MODULE 6

Principles of Asset and liability management

Minimum Correct Answers for this module: 4/8

Overall Objective:
To understand the fundamentals of Asset & Liability Management as a practice of managing and
hedging risks that arise due to mismatches between the asset side and the liability side of the
balance sheets of a bank. To explain how main risk factors like funding and liquidity risk, market risk
(FX, Interest Rate, Equity, Commodity, etc.), credit risk, leverage risk, business risk and operational
risk are interrelated and how they affect the balance sheet of a financial institution. To describe
common risk management and hedging techniques which help control these effects and to
understand how these techniques are used to set up a state-of-the-art ALM approach.

At the end of this section, candidates will be able to:

• Define the meaning and the general concepts of ALM
• Describe the impact of main risk factors on the asset and the liability side of the balance sheet:
Impact of Interest Rate Risk, Currency Risk , Liquidity Risk and Credit Risk
• Understand the importance of an efficient and reliable organizational infrastructure delivering
the necessary data with accuracy and frequency in order to manage ALM Risks
• Describe the organisational and infrastructure set up of ALM in a bank:
o ALM information systems (Management Information System, Information availability
and accuracy)
o ALM organisation (Structure and responsibilities, ALM Committee, Role of Controlling,
Level of top management involvement)
o ALM process (Risk parameters, Risk identification, Risk measurement, Risk management,
Risk tolerance levels)
• Understand the use of Gap management: interest and duration mismatches
• Explain Asset and liability management techniques: Cash Flow Management, Duration
Management, Gap Limits
• Describe the use of different types of interest rate and FX derivatives for implementing hedging
techniques against ALM risks
• Describe the use of Credit Risk Transfer Instruments for Balance Sheet Management:
Credit Derivatives and Asset Securitizations
• Explain the impact of Basel III (Liquidity Coverage Ratio, Net Stable Funding Ratio, Leverage
Ratio) on the structure of a bank’s balance sheet
• Explain the concept of funds transfer pricing as a means to ensure that funding and liquidity
costs & benefits are transparently allocated to respective businesses and products
• Describe the interaction between bank capital and leverage and the role of economic and
regulatory capital
• Describe the formulation of Liquidity Stress Test Scenarios and the use in ALM
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What is ALM
Asset and liability management (ALM) is the active management of a bank’s balance sheet that looks
to maintain an efficient mix of loans and deposits in order maximise returns to shareholders whilst
still minimising the risks faced by the business.

ALM therefore uses techniques which involve the following:

• Creating shareholder wealth

• Funding and capital management
• Risk adjusted performance management
• Manage impact of credit portfolio –assets on the balance sheet
• Measure and control the financial risks including; interest rate, liquidity and currency

As competition is reducing bank margins, the need for more precise information and a complete
asset and liability management system is becoming an absolute necessity.

The three tools used by banks for ALM:

1. ALM information systems

 The usage of Real Time information systems to gather the information about the
maturity and behaviours of loans made by the banks
2. ALM organisation
 The board should have overall responsibilities and should set the limit for liquidity
and interest rate risk
 ALCO
3. ALM process
 Establish risk parameters
 Identify risks
 Measure risks
 Manage risks in line with;
 Risk policies and tolerance levels

To control profitability and risk, asset and liability committees are set up- ALCO- which usually
include the very senior management of the bank such as the president, chief financial officer, head
of treasury and head of accounting and control. ALCO’s responsibilities includes the following:

• Balance sheet planning from a risk-return perspective

• Product pricing for both deposits and loans and desired maturity profiles
• Managing and specifying the bank’s market and liquidity risk profile
• To develop a view on the future direction of interest rate movements and decide on
a funding mix between fixed vs. floating and wholesale vs. retail deposits

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Liquidity risks
Liquidity refers to the ability of an institution to meet demands for funds, so liquidity risks arise from
funding of long term assets by short term liabilities. The basic nature of a bank is that depositors
prefer to invest for shorter periods and borrowers prefer longer term loans. So unless assets and
liabilities are matched by amount and term, the risk is that loans may have to be re-financed on a
continual rolling basis. A liquidity shortage, no matter how small, can cause great damage to a bank.
It takes a long time to build client relationships, a liquidity crisis can destroy those relationships
instantly. In order to avoid a liquidity crisis, management needs to have a well-defined policy and
established procedures for measuring, monitoring, and managing liquidity.

Liquidity gap analysis

Gap analysis is a technique used to measure interest rate risk or liquidity risk. A liquidity gap is the
mismatch between the terms of asset and liabilities and for banks this maturity gap can change over
the course of a day as deposits and withdrawals are made.

Liquidity gap analysis gives a snapshot of the bank’s current risk by comparing periods of time and
the gaps at different periods

0-3 months 3-6 months 6-12 12-24 24-36 Total

months months months
Assets 10 90 460 710 520 1790
Liabilities 100 380 690 410 210 1790
Gap -90 -290 -230 300 310 0

Positive Gap: When maturing assets are greater than maturing liabilities.
The excess liquidity can re-directed to new assets such short term securities.

Negative Gap: When maturing liabilities are greater than maturing assets
Gap needs to be financed either via wholesale or retail deposits, or even central
bank repos.

Liquidity Stress tests

As gap analysis focuses primarily on a snapshot of the current liquidity risks that a bank faces and
does not incorporate any forward looking scenarios it is necessary to apply stress testing and ‘what
if’ scenarios to develop a more robust analysis.

A well designed stress testing framework provides the ability to design forward looking extreme, yet
plausible scenarios and strategies to counter the effects of an extreme event. A framework begins
with classifying the assets and liabilities on the balance sheet as liquid or illiquid, understanding
factors which affect the balance sheet the most, and then moves on to design ‘what if’ scenarios
based on the identified factors. The analysis of the stress tests feeds the contingency plan ensuring
that all the extreme but plausible scenarios are identified and a plan of action defined.

Managing liquidity
Managing liquidity is a continuous process of raising and laying off funds depending on whether the
bank is short or long cash. One of liquidity management’s main objectives is to ensure that deficits
can be funded under all for seen circumstances without incurring prohibitive losses.

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The simplest way to manage liquidity risk is to match the book for each maturity bucket, also known
as cash matching, although this is very rare to observe in practise.

Gap limits can also be used to manage these liquidity gaps. These limits are the tolerance levels set
for mismatches on cash flows, or gaps, over specified short- and long- term horizons under both
expected and adverse business conditions. These limits can be managed as liquidity coverage ratios
or specified aggregate amounts based on historical averages or desired targets.

Bank’s hold a significant portion of their assets in the form of very liquid instruments, such as T-bills,
allowing them to maintain a reserve of liquidity in the event of a funding crisis. In addition banks can
turn to the central bank, as the lender of last resort, when they are short of cash reserves however
this is generally the most expensive form of funding.

Interest rate risk

Banks operate by taking deposits (and paying interest on them) and making loans (and charging
interest to the borrowers of these funds). The difference between what is earned in interest and
what is paid is known as the net interest income (NII) for a bank. Interest rate risk arises because
rates fluctuate from day to day and this poses a large problem to a banks NII and therefore their
profitability. For example if interest rates rise and a bank is forced to increase what it pays to short
term depositors and at the same time most of its loans are locked into long term fixed rates, this will
squeeze their NII. If assets are floating rate, there is less concern over interest rate risk if they are
funded with floating rate liabilities however this can still generate interest rate risk.

Interest rate risk is the risk to earnings arising from changes in interest rates. There are four primary
sources of interest rate risk:

 Re-pricing or maturity mismatch risk:

o A loan on the asset side might re-price every 3 months, whereas the deposit could
re-price ever 6months
 Yield curve risk:
o Interest rates don’t always change equally for all maturities
 Basis risk:
o Floating rates may be based on different benchmarks i.e. LIBOR vs. Treasury rate
 Option risk:
o Uncertainty around cash flow timing i.e. Bond holder may have option to repay
early

Various techniques are used for measuring exposure of a bank to interest rate risks:

Maturity gap analysis

Duration
Simulation

Maturity gap analysis

Gap management has liabilities and assets grouped into time buckets according to the time until the
next first possible resetting of interest rates, also known as re-pricing gap analysis.

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The interest rate gap is the mismatch between the different interest rates that each asset and
liability has been struck at.

Liability sensitive: If a negative gap occurs, when rate sensitive assets are less than rate
sensitive liabilities in a given time band, an increase in market
interest rates could cause a decline in NII.

Asset sensitive: If a positive gap occurs, when rate sensitive assets are greater than
rate sensitive liabilities in a given time band, a decrease in market
interest rates could cause a decline in NII.

Immunised balance sheet: When a bank has equal assets and liabilities that re-price during the
same period they have a balanced interest rate gap and a change in
interest rates should not affect the bank’s NII.

One of the key criticisms of gap analysis is it fails to account for optionality in assets and liabilities.
For example if rates fall and your assets repay faster or if rates rise and your assets average life
extends.

Duration gap analysis

Duration refers to the average lifespan of the asset or liability and indicates how sensitive the asset
price or liability is to changes in interest rates. Duration analysis begins by computing the individual
duration of each asset and liability and weighting the individual duration by the percentage of the
asset or liability in the balance sheet. This analysis allows management to structure the portfolio of
assets and liabilities to change equally in value whenever the interest rate changes. In essence
duration takes the gap report data and converts the information into a weighted average present-
value worth.

Duration

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Just looking at the time-bucket distribution of Assets & Liabilities makes it virtually impossible to
manage the risk adequately.

The duration gap considers the difference between the

duration of assets and the liabilities
Banks typically have a view on interest
If the portfolio’s duration gap is close to zero the market rates and don’t always prefer to be
value of the bank’s equity will not change and they will risk neutral. Their aim is also to
consider themselves immunised against interest rate risk. maximise shareholders returns.

Duration tips to remember:

 Fixed rate instruments have higher interest rate sensitivities than those with a floating
interest rate.
 The longer the maturity, the more interest rate sensitive the instrument (greater duration)
 The smaller the fixed coupon on the instrument, the more interest rate sensitive the
instrument (greater duration)

Simulation
Simulation models basically use “what if” scenarios in order to further analyse the risks and improve
the quality of information available to management. What if scenarios can include:

 An absolute shift in interest rate levels

 The sustainability of profit margins
 How debt and pre-payment levels change in different interest rate scenarios
 If there are changes in the funding mix

Currency risk
Balance sheet items are not limited to only domestically traded items, assets and/or liabilities can be
in foreign currency. A mismatch of currencies for assets and liabilities exposes the business to
foreign exchange market movements which needs to be carefully managed in order to limit the
negative effects on the NII and bank profitability. As with other financial risks currency risk can be
eliminated by matching the currencies of assets and liabilities but if this is not possible then relevant
hedges should be considered such as a forward exchange contracts, swaps or options.

Credit risk
Credit risk arises from a counterparty’s inability to pay an obligation when due and also includes the
risk of any related collateral not being sufficient to cover these obligations.

In managing the bank’s assets two factors need to be balanced in order to try maximise shareholder
returns: the highest possible return for the lowest possible risk. So the skill in asset management
often comes down to assessing who is a good credit risk and who isn’t.

ALM’s function is to manage the impact of the entire credit portfolio on the balance sheet and may
include the following responsibilities:

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 o Outline the bank’s overall risk tolerance in relation to credit risk.
o Ensure that bank’s overall credit risk exposure is maintained at prudent levels and consistent
with the available capital
o Ensure that the bank implements sound fundamental principles that facilitate the
identification, measurement, monitoring and control of credit risk.

The new Basel III framework introduces more risk sensitive approaches to the treatment of
collateral, guarantees, credit derivatives, netting, securitisation under the standardised approach
and the internal model approach.

Credit Risk Weighting approaches:

 Standardized approach which relies on external ratings; that is ratings given by rating
agencies such as Moody’s, Standard and Poor’s or Fitch

AAA - AA- A+ - A- BBB+ - BBB- and below

Corporate 20% 50% 100%

A loan made
to a ‘A+’ customer would be rated at 50% therefore a loan of $100 would attract capital of ≥
8% x ($100 x 50%) = $4

 The second approach which has received the most attention all over the world is the internal
rating based (IRB) approach (available under two options: foundation or advanced)
o Banks have to calculate the probability of default of a corporate client over a 1-year
time horizon.
o To apply the IRB approach you need two pieces of information:
 The Probability of Default (PD) and
 The maturity of the loan.

Managing credit risk

Credit derivatives allow the market participant to separate default risk from the other forms of risk,
such as interest rate and currency risk
Three basic structures
 Credit Default Swap – CDS this bases the payoff on a specific credit event, such as a bond
down grading or default. .
 A total return swap - Links a stream of payments to the total return on a specific asset.
 Credit spread options - Ties the payoff to the credit spread on a specific bank loan or bond.

Asset securitisations have also been used by banks to remove credit risk from the balance sheet (see
Leverage Ratio section below for more details)

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Basel III
The Basel III framework has been developed by the Bank of International Settlements in Basel,
Switzerland and pushed further by various other regulatory bodies.
After the financial crisis of 2007-2009 proposed amendments were made to the Basel II accords in
response to the deficiencies revealed in the financial regulations. Basel III was designed to improve
regulation, supervision and risk management within the banking sector to improve their ability to
absorb shocks. Its two main objectives are to strengthen global bank’s capital and improve their
levels of liquidity.

Basel III is divided in two main areas:

 Regulatory capital
 Asset and liability management

Regulatory Capital
The Basel accord is the main capital adequacy structure that bank supervisors use. Capital adequacy
under Basel III refers to the adequacy of a bank’s capital in relation to risk arising from:
 Assets (loans, negotiable paper)
 Dealing operations
 Off-balance sheet transactions
 Other business risk

Capital enables a bank to bear risk and absorb unexpected losses.

Regulatory Capital, prescribed by the regulatory authorities in the country, is split into two main
categories namely:
 Tier 1 (core)
 Tier 2.

Tier 1 capital is comprised of common equity capital, declared reserves and the current years
audited profits (retained earnings).

Tier 2 capital comprises undisclosed reserves of the bank and subordinated term debt with a
maturity of 5 years or longer, certain reserves and general provisions. Tier 2 capital can NEVER
be more than 100% of tier 1 capital.

Under BASEL III there are new targets for capital adequacy. The basic Capital Adequacy Directive -
CAD – include the following:

The common equity in Tier 1 must be a minimum of 4.50% with a 2.50% conservation buffer
making a total of 7.00%

Total Tier 1 capital must be a minimum of 6.0% with a conservation buffer of 2.50% making Tier
1 total 8.50%.

Total capital (Tier 1 and Tier 2) must be 8% with a 2.50% conservation buffer making a total of
10.50%

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Risk weighted assets
Not all assets bring the same risk to the balance sheet. For example extending a loan to a B rated
corporate customer has a very different risk profile to holding a short term Treasury bill. Capital
needs to be held in correct proportion depending on these risks therefore risk weighted assets
(RWA) must be considered when applying Capital Adequacy Ratios.

Principal Risk Risk RWA Capital % Capital

weighting Amount
Treasury $10,000,000 Extremely safe 5% $500,000 10% $50,000
Bill
Customer $10,000,000 Moderate risk 50% $5,000,000 10% $500,000
loan

The total value of each asset is multiplied by a percentage reflecting its risk level, then the capital
ratio is applied.

Economic Capital
Economic capital, or capital at risk (CaR), is the capital that the bank holds and allocates internally to
different parts of its businesses as a result of its own risk assessments of its specific business
activities. It represents how much the business could stand to lose and still remain solvent.

Assets and Liabilities management

Banks have to comply with two new ratios:

 Liquidity Coverage Ratio (LCR)

 Net Stable Funding Ratio (NSFR)

LCR: The Basel III rules insist that a bank maintains a high liquidity ratio that is designed to ensure
that a bank, in a stressed scenario, can survive for a period of 30 days if it experiences a “run
on the bank”. In other words the bank must have enough liquid assets (near cash) to
manage these potential shortages.

Net Stable Funding Ratio:

This ratio is designed to make sure that banks manage their assets and liabilities more
efficiently without being as reliant on the short term wholesale market to fund their long
term assets. It dictates more stable sources of funding for long term assets.

Stress testing
These are tools used to identify and manage situations which can cause extra-ordinary losses. They
can be based on the following:

 Replication of the strongest market shocks which occurred in the past

 Statistical measures with extreme multiple of historical volatility
 Subjective assumptions such as a 100BP move up or down in the Yield Curve

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Leverage Ratio
Leverage in simple terms is the extent to which a business funds its assets with borrowings rather
than equity. More debt relative to each dollar of equity means a higher level of leverage.

Securitisation
One of the underlying features of the financial crisis was that bank’s had built up excessive balance
sheet leverage whilst still showing strong capital ratios. They in part achieved this through building
up high levels of assets (i.e. making lots of loans to buy houses) and then securitising these loans into
bonds (‘asset-backed securities’ as they are collateralised by the mortgage repayments), then selling
these securities (ABS) to special purpose vehicles (SPV’s) thereby removing them from the balance
sheet. This is a popular way of freeing up capital and transferring credit risk. Often then the banks
would then borrow again in the wholesale market in order extend more loans so that they could
repeat the securitisation process. This leverage, through increased debt to equity ratios, can help to
increase returns for a bank but during the most severe part of the crisis the banking sector was
forced to reduce its leverage and this amplified downward pressures on asset prices and exposed
the banks to greater risks.

The leverage ratio, by placing an absolute cap on borrowings relative to a bank’s capital, is intended
to constrain this build-up of leverage and re-enforce the risk based requirements with a simple, non-
risk based “backstop” measure. Ideally it looks to limit the number of activities of the bank relative
to its own capital. The leverage ratio is an important component of the Basel III framework which
complements the risk-based capital adequacy regime.

Basel III's leverage ratio is defined as the "capital measure" (the numerator) divided by the
"exposure measure (the denominator) and is expressed as a percentage. The capital measure is
currently defined as Tier 1 capital and the minimum leverage ratio is 3%. The capital measure is the
Tier 1 capital measure applied under the risk-based frameworks. The exposure measure is the sum
of the on-balance sheet exposures, derivatives, securities financing transactions and off-balance
sheet items.

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Module 6: Review Questions

1. What is the principal risk identified by gap management reporting?

a. Operational risk
b. Credit risk
c. Currency risk
d. Interest rate risk

2. Which duties are commonly assigned to the ALCO?

a. Specifying and controlling interbank credit lines
b. Managing and specifying the bank’s market and liquidity risk profile
c. Verifying and administering the bank’s balance sheet accounting
d. Managing the day-to-day activities of the dealing room

3. The Liquidity Coverage Ratio imposed by Basel III requires a bank:

a. To retain enough liquidity to cover its assets against severe default risk
b. To keep enough highly liquid assets to cover its net liabilities for the next 30 days to
guard against severe liquidity stress
c. To keep enough highly liquid assets to cover its net liabilities for the next 60 days to
guard against severe liquidity stress
d. To keep enough highly liquid assets to cover its net liabilities for the next 10 days to
guard against severe liquidity stress

4. Given a flat yield curve of 4.5%, which of the following assets would have the greatest
interest rate sensitivity?
a. A 4% fixed coupon bond with 6 years to maturity
b. A 5% fixed coupon bond with 6 years to maturity
c. A zero coupon bond with 6 years to maturity
d. A floating rate note with 6 years to maturity

5. Using re-pricing gap analysis, a bank’s balance sheet is considered liability sensitive to
market interest rate changes, if:
a. More liabilities than assets will be re-priced in the near term
b. Non-interest bearing liabilities are greater than non-interest bearing assets
c. More assets than liabilities will be re-priced in the near term
d. More assets than liabilities have variable rates or short residual maturities

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