Asset-Liability Management (Alm) : Managing Core Risks in Banking

MANAGING CORE RISKS
IN BANKING:

ASSET-LIABILITY
MANAGEMENT (ALM)

BANGLADESH BANK

Asset Liability Management Policy

Asset Liability Management (ALM) is an integral part of Bank Management;
and so, it is essential to have a structured and systematic process for manage the
Balance Sheet.

Banks must have a committee comprising of the senior management of the bank
to make important decisions related to the Balance Sheet of the Bank. The
committee, typically called the Asset Liability Committee (ALCO), should meet
atleast once every month to analysis, review and formulate strategy to manage
the balance sheet.

In every ALCO meeting, the key points of the discussion should be minuted and
the action points should be highlighted to better position the banks balance
sheet. In every ALCO meeting, action points taken in the past ALCO meeting
should be reviewed to ensure implementation.

Specific functions of ALCO are:

1. To receive and review reports on liquidity risk, market risk and capital
management as covered in this report.
2. To identify balance sheet management issues like balance sheet gaps,
interest rate gap/profiles etc. that are leading to under-performance.
3. To review deposit-pricing strategy for the local market.
4. Review liquidity contingency plan for the bank.

PART A
EXECUTIVE SUMMARY. ....................................................................................................4
PURPOSE/METHODOLOGY/LIMITATIONS/DISCLAIMERS.....................................5
POLICY STATEMENT..........................................................................................................7
ORGANISATIONAL STRUCTURE.....................................................................................8
PROCESS .................................................................................................................................9
1. ALCO AND ALM................................................................................................................9
2. THE COMMITTEE..........................................................................................................10
3 KEY AGENDAS ...............................................................................................................10
4 ALCO PAPER...................................................................................................................10
4.1 COMMENTARY......................................................................................................10
4.2 INTEREST RATE TREND OF THE MARKET.................................................11
4.3 BALANCE SHEET..................................................................................................11
4.4 INDICATORS ..........................................................................................................11
4.5 MATURITY PROFILE...........................................................................................14
4.6 LIQUIDITY TEST...................................................................................................15
4.7 INTEREST RATE PROFILE.................................................................................16
4.8 COMPLIANCE........................................................................................................16
5. THE ALCO PROCESS ..................................................................................................17
6. ACTION POINTS ...........................................................................................................17
7. IMPLEMENTATION AND REVIEW OF STRATEGIES ........................................17
8. SPECIAL ALCO MEETING.........................................................................................18
9. MARKET RISK..............................................................................................................18
KEY CONCEPTS ..................................................................................................................19
4 Bangladesh Bank Focus Group
EXECUTIVE SUMMARY

Changes in market liquidity and or interest rates exposes banks/ business to the
risk of loss, which may, in extreme cases, threaten the survival of institution. As
such, it is important that senior management as well as the Board of Directors
must understand the existence of such risk on the balance sheet and they should
ensure that the structure of the institutions business and the level of balance
sheet risk it assumes are effectively managed, that appropriate policies and
procedures are established to control and limit these risks, and that resources are
available for evaluating and controlling interest rate risk. Increasingly Asset
Liability Management has become an integral part of Bank Management.
Banks are exposed to Balance Sheet Risk, where it is absolutely necessary for
the management of the bank to understand the existence of such risk and best
manage the exposure to the risk. The Asset Liability Committee (ALCO),
comprising of the senior management of a bank, is primarily responsible for
Balance Sheet Management or more specifically Balance Sheet Risk
Management.

The report aims at promoting international best practices in Balance Sheet
Management for the banking industry in Bangladesh. The purpose of the report/
guidelines is to provide guidance to management and to train new staffs. This is
intended to be the basic framework for further development as the skill sets go
up the curve and also, to introduce new policies and processes as we make
progress in understanding and implementing the basics.
Purpose

This report is aimed to provide a detailed guideline on Asset Liability
Management (ALM) of the bank for optimum Balance Sheet Risk Management.
This guide is prepared by the members of the Focus group on Foreign
Exchange Risk & Asset-Liability Management, which emphasises on
developing the market and the banking industry as a whole. The members
include:

1) Kh. Khalidur Rahman
Deputy General Manager
Bangladesh Bank
2) Ezaz Ahmed
Senior Principal Officer
Sonali Bank
3) Ahmed A Shah
Head of Global Markets
Standard Chartered Bank
4) Bashar M Tareq
Vice President
Citibank, N.A.
5) Md. Mohasin Miah
Senior Vice President
Dhaka Bank Ltd.
6) Syed Imtiaz Hasib
Senior Executive Vice President
Southeast Bank Ltd.

This guide would cover the process of Asset-Liability Management and the role
of ALCO in Balance Sheet management.

Methodology

The guideline is based on the international tools and strategies practiced by the
banks to manage its balance sheet risk. Different reports, researches, databases
etc. published in Asset Liability Management were used as primary input for
this paper.

Limitations

While utmost care has been given to cover every part of Asset Liability
Management, a few complex issues related to Market Risk have not been
covered in details. For example, in Value at Risk (VaR) the complex formulas
for calculating the VaR has not been included.

Disclaimers

All data used as references and examples are hypothetical assumptions and does
not relate to any bank or organization in any respect.
PART A: POLICY STATEMENT

Board or Management Committee of the Bank should set out the policy
statement in at least for the followings and an annual review should be done
taking into consideration of changes in the balance sheet and market dynamics.

1) Loan Deposit Ratio (LD): The AD ratio should be 80%-85%. However, the
Loan Deposit ratio of the bank should go upto 110%.
The Loan Deposit ratio = Loan/(Deposit+Capital+Funded Reserve)
The ratio will be fixed based on the banks capital, Banks reputation in the
market and overall depth of the money market.

2) Wholesale Borrowing Guidelines (WBG): The guideline should be set in
absolute amount depending on banks borrowing capacity, historic market
liquidity. The limit should be capped at the banks highest level of past
borrowings. However, this limit can be increased based on the match-
funding basis.

3) Commitments: The commitments Guideline limits should not exceed 200%
of the unused wholesale borrowing capacity of the last twelve months. The
limit can be increased if there are natural limitations on customer discretion
to draw against committed lines or a banks access to additional funds via
realisation of surplus statutory holdings.

4) Medium Term Funding Ratio (MTF): The MTF of a bank should not be
less than 30%. The ideal scenario should be 45%. Given, the overall scenario
of current market, it will be suitable to move towards the MTF limit of 45%
as we progress.

5) Maximum Cumulative Outflow: MCO upto I month bucket should not
exceed 20% of the balance sheet.

6) Liquidity Contingency Plan: A liquidity contingency plan needs to be
approved by the board. A contingency plan needs to be prepared keeping in
mind that enough liquidity is available to meet the fund requirements in
liquidity crisis situation. An annual review of the contingency planning
should be made.

7) Local Regulatory Compliance: There should be a firm policy on
compliance to the Bangladesh Bank in respect of CRR, SLR, Capital
adequacy etc.

PART B: ORGANISATIONAL STRUCTURE OF ALM

The Asset Liability Committee (ALCO) is responsible for balance sheet (asset
liability) risk management. Managing the asset liability is the most important
responsibility of a bank as it runs the risks for not only the bank, but also the
thousands of depositors who put money into it.

The responsibility of Asset liability Management is on the Treasury Department
of the bank. Specifically, the Asset liability Management (ALM) desk of the
Treasury Department manages the balance sheet. The results of balance sheet
analysis along with recommendation is placed in the ALCO meeting by the
Treasurer where important decisions are made to minimise risk and maximize
returns. Typically, the organisational structure looks like the following:

CEO / MANAGING
DIRECTOR
Head of
Consumer
Banking
Head of
Consumer
Banking
Head of
Treasury
Head of
Corporate
Banking
Head of
Finance
Head of
Credit
Head of
Operations
Head of Asset
Liability Mgt
(ALM)
Money Market
Dealers
Treasury: Responsible for ALM
The key roles and responsibilities of the ALM Desk:

1) To assume overall responsibilities of Money Market activities.
2) To manage liquidity and interest rate risk of the bank.
3) To comply with the local central bank regulations in respect of banks
statutory obligations as well as thorough understanding of the risk elements
involved with the business.
4) Understanding of the market dynamics i.e competition, potential target
markets etc.
5) Provide inputs to the Treasurer regarding market views and update the
balance sheet movement.
6) Deal within the dealers authorised limit.

PART C: PROCESS

1. ALCO & Asset Liability Management (ALM)

The banks asset liability management is monitored through ALCO. The
information flow in the ALCO can be diagramed as below:

Corporate Banking
Consumer Banking

Treasury
Analysis &
Recommendation
Depo-Adv
Trend & Outlook
ALCO
Meeting
Depo-Adv
Trend & Outlook
Finance
Key Balance Sheet Features
Other Depts.
Other Balance Sheet Features
B/S Status &
Recommended
Actions

CEO

S
T
R
A
T
E
G
Y

&

A
C
T
I
O
N

P
O
I
N
T
S
Feedback & Recommendation
2. The Committee

As the Treasury Department is primarily responsible for Asset Liability
Management, ideally the Treasurer (or the CEO) is the Chairman of the ALCO
committee. The committee consists of the following key personnel of a bank:

- Chief Executive Officer / Managing Director
- Head of Treasury / Central Accounts Department
- Head of Finance
- Head of Corporate Banking
- Head of Consumer Banking
- Head of Credit
- Chief Operating Officer / Head of Operations

The committee calls for a meeting once every month to set and review strategies
on ALM.

3. Key Agendas

ALCO attends the following issues while managing Balance Sheet Risks:

(i) Review of actions taken in previous ALCO.
(ii) Economic and Market Status and Outlook.
(iii) Liquidity Risk related to the Balance Sheet.
(iv) Review of the price / interest rate structure.
(v) Actions to be taken.

4. ALCO Paper

An ALCO paper is produced every month (usually by the Finance Department)
which covers various issues related to Balance Sheet risk management. The
ALCO paper is prepared before the ALCO meeting as the committee reviews
the ALCO paper to set strategies.

An ALCO paper typically covers the following:

4.1 Commentary
A brief summary on the following issues for the last month are provided for
review:
Combined as well as segmented (Current, STD, Term etc.) Deposit
Trend for local and foreign currency.
Combined as well as segmented (Overdraft, Term etc.) Advance
Trend for local and foreign currency.
Loan/Deposit Ratios.
Limit status and utilisation.

4.2 Interest Rate Trend of the Market
Interest rate and yield curve for Treasury Bills, Overnight funds, term money,
competitive banks published customer rates are included in the paper.

4.3 Balance Sheet
A summarised or detailed version of the banks balance sheet for the current and
previous month is provided to understand the trend in assets and liabilities. This
portion also covers the variance in assets and liabilities against the target of the
bank.

4.4 Key Management Indicators (Limits and Utilisation)
The management of every bank sets different limits in managing risk and
exposures. The current limit of all indicators along with recent utilisation is
included for management review. Also trend for last few months are also
included for better understanding of the behavior of the indicators.
Some of the key management Indicators are as follows:

(a) Wholesale Borrowing Guidelines: A key control in the management of
liquidity risk is a set of guidelines placed on each banks need to raise
funds from the wholesale market. This is a banks standard source of
marginal funding. Typically, defined as the ability of a bank to raise
funds from the wholesale market (or interbank market), it is also the most
vulnerable given the large size of individual deposits and the relatively
small number of potential counterparties. To reduce the banks
dependency on funds from the wholesale market (or the interbank
market), the ALCO should examine the funding products presently
offered and consider whether other funding products may
diversify/expand the banks funding base. Separate amounts may be
established for local currency and foreign currency balance sheets. A
banks capacity to borrow from the external wholesale market depends on
a number of factors:
- the size and turnover of the local market; our share of that
market
- the credit limits imposed by our counterparties, etc.
Given the various factors influencing the banks fund-raising from the
wholesale market, it is not possible to be absolutely sure of our exact
capacity. A number of factors are considered for setting the wholesale
borrowing guideline (WBG), which include
- Balance sheet size of the bank.
- Historical trend of market liquidity.
- Credit Rating of the bank (to understand counterparty banks
limits on the concerned bank).
- Stability of liquidity and interest rates of the market.

(b) Commitments: A banks liquidity is very much vulnerable to undrawn
commitments by customers. Undrawn commitments may be unutilised by
not drawing an overdraft limits of customers or any loan commitments,
which has not been drawn by customers. Customers have the right to ask
for these funds at any point in time and the bank is obligated to pay the
customer. Thus a ceiling should be set on a banks commitments to
customers. The undrawn commitment guideline may be established
which relates the maximum level of undrawn commitments to the banks
remaining unused wholesale borrowing capacity. These measures are to
ensure that the banks are able to raise funds in order to meet customers
demands for drawing on lines that they have granted to them.

(c) Loan Deposit Ratio: Loan deposit ratio, typically calculated as the ratio
of loans against deposits, is the most common way to see a banks
liquidity position. In an ideal scenario, loan deposit ratio should not
exceed 80% (as 20% of DTL is required for statutory requirements).
However, a bank may decide to lend out its capital or raise funds from the
interbank with a view that market interest rates would be low. But
excessive lending (a high Loan Deposit Ratio) may expose a bank in
serious liquidity and interest rate risk as the market liquidity may tighten
any time.

(d) Medium Term Funding Ratio: Banks typically make money by running
mismatches, that is, by borrowing short term and lending long term.
However, short term deposits may go out of the bank upon maturity,
whereas a bank cannot call back long term lendings. Thus a bank has to
find the right combination for longer term mismatch. Medium term
funding ratio is calculated as the ratio of liabilities with a contractual
maturity of more than one year to assets with a contractual maturity of
more than one year. This ratio is intended to highlight the extent to which
we are dependent on being able to roll over short term deposits in order to
fund medium term assets.

(e) Maximum Cumulative Outflow (MCO): Under normal conditions, the
day-to-day management of liquidity relies on the effective control of cash
flow. Maximum cumulative outflow (MCO) guidelines control the net
outflow (inflow from asset maturity minus outflow from liability
maturity) over the following periods: overnight, one week and one month.

The Treasury operation of a bank will review its funding capabilities and
recommend the guidelines to senior management. These guidelines will
be based on the estimated wholesale funding shortfall after calculating the
forecast/contractual cash flow of the entity under normal business
conditions.

The basis of cash flow measurement is to assume that funds are repaid on
their contractual maturity date. For wholesale funds, this is sufficient.
However, it is not realistic to assume that retail business will behave in
this manner. In practice, current accounts and savings deposits are not
withdrawn the next day and overdrafts are not repaid on demand. Retail
business can be expected to follow more or less predictable patterns being
influenced by seasonal factors and other trends. In monitoring liquidity,
an estimate should be made of the expected change in such
assets/liabilities with the resulting need for higher/lower funding from the
wholesale market. Whilst systems constraints will often impede frequent
and timely updating of cash flow data relating to retail business, it is
nevertheless important to include realistic estimates within the MCO data
which Treasury use to manage the banks aggregate cash requirements.

The ability to raise cash by selling marketable assets may be factored into
the MCO calculation but only to the extent that these assets are not
already relied upon in order to meet internal or statutory reserve asset
requirements. The MCO guideline is a business as usual measure,
which implies that necessary reserve liquidity must be maintained at all
times and so cannot be counted towards meeting the MCO requirement.
Whilst it may not be possible to include specific figures within MCO
controls, banks should also be aware of cash flows from settlement of
foreign exchange transactions and of intra-day exposures arising from the
operation of the daily clearing systems.

(f)Swapped Funds Guideline: A limit on the maximum amount (in
absolute terms) that can be swapped from foreign currency liabilities in
order to fund local currency assets, or, where appropriate, vice versa. The
purpose of this measure is to prevent excessive dependence on the
continued existence of an orderly foreign exchange market of sufficient
depth to meet our funding needs.

4.5 Maturity Profile Mismatch
A key issue that banks need to focus on is the maturity of its assets and
liabilities in different tenors. A typical strategy of a bank to generate revenue is
to run mismatch, i.e. borrow short term and lend longer term. However,
mismatch is accompanied by liquidity risk and excessive longer tenor lending
against shorter-term borrowing would put a banks balance sheet in a very
critical and risky position.

To address this risk and to make sure a bank does not expose itself in excessive
mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month, 1-3 months,
3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-5 years, over 5
year) maturity profile of the assets and liabilities is prepared to understand
mismatch in every bucket.

However, as most deposits and loans of a bank matures next day (call, savings,
current, overdraft etc.), bucket-wise assets and liabilities based on actual
maturity reflects huge mismatch; although we know that all of the shorter tenor
assets and liabilities will not come in or go out of the banks balance sheet. As a
result, banks prepare a forecasted balance sheet where the assets and liabilities
of the nature of current, overdraft etc. are divided into core and non-core
balances, where core is defined as the portion that is expected to be stable and
will stay with the bank; and non-core to be less stable. The distribution of core
and non-core is determined through historical trend, customer behavior,
statistical forecasts and managerial judgement; the core balance can be put into
over 1 year bucket whereas non-core can be in 2-7 days or 3 months bucket.

An example of Forecasted balance can be as follows:
In BDT Mio
TOTAL CALL 2-7D 8D-1M 1-3M 3M-1Y 1-5Y 5Y+
Reserve Assets 1,000 200 300 500
Interbank Placings 750 250 250 250
Custy Assets 4,000 300 250 1,400 300 250 1,000 500
Other Assets 500 200 300
Total Assets 6,250 950 550 1,650 550 250 1,800 500

Interbank Deposits (1,000) (750) (250)
Custy Deposits (4,500) (1,200) (1,000) (1,200) (100) (200) (800)
Capital &
Reserves
(500) (100) (400)
Other Liabilities (250) (250)
Total Liabilities (6,250) (2,200) (1,000) (1,450) (100) (300) (1,200) (0)

Custy
Commitments
(2,000) (150) (1,850)
Forward Contracts 250 100 50 100
Total Off-B/S (1,750) (0) 100 50 (50) (1,850)

NET
MISMATCH
(1,750) (1,250) (350) 250 400 (1,900) 600 500
CUMULATIVE
NET
MISMATCH
(1,250) (1,600) (1,350) (950) (2,850) (2,250) (1,750)

Balance Sheet Gap

4.6 Liquidity Test for Contingencies
The major risk a bank runs is liquidity risk. Under any circumstances a bank has
to honor its commitments. As a result, it has to make sure that enough liquidity
is available to meet fund requirements in situations like liquidity crisis in the
(2,500)
(2,000)
(1,500)
(1,000)
(500)
0
500
1,000
1,500
2,000
Total Assets Total Liabilities NET MISMATCH
market, policy changes by central bank, a name problem of the bank etc. So, a
banks balance sheet should have enough liquid assets for meeting
contingencies. Liquid assets can be as follows:

Reserve Assets.
Cash in Tills.
Specific Government Securities.
Foreign Currency in open position.
Specific FDRs.

A liquidity contingency plan should be in place to ensure a bank is prepared to
combat any crisis situation. A format of a liquidity contingency plan is attached
in Appendix 3.

4.7 Interest Rate Profile
Apart from liquidity risk, a bank also runs interest rate risk, which is the
exposure of a bank's financial condition to adverse movements in interest rates.
Accepting this risk is a normal part of banking and can be an important source
of profitability and shareholder value. However, excessive interest rate risk can
pose a significant threat to a bank's earnings and capital base. To address
interest rate risk, an interest rate profile is prepared, where consolidated yield
for assets and liabilities for different maturity buckets are shown for better
understanding of interest profile.

An example of the above is shown below:

Variable/1
D
2D-1M 1-6M 6-12M 1-5Y 5Y+
TOTAL
ASSETS
950 10% 2,200 11% 650 10% 150 12% 1,800 14% 500 14.5
%
TOTAL
LIABI-
LTIES
-
2,200
5% -
3,250
5.5% -150 7% -250 10% -400 0% -0 0%
Fwd
Contracts
0 150 100 0 0 0
Net
Mismatch
-
1,250
-900 600 -100 1,400 500

4.8 Local Regulatory Compliance
Compliance to all regulatory issues including CRR, SLR, A/D ratio, Capital
Adequacy, large exposures etc. along with any non-compliance and reasons
behind so.

5. The ALCO Process

The ALCO process or the ALCO meeting reviews the ALCO paper along with
the prescribed agendas. The Chairman of the committee, that is the Treasurer or
the CEO, raises issues related to the balance sheet. Treasurer suggests whether
the interest rates need to be repriced, whether the bank needs deposits or
advance growth, whether growth of deposits and advances should be on short or
longer term, what would be the transfer price of funds among the divisions,
what kind of interbank dependency the bank should have etc. In short, all issues
related to liquidity and market risk are covered.

Based on the analysis and views of the Treasurer, the committee takes decisions
to reduce balance sheet risk while maximising profits.

6. Action Points

The ALCO takes decisions for implementation of any/all of the following
issues:

Need for appropriate Deposit mobilisation or Asset growth in right
buckets to optimise asset-liability mismatch.

Cash flow (long/short) plan based on market interest rates and liquidity.
Need for change in Fund Transfer Pricing (FTP) &/or customer rates in
line with strategy adapted.
Address to the limits that are in breach (if any) or are in line of breach
and provide detailed plan to bring all limits under control.
Address to all regulatory issues that are under threat to non-compliance.

7. Implementation and Review of Strategies

All ALCO members are provided with the minutes (Appendix 2) of the meeting
within the next day. The minute includes:

The attendees.
The issues addressed.
The recommendations provided by the Chairman.
The action points that were fixed in the meeting.

The members communicate the action points to their respective divisions to
implement the strategies undertaken.

8. Special ALCO Meeting

Apart from the regular monthly meeting, ALCO meeting is also called as and
when any contingent situations arise. A very good example may be, during the
Eid period. At those times, market liquidity dries out and overnight rates shoot
up. Banks who are net borrowers from the market may be exposed to huge
interest expense the high rates in the market. This is an ideal time for a special
ALCO meeting, where the committee may take critical decisions for deposit
mobilisation on an urgent basis for reducing dependency from the market.

9. Market Risk and Asset Liability Management

Market Risk measures the risk of loss due to adverse movements in market
prices or rates such as interest rates, FX rates. Following are the key
management indicators for managing Market Risk:

(a) Value at Risk (VaR): Value at Risk (VaR) is a statistical estimate of an
upper boundary, within a specified confidence level, of the potential amount
a trading position or portfolio could decrease in value during the time needed
to close out a position. Specifically, it is a measure of potential loss from an
event in a normal, everyday market environment. VaR is denominated in a
currency, say Taka, where it measures the chance of losing Taka for a
movement in interest rates for a given balance sheet scenario. For example,
if a bank only has 1 month borrowing to fund 1 year customer lending, an
increase in 1 month rates would result in incremental expense for the bank.
VaR is estimated by assuming a 97.5% confidence level for movement in
relevant Market Risk Factors.
Let us construct a very simple example to understand the VaR methodology.
In the following table a simple hypothetical balance sheet for a bank is
shown, where it has BDT 100 mio 1 month borrowing to fund same amount
of assets:

1 Month (BDT
Mio)
1 Year (BDT
Mio)
ASSET 0 100
LIABILITY 100 0
MISMATCH (100) 100

Say the market interest rate for 1 month is 8% and 1 year is 10%. Now, if we
need to square the balance sheet gaps, we need to lend in 1month at 8% and
need to borrow in 1 year tenor at 10%. Therefore, the expected Value at Risk
to square the position will be:

VaR = 100 * (8% * 30 days/360 days) (100 * 10% * 360 days/360 days) =
BDT (0.67 10) = BDT 9.33 mio

Different organisations use different techniques or formulas for calculating
VaR. An example of such VaR calculation is included in Appendix 4.

(b) Factor Sensitivity: It is the sensitivity of an instrument/book to changes in
a particular risk factor.
For example, PV01 = the impact of +1bp parallel move in the zero curve.

(c) Management Action Trigger: The MAT It is a trigger level to warn of a
persistently loss-making position. It defines management's tolerance for
accepting market risk related losses on a rolling 30 day calendar day basis:

MAT level = current VaR + latest rolling monthly P/L (21 business days)

When a MAT is exceeded, trading management must review the current
position and decide whether it should be maintained, reduced or closed out.

PART D: KEY CONCEPTS

Balance Sheet Risk

Balance sheet risk can be categorised in to two major types of significant risk,
which are liquidity and interest rate risks. Changes in market liquidity and or
interest rates exposes banks/ business to the risk of loss, which may, in extreme
cases, threaten the survival of institution. As such, it is important that senior
management as well as the directors must understand the existence of such risk
on the balance sheet and they should ensure that the structure of the institutions
business and the level of balance sheet risk it assumes are effectively managed,
that appropriate policies and procedures are established to control and limit
these risks, and that resources are available for evaluating and controlling
interest rate risk.

Liquidity Risk

The risk that bank or business will be unable to meet its commitment as they
fall due leading to bankruptcy or rise in funding cost. It is the solvency of
business and which has special reference to the degree of readiness in which
assets can be converted into cash with out loss.

Banks traditionally use the statutory liquidity reserve and their borrowing
capacity in the volatile interbank money market as the source of liquidity. But a
conscious approach to measure and monitor the liquidity is somewhat lacking in
our market. We can learn and draw immense benefit by sharing the best
practices, tools and techniques of liquidity management.

Interest Rate Risk

Interest rate risk is the exposure of a bank's financial condition to adverse
movements in interest rates. Accepting this risk is a normal part of banking and
can be an important source of profitability and shareholder value. However,
excessive interest rate risk can pose a significant threat to a bank's earnings and
capital base. Changes in interest rates affect a bank's earnings by changing its
net interest income and the level of other interest-sensitive income and
operating expenses. Changes in interest rates also affect the underlying value of
the bank's assets, liabilities and off-balance sheet instruments because the
present value of future cash flows (and in some cases, the cash flows
themselves) change when interest rates change. Accordingly, an effective risk
management process that maintains interest rate risk within prudent levels is
essential to the safety and soundness of banks.

Capital Adequacy

The need to adopt the best international practices, given the globolisation of
economies and businesses. As you are aware of Basel Committee on Banking
Supervision and the emphasis on maintaining the Capital Adequacy
commensurate to exposure or risk on balance sheet. The new Basel Capital
Accord stipulates that Banks must hold capital commensurate with the level
of interest rate risk they undertake.

As mentioned earlier, Changes in interest rates expose banks to the risk of loss,
which may, in extreme cases, threaten the survival of the institution. In addition
to adequate systems and controls, capital has an important role to play in
mitigating and supporting this risk. As part of sound management, banks
translate the level of interest rate risk they undertake, whether as part of their
trading or non-trading activities, into their overall evaluation of capital
adequacy, although there is no general agreement on the methodologies to be
used in this process. In cases where banks undertake significant interest rate risk
in the course of their business strategy, a substantial amount of capital should be
allocated specifically to support this risk.


APPENDIX 1

AN ALCO PAPER FOR KOROTOA BANK LTD.
APPENDIX 2

A Demo ALCO Minutes

ACTION POINTS
(Korotoa Bank)
ALCO MEETING
(Mar 03, 2003 )
Attendees: CEO (Name)
Head of Corporate Banking (Name)
Head of Consumer Banking (Name)
Head of Treasury (Name)
Head of Operations (Name)
Head of Credit (Name)
Head of Finance (Name)
Date Item
No
Section Issue and proposed action To be Action
by
(initials) (Date)
03/03/0
3
1 PREVIOUS MINUTES 1. Revision to customer interest rates were to be discussed & new rates to be established.
Deposit growth to be reviewed.

2 ECONOMY/ MARKET 1. No significant change in macro-economic factors, other than inflationary growth.
2. Inflation rose to 4.57% in November 2002, highest since FY1999.
3. Foreign Exchange reserve stands at US$ 1.78 bio in February 2003.
4. Broad Money (M2) recorded an increase of 5.29% during July-Dec 2002 period
compared to same period last year.
5. ADP is expected to cut to BDT 16.5 bio from BDT 19.0 bio for FY 2003
6. Overnight rates in the downtrend after Eid.
7. Treasury Bill yield curve is expected to be stable with no major change in sight.
8. Secondary Market for Treasury Bills is emphasised the BBK.

3

LIQUIDITY 1. AD ratio has increased since the last meeting in Feb03
2. Lcy Deposits has no major change in February.
3. Assets have grown by approx. BDT 250 mio in February.
4. Inter-bank borrowing is approx. BDT 1,000 mio.
5. AD ratio still within limits but there is clearly a need to grow our core deposit base


and reduce reliance on inter-bank.
6. Medium Term Funding Ratio has improved due to growth in longer term deposits.

4 PRICING 1. Need to mobilise deposits on an urgent basis to reduce interbank dependency.
2. Growth of Advance and Deposits should be synchronised.

5 ACTION 1. Introduce new (increased) customer rates to encourage deposit accretion and
emphasize need to focus on account profitability for assets w.e.f. 1
st
Mar.
2. Finance to determine impact of new rates on avg CB & C&I balance sheet of Jan03
and advise ALCO.
3. Contingency action plan to manage stressed liquidity discussed & agreed.

APPENDIX 3

Liq. Contingency Plan

KOROTOA BANK
CONTINGENCY ACTION PLAN TO MANAGE STRESSED LIQUIDITY

SCOPE

To establish an action plan to manage a stressed liquidity situation created by a name
problem in the market.

PURPOSE OF THE PLAN

To provide a framework within which an effective response to a liquidity crisis can be
managed.

NB Stressed Liquidity is defined as a condition that arises from a sudden deterioration of the
perceived safety and credibility of the Bank, resulting in substantial withdrawal of funds by
depositors.

TRIGGER POINTS

Plan to be activated when two or more of the following conditions exist :

1. Bangladesh Bank has declined to open the Rediscount/Repo window at our request.

2. Call money market rates have exceeded 25% for more than 7 consecutive days.

3. Call facilities have been declined by the market or a premium over market rates has been
imposed on our borrowing.

4. Consolidated AD ratio has exceeded 100% for more than 15 days.

Version date: February, 2003 Approved at ALCO Meeting March 03, 2003


KOROTOA BANK

PHASE 1 IMPENDING CRISIS

1. Phase 1 Team

- (ALCO Members)
- Chief Executive Officer
- Head of Treasury
- Head of Finance
- Head of Credit
- Head of Operations

2. Action Points

2.1 Investigate the underlying cause of the crisis to establish:

- Extend and timing of the crisis
- Duration of the crisis
- Remedial action to avoid the crisis, agree any external/ internal
communications statement etc.

2.2 Advise all Divisional Heads of the crisis and cancel leave commitments of
key personnel.

2.3 Review liquid and market assets portfolio by maturity and prepare a
liquidation strategy.

2.4 Liquidate any long forex positions and reduce forex open position to a
minimum.

Responsibility

Team

Chief Executive

Head of Treasury
Head of Finance

Head of Treasury


KOROTOA BANK

PHASE 2 - CRISIS SITUATION

1. Phase 1 Team

- (ALCO Members)
- Chief Executive Officer
- Head of Treasury
- Head of Finance
- Head of Credit

2. Action Points

2.1 Communication

2.1.1 Convene Emergency ALCO Meeting to review the crises, agree content
of any external /internal messages and delegate tasks.

2.1.2 Inform Bangladesh Bank of crisis and proposed remedial action, if
deemed necessary.

2.1.3 Brief Dealers.

2.1.4 Brief Relationship Managers and Branch Managers.

Responsibility

Chief Executive

Chief Executive
Head of Treasury

Head of Treasury

Head of Corporate
Head of Consumer


KOROTOA BANK

PHASE 2 - CRISIS SITUATION (cont)

2.2 Assessment and Action

2.2.1 Confirm the liquid and market asset portfolio for initial selective
liquidation.

2.2.2 Assess the level of interbank borrowing capacity and raise funds to
meet liquidity from the most reliable sources.

2.2.3 Approach Bangladesh Bank for Repo.

2.2.4 Selling Fcy from forex open position limit to generate Lcy liquidity.

2.2.5 Approach Bangladesh Bank for extended use of the rediscount
window.

2.2.6 Monitor closely withdrawal patterns, under report to Head of
Treasury.

2.2.7 Do not approve early redemption of deposits without specific
approval of the Chief Executive/ Head of Treasury

2.2.8 Assess overall level of loans/OD and ensure no incremental
drawdown. No excess to be allowed.

2.2.9 Assess overall Advances portfolio and activate plan
contract/recall/seek repayment from customers.

Responsibility

Head of Treasury

Head of Treasury

Head of Treasury

Head of Treasury

Head of Treasury

Head of Treasury

Head of Corporate
Head of Consumer

Head of Corporate
Head of Consumer

Head of Corporate
Head of Consumer


KOROTOA BANK
CRITICAL CONTACT INFORMATION
1. Management Team
- Chief Executive
(Name)

- Head of Treasury
(Name)

- Head of C&IB
(Name)

- Head of Finance
(Name)

(Name)

(Name)

- Head of Credit
(Name)

Work Telephone

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

Home Telephone

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX
2. Central Bank

- Governor

- General Manager (BR&PD)

- General Manager (FEPD)

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX

XXXXXXX


KOROTOA BANK

Government and/or Central Bank Statutory Holdings / Liquidity Requirements

Regulation Parameter/Formula

Comprising

Cash reserve

4% of liabilities Lcy cash at Central Bank

Liquidity reserve

16% of liabilities Treasury Bills
Cash in Tills
Fcy balance with Central Bank
Lcy balance with Central Bank
Selected Govt Bonds

Money Market Instruments Comprising Marketable Securities and Reserve Liquidity

Instrument Features/Restrictions Included in
Marketable
Or Reserve
Treasury bills Issued by Central Bank weekly auction at discount
Tenors are 28, 91, 182, 364 days, 2 years and 5
years.

M & R


KOROTOA BANK

CONTINGENCY FUNDING PLAN

Local Book

Money Market
Term Deposit
Call Money
Repo

Central Bank (Marketable Securities and Reserve Portfolio)

Repo of Treasury bills
Encashment of surplus balance with Central Bank

Other
Cash in hand

FCY Book

Money Market
Term Deposit
Utilisation of surplus Nostro balances


KOROTOA BANK

QUANTIFICATION OF AMOUNT OF CONTINGENCY FUNDS - LOCAL CURRENCY

BDT IN MILLION

Sources of contingency funds
During
stressed liquidity

Estimated
Maximum
Available Funds

Cost to Korotoa
Money Market
F Term Deposit

500

12.00%

Central Bank
(Marketable Securities and Reserve
Portfolio)

F Repo facility for Treasury Bills

F Rediscounting window

F Balance with CB (Excess of CRR)

900

500

20

9.00-10.00%

6.00%

0.00%

Other

F Lcy Cash in hand

50

0.00%


KOROTOA BANK

QUANTIFICATION OF AMOUNT OF CONTINGENCY FUNDS FOREIGN CURRENCY

Sources of contingency funds
during
stressed liquidity

Formula/Parameters
For basis of
calculation
Estimated
Maximum
Available Funds

Cost to
Korotoa
Money Market (Marketable Securities)

Interbank Deposit

Reserve

Libor+0.50bps

1 month Libor

USD 5 mio

BDT 120 mio
(USD 2 mio
@60.0)

2.00-
3.50%

1.25%-
1.75%

Signature

Chief Executive Officer, Bangladesh

Head of Corporate Banking

Head of Treasury

Head of Consumer Banking

Head of Finance

Senior Credit Officer

Head of Operations
APPENDIX 4

A common formula for Value at Risk (VaR) calculation:

Value at Risk = 2 X Factor Sensitivity X Volatility

Where, 2 relate to 2 standard deviations (97.5 % confidence level).

For Interest Rates - using absolute volatility:

Value at Risk = 2 X Factor Sensitivity X Volatility

( )
Value at Risk
Duration
Yield
Volatility
t

+
1
]
1
1
2
1
1
Net Present Value

( )
( )
( )
( )
VAR
C
Y
Y
Y Y Y Y
t
d
y
d
y
t
t t n n

+
1
]
1
1
1

2
1
1
1
1
2
1 1
,..........,

For Interest Rates - using relative volatility:

Value at Risk

2 FactorSens itivity Volatility

( )
( )
VAR
Duration
Yield
Yield Volatility
t
t R

+
1
]
1
1

2
1
1
Net Present Value

( )
( )
VAR
C
Y
d
y
Y
Y
Y
Y
Y
Y
t
d
y
t
t
t
t
n
n

+
_
,
1
]
1
1
1

_
,
1
]
1
2
1
1
1
1
2
1
1
,.....,

Aggregation of UVAR from several positions:

Zero correlation of losses:
This approach assumes that the positions are independent and may or may not act as hedges.

VAR VAR VAR VAR
VAR VAR
P folio n
P folio i
i
n
'
'
.................
+ + +
1
2
2
2 2
2
1

100% correlation of losses:
This approach assumes that a loss is incurred on each and every position.

( ) ( ) ( )
( )
VAR Abs VAR Abs VAR Abs VAR
VAR Abs VAR
P folio n
P folio i
i
n
'
'
............. ............
+ + +
1 2
1

Perfect correlation between positions:
This approach assumes that positions are perfect hedges for each other.

VAR VAR VAR VAR
VAR VAR
P folio n
P folio i
i
n
'
'
.... ..... ...... ..... ..
+ + +
1 2
1
KOROTOA BANK
ASSET LIABI LI TY MANAGEMENT
ALCO PAPERS
FOR THE MONTH OF: FEBRUARY 2003

COMMENTARY Date
28-Feb-
03

Liquidity

LCY Month on Month Balance Sheet Movements

`- Corporate Banking Deposits increased by BDT 100 mio; Mainly due to FDR by: (a) 'A' Company (BDT 50 mio) (b) 'Z' Corporation (BDT 50 mio).

`- Corporate Banking Advances decreased by BDT 150 mio; Mainly due to overdraft repayment by: (a) 'A' Company (BDT 50 mio) (b) 'Z' Corporation (BDT 50
mio).

`- Consumer Banking Deposits decreased by BDT 100 mio; Mainly due to maturity of FDR of BDT 50 mio.

`- Consumer Banking Advances decreased by BDT 100 mio; Mainly due to overdraft repayment of BDT 50 mio and maturity of fixed loan of BDT 50 mio.

FCY Month on Month Balance Sheet Movements

`- FCY balance sheet remained relatively unchanged.

Other Liquidity I ssues

`- Savings Deposit of corporate banking has decreased by 2%, whereas FDR has increased by 2.5%.

FI NANCI AL ENVI RONMENT Date
28-Feb-
03

1) TREASURY BI LLS

(a) Treasury Bills are auctioned at every Monday.

(b) Typical Rates

TENOR I NTEREST RATES (%)
J an-03 Dec-02 Nov-02 Oct-02 Sep-02 Aug-02 J ul-02 J un-02 May-02 Apr-02 Mar-02 Feb-02 J an-02
28 D 7.80% 8.00% 7.40% 6.70% 6.30% 5.90% 5.40% 4.60% 4.30% 4.10% 4.10% 4.50% 4.10%
91 D 9.00% 7.50% 7.50% 6.90% 7.00% 5.80% 5.80% 5.10% 5.00% 5.10% 5.20% 4.90% 4.90%
182 D 7.80% 7.80% 7.60% 7.20% 6.40% 5.80% 5.80% 5.00% 5.00% 5.00% 5.00% 5.00% 4.90%
364 D 10.10% 10.00% 9.50% 8.00% 6.40% 6.30% 6.20% 5.80% 5.90% 5.80% 5.80% 5.20% 5.20%
2 Y 10.90% 10.70% 10.10% 9.00% 6.90% 6.90% 7.00% 6.90% 6.80% 6.80% 6.90% 6.90% 6.40%
5 Y 11.50% 11.20% 10.90% 10.60% 10.40% 9.30% 8.60% 8.60% 8.70% 8.80% 9.40% 9.40% 9.50%

2) Overnight rates ranged between 5-7% for the month.


COMPETI TI VE ENVI RONMENT Date
28-Feb-
03

DEPOSIT BANK 'A' BANK 'B' BANK 'C' BANK 'D' KOROTOA BANK
SAVINGS 5.00 7.50 7.50 6.50 8.00
STD 4.00 - - - -
1 MNTH - - - - -
3 MNTH 7.00 9.25 9.00 7.50 9.00
6 MNTH 7.25 9.50 9.50 8.00 9.25
12 MNTH 7.75 11.00 9.75 8.25 9.25
24 MNTH 8.00 11.50 - - 10.00
36 MNTH 8.00 12.00 - - 10.50

LENDING
Agriculture 12.00-16.00 9.00-13.00 11.00-16.00 12.00 14.00
Export Credit 7.00-9.00 7.00 7.00 7.00-9.00 7.00
Small Cottage Ind. 11.50-12.00 11.50-13.00 14.00-16.00 12.00 15.00
Term Loans 9.00-13.00 13.00-15.00 12.50-16.50 15.00 15.00
Working Cap 14.00 12.00-15.00 10.00-15.50 13.25-15.00 15.00

Commentary

1) FDR interest rates varies with amount and tenor for all banks.

2) Interest rate is fixed and non-
negotiable.

BALANCE SHEET SUMMARY Currency: BDT (Mio) Date 28-Feb-03

ASSETS Current Month Previous Month LI ABI LI TI ES
Current
Month Previous Month
Reserve Assets 1,000 900 Interbank Deposits (1,000) (625)
Interbank Placings 750 900 Corp. Custy Deposits (1,500) (1,400)
Corp. Custy Assets 2,500 2,350 Cons. Custy Deposits (3,000) (3,100)
Cons. Custy Assets 1,500 1,400 Capital & Reserves (500) (625)
Other Assets 500 600 Other Liabilities (250) (400)
Total Assets 6,250 6,150 Total Liabilities (6,250) (6,150)

ASSET CATEGORI ES LI ABI LI TY CATEGORI ES

CORPORATE ASSETS Current Month Previous Month CORPORATE LI ABI LI TI ES
Current
Overdraft 750 700 Savings Deposits (500) (550)
Fixed Loan 1,000 1,100 Current Deposits (400) (400)
Others 750 550 FDR (300) (350)
Others (300) (100)

CONSUMER ASSETS Current Month Previous Month CONSUMER LI ABI LI TI ES
Current
Overdraft 500 600 Savings Deposits (900) (900)
Fixed Loan 500 450 Current Deposits (600) (650)
Others 500 350 FDR (500) (550)
Others (1,000) (1,000)

LI QUI DI TY KEY I NDI CATORS

Currency: BDT (Mio) Date
28-Feb-
03

Key Management I ndicators
Current
Month Previous Month Limits Excess?
Wholesale Borrowing Guidelines 1,000 625 2,000 NO
Commitments 1,500 1,800 2,250 NO
Loan Deposit Ratio 89% 83% 100% NO
Medium Term Funding Ratio 60% 54% 50% NO
Swapped Funds Guideline 750 700 1,000 NO
Maximum Cumulative Outflow
(MCO)
1 Day -1,250 -1,300 -1,500 NO
2-7 Day -1,600 -1,500 -2,000 NO
8 Days to 1 Month -1,350 -2,240 -3,000 NO

FORECAST LI QUI DI TY SUMMARY

Currency:
BDT
(Mio) Date 28-Feb-03

I nterbank Placings 750 250 250 250
Custy Assets 4,000 300 250 1,400 300 250 1,000 500
Other Assets 500 200 300
Total Assets 6,250 950 550 1,650 550 250 1,800 500

I nterbank Deposits (1,000) (750) (250)
Custy Deposits (4,500) (1,200) (1,000) (1,200) (100) (200) (800)
Capital & Reserves (500) (100) (400)
Total Liabilities (6,250) (2,200) (1,000) (1,450) (100) (300) (1,200)

Custy Commitments (2,000) (150) (1,850)
Total Off-B/ S (1,750) 100 50 (50) (1,850)

NET MI SMATCH (1,750) (1,250) (350) 250 400 (1,900) 600 500
CUMULATI VE NET MI SMATCH (1,250) (1,600) (1,350) (950) (2,850) (2,250) (1,750)

LI MI TS
(1,500) (2,000) (3,000)

LIQUIDITY STRESS Currency BDT (Mio) Date
28-Feb-
03

Local Currency Day 1 Day 2 Day 3

Total Stress Day 1 Day 2 Day 3
Marketable Assets 0 0 0
Net Cumulative Cashflow
(Combined) 250 303 328
Reserve Assets 250 250 250
Stress Cash Flow -25 30 45
Surplus/ Shortfall in Reserve/Marketable
Assets 225 280 295

Foreign Currency Day 1 Day 2 Day 3

Other Sources of Liquidity Day 1 Day 2 Day 3
Marketable Assets 0 0 0 NONE
Reserve Assets 10 11 13
Stress Cash Flow 15 12 20
Surplus/ Shortfall in Reserve/Marketable
Assets 25 23 33
Net Cumulative Cashflow
(Combined) 250 303 328

USD Currency Day 1 Day 2 Day 3

Stress Compliance

Surplus/Shortfall in Reserve/Marketable
Assets 3 Day Stress Compliance Yes

I NTEREST RATE RI SK Currency BDT (Mio) Date
28-Feb-
03

Variable/ 1D 2D-1M 1-6M 6-12M 1-5Y 5Y+
TOTAL ASSETS 950 10.00% 2,200 11.00% 650 10.00% 150 12.00% 1,800 14.00% 500 14.50%
TOTAL LIABILTIES (2,200) 5.00% (3,250) 5.50% (150) 7.00% -250 10.00% (400) 0.00% 0 0.00%
Fwd Contracts 0 150 100 0 0 0
Net Mismatch (1,250) (900) 600 (100) 1,400 500

LOCAL REGULATORY COMPLI ANCE

Date 28-Feb-03

REGULATI ONS COMPLI ANCE COMMENTS
(1) Cash Reserve Requirements (CRR) and Statutory Liquidity Ratio (SLR). The bank is required to place the
following percentage of their customer deposits with the central bank, interest free on a monthly basis and Govt.
Securities and Treasury Bills. CRR-4% of average Time and Demand Deposits as at two months prior period SLR
16% of a average Time and Demand deposits as at two months prior period.

(2) Fcy Balance held with Central Bank will not qualify for CRR
Yes

(3) Advance to Deposit Ratio

Bank is not to exceed a total (lcy + fcy) advances to deposit ratio of 120% as per statutory liquidity requirement.
Central Bank does not have a set guideline but they usually come back if the ratio is over 90% for a long time.
Yes

(4) Bangladesh Central Bank Position

Banks operating in Bangladesh are required to maintain credit balance with the Central Bank minimum 4% of time
and Demand Deposits as CRR and the accounts must not be overdrawn
Yes

(5) Capital Adequacy Ratio

Banks operating in Bangladesh are required to maintain a minimum capital at 8% of total risk weighted assets
Yes

(6) Large Exposures

Banks operating in Bangladesh are required to restrict their lending to any large single relationship to 15% of their
capital and with the approval of Central Bank it can be increased to 100% of their capital
Yes

Note Regulatory changes
* Banks operating in Bangkadesh are required to maintain a minimum capital at 9% (core apital of which minimum 4.5%) of total risk weighted assets.

CONTRACTUAL LI QUI DI TY SUMMARY Currency BDT (Mio) Date
28-Feb-
03

I nterbank Placings 750 250 250 250
Custy Assets 4,000 1,250 100 600 300 250 1,000 500
Other Assets 500 500
Total Assets 6,250 2,200 400 850 550 250 1,500 500

I nterbank Deposits (1,000) (750) (250)
Custy Deposits (4,500) (1,200) (1,000) (1,200) (100) (200) (800)
Capital & Reserves (500) (100) (400)
Total Liabilities (6,250) (2,200) (1,000) (1,450) (100) (300) (1,200) 0

Custy Commitments (2,000) (150) (1,850)
Total Off-B/ S (1,750) 0 100 50 (50) (1,850)

NET MI SMATCH (1,750) 0 (500) (550) 400 (1,900) 300 500
CUMULATI VE NET MI SMATCH 0 (500) (1,050) (650) (2,550) (2,250) (1,750)

YI ELD BAROMETER Date
28-Feb-
03

Overdraft
Fixed Loan
Others

Savings A/C
Current A/C
FDR
Others


Asset-Liability Management (Alm) : Managing Core Risks in Banking

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MANAGING CORE RISKS

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