CHAPTER 8

RISK MANAGEMENT:
ASSET-LIABILITY
MANAGEMENT (ALM)
AND INTEREST-RATE
RISK
Chapter 8

LEARNING OBJECTIVES
TO UNDERSTAND
Risk management as driven by the R in
TRICK risk exposure
Asset-liability management (ALM) as the
coordinated management of a banks onand off-balance sheet activities driven by
interest-rate risk and its two components:
price risk and reinvestment risk
Accounting and economic measures of
ALM performance
Chapter 8

LEARNING OBJECTIVES
(continued)
TO UNDERSTAND

The duration or maturity imbalance

(gap) in banks balance sheets in
terms of rate-sensitive assets (RSAs)
and rate-sensitive liabilities (RSLs)
ALM risk profiles as pictures of banks
exposure to interest-rate risk and how
to hedge that risk using on- and offbalance sheet methods
Chapter 8

CHAPTER THEME

The business of banking involves the

measuring, managing, and accepting of
risk
This chapter focuses on asset-liability
management (ALM) and interest-rate risk
ALM is the coordinated management of a
banks balance sheet to take account of
alternative interest-rate, liquidity, and
prepayment scenarios
Chapter 8

Asset-Liability Management
(ALM)
Three techniques of ALM:
On-balance sheet matching of the
repricing of assets and liabilities

Off-balance sheet hedging of onbalance sheet risks, and

Securitization, which removes risk

from the balance sheet
Chapter 8

R in Trick Risk Exposure

Risk Exposure calls for Risk

Management

Basic Exposures Banks Face Arise

From:

Credit Risk
Interest-rate Risk
Liquidity Risk
Chapter 8

ALM As Coordinated BalanceSheet Financial Management

Three Stage Approach:

Stage I Reflects a global or general approach

that focuses on the coordinated management
of a banks assets, liabilities, capital, and offbalance sheet activities
Stage II Identifies specific components of a
banks balance sheet used in coordinating its
overall portfolio management
Stage III Shows that, given interest rate and
prices, a banks balance sheet generates its
income-expense statement and free cash flow
Chapter 8
7

Balance Sheet Generates

the Income-Expense
Policies to achieve objectives:
Statement

1. Spread management
2. Loan quality
3. Generating fee income and service
charges
4. Control of noninterest operating expenses
5. Tax management
6. Capital adequacy
7. Hedging practices
Chapter 8

Rate Sensitivity

An important distinction should be made

between assets and liabilities that are rate
sensitive and those that are not (RSA, RSL)

Sensitivity can be described in terms of the

effective time to repricing or duration

Reserves and other liquid assets reprice

quickly while long-term, fixed-rate securities
and loans do not; since most deposits are
short term, they reprice quickly
Chapter 8

Liability-Management (LM)
Aspect of ALM
Two Functions:

Reserve-Position LM

Generalized or Loan-Position LM

Chapter 8

10

Target Net Interest Income

(NII)

Minimization of the variability of NII

Most critical determinant of a banks

profitability is credit risk. Viewed in
terms of a banks risk index (RI):
RI = [E(ROA) + CAP]/sROA

Chapter 8

11

Net Interest Margin (NIM)

NIM can be viewed as the spread

on earning assets, hence the term
spread management and
spread model

NIM = Net Interest Income/Average Total Assets

Where NII = Interest Income Interest Expense
Chapter 8

12

Why Does NIM Vary Inversely

With Bank Size?

Competitiveness of the loan-and-deposit

markets are a major factor

Differences in the volumes, mixes, and

pricing (interest rates) of the balance
sheet

Banks with more variable-rate loans will

experience greater fluctuations in interest
revenue
Chapter 8

13

Variability of NIM Versus

ROA

Time period: 1985-2000

NIM
ROA
Mean 3.64% 0.88%
S.D.
0.18% 0.38%
CV
0.05
0.43

Chapter 8

14

Effects of InterestRate Risk on Loans

Effects on the Loan Portfolio

Interest Rates (Up)

Old Loans Worth Less

Adverse Price Effect
New Loans Worth More
Favorable Reinvestment Effect

Interest Rates (Down)

Favorable Price Effect

Old Loans Worth More

New Loans Worth Less
Adverse Reinvestment Effect
Chapter 8

15

Effects of InterestRate Risk on Deposits

Effects on Deposits

Interest Rates (Up)

Early Withdrawal (Depositors Seek Higher
Rates)
Banks Must Attract New Depositors at Higher
Rate or Face Liquidity Problems

Interest Rates (Down)

Loan Prepayments Due to Refinancing
Banks Must Issue New Loans at Lower Rates or
Face Shrinking Balance Sheet

Chapter 8

16

Risk Profiles and

Embedded Options

Loan contracts: When interest

rates decline, borrowers tend to
refinance prepayment risk
Deposit contracts: When interest
rates rise, lenders might be willing
to take penalties for early
withdrawal liquidity risk
See Figure 8-1, p. 225
Chapter 8

17

Two Faces of ALM:

Accounting and Economic
The accounting model focuses on
Perspectives

NII and NIM vis--vis measures of

maturity gap
The focal variable of the economic
model is a banks market value of
equity (MVE)

Chapter 8

18

Relationship Between
Change in Interest Rate and
Change in NII

NII = r[GAP]= r[RSA-RSL]

GAP is the difference between ratesensitive assets (RSA) and ratesensitive liabilities (RSL).
When RSA RSL > 0, bank has positive
maturity gap
When RSA RSL < 0, bank has
negative maturity gap
Chapter 8

19

General Illustration of the

Accounting Model
r

GAP=[RSA-RSL]

Pos +

Neg

Neg

Pos +

Pos

Pos

Neg +

Pos

Neg

Neg +

Neg

Pos

Chapter 8

NII

20

The Economic Model and a

Banks MVE

Table 8-4, p. 229

MVE reduced to 1.8 = 10 8.2
The duration approach
approximates this change at 8.5,
that is,
[89.4(-4.17) 87.6(-1)]0.03 = -8.5
The next slide explains duration
Chapter 8

21

Duration (Box 8-2, p.

230)

Duration can be viewed as the

effective time to repricing.
Take the difference between the
market value of assets and the
market value of liabilities with each
component weighted by its
respective duration multiplied by
change in interest rate:
V

[PV(A)x(-DA) rA-[PV(L)x(-DL)] rL
Chapter 8

22

Variable-Rate Pricing as an
ALM Tool

If the loan reprices annually, then

the bank has a built-in hedge
against rates rising
The hedge, however, is not perfect
as MVE is not immunized
To achieve this a solvent bank
must be slightly asset sensitive
Chapter 8

23

Determinants of the
Change in MVE (see eqn
Duration gap adjusted for leverage
8.4b, p. 232)

the first term below

Scale (size) of a banks operations
the second term
Magnitude of the change in
interest rates the third term
V ~ -[DA - DL][A][r/(1+r)]
Chapter 8

24

The Tactical Versus the

Strategic Bank and Yield
See Box 8-3 (p. 233), Figures 8-2 (p.
Curves

234) and 8-3 (p. 235), and Table 8-5 (p.

236)
Exploit a positively shaped yield curve
by borrowing short and lending longer,
but not too long avoid the old S&L
problem
Tactical Bank (LRBA) + Strategic Bank
(ARBL) = Overall Bank (ARBL)
Chapter 8

25

Interest-Rate Derivatives
(IRDs)

Off-Balance sheet activities (OBSAs)

that ALM managers use for hedging
or trading.

Includes forwards, futures, options,

and swaps.

Four or five of the largest

banks/BHCs dominate the IRD
market.
Chapter 8

26

Examples of InterestRate Derivatives

Interest-rate swap (plain vanilla)

Interest-rate futures

Interest-rate cap

Interest-rate floor

Interest-rate collar

See Glossary in Box 8-4, p. 238

Chapter 8

27

Citigroups IRDs
(30 September 2000)

Type
Notional value ($ mils)
Swaps 3,655,151
Forwards
926,933
OTC Options 538,634
Futures 285,765
Exchange options 37,754
Total
5,444,237
Net Fair Value:
306
Ratio of Notional to Fair Value: 17,792 to 1
Chapter 8

28

Relationships between IRDs and

Cash-Market Instruments and Among
IRDs
Figure 8-4 (p. 239)
Credit risk and performance period
Forward: pure credit instrument
with performance at maturity
Futures: Guaranteed contract with
daily performance (mark-to-market)
Swaps: Interval performance
Chapter 8

29

Swap Building Blocks

A swap can be viewed as a

portfolio of forward contracts
A swap can be viewed as a
portfolio of cash-market contracts,
e.g., a pay fixed-receive floating
swap is the same as borrowing at a
fixed rate and lending at a floating
rate
Chapter 8

30

RISK PROFILES AND

HEDGING

A LRBA bank has a negatively

sloped risk profile
An ARBL bank has a positively
sloped risk profile
Hedging profiles depend on the type
of contract. Futures, forwards, and
swaps are linear while options
(caps, floors, collars) are nonlinear
Chapter 8

31

Micro and Macro Hedges

Macro => hedge the balance sheets

MVE
Micro => hedge a particular transaction
Examples of micro hedges (pp. 242243)

1.
2.
3.
4.

Convert
Convert
Convert
Convert

a
a
a
a

fixed-rate loan to floating

floating-rate loan to fixed
fixed-rate deposit to floating
floating-rate deposit to fixed
Chapter 8

32

Swaps: Comparative
Advantage and Arbitrage
Potential
Analyze the following situations:

1. AAA BBB
10% fixed
12% fixed
LIBOR + 0.1% LIBOR + 1%

2. LIC Bank
Asset T-bill+1% (6mos.) 8% (fixed,5yrs)
Liability
7% (GIC,5yrs) T-bill+0.25%

(6

mos. CD)

Construct swaps for both situations (pp.

244-245) and assume A, L = $50 million
Chapter 8

33

Caps, Floors, and Collars

See Figures 8-7, 8-8, 8-9 (pp. 246248)

Buy cap + sell floor = collar (Fig. 87)
Buy floor + sell cap = collar (Fig. 89)
The use of collars by LRBA and ARBL
banks
Chapter 8

34

Asset Securitization

Technique for managing interestrate risk by removing risky assets

from the balance sheet.

Pass-through finance banks either

(1) originates and sells loans or

(2) originates, sells, and services

loans
Chapter 8

35

Building Blocks of ALM

Four key building blocks of ALM:
Measurement of dollar gaps based on maturity
buckets (0-90 days, 91-180 days, etc.) to
determine the amount of assets and liabilities
being repriced;
Estimating the interest rate at which these
funds will be repriced;

Projecting future interest income and interest

expense (rate x volume);

Exploring alternative interest-rate scenarios to

estimate the banks downside vulnerability.

Chapter 8

36

Risk Management
Quotes
The fact is that bankers are in the business
of managing risk. Pure and simple that is
the business of banking, Walter Wriston,
former Chairman of Citicorp
Risk management is perhaps the central
topic of the 1990s among managers of
financial institutions and their regulators,
The Economist
Chapter 8

37

Modern Risk Management

Key actions of bank risk management

can be highlighted by five action verbs:
identify, measure, price, monitor, and
control.
Two important concepts:

Value-at risk (VAR) A comprehensive

measure of risk.
Capital-at-risk (KAR) KAR tolerance level
captures the default probability of the bank in
terms of its insolvency risk or risk of ruin.

Chapter 8

38

Criticism of ALM

ALM is balance-sheet oriented and

therefore not easily adapted to OBSAs.
ALM measures, which are interest-rate
based (gaps and duration) are not
necessarily easy to translate across other
asset classes.
ALM provides little mechanism for arriving
at an overall risk level for a firm and is
not easily adapted to a risk-adjustedreturn framework.
Chapter 8

39

CHAPTER SUMMARY

Risk management is the heart of bank

financial management and ALM is one
of the most important risk-management
functions in a bank
ALM techniques include

1. Maturity or duration matching of onbalance sheet items

2. Off-balance sheet hedging using IRDs
3. Securitization
Chapter 8

40