rmpg learning series alm workshop

© IMaCS 2010

Printed 26-May-11

1

Training Session 2:

Asset Liability Management

May 2011

Dhaka

ICRA Management Consulting Services Limited

TRAINING ON CORE RISK

MANAGEMENT FOR BANGLADESH BANK

© IMaCS 2010

Printed 26-May-11

2

CONFIDENTIAL

All the contents of the presentation are confidential and should

not be published, reproduced or circulated without the written

consent of World Bank, Central Bank of Bangladesh and IMaCS

© IMaCS 2010

Printed 26-May-11

3

Agenda of the presentation

Understanding requirement for training on Asset

Liability Management

Introducing key concepts and tools for Asset Liability

Management

Outlining the current guidelines issued by Bangladesh

Bank and suggesting improvements, if any

© IMaCS 2010

Printed 26-May-11

4

Agenda for Day 1

Introduction to Asset Liability Management

ALM basic concepts

Lunch Break

Liquidity Risk

© IMaCS 2010

Printed 26-May-11

5

Agenda for Day 2

Liquidity risk Continued

Lunch Break



© IMaCS 2010

Printed 26-May-11

6

Agenda for Day 3


Lunch Break


Interest rate risk

© IMaCS 2010

Printed 26-May-11

7

Agenda for Day 4

Interest rate risk

Lunch Break

Interest rate risk continued

Interest rate risk continued

© IMaCS 2010

Printed 26-May-11

8

Agenda for Day 5

Interest Rate risk Continued

Lunch Break

Interest Rate risk Continued

Basel Guidelines, current guidelines in

Bangladesh and wrap up session

© IMaCS 2010

Printed 26-May-11

9

In this session, we will understand what constitutes assets and

liabilities in a Bank and why asset liability management is important

© IMaCS 2009

Printed 26-May-11

10

Components of Balance Sheet

Liabilities Assets

Capital Cash and Balances at Central Bank

Reserves and Surplus

Deposits

Borrow ings Investments

Other Liabilities and Provisions Advances

Contingent Liabilities Fixed Assets

Other Assets

Balance w ith banks and money at call

and short notice

Balance Sheet of a Bank

© IMaCS 2009

Printed 26-May-11

11

Components of Liabilities … 1

1. Capital:

Capital represents owner‟s contribution/stake in the bank.

- It serves as a cushion for depositors and creditors.

- It is considered to be a long term sources for the bank.

© IMaCS 2009

Printed 26-May-11

12


2. Reserves & Surplus

Components under this head includes:

I. Statutory Reserves

II. Capital Reserves

III. Investment Fluctuation Reserve

IV. Revenue and Other Reserves

V. Balance in Profit and Loss Account

© IMaCS 2009

Printed 26-May-11

13


3. Deposits

This is the main source of bank‟s funds. The deposits are

classified as deposits payable on „demand‟ and „time‟. They

are reflected in balance sheet as under:

I. Demand Deposits

II. Savings Bank Deposits

III. Term Deposits

© IMaCS 2009

Printed 26-May-11

14


4. Borrowings

(Borrowings include Refinance / Borrowings from central

bank, Inter-bank & other institutions)

I. Borrowings in Bangladesh

i) Bangladesh Bank

ii) Other Banks

iii) Other Institutions & Agencies

II. Borrowings outside Bangladesh

© IMaCS 2009

Printed 26-May-11

15


5. Other Liabilities & Provisions

It is grouped as under:

I. Bills Payable

II. Inter Office Adjustments (Net)

III. Interest Accrued

IV. Unsecured Redeemable Bonds

(Subordinated Debt for Tier-II Capital)

V. Others(including provisions)

© IMaCS 2009

Printed 26-May-11

16

Components of Assets … 1

1. Cash & Bank Balances

I. Cash in hand

(including foreign currency notes)

II. Balances with Bangladesh Bank

In Current Accounts

In Other Accounts

© IMaCS 2009

Printed 26-May-11

17


2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE

I. In Bangladesh

i) Balances with Banks

a) In Current Accounts

b) In Other Deposit Accounts

ii) Money at Call and Short Notice

a) With Banks

b) With Other Institutions

II. Outside Bangladesh



c) Money at Call & Short Notice

© IMaCS 2009

Printed 26-May-11

18


3. InvestmentsA major asset item in the bank‟s balance sheet. Reflected under 6 buckets as under:

I. Investments in Bangladesh in:

i) Government Securities

ii) Other approved Securities

iii) Shares

iv) Debentures and Bonds

v) Subsidiaries and Sponsored Institutions

vi) Others (Commercial Papers, COD & Mutual Fund Units etc.)

II. Investments outside Bangladesh in

Subsidiaries and/or Associates abroad

© IMaCS 2009

Printed 26-May-11

19


4. Advances

The most important assets for a bank.

A. i) Bills Purchased and Discounted

ii) Cash Credits, Overdrafts & Loans repayable on demand

iii) Term Loans

B. Particulars of Advances :

i) Secured by tangible assets (including advances against

Book Debts)

ii) Covered by Bank/ Government Guarantees

iii) Unsecured

© IMaCS 2009

Printed 26-May-11

20


5. Fixed Asset

I. Premises

II. Other Fixed Assets (Including furniture and fixtures)

6. Other Assets

I. Interest accrued

II. Tax paid in advance/tax deducted at source (Net of Provisions)

III. Stationery and Stamps

IV. Non-banking assets acquired in satisfaction of claims

V. Deferred Tax Asset (Net)

VI. Others

© IMaCS 2009

Printed 26-May-11

21

Contingent Liability

Bank‟s obligations under LCs, Guarantees, Acceptances on

behalf of constituents and Bills accepted by the bank are

reflected under this heads.

© IMaCS 2009

Printed 26-May-11

22

Banks Profit & Loss Account

A bank’s profit & Loss Account has the following

components:

I. Income: This includes Interest Income and Other

Income.

II. Expenses: This includes Interest Expended, Operating

Expenses and Provisions & contingencies.

© IMaCS 2009

Printed 26-May-11

23

Components of Income … 1

1. INTEREST EARNED

I. Interest/Discount on Advances / Bills

II. Income on Investments

III. Interest on balances Central Bank and other inter-bank

funds

IV. Others

© IMaCS 2009

Printed 26-May-11

24

Components of Income … 2

2. OTHER INCOME

I. Commission and Brokerage

II. Profit on sale of Investments (Net)

III. Profit/(Loss) on Revaluation of Investments

IV. Profit on sale of land, buildings and other

assets (Net)

V. Profit on exchange transactions (Net)

VI. Income earned by way of dividends etc. from

subsidiaries and Associates abroad/in Bangladesh

VII. Miscellaneous Income

© IMaCS 2009

Printed 26-May-11

25

Components of Expenses … 1

1. INTEREST EXPENDED

I. Interest on Deposits

II. Interest on Central Bank of Bangladesh/ Inter-Bank

borrowings

III. Others

© IMaCS 2009

Printed 26-May-11

26

Components of Expenses … 2

2. OPERATING EXPENSES

I. Payments to and Provisions for employees

II. Rent, Taxes and Lighting

III. Printing and Stationery

IV. Advertisement and Publicity

V. Depreciation on Bank's property

VI. Directors' Fees, Allowances and Expenses

VII. Auditors' Fees and Expenses (including Branch Auditors)

VIII. Law Charges

IX. Postages, Telegrams, Telephones etc.

X. Repairs and Maintenance

XI. Insurance

XII. Other Expenditure

© IMaCS 2009

Printed 26-May-11

27

Reclassification of liabilities

Liabilities/outflows

1&2. Capital funds

a) Equity capital, Non-redeemable or perpetual preference capital, Reserves, Funds and Surplus

b) Preference capital - redeemable/non-perpetual

3. Grants, donations and benefactions

4. Bonds and debentures

a) Plain vanilla bonds/debentures

b) Bonds/debentures with embedded call/put options (including zero-coupon/deep discount bonds)

5. Inter Corporate Deposits:

6. Borrowings

a) Short Term borrowings

b) Long Term Borrowings

7. Current liabilities and provisions:

a) Sundry creditors

b) Expenses payable (other than interest)

c) Advance income received, receipts from borrowers pending adjustment

d) Interest payable on bonds/deposits

e) Provisions for NPAs

f) Provision for Investments portfolio

g) Other provisions

© IMaCS 2009

Printed 26-May-11

28

Reclassification of Assets … 1

Inflows

1. Cash

2. Remittance in transit

3. Balances with banks (in Bangladesh only)

a) Current account

b) Deposit accounts/short term deposits

4. Investments (net of provisions)

a) Approved Trustee securities, government securities, bonds, debentures and other instruments

b) Unlisted securities (e.g. shares, etc.)

c) Unlisted securities having a fixed term maturity

d) Venture capital units

e) Equity shares, convertible preference shares, non-redeemable/perpetual preference shares, shares of

subsidiaries/joint ventures and units in open ended mutual funds and other investments.

5. Advances (performing)

a) Bill of Exchange and promissory notes discounted and rediscounted

b) Term loans (rupee loans only)

c) Corporate loans/short term loans

© IMaCS 2009

Printed 26-May-11

29

Reclassification of Assets … 2

6. Non-performing loans

(May be shown net of the provisions, interest suspense held )

a) Sub-standard

i) All overdues and instalments of principal falling due during the next three years

ii) Entire principal amount due beyond the next three years

b) Doubtful and loss

i) All instalments of principal falling due during the next five years as also all overdues

ii) Entire principal amount due beyond the next five years

7. Assets on lease

8. Fixed assets (excluding leased assets)

9. Other assets

(a) Intangible assets and items not representing cash inflows.

(b)Other items (such as accrued income, other receivables, staff loans, etc.)

C. Contingent liabilities

(a) Letters of credit/guarantees (outflow through devolvement)

(b) Loan commitments pending disbursal (outflow)

(c) Lines of credit committed to/by other Institutions (outflow/inflow)

Overdue for less than one month.

Interest overdue for more than one month but less than seven months (i.e. before the relative amount

becomes NPA)

Principal installments overdue for 7 months but less than one year

In this session, we will understand what constitutes assets and

liabilities in a Bank and why asset liability management is important

Asset Liability Management is concerned with strategic balance sheet management involving risks caused by changes in interest rates, exchange rate and the liquidity position of bank

Asset liability

management is a

strategic management

tool to measure and

manage liquidity risk,

interest rate risk and

interest rate risk faced

by Banks and Financial

Institutions. ALM is

about matching of the

assets and liabilities of

the balance sheet based

on maturity or re-pricing

for liquidity risk and

interest rate risk

respectively

ALM is the process involving decision making about the composition of assets and liabilities including off balance sheet items of the bank / FI and conducting the risk assessment

It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII

Globalization of financial markets._ Deregulation of Interest Rates._ Multi-currency Balance Sheet.

_ Prevalence of Basis Risk and Embedded Option Risk._ Integration of Markets – Money Market, FOREX Market,

Government Securities Market._ Narrowing NII / NIM

_ Mismatches in the maturity profile of assets and liabilities_ Banks borrow short term and lend long term-basis of

profitability_ Mismatches in interest rates

Liquidity mismatch→

Interest rate mismatch →

May lead to liquidation

Affects profitability

An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.

It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are:

Net Interest Income (NII)

Net Interest Margin (NIM)

Economic Equity Ratio

Bank’s liquidity management is the

process of generating funds to meet

contractual or relationship obligations

at reasonable prices at all times.

New loan demands, existing

commitments, and deposit withdrawals

are the basic contractual or relationship

obligations that a bank must meet.

Liquidity Management

FLOW APPROACH STOCK APPROACH

Measuring &

Managing net

funding requirement

Managing market

access

Contingency planning

Based on the level of

Assets & Liabilities as

well as Off balance

Sheet exposures on a

particular date and

calculating certain

ratios to assess the

liquidity position

COMPONENTS OF BALANCE SHEET

Liabilities Capital

Reserves and Surplus

Deposits

Borrowings

Other Liabilities and Provisions

Contingent Liabilities

Assets Cash and Balances

at Central Bank

Investments

Advances

Fixed Assets

Other Assets


1. Capital:Capital represents owner’s

contribution/stake in the bank.

- It serves as a cushion for

depositors and creditors.

- It is considered to be a long term

sources for the bank.


2. Reserves & Surplus

Components under this head

includes:

I. Statutory Reserves

II. Capital Reserves

III. Investment Fluctuation Reserve

IV. Revenue and Other Reserves

V. Balance in Profit and Loss

Account


3. Deposits

This is the main source of bank’s

funds. The deposits are

classified as deposits payable on

‘demand’ and ‘time’. They

are reflected in balance sheet as

under:

I. Demand Deposits

II. Savings Bank Deposits

III. Term Deposits


4. Borrowings

(Borrowings include Refinance / Borrowings from RBI,

Inter-bank& other institutions)I. Borrowings in India

i) Bangladesh Bank

ii) Other Banks

iii) Other Institutions & Agencies

II. Borrowings outside India

5. Other Liabilities & Provisions

It is grouped as under:

I. Bills Payable

II. Inter Office Adjustments (Net)

III. Interest Accrued

IV. Unsecured Redeemable Bonds

(Subordinated Debt for Tier-II Capital)

V. Others(including provisions)


1. Cash & Bank Balances

I. Cash in hand

(including foreign currency

notes)

II. Balances with Bangladesh

Bank

In Current Accounts

In Other Accounts


2. BALANCES WITH BANKS AND

MONEY AT CALL & SHORT NOTICE

I. In Bangladesh

i) Balances with Banks



ii) Money at Call and Short Notice

a) With Banks

b) With Other Institutions

II. Outside Bangladesh



c) Money at Call & Short Notice


3. Investments

A major asset item in the bank’s balance sheet. Reflected

under 6 buckets as under:

I. Investments in Bangladesh in:

i) Government Securities

ii) Other approved Securities

iii) Shares

iv) Debentures and Bonds

v) Subsidiaries and Sponsored Institutions

vi) Others (Commercial Papers, COD & Mutual

Fund Units

etc.)

II. Investments outside Bangladesh in

Subsidiaries and/or Associates abroad


4. AdvancesThe most important assets for a bank.

A. i) Bills Purchased and Discounted

ii) Cash Credits, Overdrafts & Loans

repayable on demand

iii) Term Loans

B. Particulars of Advances :

i) Secured by tangible assets (including

advances against

Book Debts)

ii) Covered by Bank/ Government

Guarantees

iii) Unsecured


5. Fixed Asset

I. Premises

II. Other Fixed Assets (Including furniture

and fixtures)

6. Other Assets

I. Interest accrued

II. Tax paid in advance/tax deducted at

source (Net of Provisions)

III. Stationery and Stamps

IV. Non-banking assets acquired in

satisfaction of claims

V. Deferred Tax Asset (Net)

VI. Others

Contingent

Liability

Bank’s obligations under LCs, Guarantees, Acceptances on

behalf of constituents and Bills accepted by the bank are

reflected under this heads.

1&2. Capital funds

a) Equity capital, Non-redeemable or perpetual preference capital, Reserves, Funds and Surplus

b) Preference capital -redeemable/non-perpetual

3. Grants, donations and benefactions

4. Bonds and debentures


b) Bonds/debentures with embedded call/put options (including zero-coupon/deep discount bonds)

5. Inter Corporate Deposits:

6. Borrowings

a) Short Term borrowings

b) Long Term Borrowings

7. Current liabilities and provisions:

a) Sundry creditors

b) Expenses payable (other than interest)

c) Advance income received, receipts from borrowers pending adjustment

d) Interest payable on bonds/deposits

e) Provisions for NPAs

f) Provision for Investments portfolio

g) Other provisions

1. Cash

2. Remittance in transit

3. Balances with banks (in India only)

a) Current account

b) Deposit accounts/short term deposits

4. Investments (net of provisions) a) Approved Trustee securities, government securities, bonds, debentures and other instruments b) Unlisted securities (e.g. shares, etc.) c) Unlisted securities having a fixed term maturity d) Venture capital units e) Equity shares, convertible preference shares, non-redeemable/perpetual preference shares, shares of subsidiaries/joint ventures and units in open ended mutual funds and other investments.


a) Bill of Exchange and

promissory notes discounted and

rediscounted

b) Term loans (rupee loans only)

c) Corporate loans/short term

loans

6. Non-performing loans

(May be shown net of the provisions, interest suspense held )

a) Sub-standard

i) All overdues and instalments of principal falling due during the next three years

ii) Entire principal amount due beyond the next three years

b) Doubtful and loss

i) All instalments of principal falling due during the next five years as also all overdues

ii) Entire principal amount due beyond the next five years

7. Assets on lease

8. Fixed assets (excluding leased assets)

9. Other assets

(a) Intangible assets and items not representing cash inflows.

(b)Other items (such as accrued income, other receivables, staff

loans, etc.)

C. Contingent liabilities

(a) Letters of credit/guarantees (outflow through devolvement)

(b) Loan commitments pending disbursal (outflow)

(c) Lines of credit committed to/by other Institutions (outflow/inflow)

Overdue for less than one month.

Interest overdue for more than one month but less than seven months (i.e. before the relative amount

becomes NPA)

Principal installments overdue for 7 months but less than one year

Managing Currency risk is one more

dimension of Asset - Liability

Management. Mismatched currency

position besides exposing the

balance sheet to movements in

exchange rate also exposes it to

country risk and settlement risk.

It is the current or prospective risk to earnings andcapital arising from adverse movements in currencyexchange rates.It refers to the impact of adverse movement incurrency exchange rates on the value of open foreigncurrency.The banks are also exposed to interest rate risk,which arises from the maturity mismatching of foreigncurrency positions. Even in cases where spot andforward positions in individual currencies arebalanced, the maturity pattern of forward transactionsmay produce mismatches. As a result, banks maysuffer losses due to changes in discounts of thecurrencies concerned

Banks also face another risk called

time-zone risk, which arises out of time

lags in settlement of one currency in

one center and the settlement of

another currency in another time zone.

The forex transactions with counter

parties situated outside Bangladesh

also involve sovereign or country risk.

LIQUIDITY COVERAGE RATIO

NET STABLE FUNDING RATIO

Objective is to examineshort term resiliency ofliquidity risk profile toensure they havesufficient high qualityresources to surviveone month in acutestress condition

Objective is to ensurelonger term resiliencyby funding activitieswith more stablefunding on an on goingstructural basis

The liquidity coverage ratio identifies theamount of unencumbered, high quality liquidassets an institution holds that can be used tooffset the net cash outflows it would encounterunder an acute short-term stress scenariospecified by supervisors. The specified scenarioentails both institution-specific and systemicshocks built upon actual circumstancesexperienced in the global financial crisis

The scenario entails:

• a significant downgrade of the institution’s public credit rating;

• a partial loss of deposits;

• a loss of unsecured wholesale funding;

• a significant increase in secured funding haircuts; and

• increases in derivative collateral calls and substantial calls on contractual and noncontractual off-balance sheet exposures, including committed credit and liquidity facilities.

The net stable funding (NSF) ratio measures the

amount of longer-term, stable sources of funding

employed by an institution relative to the liquidity

profiles of the assets funded and the potential for

contingent calls on funding liquidity arising from off-

balance sheet commitments and obligations.

The NSF ratio is intended to promote longer-term

structural funding of banks’ balance sheets, off-

balance sheet exposures and capital markets

activities.

Throughout the global financial crisis

which began in mid-2007, many banks

struggled to maintain adequate liquidity.

Unprecedented levels of liquidity support

were required from central banks in order

to sustain the financial system and even

with such extensive support a number of

banks failed, were forced into mergers or

required resolution.

These circumstances and events were

preceded by several years of ample liquidity

in the financial system, during which

liquidity risk and its management did not

receive the same level of scrutiny and

priority as other risk areas. The crisis

illustrated how quickly and severely

liquidity risks can crystallise and certain

sources of funding can evaporate,

compounding concerns related to the

valuation of assets and capital adequacy.

Banks should have in place

contingency and business

continuity plans to ensure their

ability to operate as going

concerns and minimize losses

in the event of severe business

disruption.

does management have a strategy for handling a crisis?

does management have procedures in place for accessing funds in an emergency?

A contingency plan needs to spellout procedures to ensure thatinformation flows remain timelyand uninterrupted, and that theyprovide senior management withthe precise information it needs inorder to make quick decisions.

Another major element in the planshould be a strategy for takingcertain actions toalter asset and liability behaviours.

Other components of the contingency plan involve

maintaining customer relationships with liability-

holders, borrowers, and trading and off-balance-sheet

counterparties.

Contingency plans should also includeprocedures for making up cash flowshortfalls in adverse situations. Banks haveavailable to them several sources of suchfunds, including previously unused creditfacilities. The plan should spell out asclearly as possible the amount of funds abank has available from these sources, andunder what scenarios a bank could usethem.

The plan should spell out as clearly as

possible the amount of funds a bank has

available from these sources, and under

what scenarios a bank could use them.

Holding readily marketable securities

(financial assets). The sub-prime crisis has

exposed the shortcomings in such a strategy

for coping with market wide liquidity crises.

Holding securities which can be

pledged as collateral for short term

borrowings. The repurchase (repo)

market has become an important tool for

liquidity management of this sort.

Having in place lines of credit or other

arranged borrowing facilities. The Having

in place lines of credit or other arranged

borrowing facilities.

Having at-call or short term loans

outstanding to other entities which can be

called to provide cash when needed. The

risk here is that such loans involve

counterparty risk – and calling such loans

may increase the likelihood of default if

there is widespread stress in the financial

market.

For banks, the ability to access

“Lender of Last Resort” loans or

use discount window facilities at

Central Banks provide further

potential

new issues of short- and long-

term debt instruments

new capital issues, the sale of

subsidiaries or lines of business

asset securitisation

rapid asset growth, especially when funded with potentially volatile liabilities

• growing concentrations in assets or liabilities

• increases in currency mismatches

• a decrease of weighted average maturity of liabilities

• repeated incidents of positions approaching or breaching internal or regulatory limits

• negative trends or heightened risk associated with a particular product line, such as rising delinquencies

• significant deterioration in the bank’s earnings, asset quality, and overall

financial condition

• negative publicity

• a credit rating downgrade

• stock price declines or rising debt costs

• widening debt or credit-default-swap spreads

• rising wholesale or retail funding costs

• correspondent banks that eliminate or decrease their credit lines

• increasing retail deposit outflows

• increasing redemptions of CDs before maturity

• difficulty accessing longer-term funding

• difficulty placing short-term liabilities (eg commercial paper)

All banks are

required to

produce a

Contingency

Funding Plan

(CFP). These

plans are to be

approved by

ALCO

CFP are liquidity

stress tests designed

to quantify the likely

impact of an event on

the balance sheet

and the net potential

cumulative gap over a

3-month period.

The bank's CFP

should reflect the

funding needs of

the bank

Reports of CFPs

should be

prepared at least

quarterly and

reported to ALCO

If a CFP results in

a funding gap within

a 3-month time

frame, the ALCO

must establish an

action plan to

address this

situation. The Risk

Management

Committee should

approve the action

plan.

CFPs under each

scenario must

consider the impact

of accelerated run off

of large funds

providers.

The plans must

consider the impact

of a progressive,

tiered deterioration,

as well as sudden,

drastic events.

Balance sheet

actions and

incremental sources

of funding should be

dimensioned with

sources, time frame

and incremental

marginal cost and

included in the CFPs

for each scenario.

Assumptions underlying the CFPs, consistent with each scenario, must be reviewed and approved by ALCO. The Chief Executive/Chairman must be advised as soon as a decision has been made to activate or implement a CFP.

The ALCO will implement the CFP, amending it necessary, to meet changing conditions daily reports are to be submitted to the Treasury Head, comparing actual cash flows with the assumptions of the CFP.

© IMaCS 2009

Printed 26-May-11

142

Risks

• Various sources of risk that investors are exposed to when investing in fixed income securities

– Interest Rate Risk: Sensitivity of bond prices to changes in interest rates

– Yield Curve Risk: Changes in the shape of the yield curve will negatively impact bond values

– Call Risk: Bond redeemed (called) before maturity & have to reinvest at lower yields

– Prepayment Risk: Principal on amortizing securities is prepaid, and have to reinvest at lower yields

– Reinvestment Risk: Risk of reinvesting in new security with lower yields

– Credit Risk: The risk of default and the risk of decrease in bond value due to a downgrade

– Liquidity Risk: immediate sale of security will result in a price below fair value

– Exchange-Rate Risk: Foreign exchange value of the currency that a foreign bond is denominated in will fall relative to the home currency of the investor.

– Inflation Risk: Higher inflation erodes the purchasing power of the cash flows from a fixed income security.

– Event Risk: Decrease in a security's value from disasters, corporate restructurings, or regulatory changes that negatively impact the firm.

– Sovereign Risk: Govt. may repudiate debt, prohibit debt repayment by private borrowers, or impose general restrictions on currency flows

– Credit spread risk: The default risk premium required in the market for a given rating can increase, even while the yield on Treasury securities of similar maturity remains unchanged

© IMaCS 2009

Printed 26-May-11

143

Basic Concepts-Bonds

Fixed Income Securities (FIS): An investment that provides a return in the

form of fixed periodic payments and the eventual return of principal at

maturity. Eg. Bonds

Bond Indenture: Contract that specifies all rights and obligations of issuer and

owners of FIS.

Covenants: are the contracts provisions including both affirmative and

negative covenants

Affirmative Covenants: (actions that borrower promises to perform)

1. Maintenance of certain financial ratios.

2. Timely payments of principal & interests.

Negative Covenants: (prohibitions on the borrower)

1. Restrictions on assets sales

2. Negative pledge of collateral

3. Restrictions on additional borrowings

© IMaCS 2009

Printed 26-May-11

144

Key terminologies

Interest/coupon: The charge for the privilege of borrowing money, typically

expressed as an annual percentage rate.

Frequency: The coupon frequency

Principal: The original amount invested, separate from earnings.

Maturity: The length of time until the principal amount of a bond must be

repaid.

YTM: Yield to maturity is defined as the one discount rate at which all the

coupons needs to be discounted to arrive at the market price of the bond

Day count: The number of days to be taken in a year for computation of

interest.

Face Value: Value of bond stated in indenture (denominated in currency in

which payments will be made).

Issue Price: Price at which security is issued in the market.

Market Price: Price at which bond is traded in the market.

© IMaCS 2009

Printed 26-May-11

145

Bonds

Bonds: A debt investment in which an investor loans money to an

entity (corporate or governmental) that borrows the funds for a

defined period of time at a fixed interest rate.

Types of bonds:

1. Zero Coupon Bonds -no periodic interest payments

2. Accrual bonds - interest payments at maturity

3. Step up notes -coupon rate increase over time at specified rate

4. Deferred coupon bonds- coupon payments starts after some specified

period

5. Floating Rate Securities- coupon payments varies based on specified

interest rate or index.

1. Inflation indexed bond

2. Caps, floors, collar

© IMaCS 2009

Printed 26-May-11

146

Redemption Provisions

Redemption Provisions: Refers to how, when, and under what

circumstances the principal will be repaid.

Non Amortizing: Pay only interest until maturity, at which time the entire

par or face value is repaid

Amortizing securities: Make periodic interest and principal payments over

the life of the bond.

Prepayment options: Give the issuer/borrower the right to accelerate the

principal repayment on a loan.

Call provisions: Give the issuer the right (but not the obligation) to retire

all or a part of an issue prior to maturity.

Nonrefundable bonds: Prohibit the call of an issue using the proceeds

from a lower coupon bond issue.

Sinking fund provisions: Provide for the repayment of principal through a

series of payments over the life of the issue

© IMaCS 2009

Printed 26-May-11

147

Embedded Options

Security owner options: gives additional value to the security, compared to

an otherwise-identical straight (option free) security.

A conversion option: Right to convert the bond into a fixed number of common shares

of the issuer.

Put provisions: Right to sell (put) the bond to the issuer at a specified price prior to

maturity.

Floors: Set a minimum on the coupon rate for a floating-rate bond.

Security issuer options: will be priced less (or with a higher coupon) than

otherwise identical option free securities.

Call provisions: Right to redeem (payoff) the issue prior to maturity.

Prepayment option: Right to prepay the loan balance prior to maturity, in whole or in

part, without penalty.

Accelerated sinking fund provisions: Allow the issuer to (annually) retire a larger

proportion of the issue than is required by the sinking fund provision, up to a specified

limit.

Caps: Set a maximum on the coupon rate for a floating-rate bond.

© IMaCS 2009

Printed 26-May-11

148

Treasury Securities

Type Maturity Coupon payments

T bills Less than 1 yr

(usually 4 weeks, 3, 6 months)

Similar to Zero

coupon bonds

T Notes 2,3,5,10 yrs Semiannual coupons

Bonds 20 or 30 years Semiannual coupons

Treasury Inflation

Protected Securities (TIPS)

5,10 year notes, 20 year bonds Semiannual coupons

•TIPS : The par value is adjusted semiannually for changes in the Consumer Price Index.

•If there is deflation, the adjusted par value is reduced for that period.

•The fixed coupon rate is paid semiannually as a % of the inflation adjusted par value.

•TIPS coupon payment = (Inflation adjusted coupon value)*(stated coupon rate/2)

•On-the-run issues are the most recently auctioned Treasury issues.

•Off-the-run issues are older issues replaced by a more recently auctioned issue.

•STRIPS: Strip the coupons from the principal, repackage the cash flows, and sell them

separately as zero-coupon bonds, at discounts to par value.

•Coupon Strips: Created from coupon payments stripped from the original security

•Principal Strips: Bond and note principal payments with the coupons stripped off

© IMaCS 2009

Printed 26-May-11

149

Contd.

Medium-term notes (MTN):

Issued periodically by corporations under a shelf registration

Sold by agents on a best efforts basis

Have maturities ranging from 9 months to over 30 years.

Commercial paper :

Short-term corporate financing vehicle

Does not require registration with the SEC if its maturity is less than 270 days.

• Directly-placed paper-sold directly by the issuer

• Dealer-placed paper-sold to investors through agents/brokers.

Negotiable CDs

Issued in a wide range of maturities by banks

Trade in a secondary market

Are backed by bank assets.

Bankers acceptances:

Issued by banks to guarantee a future payment for goods shipped

Sold at a discount to the future payment they promise

Short term, and have limited liquidity

Asset-backed securities :

Debt that is supported by an underlying pool of mortgages, auto loans, credit card receivables

Collateralized debt obligations (CDOs)

Backed by an underlying pool of debt securities like corporate bonds, loans etc

© IMaCS 2009

Printed 26-May-11

150

Yield Curve

Yield Curve: curve depicting relation between yield on

bonds of same credit quality but different maturities.

4 types of yield curves

© IMaCS 2009

Printed 26-May-11

151

Theories of the Yield Curve

The pure expectations theory

Rates at longer maturities depend only on expectations of

future short-term rates

Consistent with any yield curve shape.

The liquidity preference theory

Longer term rates reflect investors expectations about future

short-term rates as well as a liquidity premium

Consistent with a downward sloping curve if an expected

decrease in short-term rates outweighs the term premium.

The market segmentation theory

Lenders and borrowers have preferred maturity ranges

Shape of the yield curve is determined by the supply and

demand for securities within each maturity range,

independent of the yield in other maturity ranges.

Consistent with any yield curve shape

© IMaCS 2009

Printed 26-May-11

152

Bonds Valuation

3 major steps in bonds valuations are

Estimate the cash flows over the life of the security.

1. The coupon payments

2. The return of principal

Arbitrage-free valuation approach: discount each cash flow using spot rates.

Determine the appropriate discount rate based on the risk of the receipt of

the estimated cash flows.

3 main kinds of discount rates used are

1. Yield to maturity: The rate of return anticipated on a bond if it is held until

the maturity

2. Spot rates : appropriate discount rates for individual future payments

3. Forward rates: current lending rates for loans to be made in future periods

Calculate the present value of the estimated cash flows by multiplying the

bond„s expected cash flows by the appropriate discount factors.

© IMaCS 2009

Printed 26-May-11

153

Price Volatility Characteristics of FIS

Price/Yield relationship for option-free bonds

Price of bond changes inversely to the change in yield

Yield % 8%/ 5-year

6 108.9826

7 104.3760

7.5 102.16

7.9 100.4276

7.99 100.0427

8 100

8.01 99.9574

8.1 99.57462

8.5 97.8944

9 95.8417

© IMaCS 2009

Printed 26-May-11

154

Observation from graphs

Relationship is not linear (its convex).

Slope gives measure of sensitivity of price for variation in yield (Duration)

Higher the market yield, lower the interest rate risk (curve less steep at higher

yields).

As yield increases, price of option-free bond decreases.

For discount and premium bonds, the price changes even if the yield remains the

same as we move towards maturity.

Price of discount (premium) bond increases (decreases) as it moves towards

maturity, reaching at par value at maturity.

Absolute dollar price change and absolute % price change are different for an

equal increase and decrease in yields

Volatility can be measured in terms of dollar price change and percentage price

change . It depends on maturity, coupon rate, YTM

© IMaCS 2009

Printed 26-May-11

155

Bonds with options

Negative convexity in putable and callable bonds

Price of callable bond can not exceed the call price (negative convexity).

Value of callable bond = (value of option free bond - call premium)

(Value of callable bond) < (value of option free bond)

Value of putable bond cannot decline more than put price (negative convexity).

Value of putable bond= (value of option free bond+ value of put)

Value of putable bond > value of option free bond

© IMaCS 2009

Printed 26-May-11

156

Discounting curves

Time to Maturity

YieldPar Curve

ZCYC Curve

Forward Curve

© IMaCS 2009

Printed 26-May-11

157

Debt Market in India

60% of AAA securities accounted for 80% of the total trade in past 2 years

1%0% 1%

8%1%

10%

79%

Distribution of number of trades

A

A-

A+

AA

AA-

AA+

AAA

1%1%

2%

14%

3%

17%62%

Distribution of securities

A

A-

A+

AA

AA-

AA+

AAA

© IMaCS 2009

Printed 26-May-11

158

Interest rate movement in India

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

3M

6M

9M

12M

© IMaCS 2009

Printed 26-May-11

159

Yield curve structure-India –current scenario

7.00%

7.50%

8.00%

8.50%

9.00%

9.50%

10.00%

0.25-0.5 0.5-1 1.0-2.0 2.0-3.0 3.0-4.0 4.0-5.0 5.0-6.0 6.0-8.0 8.0-10.0 >10.0

© IMaCS 2009

Printed 26-May-11

160

EXERCISE

Pricing of bonds

© IMaCS 2009

Printed 26-May-11

161

Introduction to Interest rate risk

Risk due to variation in financial condition of the Bank due to

variation in interest rates

Reprising risk

Yield curve risk

Option risk

Basis risk

The immediate impact of variation in interest rates is on the

earning of the Bank

A long term impact of change in interest rates is on the net

worth, since the economic value of assets and liabilities get

affected

© IMaCS 2009

Printed 26-May-11

162

Types of interest rate risk … 1

Re-pricing risk

Risk due to timing difference in the maturity (for fixed rate) and

repricing (for floating rate) of assets and liabilities and off balance

sheet (OBS) position

Banks usually have assets deployed at fixed rates (pre-determined at

the time of contract) and also at variable rates (changes with change in

benchmark interest rates), which get run down in the EMI structures

regularly.

On the other hand the liabilities have varying structures that include

repayment in installments and bullets. This leads to reprising risk

© IMaCS 2009

Printed 26-May-11

163


Yield curve risk

Yield curve risk is the risk of change in the shape or slope of the yield

curve

Usually banks borrow short term and lend long term, thus flattening

of the yield curve increases the cost of funds, whereas the interest

earned does not increase proportionately. Thereby leading to pressure

on the profitability of the Bank

© IMaCS 2009

Printed 26-May-11

164

Example of yield curve risk

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

15-Feb-10 15-Mar-10 15-Apr-10 15-May-10 15-Jun-10 15-Jul-10 15-Aug-10 15-Sep-10 15-Oct-10 15-Nov-10

3M

6M

9M

12M

© IMaCS 2009

Printed 26-May-11

165


Basis risk

Assets and liabilities are linked to different benchmark yield curves

Movement in the benchmark yield curves are seldom same in

direction and magnitude

Any variance in the direction and magnitude of different benchmark

yield curves would lead to volatility in the profitability of the bank

The risk that value of assets and liabilities change by the same

magnitude by change in interest rates is termed as basis risk

© IMaCS 2009

Printed 26-May-11

166


Option risk

Change in interest rate that could lead to funds being withdrawn by

the exercise of the option embedded with the product

Also change in interest rate could lead to cash flows being received

earlier than expected as a result of options being exercised

Thus option risk is the risk that a change in prevailing interest rates

will lead to an adverse impact on the earnings or capital by change in

timing of the cash-flows of assets or liabilities

© IMaCS 2009

Printed 26-May-11

167

Reasons for interest rate risk

On account of asset transformation

Many deposits are used for one big loan

Non-periodical review of assets and liabilities

Due to mismatches between maturity / reprising dates as well

as maturity amounts between assets and liabilities

Depositors and borrowers may pre-close their accounts

© IMaCS 2009

Printed 26-May-11

168

Earnings vs. economic value

Earnings perspective: It involves the impact of changes in

interest rates on accrual or reported earnings in the near term.

This is measured by measuring the changes in NII and NIM

Economic value perspective: It involves the impact of interest

rates on the expected cash-flows on assets minus the expected

cash-flows on liabilities. It focuses on the risk to net worth

arising from all reprising mismatches and other interest rate

sensitive positions. It identifies the risk arising from long

term interest rate gaps

© IMaCS 2009

Printed 26-May-11

169

Factors Affecting NII.

Changes in the level of interest rates.

Changes in the volume of assets and liabilities.

Change in the composition of assets and liabilities.

Changes in the relationship between asset yields and

liabilities. cost of funds.

© IMaCS 2009

Printed 26-May-11

170

Example-impact of interest rate on profitability

Expected Balance Sheet for Hypothetical Bank

Assets Yield Liabilities Cost

Rate sensitive 500 8.0% 600 4.0%

Fixed rate 350 11.0% 220 6.0%

Non earning 150 100

920

Equity

80

Total 1000 1000

NII = (0.08x500+0.11x350) - (0.04x600+0.06x220)

78.5 - 37.2 = 41.3

NIM = 41.3 / 850 = 4.86%

GAP = 500 - 600 = -100

© IMaCS 2009

Printed 26-May-11

171

Exhibit 1

1% increase in the level of all short-term rates.

1% decrease in spread between assets yields and interest cost.

RSA increase to 8.5%

RSL increase to 5.5%

Proportionate doubling in size.

Increase in RSAs and decrease in RSL‟s

RSA = 540, fixed rate = 310

RSL = 560, fixed rate = 260.

© IMaCS 2009

Printed 26-May-11

172

1% Increase in Short-Term Rates




Fixed rate 350 11.0% 220 6.0%

Non earning 150 100

920

Equity

80

Total 1000 1000

NII = (0.09x500+0.11x350) - (0.05x600+0.06x220)

83.5 - 43.2 = 40.3

NIM = 40.3 / 850 = 4.74%

GAP = 500 - 600 = -100

© IMaCS 2009

Printed 26-May-11

173

1% Decrease in Spread




Fixed rate 350 11.0% 220 6.0%

Non earning 150 100

920

Equity

80

Total 1000 1000

NII = (0.085x500+0.11x350) - (0.055x600+0.06x220)

81 - 46.2 = 34.8

NIM = 34.8 / 850 = 4.09%

GAP = 500 - 600 = -100

© IMaCS 2009

Printed 26-May-11

174

Proportionate Doubling in Size



Rate sensitive 1000 8.0% 1200 4.0%

Fixed rate 700 11.0% 440 6.0%

Non earning 300 200

1840

Equity

160

Total 2000 2000

NII = (0.08x1000+0.11x700) - (0.04x1200+0.06x440)

157 - 74.4 = 82.6

NIM = 82.6 / 1700 = 4.86%

GAP = 1000 - 1200 = -200

© IMaCS 2009

Printed 26-May-11

175

Increase in RSAs and Decrease in RSLs




Fixed rate 310 11.0% 260 6.0%

Non earning 150 100

920

Equity

80

Total 1000 1000

NII = (0.08x540+0.11x310) - (0.04x560+0.06x260)

77.3 - 38 = 39.3

NIM = 39.3 / 850 = 4.62%

GAP = 540 - 560 = -20

© IMaCS 2009

Printed 26-May-11

176

There are four methods for measuring Interest

Rate Risk

Gap Analysis method

Duration and Convexity method

Simulation and Scenario analysis method

Value at Risk method

Each method has its advantages, disadvantages and

complexities which is explained subsequently. For this

workshop, we will limit our discussions to Gap method and

duration method.

© IMaCS 2009

Printed 26-May-11

177

What is a Gap?

1. Risk Sensitive Assets and Liabilities are those whose values are

affected by interest rate movement

2. For interest risk analysis, gap is calculated for each bucket

according to repricing or residual maturity, whichever earlier

3. If they do not have contractual maturity, behaviourial maturities

to be used

4. Gap analysis, though simple, forms the basis of calculations

based on which Asset-Liability Mismatch limits are set

Gap = Risk Sensitive Assets (RSA) - Risk Sensitive Liabilities (RSL)

© IMaCS 2009

Printed 26-May-11

178

Gap Report: Key concepts

A gap report calculates the gap over different time intervals

and the cumulative gap of a period

Gap report based on reprising maturities is used for analysis of Interest Rate

Risk

Gap report based on actual maturities is used for analysis of Liquidity Risk

Gap reports can be Static or Dynamic:

Static Gap report is based on actual data on assets, liabilities and hedges on

a particular day

Dynamic Gap report is based on projections of assets, liabilities and hedges

on a particular day taking into account bank‟s business plans

© IMaCS 2009

Printed 26-May-11

179

Bucketing

1 to 14 days

15 day to 30 / 31 days (one month)

Over one month and up to 2 months

Over 2 months and up to 3 months

Over 3 months and up to 6 months

Over 6 months and up to 1 year

Over 1 year and up to 3 years

Over 3 years and up to 5 years

Over 5 years

© IMaCS 2009

Printed 26-May-11

180

Bucketing of assets and liabilities

Liabilities

1. Capital Non-sensitive

a) Equity and perpetual preference

shares Non-sensitive

b) Non-perpetual preference shares Non-sensitive

2. Reserves & surplus Non-sensitive

3. Gifts, grants, donations &

benefactions Non-sensitive

4. Notes, bonds & debentures


Sensitive; reprice on the roll- over/repricing date should

be slotted in respective time buckets as per the

repricing dates.

b) Bonds Debunture with embedded options

Sensitive; could reprice on the exercise date of the

option particularly in rising interest rate scenario. To be

placed in respective time buckets as per the next

exercise date.

c) Fixed rate notes

Sensitive; reprice on maturity. To be placed in

respective time buckets as per the residual maturity of

such instruments.

© IMaCS 2009

Printed 26-May-11

181

Bucketing of assets and liabilities(contd.)

5. Deposits

a) Term deposits from public

Sensitive: could reprice on the repricing date in case of

floating or reprice on maturity if fixed

b) ICDs

Sensitive; reprice on maturity. To be placed in respective

time buckets as per the residual maturity of such

instruments.

c) Certificate of Deposit



instruments.

6.Borrowings

a) Term money borrowings from

Banks



instruments.

b) From Bangladesh Bank, Govt., &

others



c) Bank Borrowings in the nature of

WCDL, CC etc

Sensitive: could reprise on the reprising date in case of

floating or reprise on maturity if fixed

© IMaCS 2009

Printed 26-May-11

182


7. Current Liabilities & provisions:

a) Sundry creditors Non-sensitive

b) Expenses payable (other than

interest) Non-sensitive

c) Advance income received, receipts

from borrowers pending adjustment Non-sensitive

d) Interest payable on bonds/deposits Non-sensitive

e) Provisions (other than for NPAs) Non-sensitive

8. Contingent Liabilities

a) Letters of credit/guarantees Non-sensitive

b) Loan commitments pending

disbursal (outflows) NA

c) Lines of credit committed to other

institutions (outflows) NA

d) Outflows on account of forward

exchange contracts, rupee/dollar swap

Sensitive: should be bucketed according to the maturity of

the contract

9. Commercial Paper



10. Others (Subordinate Debt)



© IMaCS 2009

Printed 26-May-11

183


Assets

1. Cash Non-sensitive

2. Remittance in transit NA

3. Balances with banks

a) Current account Non-sensitive

b) Deposit /short-term deposits



instruments.

4. Investments (net of provisions)




a)Bills of exchange and promissory

notes discounted & rediscounted



instruments.

b) Term loans (only rupee loans)



c) Corporate loans/short term loans



© IMaCS 2009

Printed 26-May-11

184


6. Non-performing loans Same as Bucketing criteria of SLG

7. Inflows from assets on lease

Sensitive on cash flows. The amounts should be

distributed to the respective maturity buckets

corresponding to the cash flow dates.

8. Fixed assets (excluding assets on

lease) Non-sensitive

9. Other assets :

a) Intangible assets & other non-cash

flow items Non-sensitive

b) Interest and other income receivable



c) Others

In respective maturity buckets as per the timing of the

cashflows.

10. Lines of credit committed by

other institutions (inflows) 1-14 day time bucket

11. Bills rediscounted (inflow)



12. Inflows on account of forward

exchange contracts, dollar/rupee

swaps

In the respective time buckets as per the residual maturity

of the underlying bills/transactions.

13. Others NA

© IMaCS 2009

Printed 26-May-11

185

Important points to be considered while auditing Gap

Statements for measuring interest rate risk

Number of time buckets

Choosing too few may not give meaningful results

Choosing too many will be difficult to interpret

5 to 12 time buckets may be ideal

Length of time buckets may depend on maturity mix of assets and liabilities

Length of bucket depends on the type of institution

It depends on the how developed the market for asset and liabilities are across

maturities

The first few buckets are generally shorter

Buckets should not be too heavy or light under “normal” conditions

A bucket having 30% or more of assets or liabilities should be split into two

buckets

Buckets containing less than 5% of the assets or liabilities are considered light

and should be combined

© IMaCS 2009

Printed 26-May-11

186

Important points to be considered while auditing slotting

of assets and liabilities for measuring interest rate risk

On and off- Balance sheet items are slotted into appropriate buckets as per

maturities. Maturities can be classified into three types:

Repricing

Contractual

Remaining

For estimating interest rate risk repricing maturities may be used.

For example: 5 year variable rate bond with a coupon of 6-months LIBOR will be

slotted in the 6-month bucket as the bond will reprice according to movements in

6-month LIBOR.

Non-interest sensitive items like capital are slotted into the last time bucket.

© IMaCS 2009

Printed 26-May-11

187

The bonds with following maturity details should be classified under which time

bucket. Options are: (a) Less than 1 month, (b) 1 to 3 months, (c) 3 to 6

months, (d) 6 months to 1 year, (e) 1 to 3 years and (f) 3 to 5 years

Group Exercise : Slotting of cash flows

i. Today: 1st February, 2005

ii. Issue Date: 1st January, 2000

iii. Maturity Date: 30th June,

2005

iv. Bond reprices on 1st January

© IMaCS 2009

Printed 26-May-11

188

Other important points to be considered while auditing slotting of

assets and liabilities for estimating interest rate risk

Principal vs.

Cash Flows

Amortizing Loans

Liabilities

The principal to be slotted in the contractual

maturity

Accrued interest, if shown in balance sheet, should

be slotted in the bucket it will be actually received

Calculate payments and segregate the principal and

interest components

Slot only the principal in the bucket

Liabilities with non-contractual maturities

• Core vs. Volatile

• Trend, seasonal and cyclical components

© IMaCS 2009

Printed 26-May-11

189

Gap report

Time Buckets RSA RSL GAP

Residual

Period

(Mid Point)

Impact of 1%

change in

Interest Rate

A B C=A-B D 1%*C*D/12

1 to 14 days 797 390 407 0.25 0.08

14 days to 30 / 31 days (one

month)297 349 -52 0.75 -0.03

Over one month to 2 months 202 168 34 1.50 0.04

Over 2 months to 3 months 1309 1240 69 2.50 0.14

Over 3 months and up to 6

months618 1051 -433 4.50 -1.63

Over 6 months and up to 1 year 1381 900 481 9.00 3.61

Total 4604 4098 506 2.22

© IMaCS 2009

Printed 26-May-11

190

Different types of Gap

Periodic Gap

Gap for each time bucket

Measures the income effects from interest rate changes

Cumulative Gap

– Sum of periodic Gaps

– Measures aggregate interest rate risk over the entire period

© IMaCS 2009

Printed 26-May-11

191

Types of Gap: Positive Gap & Negative Gap

A positive gap for a particular time

bucket is when the Rate Sensitive Assets

exceed Rate Sensitive Liabilities

A negative gap for a particular time

bucket is when the Rate Sensitive

Liabilities exceed Rate Sensitive Assets

An increase in interest rate leads to an

decrease in NII

An increase in interest rate leads to a

increase in NII

Liabilities reprice faster than assets

Long term assets funded with shorter

term liabilities

Assets reprice faster than liabilities

Short term assets funded with Long term

Liabilities

© IMaCS 2009

Printed 26-May-11

192

Illustration: A liability sensitive gap

1.Since there are more liabilities at the

shorter end, the institution is

borrowing short and lending long.

2. Therefore liabilities reprise faster

than assets

3. Increase in interest rates leads to a

decrease in the Net interest income.

4. This is called a negative gap.

Gap and Cumulative Gap

-250

-200

-150

-100

-50

0

50

100

150

1 2 3 4 5 6 7

Period 1 2 3 4 5 6 7

Assets 20 50 60 40 80 100 150

Liabilities 90 160 70 60 50 40 30

Gap -70 -110 -10 -20 30 60 120

Cum. Gap -70 -180 -190 -210 -180 -120 0

© IMaCS 2009

Printed 26-May-11

193

Illustration: An asset sensitive gap

Period 1 2 3 4 5 6 7

Assets 100 150 70 60 50 50 30

Liabilities 30 50 60 40 80 100 150

Gap 70 100 10 20 -30 -50 -120

Cum. Gap 70 170 180 200 170 120 0

1.Since there are more assets at the

shorter end, the institution is

borrowing long and lending short

2. Therefore assets reprice faster than

liabilities

3. Increase in interest rates leads to an

increase in the Net interest income.

4. This is called a positive gap

Gap and Cumulative Gap

-150

-100

-50

0

50

100

150

200

250

1 2 3 4 5 6 7

© IMaCS 2009

Printed 26-May-11

194

Management of gaps

Management should cap the gap for each time bucket and the

cumulative gap based on

Regulatory requirement

Risk appetite of the Bank

The gap can be adjusted to positive or negative based on the

interest rate perception of the bank

Should have more rate sensitive assets in case of interest rates are

perceived to go up

Should have more rate sensitive liabilities in case interest rates are

perceived to go down

© IMaCS 2009

Printed 26-May-11

195

Group Exercise

Bank’s asset liability maturity profile is given below:

1. Does the Bank have a positive gap or a negative gap?

2. Find the interest rate sensitivity of the bank‟s NII to a 5% increase

in interest rates for (a) Quarter (b) Half year (c) Year

Assume all assets and liabilities as fixed rate.

Hint: If interest rates change and we are noticing the impact for a quarter, only the cash flows

relevant up to the quarter will be effected and for a quarter only

Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months

Total assets 97967 502495 71691 11519 44840 18937

Total liabilities 203567 285347 285302 30967 4513 3070

© IMaCS 2009

Printed 26-May-11

196

Help guide for Exercise

Step 1: Calculate the Net Gap

Step 2: Calculate duration for repricing

Step 3: Calculate the impact of 5% rise in interest rate on the

NII by using the following formula:

[(Net Gap) * (duration for repricing) * (period/12) * (change in interest

rate)]

© IMaCS 2009

Printed 26-May-11

197

Step 1: Calculate the Net Gap

Step 2: Calculate duration for reprising

= [(3 months/ 12) – (Reprising after how much time)]

Step 3: Calculate the impact of 5% rise in interest rate on the

NII by using the following formula:

= [(.25*-105600*.25*5%) + (.208*217148*.25*5%) + (.083*-

213611*.25*5%) ]

= 12.98

Solution : Impact of 5% increase in interest rate for

one Quarter


Total assets 97967 502495 71691 11519 44840 18937

Total liabilities 203567 285347 285302 30967 4513 3070

Gap -105600 217148 -213611 -19448 40327 15867

0.000 0.042 0.167 0.375 0.625 0.875


© IMaCS 2009

Printed 26-May-11

198

Solution: Impact of 5% increase in interest

rate for half year and full year

For a quarter- 12.98

For half year- 0.500 0.458 0.333 0.125

-105600 217148 -213611 -19448

x x 0. 5 x 5%= -672.7

For whole year-

1.000 0.958 0.833 0.625 0.375 0.125

-105600 217148 -213611 -19448 40327 15867

x x 1 x 5%= -3528

© IMaCS 2009

Printed 26-May-11

199

Solution : Diagrammatic representation of the solution

13

-673

-3528-10.7%

0.0%

-2.0%

-4000

-3500

-3000

-2500

-2000

-1500

-1000

-500

0

500

Quarter Half-year Full-year

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

NII

% of PBT

Impact of a 5% upward shock on interest rate will be as follows:

© IMaCS 2009

Printed 26-May-11

200

Relation between NII and interest rates

Asset Sensitive

Liability Sensitive

Fully Hedged

NII

Interest rates

NII

Interest rates

NII

Interest rates

© IMaCS 2009

Printed 26-May-11

201

Stress testing

Analyse the impact of change in interest rate due to parallel

and non parallel shift in yield curve

Time Buckets RSA RSL GAP

Residual

Period

(Mid Point)

Non-Parallel

Shift

Impact of

change in

Interest

Rate

A B C=A-B D E E*C*D/12

1 to 14 days 797 390 407 0.25 1% 0.08

14 days to 30 / 31 days (one

month)297 349 -52 0.75 1% -0.03

Over one month to 2 months 202 168 34 1.5 0.75% 0.03

Over 2 months to 3 months 1309 1240 69 2.5 0.75% 0.11

Over 3 months and up to 6 months 618 1051 -433 4.5 0.50% -0.81

Over 6 months and up to 1 year 1381 900 481 9 0.50% 1.80

Total 4604 4098 506 1.18

© IMaCS 2009

Printed 26-May-11

202

While Gap method is simple for estimating the

interest rate risk, it has a few limitations

Gap method does not capture the impact of non parallel shift

in yield curves, volatility, basis risk, mismatches within a

time bucket, dynamic positions and change in timing

differences

• Could lead to errors in risk quantification

• Limits the ability to do sensitivity analysis

Implications

© IMaCS 2009

Printed 26-May-11

203

There are four methods for measuring Interest

Rate Risk

Gap Analysis method

Duration and Convexity method

Simulation and Scenario analysis method

Value at Risk method

Each method has its advantages, disadvantages and

complexities which is explained subsequently. For this

workshop, we will limit our discussions to Gap method and

duration method.

© IMaCS 2009

Printed 26-May-11

204

What is Duration?

Duration is a quantitative technique to measure the “first

order” interest rate sensitivity of assets and liabilities

It is the weighted average maturity of a bond where the

present value of cash flows is used as weights (Macaulay

Duration)

Duration is also a interpreted as a measure of the price

elasticity of a bond (Modified Duration)

The concept of duration can be used for: all assets, liabilities

and off-balance sheet items, single asset, a portfolio of assets,

or the entire balance sheet.

© IMaCS 2009

Printed 26-May-11

205

How to calculate Macaulay Duration?

Macaulay duration is a “time -weighted ” present value.

N

t

N

t

tPV

tPVtD

1

1

)(

)(

Macaulay Duration can be measured as follows:

Where t=Period, and PV(t)=PV of cash flows in period t

© IMaCS 2009

Printed 26-May-11

206

How to calculate Modified Duration?

The Macaulay duration is easy to understand as an „average” maturity of

an instrument. However, the more important use of duration is to predict

“first order” price sensivity due to changes in the interest rate. Modified

duration, elasticity to interest changes, is the measure for this.

i

DP

di

dPMD

1

Where P = Price of the bond, and I = prevailing yield

i

DMD

1

It can be shown that:

Change in Price ≈ MD x Change in Yield

Modified Duration can be measured as follows:

© IMaCS 2009

Printed 26-May-11

207

Mathematically duration is defined as follows

1. Taylor series is a mathematical expression of the extent to which price

changes with the change in interest rates

2. Mathematically duration is the first term of Taylor series

3. Convexity, is the rate of change of price owing to change in interest rates and

contributes to the non-linear shape of the price-yield relationship

Duration Convexity

© IMaCS 2009

Printed 26-May-11

208

Five steps in calculating duration of an asset or

portfolio

Step 1

Step 2

Step 3

Step 4

Define timing and magnitude of cash flows

Calculate PV (t). Sum Present Value of all cash

flows

Calculate t PV (t). Sum time –weighted Present Value of all cash

flows

Divide t PV (t) by PV (t)

Step 5 Calculate Modified Duration

© IMaCS 2009

Printed 26-May-11

209

Assumptions for Duration framework

Duration measures the “first order” approximation of price

sensitivity to interest changes and works exactly under the

following assumptions:

Change in

interest rates

Cash flows • Cash flows do not change with interest rates. Exceptions:

Collateralised Mortgage Obligations (CMOs), Callable Bonds

• Change in interest rates must be “small”.

Yield change • Yield changes are assumed to be instantaneous

Shift in curve • Parallel shift in the yield curve is assumed.

© IMaCS 2009

Printed 26-May-11

210

Calculation of duration of fixed coupon bond

Serial No. Cash Flow Maturity Coupon Principal Cash Flows PV @8% PV*Maturity

1 1-Jan-09

2 1-Jul-09 0.50 3.75 3.75 3.61 1.80

3 1-Jan-10 1.00 3.75 3.75 3.47 3.47

4 1-Jul-10 1.50 3.75 3.75 3.34 5.01

5 1-Jan-11 2.00 3.75 3.75 3.22 6.43

6 1-Jul-11 2.50 3.75 3.75 3.09 7.73

7 1-Jan-12 3.00 3.75 3.75 2.98 8.93

8 1-Jul-12 3.50 3.75 3.75 2.86 10.03

9 1-Jan-13 4.00 3.75 3.75 2.76 11.03

10 1-Jul-13 4.50 3.75 3.75 2.65 11.94

11 1-Jan-14 5.00 3.75 100.00 103.75 70.61 353.05

Total 98.59 419.42

(a) (b)

Duration (b)/(a) 4.25

Modified Duration = Duration/(1+Discount factor of 8%/coupon frequency of 2) 4.09

© IMaCS 2009

Printed 26-May-11

211

Calculation of duration of Floating rate bond

Serial No. Cash Flow Maturity Coupon Principal Cash Flows PV @8% PV*Maturity

1 1-Jan-09

2 1-Jul-09 0.50 3.75 3.75 3.61 1.80

3 1-Jan-10 1.00 3.75 100.00 103.75 96.06 96.06

4 1-Jul-10 1.50 0.00 0.00 0.00

5 1-Jan-11 2.00 0.00 0.00 0.00

6 1-Jul-11 2.50 0.00 0.00 0.00

7 1-Jan-12 3.00 0.00 0.00 0.00

8 1-Jul-12 3.50 0.00 0.00 0.00

9 1-Jan-13 4.00 0.00 0.00 0.00

10 1-Jul-13 4.50 0.00 0.00 0.00

11 1-Jan-14 5.00 0.00 0.00 0.00

Total 99.67 97.87

(a) (b)

Duration (b)/(a) 0.98

Modified Duration = Duration/(1+Discount factor of 8%/coupon frequency of 2) 0.94

© IMaCS 2009

Printed 26-May-11

212

Weighted average duration

Serial No. Home Equity Loan Amount DurationWeighted Avg.

Duration

1 A 100000.00 2.00 200000.00

2 B 200000.00 2.30 460000.00

3 C 300000.00 5.00 1500000.00

4 D 400000.00 3.20 1280000.00

5 E 500000.00 2.10 1050000.00

6 F 600000.00 2.20 1320000.00

7 G 700000.00 2.30 1610000.00

8 H 800000.00 1.50 1200000.00

9 I 900000.00 1.80 1620000.00

10 J 1000000.00 2.00 2000000.00

Total 5500000.00 12240000.00

(a) (b)

Weighted Avg. Duration (b)/(a) 2.23

© IMaCS 2009

Printed 26-May-11

213

Duration Gap analysis

Modified duration gap (DGAP) is derived as:

DGAP = Modified DA-W*Modified DL

Where

W = RSL/RSA

DA = Weighted average MD of Assets

DL = Weighted average MD of Liabilities

MD of equity = DGAP*Leverage

Where

Leverage = RSA/Net worth

Net Worth = Equity + reserves and surplus

© IMaCS 2009

Printed 26-May-11

214

Example

Outflows Amount Mod. Duration DL

Capital 366.47 NS

Reserves & Surplus 341.96 NS

Bonds and Debentures 2071.5 4

Borrowings 3353.89 1

Current Liability &provisions 429.7 0.5

Others 146.43 1

Total outflow 6709.95

1.999689

Inflows

Cash 0.06

Balances with Banks 1553.66

Investment 405.22 0.5

Advances 4316.25 4

NPA 163.98 4

Total Assets 6439.17

3.709696

© IMaCS 2009

Printed 26-May-11

215

Contd.

Duration of Equity of 8.64 means that an increase of interest rate by 1% would

result in a decrease in equity by 8.64%

RSA 4885.45

RSL 6001.52

DA 3.709696

DL 1.999689

Net worth 708.43 Equity + reserves and surplus

W 1.228447738 RSL/RSA

DGAP 1.253182572 DA-DL*W

Leverage 6.896164759 RSA/Net-worth

Duration of equity 8.642153489 Leverage*DGAP

© IMaCS 2009

Printed 26-May-11

216

Duration Ratio

Duration ratio is defined as the ratio of the duration of assets to that of the

liabilities. The impact on Net Interest Income (profitability) is as follows:

Duration Ratio Net Sensitivity Interest rate ↑ Interest rate ↓

Less than 1 Liability Sensitive Adverse

Impact on NII

Favorable

Impact on NII

Equal to 1 Matched Insulated * Insulated*

Greater than 1 Asset Sensitive Favorable impact

on NII

Adverse Impact on

NII

* Assuming parallel shift

© IMaCS 2009

Printed 26-May-11

217

MATURITY GAP METHOD(IRS)

THREE OPTIONS:

A) RSA>RSL= Positive Gap

B) RSL>RSA= Negative Gap

C) RSL=RSA= Zero Gap

© IMaCS 2009

Printed 26-May-11

218

Management of gaps

Each bank to set its prudential limits on individual gaps with

approval of Board

Prudential limits set with respect to bearing on Total Assets,

Earning Assets or Equity

Bank‟s may work out their Earnings at Risk – 20-30% of last

year‟s NII or NIM

© IMaCS 2009

Printed 26-May-11

219

Asset Liability Risk Mitigation Strategies

Business Strategy•product mix

•product pricing

Investment Strategy

•maturity mix•rate profile of

investments

Derivative

Strategy

•IRS

•options

• structured

products

ALM

© IMaCS 2009

Printed 26-May-11

220

Business Strategy…Impact on NEV must be assessed

Risk Mitigation

Product mix Product Pricing

•How much long term/short

term?

•Advance portfolio

composition

•Charging a premium for

products not offered by

competitors?

© IMaCS 2009

Printed 26-May-11

221

Investment Strategy…Impact on NEV must be

assessed

Risk Mitigation

Maturity mix Rate profile of investments

•How much long term/short

term •High risk-high return?

•Additional risk such as currency

risk?

© IMaCS 2009

Printed 26-May-11

222

Exercise : Estimate duration of a bond

Face value of bond: Amount 100,000

Annual coupon rate: 12%

Remaining maturity: 4 years

Yield curve is flat at 11%

Find the duration and modified duration of the bond.

© IMaCS 2009

Printed 26-May-11

223

Exercise : Help guide for measuring duration and

modified duration of a bond

Step 1

Step 2

Step 3

Step 4

Define timing and magnitude of cash flows

Calculate PV (t). Sum Present Value of all cash

flows

Calculate t PV (t). Sum time –weighted Present Value of all cash

flows

Divide t PV (t) by PV (t)

Step 5 Calculate Modified Duration

© IMaCS 2009

Printed 26-May-11

224

Solution : Estimating duration of a bond

A B C D

Period CashflowPresent

ValueA*C

1 12000 10811 10811

2 12000 9739 19479

3 12000 8774 26323

4 112000 73778 295111

103102 351724Yield 11%

073.311.01

411.3.DurationM

1. The present value of cash flows

(column C) is obtained by discounting

the cash flows in column B with a

discount rate of 11%.

2. Last column (column D) is the product

of the discounted cash flows and time

periods.

3. Duration is calculated by dividing the

total of column D by that of column C

4. Duration divided by the discounting

gives Modified duration.

411.3C Col. of Sum

D Col. of Sum Duration

1. Modified Duration is an approximate measure of the price elasticity of a bond.

2. A more exact measure can be calculated by using both duration and convexity

© IMaCS 2009

Printed 26-May-11

225

Exercise: Estimate the impact of change in

interest rate and coupon on duration

Consider the following 3 bonds

Maturity Coupon Yield

A 4 12% 11%

B 4 11% 11%

C 4 11% 10%

1. What is the impact on duration if coupon changes ? (Bond B)

2. What is the impact on duration if yield changes ? (Bond C)

Duration

3.411

M. Duration

3.073

© IMaCS 2009

Printed 26-May-11

226

Solution: Impact of duration if coupon

changes



A 4 12% 11%

B 4 11% 11%

C 4 11% 10%

1. What is the impact on duration if coupon changes ? (Bond B)

D=3.444 MD=3.102

If the coupon decreases, the duration increases. In fact the duration of a

zero coupon bond is equal to its maturity

D=3.411 MD=3.073

© IMaCS 2009

Printed 26-May-11

227

Exercise : Impact on duration if yield changes



A 4 12% 11%

B 4 11% 11%

C 4 11% 10%

2. What is the impact on duration if yield changes ? (Bond C)

D=3.453 MD=3.139

D=3.444 MD=3.102

If the yield decreases, the duration increases.

© IMaCS 2009

Printed 26-May-11

228

Exercise: What is the duration of an portfolio

Assume there is an investment portfolio of 3 assets:

Mark-to-market valuation: Amount 90, Amount 125 and

Amount 65 respectively

Book values of the assets: Amount 80, Amount 130 and

Amount 40 respectively

The duration of these assets are 2, 3.5 and 6 respectively.

What is the duration of the portfolio?

Hint: The Duration of a portfolio is the weighted average of the Mark-to-Market value of the

portfolio.

© IMaCS 2009

Printed 26-May-11

229

Solution: Duration of investment portfolio

Mark-to-market value of the investment portfolio is :

(90 + 125 + 65)= 280

Average duration of the portfolio is (in years) :

598.3280

6655.3125290

Duration of a portfolio of assets (for assets or liabilities)

V

vdD

i

n

i i

P1

© IMaCS 2009

Printed 26-May-11

230

Exercises (1): Rapid fire questions

Q 1 Modified duration is a more accurate measure of interest rate sensitivity than duration.

1 True

2 False

Q 2 Duration of a bond generally increases with an increase in:

1 Coupon

2 Yield

3 Term to maturity

4 Frequency of coupon payments

Q 3 Assuming the following bonds has the same yield, which one has the shortest duration?

1 Zero coupon, 30-year maturity

2 10% coupon, 30-year maturity

3 Zero coupon, 5-year maturity

4 10% coupon, 5-year maturity

© IMaCS 2009

Printed 26-May-11

231


Q 4 With a zero coupon bond, duration is

1 Less than maturity

2 Greater than maturity

3 Depends on yield

4 Equal to maturity

Q 5 Duration is a measure of

1 Length of time until a bond matures

2 Timing of cash flows weighted by the proportionate present value of cash flows

3 Timing of cash flows weighted by the magnitude of cash flows

4 Original maturity of the bond

Q 6 An investment is made in a bond. The credit rating of the bond has been upgraded by the rating

agency. How would duration of the bond react?

1 Increase

2 Decrease

3 Does not change

© IMaCS 2009

Printed 26-May-11

232


Q 7 A bond's modified duration is 3.7. Its value is Rupees 100,000. If interest rates increase by 20

basis points, the price will:

1 Decrease by Rupees 740

2 Increase by Rupees740

3 Increase by Rupees 7400

4 Decrease by Rupees7400

Q 8 For regular coupon paying bonds (with no structured features), duration is:

1 Equal to maturity

2 Less than maturity

3 Greater than maturity

4 None of the above

Q 9 Assuming the following bonds has the same yield, which has the shortest duration?

1 10-year, 10% coupon



4 10-year, zero coupon

RISK MANAGEMENT

FRAMEWORK

ALM

ORGANISATION

RISK MANAGEMENT FRAMEWORK

A risk management framework encompasses the scope of risks to be managed, the

process/systems and procedures to manage risk and the roles and responsibilities of

individuals involved in the risk management.

Risk Management Framework

• It includes

A well constituted organisational structure defining clearly roles & resposibilities of individuals involved in risk taking & managing it

An effective Management Information System

Mechanism to ensure ongoing review of systems policies and procedures to adopt changes

BUSINESSLINE ACCOUNTABILITY

In every banking organization there arepeople who are dedicated to riskmanagement activities, such as risk review,internal audit etc. It must not be construedthat risk management is something to beperformed by a few individuals or adepartment. Business lines are equallyresponsible for the risks they are taking.Because line personnel, more than anyonee lse, understand the risks of the business,such a lack of accountability can lead toproblems.

Risk Evaluation/Measurement

To adequately capture institutions riskexposure, risk measurement should representaggregate exposure of institution both risk typeand business line and encompass short run aswell as long run impact on institution.

To the maximum possible extent institutions

should establish systems / models that quantify

their risk profile

Independent review.

One of the most important aspects in riskmanagement philosophy is to make sure thatthose who take or accept risk on behalf of theinstitution are not the ones who measure, monitorand evaluate the risks.To be effective the review functions should havesufficient authority, expertise and corporatestature so that the identification and reporting oftheir findings could be accomplished without anyhindrance.

Contingency planning

Institutions should have a mechanism toidentify stress situations ahead of timeand plans to deal with such unusualsituations in a timely and effectivemanner.

Board and Senior Management Oversight

To be effective, the concern and tone for risk

management must start at the top. While the

overall responsibility of risk management rests

with the BOD, it is the duty of senior

management to transform strategic direction set

by board in the shape of policies and procedures

and to institute an effective hierarchy to execute

and implement those policies.

The formulation of policies relating to risk management onlywould not solve the purpose unless these are clear andcommunicated down the line. Senior management has toensure that these policies are embedded in the culture oforganization. Risk tolerances relating to quantifiable risks aregenerally communicated as limits or sub-limits to those whoaccept risks on behalf of organization. However not all risksare quantifiable. Qualitative risk measures could becommunicated as guidelines and inferred from managementbusiness decisions.


To ensure that risk taking remains within limits

set by senior management/BOD, any material

exception to the risk management policies

Introduction and tolerances should be reported

to the senior management/board who in turn

must trigger appropriate corrective measures.


To keep these policies in line with significant changes in internal and external environment, BOD is expected to review these policies and make appropriate changes as and when deemed necessary.


BANGLADESH BANK RECOMMENDATION

1. The Asset Liability Committee (ALCO) isresponsible for balance sheet (asset liability)risk management.

2. The responsibility of Asset Liabilitymanagement is on the Treasury Departmentof the bank.

3. Specifically, the Asset liability Management(ALM) desk of the Treasury Departmentmanages the balance sheet.

4. The results of balance sheet analysis alongwith recommendation is placed in the ALCOmeeting by the Treasurer where importantdecisions are made to minimise risk andmaximize returns.


BANGLADESH BANK RECOMMENDATION –POLICY STATEMENT

© IMaCS 2009

Printed 26-May-11

255

Basel I

Basel I was published in 1988 to set out a minimum capital

requirement for Banks

Basel I primarily focused on credit risk when published first,

though in subsequent issue in 1996 the minimum capital

requirement for market risk was introduced

Under Basel I assets were classified under 5 risk categories as

0%, 10%, 20%, 50% and upto 100% based on the risk profile

of the assets

Banks with international presence were required to maintain

capital of 8%.

Basel I is now outmoded and a more comprehensive

guidelines in the form of Basel II has been introduced

© IMaCS 2009

Printed 26-May-11

256

Basel II

Basel II was intended to cover risk in a more comprehensive

manner as compared to Basel I

Basel II is a three pillar system

Minimum capital requirement

• Credit risk

• Market risk

• Operational risk

Supervisory review process

• Regulatory framework for banks

• Supervisory framework

Market discipline

• Disclosure requirements for banks

© IMaCS 2009

Printed 26-May-11

257

Menu for estimating capital as per Basel II Accord

For Measuring Credit Risk

Standardized Approach

Foundation Internal Ratings-based Approach

Advanced Internal Ratings-based Approach

For Measuring Market Risk

Standardized Approach

Internal VaR Models

For Measuring Operational Risk

Basic Indicator Approach

Standardized Business Line Approach

Internal Measurement Approach

© IMaCS 2009

Printed 26-May-11

258

Amendment to the Basel Accord to incorporate

Market Risk

In 1996, the Basel Committee amended the Basel Capital

Accord to incorporate market risks. The Amendment

separated the bank's assets into:

Trading Book

This is the bank portfolio

containing financial

instruments that are

internationally held for

short-term resale and are

marked-to-market.

Banking Book

This consists of other

instruments, mainly

loans.

Amendment required institutions to hold capital to cover their exposure to market risks,

associated with foreign exchange, commodity positions, debt and equity positions in the

trading account.

© IMaCS 2009

Printed 26-May-11

259

To cover the capital charge for Market Risk, Basel

suggested “Tier III” capital

1. To cover market risks as well as credit risks, Basel suggested another tier of

eligible capital titled "Tier 3" capital.

2. Tier 3 capital can only be used to support the market risk capital charge and

will be limited to 250% of a bank's Tier 1 capital.

3. Only short-term subordinated debt with an original maturity of greater than two

years.

This implies that at least 28.5% of original Tier I capital has to be set aside for

supporting market risk

© IMaCS 2009

Printed 26-May-11

260

Basel II approaches to measuring Market risk

Standardise

d

Internal

Models

Based

*Amendment to the Basel Accord to Incorporate Market Risk (1996/8)

Market Risk

Approaches

Covering SpecificGeneral Market

Yield curve sensitivity

(Duration) based.

Decided by the Regulator

VaR based- Bank‟s own

models stress- tested by

regulator

+

© IMaCS 2009

Printed 26-May-11

262

Standardised Approach - Capital Charge for General

Market Risk

General Market

Duration

MethodMaturity

Method

Risk weights specified by Basel

II, where Bank unable to

calculate duration

1. Yield curve shift specified,

and its impact on portfolio

calculated

2. Minor adjustments for non-

parallel shifts in yield curve

1.Time slotting of cash flows (on and off-balance sheet) into 15 categories.

2.The change in portfolio value as a result of yield changes in Duration method

“roughly” corresponds to the risk weights assumed

Or

© IMaCS 2009

Printed 26-May-11

263

Standardised Approach: Capital charge for General Market risk by

Maturity Method

Residual Maturity buckets

Risk

Weig

hts

1 2 15

1.In the maturity method, the cash flows are slotted into time buckets as per their residual

maturities

2. Risk weights are applied as indicated in the table.

3

Normal Coupon

Low Coupon

© IMaCS 2009

Printed 26-May-11

264

No. Mod. Duration

Assumed

yield

change

Zone 1

1 1 month or less 1%

2 1 to 3 months 1%

3 3 to 6 months 1%

4 6 to 12 months 1%

Zone 2

5 1.0 to 1.9 years 0.90%

6 1.9 to 2.8 years 0.80%

7 2.8 to 3.6 years 0.75%

Zone 3

8 3.6 to 4.3 years 0.75%

9 4.3 to 5.7 years 0.70%

10 5.7 to 7.3 years 0.65%

11 7.3 to 9.3 years 0.60%

12 9.3 to 10.6 years 0.60%

13 10.6 to 12 years 0.60%

14 12 to 20 years 0.60%

15 over 20 years 0.60%Residual Duration buckets

Yie

ld

1 2 4..

1%

158

0.75%0.6%

Current

ChangedZone 1

Zone 2Zone 3

Standardised Approach: Capital charge for

General Market risk by Duration Method

1. In duration method, instruments are slotted into time buckets as per their residual

duration and their sensitivities calculated. This is summed across to determine capital

charge

2. Minor adjustments to capture basis risk (vertical disallowance) and between “Zones”

(horizontal disallowance) are added to modify capital charge

© IMaCS 2009

Printed 26-May-11

265

Standardised Approach: Capital Charge for Specific Risk

1.Govt. Securities•T-Bills•Govt. Securities

2.Qualifying Category•Public Sector Entities•Multilateral DevelopmentBanks•Investment Grade Securities

3.Other•Private Sector Entities

Maturity-

6m or less

Maturity -

6m - 24m

Maturity-

greater than 24

m

0%

0.25%

1.0%

1.60%

8.0%

Cap

ital Ch

arge

Govt.

SecuritiesOther

CategoriesQualifying Category

Specific Risk measures

price changes of

individual securities

owing to the factors

related to individual

issuer. No offsetting of

positions

© IMaCS 2009

Printed 26-May-11

267

Basel market capital charge using VaR method

(Internal Models Approach)

1. Internally measured VaR with 99% confidence interval

2. A horizon of 10 days or two calendar weeks

3. An observation period of at least a year of historical data

and updated at once a quarter

Capital requirements will be the maximum of:

1. Previous day‟s 10 day 99% VaR

2. Average of daily VaR for the previous 60 days multiplied by a multiplication

factor (3+ where (0,1)

The alpha factor depends on the stress test of the VaR model and the discretion of

the national supervisor

© IMaCS 2009

Printed 26-May-11

268

Use of the discretionary plus factor for

calculating capital requirements for Market risk

Less than 3 More than 9

This is the penalty component added to the multiplicative factor 'k', if

backtesting reveals that the internal model incorrectly forecasts risks. It

gives incentives to banks to improve predictive accuracy of models

3- 6 6- 9

0 0.5 1 Reject VaR

model

Specific risk is either the by the Standardized approach or that from internal

models (not to be less than 50% of the Standardized amount)

Specific Risk

Number of instances of breach of the daily VaR as stated by model

© IMaCS 2009

Printed 26-May-11

269

Basel III

Basel III remains the same as Basel II with the major

difference as given below:

Tier I capital has been increased from 4% to 6%

Core tier I capital is increased from 2% to 4.5%

• Core tier I capital is common equity minus deductions

Capital conservation buffer is introduced in Basel III

• A buffer of 2.5% of core capital needs to be plugged in addition to

4.5% to withstand future periods of stress bringing the total common

equity requirements to 7%. This is to be implemented by 2019

• The purpose of the conservation buffer is to ensure that banks

maintain a buffer of capital that can be used to absorb losses during

periods of financial and economic stress.

© IMaCS 2009

Printed 26-May-11

270

Contd.

Countercyclical capital buffer

• A countercyclical buffer within a range of 0% – 2.5% of common

equity or other fully loss absorbing capital will be implemented

according to national circumstances.

• Banks that have a capital ratio that is less than 2.5%, will face

restrictions on payouts of dividends, share buybacks and bonuses.

The buffer will be phased in from January 2016 and will be fully

effective in January 2019.

• Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 =

0.625%, 1st January 2017 = 1.25%, 1st January 2018 = 1.875%, 1st

January 2019 = 2.5%

© IMaCS 2009

Printed 26-May-11

271

Current guidelines on ALM

The current guidelines looks at the following parameters to

be monitored

Loan to deposit ratio

• Loan to deposit ratio should not increase more than 80%

• Banks can also lend more than 80% by lending from capital or raise

funds from interbank market, but excessive lending could put the

bank under tremendous liquidity crisis in case liquidity in the

market tightens

Wholesale borrowing guidelines

• Set up guidelines for borrowing from the wholesale market

• Reduce dependency on wholesale market for funding

• Alternative products to borrow from the market

• Set limits to borrow from the wholesale market

© IMaCS 2009

Printed 26-May-11

272

Contd.

• Number of parameters needs to be analyzed to determine the limit of

borrowing from the wholesale market

- Balance sheet size of the bank

- Historical trend of the market liquidity

- Credit rating of the bank

- Stability of liquidity and interest rates in the market

Commitments

• These are undrawn parts of the overdraft limit given to the

customers, which may be withdrawn at any point in time

• There should be limit to the undrawn part of the commitment

• The limit should be visa-a-via the undrawn part from the wholesale

borrowing limit

© IMaCS 2009

Printed 26-May-11

273

Contd.

Medium term funding ratio

• Banks borrow sort term and lend long term, thereby there are

mismatches.

• Thus the Bank needs to have medium term sources of funds

• Medium term funding ratio is calculated as the ration of liabilities

with maturity more than 1 year to that of assets maturing in more

than 1 year

• This ratio shows the extent to which the bank is dependent on roll

over to fund medium term assets

Maximum cumulative outflow

• This can be calculated for different tenors, for example a month or a

year.

• The MCO should be limited to the maximum amount that could be

raised from the wholesale market and the amount of liquid assets

held by the bank

© IMaCS 2009

Printed 26-May-11

274

Contd.

Swapped fund guidelines

• There should be cap on the maximum amount in absolute terms that

can be swapped from foreign currency liabilities in order to fund

domestic currency assets or vice-versa.

• This is to prevent excessive dependence on the foreign exchange

market

Local regulatory compliance

• Maintain CRR, SLR and capital adequacy ratios

Liquidity contingency plan

• Prepare a liquidity contingency plan to manage liquidity crisis

• Maintain liquid assets in the form of reserve assets, t-bills, specific

Government securities, open foreign currency position and specific

FDR’s

© IMaCS 2009

Printed 26-May-11

275

Contd.

Maturity profile mismatches for liquidity risk and interest rate risk Classification of the balance sheet into different time buckets based on

the maturity profile and behavioral pattern for liquidity risk and based on re-pricing or maturity for interest rate risk

Calculation of mismatches between inflows and outflows for every bucket and also the cumulative outflow

Based on the mismatches the ALCO takes the following action points Deposit mobilization or growth in assets in the appropriate time

buckets

Cash-flow plan (long/short) based on market interest rates and liquidity

Change in FTP or customer rates

Address to the breach in limit and also provide plan to bridge the gap

Address all regulatory compliance

© IMaCS 2009

Printed 26-May-11

276

Contd.

VaR

Calculation of expected loss at a confidence interval of 97.5% as to

loss due to change in market rates

Factor sensitivity

To estimate the change in value of the instruments with move in

interest rates by 1 bps (PV01)

Management action trigger (MAT)

Is equal to the current VaR + latest rolling monthly P/L (21 working

days)

It is a trigger point of a persistent loss making position

© IMaCS 2009

Printed 26-May-11

277

Contd.

Other analysis done

Overall assessment of the market interest rates and liquidity

Peer group comparison on deposit and lending rates

Balance sheet performance as compared to the lat month

Three day liquidity stress, wherein it is assumed that more outflows

are there as compared to normal days for the next three days

© IMaCS 2009

Printed 26-May-11

278

Organization structure

The responsibility of ALM is on the treasury department

Managed by the ALM desk of the treasury department

The roles and responsibilities of the ALM desk are as follows

• Assume overall responsibility of the money market activities

• Manage liquidity and interest rate risk of the Bank

• Comply with statutory requirement

• Understanding market dynamics, i.e. competition, potential target

markets, etc.

• Deal with dealer authorization limits

• Provide market views to the treasurer

The analysis and recommendation is presented to ALCO

ALCO is set up and is responsible for the overall

management of the balance sheet risk

© IMaCS 2009

Printed 26-May-11

279

Recommendations … 1

Organization structure to be decided

Roles and responsibilities to be defined

Process flow has to be put in place for proper and smooth

functioning of the ALM

MIS

Define systems

Data flow

© IMaCS 2009

Printed 26-May-11

280


Liquidity risk management

Bucketing criteria to be defined

Set limits for each bucket as the tolerance limit (both positive and

negative gaps)

Set limit for cumulative gap

Analysis of detailed ratio analysis (some are covered but there are

other that also need to be monitored)

Dynamic liquidity statement to be done on a fortnightly basis

Resource planning to be done

Stress testing and models

Back testing

© IMaCS 2009

Printed 26-May-11

281


Interest rate risk

Define bucketing criteria

Define limits for gaps

Implement the entire process for NEV method for interest rate risk

management

Stress testing

In case of FOREX exposure the Banks should also implement

the ALM in managing Currency risk using the net open

position method

© IMaCS 2009

Printed 26-May-11

282

IMaCS does not assume any liability, financial or otherwise, for any loss or injury that the user of the

recommendations in this report may experience in any transaction. All information contained herein is

obtained by IMaCS from sources believed by it to be accurate and reliable. Although reasonable care

has been taken to ensure that any information herein is true, such information is provided „as-is‟ without

any warranty of any kind and IMaCS, in particular, makes no representation or warranty, express or

implied, to the accuracy, timeliness or completeness of any such information. The analysis and

recommendations should not be construed to be a credit rating assigned by ICRA‟s rating division for

any of the company‟s debt instruments.

DISCLAIMER

rmpg learning series alm workshop

Economy & Finance