KRC

Asset and Liability Management

Presented to Coronation Merchant Bank

– Training School

2020
• Asset-liability Management (ALM) refers to the process by which an
institution manages its balance sheet in order to allow for alternative interest
rate and liquidity scenarios.

• Banks and other financial institutions provide services which expose them to
various kinds of risks like credit risk (probability of default), interest rate risk
(pricing difference between loans and deposits including ability to reprice) and
liquidity risk (occurs when there is a mismatch of assets and liabilities.
• Asset and Liability Management is an approach that provides institutions with

protection that makes such risk acceptable.

• Asset and Liability Management models enable institutions to measure and
monitor risk and provide suitable strategies for their management.

• ALM incorporates the modern techniques used in profitability and risk

management of commercial banks

1
Objectives of
ALM
Generic Objectives of ALM are usually set in the following areas:
1. Short-run
a. Maximization of net income;
b. Balance sheet growth;
c. Pricing of credit risk
d. Management of interest rate and liquidity risks
e. Profitability enhancement – balance between profitability and liquidity

2. Long-run
a. Capital growth
b. Dividend growth
c. Maximization of market value
d. Maintain financial strength and flexibility in an effective manner
e. Assists the bank to manage its asset-liability risks and financial position

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

2
ALM
Framework

1. ALM information systems

• Management Information System, Information availability, accuracy, adequacy and
expediency·

2. ALM Organization
• Structure and responsibilities, Level of top management involvement

3. ALM process
• Risk parameters, Risk identification, Risk measurement, Risk management, Risk
policies and tolerance level
3
ALM
Policy
• Preparation and adoption of a high-level liquidity and interest rate risk policy at
board level. This sets general guidelines on the type and extent of risk
exposure that can be taken on by the bank
• Setting limits on the risk exposure levels of the banking book. This can be by
product type, desk, geographic area and so on and will be along the maturity
spectrum
• Actively measuring the level of liquidity and interest rate risk exposure at
regular, specified intervals.
• Reporting to senior management on general aspects of risk management, risk
exposure levels, limit breaches and so on.
• Monitoring risk management policies and procedures by an independent
“middle office” risk function.
• Maintaining capital ratios at the planned minimum and ensuring the safety of
the deposit base
4
ALM
Organization
• The Board should have overall responsibility for management of risks and should
decide the risk management policy of the bank and set limits for liquidity, interest
rate, and foreign exchange risks.
• The Asset - Liability Committee (ALCO) consisting of the bank's senior
management including CEO should be responsible for ensuring adherence to the
limits set by the Board as well as for deciding the business strategy of the bank (on
the assets and liabilities sides) in line with the bank's budget and decided risk
management objectives.
• The ALM desk consisting of operating staff should be responsible for analyzing,
monitoring and reporting the risk profiles to the ALCO. The staff should also
prepare forecasts (simulations) showing the effects of various possible changes in
market conditions related to the balance sheet and recommend the action needed
to adhere to bank's internal limits.

5
ALC
O
• The Bank’s Asset and Liability Management Committee (ALCO) often oversee the
ALM reporting process.

• The ALCO is a decision-making unit responsible for balance sheet planning from risk -
return perspective including the strategic management of interest rate and liquidity
risks. Each bank will have to decide on the role of its ALCO, its responsibility as well
as the decisions to be taken by it.

• It is responsible for setting and implementing ALM and hedging policy.

• Its composition varies in different bank but usually includes heads of business lines as
well as director-level staff such as the finance director. Typical ALCO Composition
• GMD/CEO or his representative (Chairperson)
• Business EDs
• CFO
• Treasurer
• CRO
• Head Market Risk 6
• Head ALM (ALCO Secretary)
ALM
Desk
• The ALM desk or unit is a specialized business unit that fulfils a range
of functions.
• If an ALM unit has a zero-profit target, it will act as a cost center with a
responsibility to minimize operating costs. This would be consistent with
a strategy that emphasizes commercial banking as the core business of
the firm, and where ALM policy is concerned purely with hedging
interest rate and liquidity risk.
• The next stage of development is where the ALM unit is responsible for
minimizing the cost of funding. This would allow the unit to maintain an
element of exposure to interest rate risk, depending on the view that
was held as to the future level of interest rates.
• The ALM desk is responsible for monitoring and managing this risk and,
of course, is credit with any cost savings in the cost of funds that arise
from this exposure.
7
ALM
Responsibilities
ALM is responsible for the following actions on ALM risk as they relate to the banking operations:
• Propose and implement policy and procedures related to ALM risk
• Identify, measure and quantify ALM risk.
• Propose and implement risk limits on ALM risk
• Propose and implement strategies to manage ALM risk
• Establish and implement a framework that ensures consistent management of the net
interest income within the group
• Implement an optimal asset and liability balance sheet structure that ensures effective
balance sheet management to achieve the strategic objectives of the banking
operations.
• Monitor and endorse asset and liability pricing models
• Manage, optimise and monitor the liquid asset portfolio and cash reserve balance to ensure
that the Bank is within regulatory limits
• On a strategic level, manage the funding mismatch to ensure desired levels of liquidity,
optimal funding mix and ownership of the Bank’s overall funding strategy
• Monitor and manage the currency translation exposure on offshore investments
• Ensure structural liquidity risk management within the banking operations.
• Preserve and enhance the net interest income of the bank through the optimisation of interest
rate risk. 8
• Monitor and manage the investment profile of the bank’s capital
Risks In
ALM
• Fundamental risks
• Systemic Risk
• Unsystemic Risk

• Financial Risks
• Market Risk
• Liquidity
Risk
• Credit or
Default
Risk
• Operational
Risk
• Country
Risk
• Foreign
Exchange
• Risk
Rate Riskidentification;
• Risk assessment;
• Interest
• Risk
Rate Riskacceptance;
• Risk mitigatio
• Political 9
• ForRisk
ALM to be successful, this must be done on a continuous basis.
Fundamental
Risks
• Systemic Risk
• The risk that exists purely from being active in that specific asset class
or business
• There is hardly any way in which to eliminate, reduce or avoid this risk
• It generally is the core risk that remains that are priced or compensated
for when doing business. For example - a fire fighter will always have
the risk of getting burnt
• Similarly, investing in the stock market in general has risks that affect
the entire universe of stocks that cannot be diversified away

• Unsystemic Risk
• This is a specific risk applicable to a small or specific asset. For
example - news related to one specific stock will make that stock move
irrespective of the market.
• This type of risk is reduced via the process of diversification

10
Financial
Risks
• These are risks that are generally associated with dealing in and with the
financial markets
• This typically would be risks which banks would identify and allocate a specific
limit towards
• Many of these risks cannot be eliminated but when viewed holistically one can
stomach each due to the collective revenue potential, and risk mitigation of a
bank not just doing business in one product, with one client in one region.

There are six risk categories that are of fundamental relevance in ALM.
1. Market Risk risk
2. Interest Rate Risk
3. Liquidity Risk
4. Credit Risk
5. Operations risk
6. Currency risk
7. Country or sovereign risk

11
Market
Risk
• Often the most visible

• Quite often the most tricky

• All financial assets have a price

• The present value of all expected future cash flows to be
received from this

• Prices change daily (and literally by the minute in some cases)

• New information makes its way into the system
• Global events
• Market sentiment
• Economic conditions not as expected
• Flavor of the month goes sour

12
Interest Rate
Risk
• The risk associated with the effects a change of interest rates has on
the value of an investment, loan or commitment.

• This risk will obviously affect interest bearing instruments more than
for example stocks (though it may also effect stocks)

• Bonds for example will have material price changes should interest
rates change

• Similarly, from an issuer point of view it may have some

implications.

• Chances that changes in interest rates during the tenor of an asset

or liability will bring the bank into a loss.

13
Liquidity
Risk
• Liquidity risk, which refers to both the
• Market liquidity
• Funding liquidity.

• A key characteristic of a good investment is the ability to move in and out of the
investment with ease and at a reasonable price.

• In the absence of the above, pricing is usually adjusted to consider

• Not a broad range of market makers
• Not a lot of the particular security available (or alternatively it does not trade
frequently)

• Implications
• Price may not be a true reflection of value
• Price may not be a true reflection of exit value
• Exaggerated market movements
• Holding period may be longer than expected

• Chances of loss arising from the inability of the bank to meet its short-term 14
financial obligations.
Credit
Risk
• Also often referred to as Default Risk

• The risk that a counterparty is

• Unable to honor their financial commitments arising from the trade
• Or is purposely unwilling to do so

• This risk is not only applicable to bonds (i.e. where the issuer
can’t service the bond coupons or principal redemption)

• Any contractual obligation entered into between clients

and their banks have the risk of default.

15
Questio
nWhat are the primary reasons for taking an initial margin in a
classic repo?

a. Counterparty risk and operational risk

b. Counterparty risk and legal risk
c. Collateral illiquidity and counterparty risk
d. Collateral illiquidity and legal risk

16
Answe
rWhat are the primary reasons for taking an initial margin in a
classic repo?

a. Counterparty risk and operational risk

b. Counterparty risk and legal risk
c. Collateral illiquidity and counterparty risk
d. Collateral illiquidity and legal risk

17
Questio
nWhich of the following statements is correct?

a. The best strategy to treat and mitigate risk is avoiding the risk
by avoiding the business

b. The best strategy to treat and mitigate risk is transferring the

risk to another party, e.g. by transfer to an insurance company

c. The best strategy to treat and mitigate risk is to establish the

appropriate processes for identifying, assessing, managing,
monitoring and reporting risks

a. The best strategy to treat and mitigate risk is to reduce the

negative effect of the risk, e.g. by hedging
18
Answe
rWhich of the following statements is correct?

a. The best strategy to treat and mitigate risk is avoiding the risk
by avoiding the business

b. The best strategy to treat and mitigate risk is transferring the

risk to another party, e.g. by transfer to an insurance company

c. The best strategy to treat and mitigate risk is to establish

the appropriate processes for identifying, assessing,
managing, monitoring and reporting risks

d. The best strategy to treat and mitigate risk is to reduce the

negative effect of the risk, e.g. by hedging
19
ALM
Process

20
ALM
Methodology
ALM is a three-stage process of:

• Segmenting the balance sheet:

a. Assets into earning and non-earning assets
b. Liabilities into interest-bearing and non-interest bearing
• Arranging:
a. the assets in descending order of yields
b. the liabilities in ascending order of costs
• Shift emphasis to:
a. High yield assets within the tolerable risk limits
b. Low cost funds also within acceptable risk levels.

21
Balance Sheet
Management
• The key to understanding the ALM process in banking is the “balance sheet”.
• This is essentially a record of the value of a bank's assets, liabilities, and owner's
equity at a specific period, usually at the end of an accounting period, such as a
quarter or a year.
• An asset is anything that can be sold for value (i.e., what the banks owns, and
what people owe to the bank).
• A liability is an obligation that must eventually be paid (i.e., everything the bank
owes to other people or other banks and whatever’s left for the shareholders),
and, hence, it is a claim on assets.
• The owner's equity in a bank is often referred to as bank capital, which is what is
left when all assets have been sold and all liabilities have been paid.
• The relationship of the assets, liabilities, and owner's equity of a bank is shown
by the following equation:

Bank Assets = Bank Liabilities + Bank Capital

22
Balance Sheet
Management
A general bank balance sheet structure is displayed in the following table

ASSETS LIABILITIES
What the bank owns What the bank owes to other
• Buildings people and banks
• Cash in tills • Deposits
• Government securities • Wholesale Funding
• Other financial assets
What people owe to the bank Whatever is left for the
• Loans shareholders
• Mortgages • Shareholders Equity
• Overdrafts
• Credit cards

23
Balance Sheet
Management
Assets – Uses of Funds
Assets earn revenue for the bank and include cash, securities, loans, and property and equipment that
allow it to operate.
• Cash and Cash Equivalents - a bank must maintain a certain level of cash compared to its
liabilities to maintain solvency. A bank must hold some cash as reserves, which is the amount of
money held in a bank's account at the Central Bank. Cash equivalents are short-term investments
that can either be used as cash or can be quickly converted to cash without loss of value, such
as demand deposits, T-bills, and commercial paper.
• Securities - Securities can be divided in 3 major categories:
1. Debt securities (e.g., banknotes, bonds and debentures)
2. Equity securities (e.g., common shares, preference shares)

3. Derivatives (e.g., forwards, futures, options and swaps)

The primary securities that banks own are government issued debt instruments. These bonds can
be sold quickly in the secondary market when the bank needs cash.
• Loans - Loans are the major asset for most retail and commercial banks. They earn more interest
than banks have to pay on deposits, and, thus, are a major source of revenue. Often banks will
sell the loans, such as mortgages, credit card and auto loan receivables, to be securitized into
asset-backed securities that can be sold to investors. This allows banks to make more loans while
also earning origination fees and/or servicing fees on the securitized loans. 24
Balance Sheet
Management
Liabilities – Sources of Funds
Liabilities are either the deposits of customers or money that banks borrow from other sources to use
to fund assets that earn revenue.
• Deposits - Deposits are like debt - it is money that banks owe to the customer but they differ from
debt in that the addition or withdrawal of money is at the discretion of the depositor. This
ambiguity in the withdrawal of money by depositors often on demand is a major source of liquidity
risk
• Cheque/Current accounts - deposits where depositors can withdraw the money at will and
on demand. Pay very little or no interest
• Non-transaction deposits include savings accounts and time/ notice deposits, which are
basically certificates of deposits
• Borrowings - Banks also borrow money, usually from other banks in what is called the interbank
market so called because it is a market in which banks extend loans to one another for a specified
term. Most interbank loans maturities are overnight and no longer than a week. Banks are
required to hold an adequate amount of liquid assets, such as cash, to manage any potential
withdrawal by clients. If a bank cannot meet these liquidity requirements, it will need to borrow
money in the interbank market to cover the shortfall.
• Bank Capital is the equity of the bank. It is important, as it is the cushion that absorbs any
unreserved losses that the bank incurs. By acting as this cushion, it enables the bank to continue
25
operating and thus avoid insolvency or bankruptcy during period of market correction or economic
Balance Sheet
Management
Approaches
A. Portfolio Approach
• Positioning or management of separate “portfolios” within the balance sheet such as
Fixed rate Mortgage
• Typically with broadly defined risk limits and limited forecast
• Primary objective is to maximize Net Interest Income
B. Balance Sheet Approach
• Manage more than just a group of portfolios
• Examine natural offsets
• Measure and manage the sensitivity of Net Interest Income, Capital, Liquidity and market
value of equity to risks and uncertainty

 Simulation analysis can be used to track interest rate risk exposure. Techniques can be used for
both Net Interest Income and Market Value of Equity. It is believed that simulation is the most
informative and reliable method currently available for assessing ways to improve the bank’s
interest rate risk position.

 Please note that Simulation is the only measurement that will identify ASYMMETRIC profiles
with any success.

26
Cost of
Funds
• There really are only two overarching types of ways in which the cost of funds
are expressed
• Fixed Rate
• The same rate charged over the life of the transaction on a predetermined
basis for example 10% NACQ (act/365)
• Floating Rate
• The interest rate is reset periodically, linked to a reference rate such as
Libor
• The Interest Rate Market is a dynamic market where suppliers and users of
funds meet
• The price of money (interest rate) therefore can never be static given that
numerous factors influence the cost of money, such as:
• Availability
• Type of security provided
• The liquidity of the instruments once entered into
• The economic conditions prevailing in the country

27
Cost of
Funds
1. Cost of Funds refers to the total costs incurred in generating & managing deposits liabilities.

2. Has Several Variants:

• Weighted average
• Marginal
• Administrative
• Regulatory
• Effective

3. Book Yield Maximization

• Net book yield compares the yield on assets with the cost of funds.
• Positive net book yield is desirable, and it is advisable that the bank should set a
benchmark.

There are three clear reasons why cost of funds computations may be carried out. These
are:

• To know the exact cost of funds being mobilized. This is the one being required by CBN for
monthly returns. (Corporate overhead is not added).

• To know the cost of doing business. This is used internally by Management and it
involves adding overhead to the cost of funds.

• To fix the lending rate or price of product / service. This is also used internally by
Management and it involves the addition of the corporate margin to cost + overhead. 28
Evaluating Cost Of Funds
1. The cost of funds is calculated using the following:
a. Average Volume of Deposits (for usage to ascertain b. – e.)
b. Direct cost of funds
c. Overhead Costs
d. Statutory Costs
e. Opportunity
Cost of holding
2. Overhead % + liquid
excess Policy Margin % will be ascertained internally. These items vary from
assets
Bank to Bank.

3. The CBN’s monetary policy rate (MPR) of 12.5% is expected to guide banks. The
CBN establishes a corridor around the MPR at which lends to and borrows from
banks. The current corridor is +200/-500 basis points. This means that the CBN will
borrow from banks at 7.5% and lend to them at 14.5%.

4. Under a fixed rate regime, the deposit and lending rates are normally fixed by the
Central Bank and banks cannot exceed these rates.

29
Interest Calculation
Calculate the interest to be paid to a customer that deposits
N1,000,000 with the bank at the rate of 5% for 90 days?

30
Interest Calculation
Calculate the interest to be paid to a customer that deposits
N1,000,000 with the bank at the rate of 5% for 90 days?

Answer
Interest = P * R * T
= 1,000,000 * 5% * 90/365
= 12,328.77

31
Interest Calculation
Calculate the cost of funds for a bank with the following deposits
• 10,000,000 at 5%
• 50,000,000 at 7%
• 100,000,000 at 3%

32
Interest Calculation
Calculate the cost of funds for a bank with the following deposits
• 10,000,000 at 5%
• 50,000,000 at 7%
• 100,000,000 at 3%

Volume Rate Interest

10,000,000 5.00% 500,000
50,000,000 7.00% 3,500,000
100,000,000 3.00% 3,000,000
160,000,000 7,000,000

Cost of Funds = 7,000,000

160,000,000

= 4.38%
33
Cost Of Funds Calculation
Calculate the cost of deposits and cost of funds for a bank
with the following liabilities
• Deposits
• N10,000,000 at a rate of 5%
• N50,000,000 at a rate of 7.5%
• Commercial Paper
• N100,000,000 at a rate of 8%
• N250,000,000 10yr bond at a rate of 15%

34
Cost Of Funds Calculation
Calculate the cost of deposits and cost of funds for a bank
with the following liabilities
• Cost of Deposits
Volume Rate Interest
10,000,000 5.00% 500,000
50,000,000 7.50% 3,750,000
60,000,000 7.08% 4,250,000

• Cost of Funds
Volume Rate Interest
Deposit 1 10,000,000 5.00% 500,000
Deposit 2 50,000,000 7.50% 3,750,000
Commercial Paper 100,000,000 8.00% 8,000,000
10yr Bond 250,000,000 15.0% 37,500,000
410,000,000 12.13% 49,750,000 35
Net Interest Income Calculation
Calculate the net interest income for a bank with has
deposits for 100,000,000 at a rate of 5% and has
disbursed a loan with an interest rate on 12%.

36
Net Interest Income Calculation
Calculate the net interest income for a bank with has
deposits for 100,000,000 at a rate of 5% and has
disbursed the total deposit as loan with an interest rate on
12%.

Interest Income = 100,000,000 12.0% 12,000,000

Interest Expense = 100,000,000 5.0% 5,000,000

Net Interest Income = 12,000,000 - 5,000,000

= 7,000,000

37
Closing
Remarks
• The ALM staff is the strategist, think tank and the major adviser to the
Bank on asset creation and liability generation issues.
• A bank should mobilize cheap funds from any sector of the economy in
order to maintain a decent margin.
• Buying funds at distressed rates is a clear route to distress and thus
should be avoided.
• The balance sheet of a bank should be analyzed continuously preferably
with the use of automated tools
• Minimize non-interest earning assets because they do not improve the
book yield.
• Ideally, the ALCO SECTRETARIAT is coordinated by the ALM
personnel.
• Finally, the ALM personnel is the COMPASS amid TREASURY…to give
direction.
38
Questions