Risk Management

ALM and Liquidity Risk

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Scene at a typical US Savings Bank in 1979
Customers walk into the bank to place money in
savings accounts - @ 3%

Bank gives out housing loan/mortgage - @ 6%

Bank makes spread of 3% (without doing anything

actually)

Satisfied CEO leaves at 3 PM to play golf

3-6-3 banking: Easiest thing in the world!

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 What makes it so easy
US Federal Reserve follows regulated interest rate
policy

Note: Banks are borrowing 3-6 m and lending 10-12

yrs

Current practice yields profit as long as:

3m rate < 10 yr rate

But is there a guarantee that it will?..

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Scene at US Fed Reserve: Oct 1979
Fed Reserve Chairman makes major announcement
on Fed Policy change

Short term interest rates were made floating

Result: 3m rates zoom to nearly 20%

10 yr money remains at 6%

What happens to the Savings Banks?

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 Nightmare ending to the story
Savings banks cannot afford to borrow 3m money
and incur negative spread of up to 14%

Banks forced to sell loans at ridiculous rates to raise

cash

Result: Entire industry practically wiped out overnight

Morale of the story: No regard to integrated planning

of assets and liabilities can ruin you.

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 Direct outcome of this crisis
Creation of a new field of study and practice known as:

Asset Liability Management

Defined as the strategic positioning of the balance sheet

to:
– Immunise profitability from core banking activities
– Optimize intrinsic value of the bank
– Ensure ability at all times to meet claims by creditors

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 What ALM is about
Banks make profit by playing the spread between
asset/liability interest rates

Thus ALM in summary is all about managing two

central risks:
– Interest Rate Risk
– Liquidity Risk

For banks with forex operations:

– Currency risk (additionally)

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 Regulatory Initiatives
Office of Thrift Supervision (OTS), regulatory
authority for savings banks (USA) issued Thrift
Bulletin -13 (TB-13) in 1989
– Comprehensive guidelines for interest rate risk
management
– Focused on advanced measures
– Gave a boost for ALM/Risk Management
technology vendors

Reserve Bank of India issued ALM Guidelines in

February 1999

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 Managing risks in general

‘Managing’ a risk has several distinct steps:

– Identifying the risk(s)

– Measuring the risk(s)

– Attempt to restrict the risk involved by:

Placing limits on the risk(s) - imposing discipline
Constantly monitoring the risk (to avoid unpleasant
surprises)
Taking suitable measures to avoid breaching the
limits

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 Identifying the Risk(s)
Interest Rate Risk
– Arises because a bank has differing ‘repricing’
profiles on assets and liabilities

– Dilemma is that banks make money as a result of

this mismatch
Hence in practice, the idea is to limit the
mismatches rather than aim at zero
mismatches

– Basis risk: When two floating rates are involved

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 Liquidity Risk
The risk that a bank may not be able to generate
cash to meet expected/unexpected claims.

– One of the most difficult risks to define and model

– Can occur due to:
Systemic or non-systemic factors
Market shock leading to sudden drying up of
activity
No lenders/buyers available in the market
Bunching up of outflows and counter-party
limits become an obstacle to further borrowing.
– Bank paying more to borrow in tight situations also
qualifies as liquidity risk.

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 Currency Risk

The risk of adverse movements in a particular currency

– Position limits combined with sensitivity limits can

reduce the potential exposure

– Ex. If currency A is more volatile than currency B then

smaller position in A has similar risk to larger position
in B.

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 Measuring the Risks
Interest Rate Risk
– Measurement tools/techniques -
Gaps (Static and dynamic)
Duration
Value-at-Risk
Simulation

– To perform a diagnosis a doctor performs multiple

tests (cannot rely on one technique alone)

– Banks adopt these techniques in the above order

(as per increasing sophistication levels)

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 Measuring the Risks

Liquidity Risk
– Measurement tools/techniques
Gaps (static/dynamic)
Refined gap - cash flow ladder
Stress tests

– Lack of tools/techniques only shows how much of a

grey area liquidity risk is.

Currency Risk
– Gap reports
– Value-at-Risk
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 Measuring Interest Rate Risk
A gap report can be of two types:
– Static Gap
– Dynamic Gap

It involves taking all interest rate sensitive items and

classifying them as per the time period in which the
interest rate will be reset (repricing).

Static gap assumes the current balance sheet and

positions stay as they are and are allowed to run
down gradually

Dynamic gap assumes that new business will be

added on
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 Gap Methodology
Consider a 3m fixed deposit (Rs. 100) contracted at 10%.
– At the time of maturity the depositor can renew
– Deposit thus reprices after 3 months.

Consider a 3m CP linked Floating Rate Bond (Rs. 80)

– Bond matures in 2002 (3 years)
– Interest rate is reset after every 3 months
– Bond thus “reprices” in 3 months

‘Repricing Gap’ in 3 months is difference between assets

and liabilities (Rs. 20)

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 Gap Methodology

Since measuring gaps for each day is too cumbersome,

one does it for time intervals (called time buckets)

Time buckets should be more refined where bank

perceives more activity

RBI issued guidelines in 1999 specifying the following

time buckets:
<1m 1-3m 3-6m 6-12m
1-3y 3-5y >5y Non-sensitive

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 Gap Methodology
For fixed rate items (term deposits, investments, bills
discounted )
– Classification as per maturity

For floating rate items

– Classification as per next repricing date
– PLR linked assets are classified as per expected
date of PLR change

Items like cash, current account, capital, funds

payable, other assets/liabilities etc. are classified in
Non-sensitive category.

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 Gap Methodology
300

250

200

150

100

50

-50

-100

-150
<1m 1-3m 3-6m 6-12m 1-3y 3-5y >5y NS

Assets 70 45 280 200 200 225 130 50

Liabilities 135 110 250 210 120 90 95 190
Gap -65 -65 30 -10 80 135 35 -140
Cum Gap -65 -130 -100 -110 -30 105 140 0

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 Gap Methodology
Cumulative Gap after 1yr is Rs. (110).
– So what?

Gap Figure must be used to arrive at a kind of loss

estimate

This is called Earnings at Risk (EaR):

– It is a loss estimate given the current gap position
and an adverse rate movement
– Since gap in <1m bucket is negative, bank will
incur a loss if interest rates increase.

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 Gap Methodology
EaR calculation in <1m bucket:

Gap = -65
Say interest rates rise by 1%
On average, bank incurs the additional cost over 350
days (360-15 days)

EaR = (-65)*(350/365)*(1/100) = Rs. 0.62

This is the figure that banks need to monitor to cap

interest rate exposure

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 Duration Gap Methodology
Problem with traditional gap methodology is that it
does not recognize sensitivities of various
assets/liabilities
Can be resolved using “duration”
– Very popular concept in bond markets
– Defined generally as sensitivity of bond value to
change in interest rates
– Bond prices decrease when interest rates increase
– Greater the duration; greater the sensitivity

Modified duration is the (%) change in price due to a

100 bps parallel shift in the yield curve

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 Duration Gap
A bank has Rs. 100 asset (of Mod. Durn 3)
A bank has Rs. 90 liability (of Mod. Durn 2)
Difference between assets/liabilities is Equity
– used as a buffer to absorb losses

Interest rates increase by 100 bps

– Loss in assets (3% * 100) = 3
– Gain in liabilities (2% * 90) = 1.80
– Net loss to the Bank = 1.20 (Erosion in capital
funds)
– Sensitivity of capital = 1.20/10 = 12%
– Mod Duration of Equity = (DA * A - DL * L) / (A - L)

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 Duration Gap
Bank is assumed to have issued bonds (liabilities)
and invest in bonds (assets)
– Deposits/loans can be treated as bonds
– These have to be marked to market (using
appropriate discount rates)
– Duration can be computed easily

Duration is an “economic value” risk measure

Earnings at Risk is an “earnings” risk measure
Both need to be considered

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 Value at Risk

Defined as the maximum loss in value expected to occur

for a given
– Time horizon
– Confidence level (Probability)

Say VaR at 99% confidence over one day for a trading

position is Rs. 2 crore
– 99 days out of 100 the loss will be less than Rs. 2
crore
– On one day the expected loss is not determinable
– VaR is now widely used as a trading risk measure

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 Value at Risk
Does VaR have a place in ALM, which is generally
not concerned with trading risks?

Refer duration discussion where all assets/liabilities

are expressed as bonds
– VaR for a bond is expressed as loss in value; not
loss in income (bond is fixed income instrument)
– Floating rate bonds reprice quickly - hence small
loss in value but potentially large loss in income

VaR in the ALM context applies to loss in economic

value or market value

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 Value at Risk & Simulation

Suppose a 3m deposit is taken today

– It will be rolled over 3 times over a one year
horizon
– At what rate will those rollovers happen?

We do not know but if we make thousands of

guesses, the average of those guesses is the
best estimate available today

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 Simulation
This is the idea behind simulation
– Make thousands of guesses about how the 3m
deposit rate will evolve over one year
Each guess is technically known as a
“scenario”
– Under each scenario the total interest expense
can be calculated
– The mean of those expenses is the best available
“single guess” for the expected deposit expense
over one year

But how does one guess an interest rate?

– Monte Carlo Simulation

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 Simulation
The purpose of simulation is to generate interest rate
scenarios
– Simulation is not a measure of risk (like duration,
VaR etc.)
– The variability in income as a result of various
interest rate scenarios is the risk
– Preference is to stay as close to budgeted levels
irrespective of the interest rate scenario
Only recourse is to hedge using off-balance
sheet items (most efficient means)

The result of a simulation is a management action on

reducing NII variability

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 The Big Picture
Gaps are simple to use and are quick & dirty

Duration needs large amounts of data

– Talks about mismatches and sensitivities
– Does not talk about probability of losses

VaR uses probabilities (very useful)

– Large amounts of data required (headache)
– Statistical/econometric skills for modelling
– What happens beyond 99% probability (nobody
knows the extent of the loss)
– “Loss in value” risk measure

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 The Big Picture
Simulation is state-of-the-art
– Can handle “loss in income” and “loss in value”
measures

– Resources - intensive data, qualified staff, huge

computational power
Expensive proposition

ALM is not only about complex calculations

– It is about judgements and prudence in taking
risks given expectations of market movements
– ….and making money as well in the process

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ALM– A Case Study

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 Case Study
Liquidity position of a bank is as under :
ALCO approval for call borrowing Rs.800 Cr
Currently borrowing in call Rs. 500 Cr
Existing liquid assets : Rs.1000 Cr
Further outflows during next 14 days
– Retail Deposits 100 Cr
– Corporate Deposits 300 Cr
Disbursements of loans lined up Rs.300 Cr
Additional investment in SLR bonds required in next
fortnight Rs.150 Cr
Guarantees of Rs.100 Cr likely to devolve

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 Case Study cont…

Requirement :
Higher profits through higher NII

Other factors :
Capital adequacy at 9.10%
Negative Gap to be capped at 20%

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 Inferences

Total outflows during the next 14 days :

Retail Deposits 25 Crs
(assuming 75% renewal)
Corp. Deposits 300 Crs
Disbursement 300 Crs
SLR 150 Crs
Gurantee 100 Crs

Total 875 Crs

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 Inferences contd…

Call Borrowing would increase as under :

500 Cr
+ 875 Cr
1375 Cr

ALCO limit of Rs.800 Cr being breached

Capital adequacy ratio likely to fall below 9%

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 Inferences contd…

Gap position in next 14 days as under :

Inflows 1000 Cr ( liquid assets )
Outflows 1375 Cr
Gap (-) 375 Cr

Negative Gap as a percentage of outflows : 27%

(Higher than the 20% regulatory limit)

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 Remedial Measures

Activate all resource raising units

Retail to be asked to bring additional
Rs.50 Cr
Corporate banking to ensure renewal of at
least 75% of deposits maturing
Explore possibility of renewal of guarantee

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 Remedial Measures contd…

Sale of liquid assets to bring borrowing within ALCO

limits and help maintain CAR
Explore possibility of interest rate swaps which provide
scope for NII without funding requirements
Explore interest earning opportunities by switching
securities

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Thank You

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