Financial Intermediation: Over Come It

Financial Intermediation Chapter 7 - Analysing
Bank’s Performance
Chapter 2
Banking Regulations
-Bank runs and how to
over come it
Chapter 1 - Theories of
Financial Intermediation
-What do banks do? Chapter 3 - Risks in
Banking
Chapter 4 - Credit Risks
-Introduction to other
risks
Credit Chapter 6 - Risk

Transfer Securitization
Country
& Credit Derivatives
Market
Interest Chapter 8 - Risk

Management with
Liquidity derivatives
Chapter 5
ALM –Liquidity, Interest Operations
rate Risk
Solvency
Prepared by Adam Wong
Chapter 5 –
Balance Sheet Management
Liquidity Risk & Interest Rate Risk
Overview
Definition of ALM
Causes of Interest rate & liquidity risk
Relationship between interest rate risk and liquidity risk
ALM
Why is ALM required
Objectives of ALM
General ALM strategies
Problems for Banks Associated with ALM – Issues & mitigation

Seasonal loan demand and deposit flows
Changes in economic environment
Monetary policy and banking supervision
Financial markets
Customer relationship
ALM Techniques
Liquidity Gap Analysis
Interest Rate Gap Analysis
2
3
Aim
• Explain the purpose and focus of balance sheet (Asset & Liability)
management
• Consider the relevance of liquidity risk and interest rate risk within
the context of asset and liability management
• Identify techniques used by banks in the management of liquidity

risk and interest rate risk.
4
5
Learning Objectives
Be able to:
• Discuss the principles of asset and liability management
• Describe and evaluate the importance of liquidity and interest rate

risk
• Explain how banks manage liquidity and interest rate risk
• Measure the amount of risk

• Take necessary action to contain or lower risk
6
Bank’s Balance Sheet
Liabilities
Asset (Funding)
Capital
7
Why ALM is Required (Rationale for ALM) – 1/3
Banks engage in diversified activities to spread risks while increasing

profitability.
Banks deals in a very wide range of financial instruments

1. Liabilities (Deposits) – Source of funding
2. Assets (Loans) – Application of funds
3. Off-balance-sheet activities (Guarantees, Letters of Credits)
4. Derivatives for hedging and trading
Note for info:

– Balance Sheet Items generates → Interest Income
– Off Balance Sheet Items generates → Generally Fee income
8
Customers’ needs are varied – banks need to meet their needs
• If banks’ assets and liabilities are poorly adjusted, it give rise to

a. Liquidity Risk: bank finds itself without adequate liquidity (inability to
meet commitment – to fund the loans committed or pay liabilities when they
fall due)
and / or
b. Interest Rate Risk: incur substantial losses due to changes in interest
rates. Details in later slide
Either of which may lead to the bank’s insolvency

This is ALM
Therefore, banks needs to adopt a systematic approach to managing

their balance sheet and off-balance sheet positions.
9
ALM techniques are most applicable to commercial banks involved in

deposit collection and lending businesses.
• As such, it focuses on liquidity risk and interest rate risk at the

balance sheet level.
• It is a subset of the bank’s overall risk management process.
SIMLOCC
Risk Management Process Risk measurement

1. Monitor existing position of a bank.
2. Evaluate the variance from the desired position
3. Take action including hedging to move the bank
towards the desired position. Risk management
10
Interest rate risk relates to risk of loss
Objectives of ALM incurred due to changes in market
interest rates, through reduced
1. Interest Rate Risk Management interest margins on outstanding loans
a. Protect net interest margin (NIM).

– Minimise the variability of NIM or net interest income (NII) for a target level of
NIM (example: the bank want to achieve a NIM of 3%, how does it ensure that this will
not vary due to changes in interest rate scenario)
or
– Maximise NIM for a given level of risk.
 NII = (Interest revenue from assets) – (Interest cost of funding the loan)
Loan 10,000
NII
Revenue 5% 500
 Net interest margin (NIM) = -------------- Interest Cost -2% (200)
Total Asset to derive NII 3% 300 NII
NIM 5% - 2% = 3%
b. Enhance profitability while: 300 / 10,000 = 3%
– controlling and limiting different risks inherent in
– modern banking
11
Causes of Interest Rate Risk
Variable i i
Risk
time time
Interest
charged on
loans Risk
i i
Fixed
time time
Fixed Variable
Interest cost of funding loans
Numeric examples in following slides

12
Year 1 Year 2
Loan A Loan A Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Sibor 1.8 2.5 1.7 1.5 3 3.5 1.3 2.8
Loan Rate – 3 mth Sibor + 1% Margin above SIBOR 1 1 1 1 1 1 1 1
Cost – 3 mth Sibid Rate Payable by Borrower 2.8 3.5 2.7 2.5 4 4.5 2.3 3.8
Cost of Funds (SIBID) 1.675 2.375 1.575 1.375 2.875 3.375 1.175 2.675
Margin 1.125 1.125 1.125 1.125 1.125 1.125 1.125 1.125
SIBOR – 0.125%
5 revenue
4
Revenue
Fix Float
3 Constant Net Margin

2
Fix Float 1 cost

Cost
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Year 1 Year 2
Year 1 Year 2
Loan B Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Loan B Sibor 1.8 2.5 1.7 1.5 3 3.5 1.3 2.8
Loan Rate – 3 mth Sibor + 1% Margin above SIBOR 1 1 1 1 1 1 1 1
Rate Payable by Borrower 2.8 3.5 2.7 2.5 4 4.5 2.3 3.8
Cost – 3% Fixed Rate Cost of Funds (3%) 3 3 3 3 3 3 3 3
Margin -0.2 0.5 -0.3 -0.5 1 1.5 -0.7 0.8
5
4
Revenue
Fix Float
3
Fluctuating Net Margin
2
Fix Float 1
Cost 0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Year 1 Year 2
13
Year 1 Year 2
Loan A Loan A Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Loan Rate – 3.5% Fixed Rate Payable by Borrower 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5
Cost of Funds (SIBID) 1.675 2.375 1.575 1.375 2.875 3.375 1.175 2.675
Cost – 3 mth Sibid Margin 1.825 1.125 1.925 2.125 0.625 0.125 2.325 0.825
4
3.5
3
Fluctuating Net Margin
Revenue
Fix Float
2.5
2
1.5
1
Fix Float
Cost 0.5
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Year 1 Year 2
Year 1 Year 2
Loan B Loan B Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Loan Rate – 3.5% Fixed Rate Payable by Borrower 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5
3% Fixed 3 3 3 3 3 3 3 3
Cost – 3% Fixed Rate Margin 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
3.6
3.5
3.4
Revenue
Fix Float
3.3
3.2
Constant Net Margin
3.1
3
Fix Float 2.9
Cost 2.8
2.7
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Year 1 Year 2
14
Risks that are associated with a
Objectives of ALM bank finding itself unable to
meet its commitments on time,
or only being able to do so by
recourse to emergency
2. Liquidity Risk Management
borrowing
• The aim is to increase the earning capacity of the bank

while at the same time ensuring an adequate liquidity
cushion
• Complying with the constraints of banking supervision
Liquidity risk Banks require liquidity for four
major reasons:
• as a cushion to replace net
outflows of funds
• in order to compensate for the
non-receipt of expected inflows of
funds
• as a source of funds when
contingent liabilities fall due
• as a source of funds to undertake
new transactions when desirable
Slide from chapter 3

15
Relationship Between Liquidity & Maturity
Maturity period of an asset – refers to the length of period required

before the holder of the asset gets repaid by the issuer.
Liquidity - refers to how easily the assets can be converted into cash.
Possible
e.g. a high quality
Long Term LT government LT assets are illiquid
Maturity security may be
sold easily
Asset Maturity
Short Term
Unlikely
Maturity
Same analysis for
liabilities
Liquid Illiquid
Assets Assets
Short time needed Long time needed
for asset to be for asset to be
converted to cash converted to cash
16
A15 Q5
Explain the nature of liquidity risk and interest rate risk, and analyse the relevance of
gap analysis for managing these risks.
17
Pg 20 of Study Guide
ALM is required to overcome this problem
18
Funding of Assets
Asset Type Funding
Short Term
Maturity
Short Term
Maturity
Eg. A loan Long Term
maturing in 3 Maturity
months
Assets
Short Term
Maturity
Long Term
Maturity
Eg. A loan Long Term
maturing in 10 Maturity
years
19
Liquidity Risk
Risk arise due to mismatch between the sizes and
maturities of assets and liabilities
Asset Liabilities
ST
Maturity ST
Maturity
LT
Maturity LT
Maturity
When this portion of liabilities is due

for payment, there are insufficient
immediate resources to make the
20 payment
Different Emphasis of ALM
Asset Liability
Management Management
Maximize return on Maximize return in the
loans granted and interbank market#
securities purchased # Interest Rate
Risk
Credit risk Minimize default risks Minimize cost of
management
funding#
Maintain adequate Minimize withdrawal
liquidity to fund risks by maintaining
loans* adequate liquidity to
prevent bank run*
* Liquidity
risk management * Liquidity risk
21
Risk Management Strategy
In deciding on the ALM strategy, the bank has to consider many factors,
including the bank’s attitude towards risk.
If the bank is ‘risk-averse’ it will prefer to match

If the bank is prepared to take increased risk, then greater mis-matching
and more complex hedging arrangements will be undertaken in the hope of
earning extra margin.
Matched in terms of Direction taken depends Mis-matched in terms of

• Maturity on the bank’s attitude • Maturity
• Interest rate towards risks • Interest rate
Lower risk Higher risk

 Lower revenue  Higher revenue
Complex Hedging
22
A16 Q5
Explain the general risk measurement and risk management functions of banks.
Discuss how these functions are applied by banks when they use Asset and
Liability Management and gap analysis to manage liquidity risk and interest rate
risk.
A14 Q5
Discuss the motivations and techniques of Asset and Liability Management
B08 Q5
Discuss the rationale for asset and liability management in banks, and analyse the
techniques which are employed.
23
Assets Growth Needs to Be Funded
New Assets Funding Funding ??
Liability
Assets
Capital
Problems for Banks in Funding

• Bank portfolios are constantly changing due to new transactions:
– maturities, (Long vs Short)
This chapter
– interest rates (Fixed vs Floating)
– exchange rates change (Currency mismatch) Chapter 8
24
Managing Risk of Assets Growth
2 ways to manage risk of assets growth with insufficient funding

1 - Attract
1. Get more funding by more
deposits
– varying the terms bank’s offer to deposit clients
2. Raise funding through securitisation A L

– transforms illiquid assets into marketable instruments
E
4 – so that new assets can be funded

(iv)
with cash freed
New
Assets Sell assets or
use assets as
issue collateral 2 - If cannot
attract enough
(ii) (i) A deposits
(iii)
Existing L
Cash Securities Assets
3 – reduce
level of
existing E
assets
25
Off Balance Sheet Growth Also Needs Funds

Off Balance Sheet Growth caused by:
• Guarantees given
• Increase in the use of currency and interest rate

swaps,
• Financial futures, Further

discussion
in chapter 8
• Options
• Forward-rate agreements
Funding is needed when the bank’s obligation to

pay under the derivate contract materialize
26
27
Relationship between Interest Rate & Liquidity Risk
• Liquidity and interest rate policies are interdependent.
• Any projected liquidity gap will be funded at an unknown rate unless

a hedging transaction is initiated immediately.
Time
Position 12 months ahead
Maturity of Asset
Now
$100m loans @ 10%
Projected Assets
Liquidity Gap
Projected Liabilities $100m funding
(liabilities @ 6%)
3 months 9 months
1 - Loan is fully 2- Initial funding 3- If bank cannot 4 – Even If bank can get
funded @ the matures get funding, it will be funding, to repay the 5 – NIM
beginning by Bank seeks unable to repay the initial liability – NOT sure Uncertainty
Liability funding again initial liability – subsequent funding cost - Interest
Liquidity Risk Rate Risk
28
Asset Funding
Funding
VR Asset
S T Maturity S T Maturity i
Liquid VR Volatile
Assets Liabilities
time
Liquid Assets FR
Non Liq Assets
FR
Volatile Liab
Interest rate risk
Non Volatile Liab
VR
Equity
VR
LT Maturity LT Maturity Asset

FR
Non Non
Liquid FR Volatile
Assets Liabilities i Funding
Equity
time
Conclusion
Above example - no liquidity risk
but have interest rate risk
Refer back to Chapter 3 - why banks wants
to have a mismatch of interest rate?
29

Asset Funding
S T Maturity
VR VR Matched
Liquid
Assets
S T Maturity
FR Interest rate risk Volatile
Liabilities
Liquidity risk
FR Liquidity risk & interest rate risk

VR
LT Maturity VR Matched
Non
Liquid Interest rate risk LT Maturity
Assets Non
FR
Volatile
FR Matched Liabilities
Equity
Liquid Assets
Non Liq Assets
Volatile Liab
Non Volatile Liab
Equity
30
Assets Liabilities
Fixed
A Fixed B Rate 1 Fixed 2 Fixed
Rate Rate
Rate
Fixed Non- Fixed
Liquid Non-
Rate Liquid Rate Volatile
Volatile
Asset Asset Liabilities
Liabilities
C D Variable Variable
Rate 3 Variable 4
Variable Rate
Floating Rate Floating Rate
Rate Non- Rate Non-
Liquid Liquid Volatile Volatile
Asset Asset Liabilities Liabilities
S T Maturity LT Maturity S T Maturity LT Maturity

Liquid Non Liquid Volatile Non Volatile
Assets Assets Liabilities Liabilities
Int Rate Liquidity Int Rate Liquidity

Risk Risk Risk Risk
A1 A3
A2 A4
B1 B3
B2 B4
C1 C3
C2 C4
D1 D3
D2 D4
31
Summary of Factors Impacting The Balance Banks’ Sheet
• Increased competition
• Breakdown in demarcation lines between

different types of business → Banks deal in a
very wide range of financial instruments both
as assets and liabilities
Need for ALM
• Technological and financial innovation
Further discussion in later
slides
• Prudential re-regulation - legal framework for
financial operations
• Increased volatility of interest and exchange

rates
derivatives
• Increased usage of securitisation and off-

balance-sheet (OBS) activities to spread risk
while increasing profitability.
32
Bank makes money
through Asset 3
1 Transformation
Bank concerns
Unable to meet commitment
Loss incurred due to changes in market interest rates
Liquidity 3a 3b Interest
2 Risk Rate Risk
Factors Impacting The Balance Banks’
Sheet
• Increased competition 4 Why ALM required
• Bank’s diverse range of activities
• Re-regulation
• Customer needs
• Interest & exchange rate volatility
• Subset of SIMLOCC
• Securitisation & derivatives
• Most applicable to commercial banks
Objectives of ALM
Liquidity Risk Management Interest Rate Risk management

• Increase the earning while • Protect / Enhance NIM
ensuring an adequate liquidity • Control / limit risk
• Comply with banking supervision
33
Recap 1
1. What is ALM?
2. What give rise to interest rate risks?
3. What give rise to liquidity risks?
4. Do banks make profit from the asset side or liability side

of its balance sheet?
5. What are the objectives of ALM?
6. What are the key areas of emphasis when managing

assets and liabilities.
7. What are the problems faced by banks in a growth

situation?
8. What are the 2 general possible ALM strategies?
34
35
Summary of Impact
Factors Impact
Seasonal flows – loan demand,

Affects Liquidity
deposit withdrawals
Changes in economic
Affects Liquidity
environment - loan demand
Monetary policy and banking

supervision – influence on the Affects Interest Rate / Liquidity
direction of interest
Affects how loans will be funded

Financial markets – interest rates
and the types of loans (FR or VR
expectations
loans)
Customer relationship –
Affects Liquidity
unexpected draw downs
Details in following slides

36
37
Seasonal Flows – Affects Liquidity

Issue
• Banks have little control over
– seasonal loan demand
– seasonal deposit flows (outflow of deposits)
• Seasonal flows differ according to local conditions and the trade

cycles of customers.
Mitigation - Bank management has to

• Structure the maturities of assets and liabilities such that funds are available
when needed.
– Ensure that funds earn the highest possible returns when not needed (e.g. funds
not deployed in loans).
– Ensure that balance sheet structure is flexible enough to meet unanticipated

demand for funds, or withdrawals of funds e.g. limit on amount of funding from
unstable source.
38
Banks have little
control over seasonal
loan demand and
deposit withdrawal
39
Changes In The Economic Environment – Affects Liquidity
Issue
Economic conditions are important determinants of the banks’ assets
and liabilities composition
Mitigation
Strong Economy Weak Economy
• Strong loan demand • Weak loan demand
• Banks run down their liquid asset • Banks to rely less on external
portfolios in order to support loan borrowings since there are less
demand (convert assets into loans to fund
cash for lending out)
• Banks primarily concerned with

• Bought-in funds (eg borrowing liability management may revert
from the inter bank market) will back to asset management i.e.
also become an important How to generate more assets to
activity drive revenue
40
Strong economy –
Banks have little
how to fund asset
control over seasonal
growth
loan demand and
Weak economy –
deposit withdrawal
how to generate
Prepared by Adam Wong asset growth 41
(1) Monetary Policy And Banking Supervision – Affects Liquidity
Issue
• Regulatory capital requirements constrain bank’s abilities to manage
its portfolios. Regulators set rules on the amount of capital & types of
liabilities bank is required to have.
Liquidity
Regulations
Regulators set rules on minimum liquid assets to hold
Mitigation
• Balance sheet structure should be flexible to accommodate
unexpected loan demands and changes in customer portfolio
preferences due to:
– changing availability of funds Impacted by regulators
– rising cost of short-term funds Further discussion in following slides
42
(2) Monetary Policy And Banking Supervision – Affects Interest Rate
• Monetary policy that have a direct impact on:

– Interest rates
– Reserve requirements (Liquidity impact)
• Tight monetary policy* → rising short-term interest rates

→ slower rate of growth of non-borrowed
reserves (bank’s own reserves) relative to
Details in next slide loan demands
• Reserve requirements are the amount of funds that a depository

institution must hold in reserve against specified deposit liabilities.
– Tight monetary policies leads to lower loan demand
– Lower loan demands leads to lower deposit liabilities
– Lower deposit liabilities leads to lower reserves
* Policy designed to curb inflation by reducing the money

supply, through open market operations
43
Explanation of Borrowed Reserves
Federal Reserve loan granted to a bank or

a savings institution with insufficient
2 reserves on hand to meet its legal Reserve
1-Total Bank’s own Requirements
Reserves Reserves
(member bank
deposits in Amount of funds that banks must hold in
Federal reserve against deposits made by their
Reserve customers. This money must be in the
Banks, plus bank's vaults or at the closest Federal
vault cash) Reserve bank.
3-Borrowed
Reserves
at the Federal
Reserve
Discount
Window.
44
Strong economy –
Banks have little Monetary policy
how to fund asset
control over seasonal impacts interest
growth
loan demand and rates a and
Weak economy –
deposit withdrawal market liquidity
how to generate
Effects of Financial Markets – Affects Interest Rate
Issue
• Interest rate is determined by the market.
• Individual banks have no control of the direction of interest rate

movements.
Mitigation
• Banks based their funding and lending strategies based on the
expected market direction of interest rates. (see next slide for more
details)
46
Effects of Funding Strategy When Bank Expects
Interest Rates To Rise
Assets Liabilities
(Uses) (Funding)
LT LT
Lock in
ST ST
VR FR VR FR
Expected Interest Revenue - increasing Funding Cost – locked in

Rate
Rate
time time
47
Financial Markets – Effects of interest rate strategy

depending on interest rate view
• If bank believes that interest rates are going to rise,

– It would lend with short maturity (eg. Loan to customer to be repriced every 3
mth)
Chart 1
Bank’s INTERNAL view of 3 months
Interbank Rate
15.2% x
x6
x5
x4
x3
x2 Bank believes that when the current loan
7.8% x1
x0 matures in mth 3, a new 3 mth loan (from mth
3 to mth 6 will be priced higher @x1
Now
3 6 9 12 15 18 21 24
The rate for a 3 months loan (maturing in mth
3) now is 7.8%
48
Bank borrow with long a maturity as possible (e.g. 24 mth fixed rate funding) →
Lock in low cost of funds
3 6 9 12 15 18 21 24
COF 7.80% 8.20% 8.60% 8.90% 9.10% 9.30% 9.42% 9.50%
3 6 9 12 15 18 21 24
Cost of borrowing for 3 mths today 7.80%
Yield Curve - A
line that plots 15.00%
the interest rates, 14.00%

at a set point in Yield Curve
13.00%
time, of bonds 12.00%
having equal credit
11.00%
quality, but differing
10.00%
maturity dates
9.00%
http://www.treasury.gov/resource-center/data-
8.00%
chart-center/interest-
rates/Pages/TextView.aspx?data=yieldYear&ye
ar=2011 7.00%
3 49
6 9 12 15 18 21 24
http://www.treasury.gov/resource-center/data-
Bank’s INTERNAL view of 3 months chart-center/interest-
rates/Pages/TextView.aspx?data=yieldYear&ye
Interbank Rate ar=2011
15.2%
Current Yield Curve
9.5%
7.8%
Now
3 6 9 12 15 18 21 24 3 6 9 12 15 18 21 24
Effects of locking in long term funds now @ 9.5%
3 6 9 12 15 18 21 24
3 mth loan rolled over at 7.80% 8.6% 9.4% 10.4% 11.4% 12.6% 13.8% 15.2%
Borrow for 24 mths at 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50% 9.50%
Quarterly NIM -1.70% -0.92% -0.06% 0.88% 1.92% 3.06% 4.32% 5.70%
Expected interest to charge customer

15.2%
Cost locked in today

Result of Strategy
9.5% Cost
7.8%
50
Prepared by Adam Wong Now 3 6 9 12 15 18 21 24
Effects of strategy when Bank Expects interest
rates to fall
Assets Liabilities
(Uses) (Funding)
LT LT
Lock in
ST ST
VR FR VR FR
Interest Revenue – locked in Funding Cost – decreasing

Rate
Rate
time time
51
Financial Markets – cont’d
• If bank believes that interest rates are going to fall,

– should lend with long maturity e.g. (24 mth fixed rate loan) → Lock in
higher yield
– borrow with short maturity (Funding reprice every 3 mth)
Forecasted 3 months Current Yield Curve

Interbank Rate 8%
7.8 %
3.7%
Now 3 6 9 12 15 18 21 24 3 6 9 12 15 18 21 24
3 6 9 12 15 18 21 24
Loans rate locked in for 24 months 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Fund by renewing rate every 3 mths 7.8% 7.0% 6.3% 5.7% 5.1% 4.6% 4.1% 3.7%
Quarterly NIM 0.2% 1.0% 1.7% 2.3% 2.9% 3.4% 3.9% 4.3%
52
Financial Markets – cont’d
Forecasted 3 months Current Yield Curve
Interbank Rate 8%
7.8 %
3.7%
Now 3 6 9 12 15 18 21 24 3 6 9 12 15 18 21 24
3 6 9 12 15 18 21 24
Loan 24 months 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
3 mth COF 7.8% 7.0% 6.3% 5.7% 5.1% 4.6% 4.1% 3.7%
Quarterly NIM 0.2% 1.0% 1.7% 2.3% 2.9% 3.4% 3.9% 4.3%
8.0% Expected interest to charge customer
7.8%
Margin
Result of Strategy
3.7% Cost
53 Now 3
Prepared by Adam Wong 6 9 12 15 18 21 24
When Interest Rate Forecast is Wrong
• Decline of the US savings and loans (S&Ls) industry from the late
1970s onwards.
4 Cost of variable funding
Interest 1 Fixed rate loans return

Rate 3
2
Time
1 2
• Many S&Ls had lent at fixed rates when interest rates were low 3
and yet they had to fund these by taking deposits at ever increasing
variable rates.
4
• The cost of funds began to exceed returns on loans, which spelt

disaster for the industry.
54
Maturity Transformation Function
• Borrowing short to lend long was the financial structure that federal policy
effectively forced S&Ls to follow in the aftermath of the Great Depression.
• S&Ls used short-term passbook savings to fund long-term, fixed-rate home

mortgages. Although the long-term, fixed-rate mortgage may have been an
admirable public-policy objective, the federal government picked the wrong
horse—the S&L industry—to do this type of lending because S&Ls funded
themselves primarily with short-term deposits.
• The dangers inherent in this “maturity mismatching” became evident every

time short-term Interest rates rose. S&Ls, stuck with long-term loans at fixed
rates, often had to pay more to their depositors than they were making on
their mortgages. In 1981 and 1982 the interest rate spreads for S&Ls (the
difference between the average interest rate on their mortgage portfolios
and their average cost of funds) were − ve 1.0 percent and − ve 0.7 percent,
respectively.
Adapted from Savings and Loan Crisis by Bert Ely
55
Examples of Wrong Reading of Interest Rates by Banks

VRA – VRL
• All 3 banks believed that interest rate will fall.
• Banks opened up a –ve variable interest rate gap (Variable rate
Asset < Variable rate Liabilities)
Example Fixed Rate Var Rate

Assets 100 0
Liabilities 0 100
-100 Variable rate gap This is just an
example, not all
liabilities are
necessarily variable
rate
Locked in revenue
% Lend fixed
Expected COF Borrow

variable
3 6 9 12 15 18 21 24
Further discussion under interest

56
rate gap analysis in later slides
Examples of Wrong Reading of Interest Rates by Banks
• Int Rate did not fall, but rose instead
• Result
Actual COF
Locked in revenue
% Lend fixed
Expected COF Borrow

variable
3 6 9 12 15 18 21 24
Bank Losses
Midland Bank (HSBC) £110
RBS closed
their gap in Barclay £22
million
time (details in National Westminister (RBS) £0
next slide)
Further discussion under interest
57
rate gap analysis in later slides
Closing the Variable Rate Gap
Original situation
Fixed Rate Var Rate
Assets 100 0 i
Liabilities 0 100
-100 Variable rate gap time
Remedied situation
Fixed Rate Var Rate

Assets 100 0
Liabilities 100 0 Convert the variable rate funding to fixed funding
0 Variable rate gap closed
Under this situation, the bank’s margin is time

unaffected when interest rate rise
58
Quotation - About Interest Rate Risk
• Ho and Saunders (1981) view the bank as a dynamic dealer, setting

interest rates on loans and deposits to balance the asymmetric
arrival of loan demand and deposit supplies.
• The non-synchronous arrival of loans and deposits generates a cost

for the bank given that it will have to hold either a long or short
position in the money market.
• This therefore exposes the bank to changes in the money market

interest rate (i.e. interest rate risk)
59
Strong economy –
Banks have little Monetary policy Expected
how to fund asset
control over seasonal impacts interest movements in
growth
loan demand and rates a and market rates
Weak economy –
deposit withdrawal market liquidity affects the banks’
how to generate
strategies
Customer Relationships – Affects Liquidity
Issue
• Banks have commitments to customers
– (e.g. unused overdraft and credit lines, revolving credit facilities) and
guarantees (e.g. standby letters of credit, commercial letters of credit)
which can be drawn on during periods of tight money or unusual

circumstances by customers.
• In difficult financial times - Customer are now more dependent on

banks to fund their operations.
– Resulting in more demand for funds from customers.
Mitigation
• Bank must know
– lines of credit and guarantees that have been extended,
– expected drawdown of these facilities in the future.
(Example in next page)
61
Example of Customer Relationship
• Deutsche Bank faced liquidity problems in Feb 2008 when Porsche

drew down Euro 10 bio line. take over of Volkswagen
• While the line was there, Deutsche Bank did not expect Porsche to
draw down the line.
• Sudden drawdown created liquidity problems for the bank to fund

the loan to Porsche due to tight market liquidity conditions at that
time.
62
Summary
Recap
Strong economy –
Banks have little Monetary policy Expected
how to fund asset Demands by
control over seasonal impacts interest movements in
growth customer for funds
loan demand and rates a and market rates
Weak economy – leading to liquidity
deposit withdrawal market liquidity affects the banks’
how to generate problem for banks
strategies
Bank makes money

through Asset 3
1 Transformation
Bank concerns
2 Risk Rate Risk
Sheet
• Re-regulation
• Customer needs
5 Issues associated with ALM Objectives of ALM

• Seasonal flows
• Changes in economic environment Liquidity Risk Management Interest Rate Risk management
• Monetary policy • Increase the earning while • Protect / Enhance NIM
• Financial markets ensuring an adequate liquidity • Control / limit risk
• Customer relationships • Comply with banking supervision
64
Recap 2
9. What are the 5 potential problem areas that affect

effective management of Asset & Liabilities for a bank?
10. What risks does Seasonal loan demand and deposit

flows give rise to?
11. How do changes in economic environment impact the

bank’s asset and liability management?
12. What risks does Monetary policy and banking

supervision give rise to?
13. Explain how changes in the market interest leads to risks

faced by banks?
14. What risks does the bank customer relationships give

rise to?
65
Fixed Variable
Rate Rate
Assets
Liabilities
Definition
FIXED Rate Gap
fixed rate assets - fixed
rate liabilities
VARIABLE Rate Gap

Interest sensitive assets -
interest sensitive liabilities
Impact of variations in the net interest

margin to variations in interest rates
66
Interest Rate Gap
• The interest rate gap links variations in the net interest margin to
variations in interest rates.
– It is a standard measure of interest rate risk exposure
In other words
• Interest rate gap analysis can be used to determine
– the effect on net interest margin or net interest income
– Based on changes in the interest rate environment
Step 1 – size of gap (-ve Var Rate Gap)
Interest rate gap analysis

Step 2 – NIM or NII impact based on
size of gap and expected
interest rate changes
Change in NIM will naturally lead to change in NII
Interest Rate Gap – Affects the margin directly
Step 1 - in Interest Rate Gap Analysis – size of Interest Rate Gap

• Decide which assets and liabilities are rate-sensitive
• The gap for a given period is defined as

– FIXED Rate Gap = (amount of fixed rate assets) less (amount of fixed
rate liabilities)
– VARIABLE Rate Gap = (amount of interest sensitive assets) less
(amount of interest sensitive liabilities)
Assuming that Total Assets = Total Liabilities
(in $M) Assets Liabilities Gap

Fixed int Rate 500 300 200 Fixed rate gap
Var int Rate 700 900 (200) Variable rate gap
1,200 1,20068
-
We use this gap for analysis in step 2

Step 2 - in Interest Rate Gap Analysis
Determine Interest Margin Impact Due to Changes in Interest Rate
• Assumption
– gap is constant over the period of investigation, (example below is for 1 year)
– interest rates on all maturities change by the same amount
• the change in interest margin (IM) due to a change in the common
interest rate, i, will be:
Var Rate Gap
IM impact = (VRA – VRL) x ∆i

-ve variable rate gap Refer back to slide 56,57 on banks opening a negative variable rate gap
Proof of equation Original Scenario 1 Scenario 2

Int rate ↑1% Int rate ↓1%
VRA < VRL $ Rate $ Rate $ Rate $
Excel
Var Rate Assets 700 8% 56.0 9% 63.0 7% 49.0
Var Rate Liabilities 900 5% 45.0 6% 54.0 4% 36.0
Var Rate Gap (200) Profit 11.0 Profit 9.0 Profit 13.0
Change in Profit
compared to original Int rate increased by +1% (2.0) 2.0
(700-900 X +1%)= -$2 (700-900 X -1%)= $2

69
Interest Rate Gap – Other Scenarios

Interest Rate ↑ Interest Rate ↓
+ve Variable Rate Gap Profit ↑ Profit ↓
VRA > VRL
-ve Variable Rate Gap Profit ↓ Profit ↑
VRA < VRL
Assume that VR asset and VR Interest rate ↑ by 1% Interest rate ↓ by 1%

liabilities are sensitive to a compared to original compared to original
common interest rate index
Original Scenario 1 Scenario 2
VRA > VRL $ Rate $ Rate $ Rate $
Var Rate Assets 900 8% 72 9.0% 81 7% 63
Var Rate Liabilities 600 5% 30 6.0% 36 4% 24
Gap / NIM /Profit 300 3% 42 3% 45 3% 39
Change in Profit compared to
original 3 (3)
Original
+ve Scenario 1
variable rate gap Scenario 2
Value Rate $ Rate $ Rate $
Var Rate Assets 700 8% 56 9.0% 63 7% 49
Var Rate Liabilities 900 5% 45 6.0% 54 4% 36
IM impact = (VRA – VRL) x ∆i
Gap / NIM /Profit (200) 3% 11 3% 9 3% 13
Change in Profit compared to
+$300 X +1% = +$3 +$300 X -1% = -$3
original (2) 2
70
Summary of NIM Impact Due to Changes in
Interest Rate
VRA - VRL Interest Interest

(Va ri a bl e Rate Margin
Ga p) Change Impact
When interest rate gap is
+ve Gap ↑ ↑ +ve, changes in interest rate
+ve Gap ↓ ↓ and interest margin moves in
the same direction
-ve Gap ↑ ↓
-ve Gap ↓ ↑
-ve Variable rate gap

Interest rate rose
Bank Losses
Midland Bank (HSBC) £110
Barclay £22
Refer back to slide 56,57 on banks opening a negative variable rate gap
71
Interest Rate Gap – Profit Maintenance Strategy

VRA > VRL
-ve Variable Rate Gap Profit ↓ Profit ↑
VRA < VRL
• If profit is expected to ↓ bank should consider managing the interest

rate risk – lessen the potential loss
If VRA-VRL=0
Changes to IM also = 0 when i changes
• Interest Rate Risk Management Strategy
– adjust the balances of rate-sensitive assets and liabilities towards an
interest rate gap of zero
change in interest margin = (VRA – VRL) x ∆int rate
– interest margin is immunised against changes in interest rates.

• This position is rarely achieved in practice.
– Position is not necessarily desired since it could imply a limitation of
profit-generating opportunities (that’s why some banks purposely open a gap)
72
Examples of Interest Rate Gap Management
When interest rate gap = 0, the balance sheet is “immunised”
Scenario 1
VR Asset > VR Liab Situation 1
Scenario 2 -ve Variable Rate Gap Profit ↓ Profit ↑
VR Asset < VR Liab Situation 2
Situation 1
– ↓VR Asset & ↑VR Liab  Convert fixed rate funding to variable rate
funding
Fixed Rate Var Rate Fixed Rate Var Rate
Assets 0 100 Assets 0 100
Liabilities 100 0 Liabilities 0 100
VR Gap +100 VR Gap 0
Situation 2
Convert using interest rate swap
– ↑ VR Asset ↓VR Liab  Convert variable rate funding to fixed rate
funding
Fixed Rate Var Rate Fixed Rate Var Rate
Assets 100 0 Assets 100 0
Liabilities 0 100 Liabilities 100 0
VR Gap -100 VR Gap 0
Prepared by Adam Wong Refer back to slide 56,57 on banks opening a negative variable rate gap
Interest Rate SWAP
Asset Liability
Fixed Floating
Rate @ 5% Rate @ LIBOR
Underlying
Lend @ fixed rate Loan funded by variable rate transaction
Bank
VRA < VRL
Fixed Floating • -ve variable rate Gap
Interest payments to each
Rate @ Rate @ • Convert floating rate
other @ regular intervals 4.5% LIBOR liability to fixed rate
liability Hedging
transaction
Swap
Counter
Party
74
Gap Analysis vs IRS
• Interest rate gap analysis helps banks to adjust the composition of

the balance sheet.
• Interest rate swaps allow hedging of risk due to this composition of

the balance sheet).
Changing the size of the gap
75
Technique used to analyse changes in interest income due

to changes in :
• Rates
• Volume
• Mix
76
Interest Margin Variance Analysis (IMVA)
Factors affecting interest income in assets
• Rates
• Volume
• Mix
Purpose - Analyse the effect of interest rate changes by adopting the

appropriate volume and mix strategies.
Situation A Situation B Situation C

Margin Revenue Margin Revenue Margin Revenue
Volume NIM NII Volume NIM NII Volume NIM NII
Product 1 1,000 3% 30 2,300 3% 69 1,000 3% 25
Product 2 1,000 4% 40 500 4% 20 1,000 1% 10
Product 3 1,000 5% 50 200 5% 10 1,000 6% 60
3,000 120 3,000 99 3,000 95
Total Vol no change Total Vol no change
NIM no change NIM changed
Pdt Mix changed Pdt Mix no change
Spend more effort to increase sales of product 3

Sell less of product 2 and
77
more of product 3
Recap 3
15. What is an Interest rate Gap?
16. What is a positive Variable rate Gap?
17. What is a negative Variable rate Gap?
18. What happens to profit when interest rate increases in a

positive Variable rate gap situation?
19. What happens to profit when interest rate increases in a

negative Variable rate gap situation?
20. What is interest margin immunization
21. What are the 3 factors that affect the interest margin?
78
Bank makes money
through Asset 3
1 Transformation
Bank concerns
2 Risk Rate Risk
Sheet
• Re-regulation
• Customer needs
5 Issues associated with ALM

Seasonal flows
Monetary policy
Financial markets
Customer relationships • Comply with banking supervision
6
Opening Gaps Int margin variance

Int gap analysis analysis
VRA – VRL • Rates
Income impact • Volume
and interest rate • Mix
change Strategy to address
79
Prepared by Adam Wong Immunisation
Liquid
Assets Volatile
Liabilities
Definition
Difference between the amount of
net liquid assets (Net LA) and
net volatile liabilities (Net VL).
To take actions to reduce

gap if necessary
80
81
Part of Asset Transformation

Cause of Maturity Mis-matching
• Banks are in the business of maturity transformation;
– Lend for longer periods than those for which they borrow / fund.
– Expect to have a mismatched balance sheet with short-term liabilities
greater than short-term assets and with assets greater than liabilities at
medium and long term.
Balance Sheet in $millions

Assets with maturity in 1 year 146,291 Liab with maturity in 1 year 234,259
Assets with maturity in > year 137,419 Liab with maturity in > year 16,349 Approx
$50 b
Equity 33,102
283,710 283,710
Actual balance sheet of a local bank
• Maturity mismatching is an intrinsic feature of banking

– Need to manage the mismatching in order to avoid liquidity problems.
82
Liquidity
• Liquidity – general definition:

– Ability to meet commitments when they fall due (e.g. deposit
withdrawals) – Liability side of balance sheet
Recap
Ch3
• Unexpected changes in the flows of loans and volatile liabilities

create liquidity problems for banks.
– Therefore, the maintenance of adequate liquidity remains one of

the most important features of banking.
83
Why Banks Require Liquidity (from Chap 3) Recap

Ch3
Banks require liquidity for four major reasons:
1. As a cushion to replace net outflows of funds.
2. In order to compensate for the non-receipt of expected inflows of

funds (Loan defaults by borrowers).
3. As a source of funds when liabilities fall due.
4. As a source of funds to undertake new transactions when

desirable.
Liquidity risk - relates to the eventuality that banks cannot fulfill one or
more of the above needs
84
Balance Between Liquidity & Profitability
• Banks can either store liquidity in
– assets (e.g. cash or short term liquid investments) or
– purchase it in money and deposit markets (make a REPO
Recap overnight loan). – Reverse repo borrower agrees to
Ch3 – Nothern Rock depended very much on money market sell immediately a
which dried up. security to a lender
(next slide – Balance Sheet of Bank) and also agrees to
(Sources of liquidity in later slides) buy the same
security from the
• Liquid assets have lower returns, lender at a fixed
– stored liquidity has an opportunity cost that results in price at some later
a trade-off between liquidity and profitability. date.
(Generally - Shorter the term of the asset the lower the rate
of return)
• ALM aims to
1. increase the earning capacity of the bank
2. while at the same time ensuring an adequate liquidity
cushion. Liquidity Profitability
85
Balance Sheet of Bank
Stored liquidity has an opportunity cost that results in a trade-off

between liquidity and profitability – so banks keep less of it
Recap
Ch 1
$ mio
Loans 194,275 Non Bank Customers 218,992
Cash 25,304 Bank 27,601
11% of
total SGS 12,503 Others 61,185
assets Due from Banks 20,306 Total Liabilities 307,778
Others 88,459 Capital & MI 33,069
340,847 340,847
86
What is a Liquidity Gap?
The liquidity gap is typically defined as the difference in amount
between
– net liquid assets (Net LA) and net volatile liabilities (Net VL).
• Liquidity risk arises due to mismatch between the sizes and

maturities of assets and liabilities.
• The risk results in the possibility of holding inadequate resources to

meet the bank’s commitments.
Mainly short term maturity
$30m Liq Assets

Volatile $70m
Liabilities Liq Gap = Net LA – Net VL
= -$40m
Non Liq
Non
Assets Insufficient liquid assets to pay
Volatile
Liabilities the volatile liabilities when due
87
Maturity Profile
Step 1 – Size of gap
Static & Dynamic

Liquidity gap Liquidity Gaps
management
Step 2 – Actions to
be taken
based on
Gap
88
Step 1 - How Does Bank Know Whether A Gap Exist?
Maturity Profile
At a specific point in time
Liquidity Gap
Analysis
(Size of Gap)
Static & Dynamic Liquidity Gaps

Gap tells us how
much funding is Projected into the future
required Use for funding / deployment of funds
89
Maturity Profile (Repayment Obligations)

as at 31 Dec
c
d
a-b- c-d
<7 7 to 30 to 90 to
days <30 <90 <365
(Liabilities due in < 7days) exceeds (assets maturing in <7 days) by this amount
Maturity buckets
90
(Liquidity Gap Analysis) - 1-Maturity Profile
At a specific point in time
• Maturity profiles of assets and liabilities @ a specific moment in time

provide an insight into the current liquidity position.
• Maturity profiles need to be used in conjunction with information

about off-balance-sheet business, management objectives and
management control systems for a more accurate assessment of
the liquidity position.
Example: Depending on
Example: Off balance interest rate strategy the
sheet commitments that bank may:
materialize needs to be E.g. Borrow ST variable &
funded & paid Lend LT fixed rate
91
How Does Bank Know Whether A Gap Exist?
Maturity Profile
At a specific point in time (past data)
Liquidity Gap
Analysis
Static & Dynamic Liquidity Gaps

Projected into the future
Use for funding / deployment of funds
92
Static vs Dynamic Gaps
Dynamic Gap Analysis

Existing loans 100
Static Gap Analysis Repayment -40
New Assest 100 New Assest 100
New Liabilties 75 160
Gap to be funded 25
Exisiting Liabilities 100
Repayment -60
New Liabilities 75
115
Gap to be funded 45
93
Recap 4
22. What is a Liquidity Gap?
23. Why do banks have Liquidity Gap?
24. What are the methods to analyse liquidity gaps?
94
Step 2
Actions Required When a Projected Liquidity Gap is Detected
Recap
Static Liquidity Gaps – differences of projected future assets & liabilities
Dynamic Liquidity Gaps - projected new loans and new deposits are added
to the amortisation profiles of existing assets & liabilities
Projected Projected • If the bank’s projected assets exceed

Assets Liabilities liabilities, the gap should be funded from the
A L market.
+ve Gap
Non LA Non VL
LGap = Net LA – Net VL
95
Step 2
Actions Required When a Projected Liquidity Gap is Detected
Projected Projected
Assets Liabilities
A
• If the bank’s projected liabilities L
exceed assets, the excess funds (from -ve Gap
the liabilities) must be invested. Non LA Non VL
Reason
Liquid assets have lower returns, stored liquidity has an
opportunity cost that results in a trade-off between liquidity and
profitability.
The aim of Liquidity Gap Management is to increase the earning

capacity of the bank while at the same time ensuring an adequate
liquidity cushion.
96
Interest Rate Risk Liquidity Risk
Technique to Var interest rate Liquidity gap
measure size gap NLA - NVL
VRA – VRL
 +ve or -ve
Impact on margin Increase or
decrease in interest
rate
Manage the Close the gap by  +ve Liq gap –
problem rearranging VRA or Fund the gap
VRL – one of tool  -ve gap – invest
used IRS the surplus
funds
When Gap = 0
Interest margin is
immunised
97
A15 Q5
Explain the principles and application of liquidity gap analysis and interest rate gap
analysis.
A11 Q5
Explain the principles and application of liquidity gap analysis and interest rate gap
analysis.
A16 Q5
Explain the general risk measurement and risk management functions of banks.
Discuss how these functions are applied by banks when they use Asset and
Liability Management and gap analysis to manage liquidity risk and interest rate
risk.
A14 Q5
Discuss the motivations and techniques of Asset and Liability Management
B14 Q5
Explain how banks may manage interest rate risk by using gap analysis and interest
rate swaps.
98
99
Sources of Liquidity - General
• Most common – generate liquidity from the maturity structure of the

balance sheet (where expected outflows of funds are matched by
expected inflows).
Collect from loans
that mature Pay depositors
Borrower BANK Depositor
100
Sources of Liquidity - General
Asset side Liabilities side

• sell assets • raise new money at short
– Single loan notice in the money market
– Pool of loan (securitization)
• discount or pledge assets at
short notice (store of liquidity)
2 - Convert Assets into Cash 1 3 - Take in More Deposits
Due for New

Cash
payment Liabilities
Original
Assets
Other
Liabilities
101
Sources of Liquidity – Comparison
Small Banks Large Banks

• Hold a portfolio of short-term • Derive liquidity from both sides of
assets. (Lower ability to borrow the balance sheet by using (short
from inter-bank) term assets) and (the inter-bank
and other wholesale markets) as a
Tie up resources in lower yielding assets source of short-term funds.
• Arrange borrowing facilities,
whether at the central bank or with • Have large volumes of retail
other banks. deposits and retail lending which
provides stability in predicting
future liquidity requirements.
Summary
Banks
Set up pre-arranged
Small Big
bank lines
Short term assets   Funding by borrowing
Interbank borrowing  from other banks
Retail deposits  Borrow from inter
Arranged bank lines   bank market
Lender of last resort  
102
Current Current
Other Factors Affecting Liquidity Due for
payment
– Ability to Borrow Convert LT to
Non Non
liquid assets
Current Current
Assets Liabilities
1. Some banks are in a better position to rapidly alter the maturity

pattern of the balance sheet.(switch from LT to ST and vice-versa) –
securitisation in next slide
2. Some banks find it much easier to borrow than others, a factor that
cannot be readily assessed by maturity profiles.
– This ability to borrow is crucial, yet it rests on a conception of a bank’s

‘standing in the market’.
New Even if a bank do not have sufficient assets
Borrowings to meet the demands of its liabilities, it can
Due for repayment
borrow to meet its liabilities.
Liab
Equity
103
Securitisation as A Source of Funds
• Recent technological and financial innovations have provided banks

with new ways of funding their activities and managing their liquidity
(for example securitization).
• A declining ability to rely on core deposits, together with increased

reliance on wholesale funds has changed the way banks view
liquidity.
(iii)
New
Assets A
L
E
(ii) (i)
Existing Sell off of
Cash Assets existing assets
104
Bank makes money
through Asset 3
1 Transformation
Bank concerns
2 Risk Rate Risk
Sheet
• Re-regulation
• Customer needs
5 Issues associated with ALM

Seasonal flows
Monetary policy
Financial markets
Customer relationships • Comply with banking supervision
6
• Liq Gap = NLA – NVL 7 Sources of liquidity Int margin variance

Opening Gaps
• Maturity profile – insight into • From the maturity structure analysis
Int gap analysis
liquidity position • Assets as a store of liquidity Rates
VRA – VRL
• Static & Dynamic gaps • Raise deposit Volume
Income impact
• Actions required when a • Interbank borrowings Mix
and interest rate
projected liquidity gap is detected • Securitisation Strategy to address
change
105
Prepared by Adam Wong Immunisation
End
106

Financial Intermediation: Over Come It

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Financial Intermediation Chapter 7 - Analysing

Credit Chapter 6 - Risk

Interest Chapter 8 - Risk

Prepared by Adam Wong

Problems for Banks Associated with ALM – Issues & mitigation

• Identify techniques used by banks in the management of liquidity

• Describe and evaluate the importance of liquidity and interest rate

• Explain how banks manage liquidity and interest rate risk

• Measure the amount of risk

Why ALM is Required (Rationale for ALM) – 1/3

Banks engage in diversified activities to spread risks while increasing

Banks deals in a very wide range of financial instruments

Note for info:

– Off Balance Sheet Items generates → Generally Fee income

Customers’ needs are varied – banks need to meet their needs

• If banks’ assets and liabilities are poorly adjusted, it give rise to

Either of which may lead to the bank’s insolvency

Therefore, banks needs to adopt a systematic approach to managing

Why ALM is Required (Rationale for ALM) – 3/3

ALM techniques are most applicable to commercial banks involved in

• As such, it focuses on liquidity risk and interest rate risk at the

• It is a subset of the bank’s overall risk management process.

Risk Management Process Risk measurement

a. Protect net interest margin (NIM).

Causes of Interest Rate Risk

Numeric examples in following slides

3 Constant Net Margin

Fix Float 1 cost

• The aim is to increase the earning capacity of the bank

Slide from chapter 3

Relationship Between Liquidity & Maturity

Maturity period of an asset – refers to the length of period required

ALM is required to overcome this problem

Asset Type Funding

When this portion of liabilities is due

Risk Management Strategy

If the bank is ‘risk-averse’ it will prefer to match

Matched in terms of Direction taken depends Mis-matched in terms of

Lower risk Higher risk

Assets Growth Needs to Be Funded

New Assets Funding Funding ??

Problems for Banks in Funding

2 ways to manage risk of assets growth with insufficient funding

2. Raise funding through securitisation A L

4 – so that new assets can be funded

Off Balance Sheet Growth Also Needs Funds

• Increase in the use of currency and interest rate

• Financial futures, Further

Funding is needed when the bank’s obligation to

Relationship between Interest Rate & Liquidity Risk

• Liquidity and interest rate policies are interdependent.

• Any projected liquidity gap will be funded at an unknown rate unless

LT Maturity LT Maturity Asset

Relationship between Interest Rate & Liquidity Risk

FR Liquidity risk & interest rate risk

S T Maturity LT Maturity S T Maturity LT Maturity

Int Rate Liquidity Int Rate Liquidity

Summary of Factors Impacting The Balance Banks’ Sheet

• Breakdown in demarcation lines between

• Increased volatility of interest and exchange

• Increased usage of securitisation and off-

Loss incurred due to changes in market interest rates