

ALM Department

Principles and tools for risk management

• In order to guarantee that the Commercial Department receives its due share of the margin, the bank has set up the ALM Department, which matches every customer loan and every customer deposit at the market rate by going through the bank’s Treasury.

4.5% over 5 years

3% over 3 months5% over 5 years

3% over 3 months

4.5% over 5 years

2% over 3 months

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Principles and tools for risk management

• Transformation and anti-transformation– Two words with opposite meanings:

• Transformation: short-term resources of funding matched by long-term uses• Anti-transformation: means borrowing long to lend short• The transformation margin: is the gain realised on the difference between short and

long-term rates.

2,5

3

3,5

4

4,5

5

0 1A 2A 3A 4A 5A 6A 7A 8A 9A 10A 11A 12A 13A 14A 15A 16A 17A 18A 19A 20A3

3,1

3,2

3,3

3,4

3,5

3,6

3,7

3,8

3,9

0 1A 2A 3A 4A 5A 6A 7A 8A 9A 10A 11A 12A 13A 14A 15A 16A 17A 18A 19A 20A

Transformation: margin if the curve is positive

Anti-transformation: margin if the slope is negative

Interest rate risk hedging

• Example 1: Hedging by term borrowings starting spot (if there is no swap market )

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Limit = 1 A0 A1 A2 A3 A4 A5 A6 A7 A8 A9 A10

Interest Rate Gap - 73 - 67 - 56 - 45 - 45 - 28 - 7 - 19 33 - -

Sensitivity before hedging = -2.7FR Interbank borrowing 100 100 100 FR Interbank borrowingFR Interbank borrowing

Interest Rate Gap after hedging - 27 33 56 - 45 - 45 - 28 - 7 - 19 33 - -

Sensitivity after hedging = 0

A1 1,0A2 1,9A3 2,7A4 3,5A5 4,3A6 5,1A7 5,8A8 6,5A9 7,1A10 7,7

Sensitivity of an operationof notional 100 and of maturity :

-80

-60

-40

-20

-

20

40

A0 A1 A2 A3 A4 A5 A6 A7 A8 A9 A10

Interest Rate Gap

Interest Rate Gap after hedgingPassifs

Actifs

Building the liquidity gap: illustrations

• Example: Fixed term loan falling due in 10 years (a kind of repayment loan with constant payment intervals).

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Constant payment amortisation profile

Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10

Liquidity riskBuilding the liquidity gap: illustrations

• Example: building a liquidity gap - Assets

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Assets

0

50

100

150

200

250

300

350

400

450

A0 A1 A2 A3 A4 A5 A6 A7 A8 A9A10

Commitments givenFixed assetsIndexed rate loansFR loansSecurities

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

janv.-

03

sept.

-03

mai-04

janv.-

05

sept.

-05

juin-

06

févr.-

07

oct.-0

7

juin-

08

mars-09

nov.-

09

juil.-1

0

mars-11

nov.-

11

3M 12M 5Y 10Y

Origins and impact of interest rate risk

Inversion of the yield curve

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Market rate volatility.

Steepening of the yield curve

Flattening of the yield curve

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Internal transfer rate

• Principle of notional backing within ALM

– Example with a loan customer.

– Example with a client term deposit.

ALM Branch ClientVirtual Loan

same characteristics as the loan customer

Loan to the client

ALM Branch ClientVirtual Placement

same characteristics as the customer deposit

Customer deposit

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Internal transfer rate

• The internal transfer rate (ITR) intervenes in the interest margin breakdown : – Example for a loan that the Branch performs with his client:

Markets Branch ClientTreasury ALM

CUSTOMER RATE

ITR ALMREFUNDING

RATE

MARKETSREFUNDING

RATE

Net interest income credit

Cash marginALM margin

InteresGross Margin

t

Margin = Sales + structure + costs + Credit costs Cost of

Equity ...

Internal transfer rate

• Example 1: Indexed rate loan

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Customer rate 3M EURIBOR + Margin : 3.5%

3M EURIBOR: 2%

Liquidity: 0.4%

Commercial margin: 1.1%

FTP 2.4%

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Internal transfer rate • Example of calculation for a profile depreciable/amortizing profile? (non-linear).

Width W (years) 1 2 3 4 5

1 year 2 years 3 years 4 years 5 years Period

amount

75

ITR 2 years = 3.55%

ITR 1 year = 2.5%

ITR 3 years = 4.15%

ITR 4 years = 4.75%

ITR 5 years= 5%

Height H (amount) 17.2 16.1 14.9 13.9 12.9

Area = W H 17.2 32.2 44.7 55.6 64.5

ITR 2.5% 3.55% 4.15% 4.75% 5%

ITR Area 0.43 1.14 1.86 2.64 3.22

Sum ( ITR Area)

Sum ( Area)= 4.34%

Calculation of the sensitivity within SRC

• ALM has tried to approach the sensitivity formula for a variation of 1%.• We can write that the value of a loan of a nominal 1 and of annual coupon C is equal (with a

single discount rate) to:

• The change in value of the loan to an increase of 1% is written as:

• For a loan, we recall that if rates rise, its value decreases.• The cash flows Gap represents the trades to be set up to immunize the position.

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nn

nnn

nn

n

pp

nn rrr

Crr

CrCV)1(

1)1(

11)1(

1)1(

),(1

nr

1%)1,(),(%)1,(

nn

nnnn

rrVrrVrrVV

Calculation of the sensitivity within ALM

• If the trade to be set up is a loan and is not hedged, the entity will realize a gain if rates rise.• To characterize this gain, we will write that the change in value of the loan must be positive and will be

calculated as follow :

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nnn

nnn

nn

nnn

nnn

n

nnn

nnn

nnn

nn

nn

nnn

nnn

rr

rrr

rrrrr

rrrrrrrr

rrrrrrVV

%)11(11

%1%1

%)11(%)1(1%)11(%1

%)11(%)1(%1)%1(%)11(

%)11(%)1(%)1(%)11(%)11(%)1(

%)11(1

%)11(11

%11%)1,(1

Prepayment modelling:Prepayment modelling:

• Step 1 - Calculation of the outstanding loan balance

• Step 2 - Calibration of the seasonality parameters by stratification

• Step 3 - Calibration of the parameters of seasoning by stratification

• Step 4 - Calibration of the dependence on interest rate

• Step 5 - Validation : consistency & predictive power

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Step 2 - Modeling of the seasonality

Stratification :To avoid rate effect on seasonal coefficients, we sort the couples (i,t) of loan i and date t in 10 divisions that we call “strate”.

Prepayment rate by division

Minimization

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Step 4 – PP Dependence on interest rates • In theory, there is a level of interest rates at which all rational agents would have to

prepay. Thus we seek a function with a “threshold effect" to illustrate the dependence of PP on interest rates.

• Arctangent function with rate dependent coefficients

• Minimization

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Sensitivity of the NAV

The NAV of the 5-year bond paying a 4% yield is the following :

Year Rate Cash Flow Df « Rate" Discounted Cash Flow

Notional : 1 1,30% 4 0,987 3,9

100 2 1,60% 4 0,969 3,9

Coupon : 3 2,10% 4 0,940 3,8

4% 4 2,50% 4 0,906 3,6

5 2,80% 104 0,871 90,6

Total 105,8

Goal. Compute the NAV of the bond after an increase of the yield curve of 0.5%.

Step 1. Compute the new discount factors.

Year Rate Rate +0.5% Cash Flow Df « Rate+0.5%" Discounted Cash Flow

Notional : 1 1,30% 1,80% 4 0,982

100 2 1,60% 2,10% 4 0,959

Coupon : 3 2,10% 2,60% 4 0,926

4% 4 2,50% 3,00% 4 0,888

5 2,80% 3,30% 104 0,850

Total

Exercice