In this post we will talk about ALM.

The difference between the external customer rate and internal FTP rate is known as the “commercial margin” which is effectively the pnl of the business. A constant commerical margin is a defining feature of FTP. The FTP rate is calculated at deal inception and guaranteed by Treasury over the deal’s lifetime. This will generate the risk on Treasury side.

The main task of Treasury is to ALM management which is to manage the aggregate net mismmatch position with the bank’s desired risk-return profile.

Product Pricing

Product pricing is the determination of an internal hurdle rate and the difference between the external customer rate and the internal rate is called “marginal”. In other words, FTP in product pricing ensures the customer deal is only acepted f it generates positive commerical margin.

Product pricing by its nature takes an ex-ante view while cost allocation (favored by Finance department) takes an ex-post view. The implementation of the FTP rate should take care of the deal which is deemed profitable in product pricing by business and subsequent after contraction, deemed profitable in cost allocation by Finance as well.

Liquidity Metrics

It is essential that banks use a range of liquidity measures for risk estimation and forecasting.

Loan-to-Deposit Ratio (LTD)

LTD measures the relationship between lending and customer deposits, and is also a measure of the self-sustainability of the bank. A level above 100% is an early warning sign. A level below 70% implies excessive liquidity and indicate a potential inadequate return on funds. Industy best practice is a value between 95% and 105%.

\[\begin{aligned} \text{LTD Funding Gap} &= \text{Total Customer Lending} - \text{Total Customer Deposits} \end{aligned}\]

Survival Days (SD)

The number of days the bank can remain an ongoing concern before it has to access central bank emergency facilities.

Basel Liquidity Metrics

To ensure that a stable and balanced liquidity profile over the medium and long term by maintaining an appropriate ratio between liabilities and assets in the medium and long term will prevent funding pressure during stress situations. As part of this, two metrics were made mandatory by regulators following the Basel Committee guidelines in 2010.

1. Liquidity Coverage Ratio (LCR)

The LCR measures the short-term resilience to liquidity shocks by identifying the amount of unencumbered (assets that can be sold or serve as collateral for loan/repo), high quality liquid assets required to offset the net cash outflows arising in a short-term liquidity stress scenario:

\[\begin{aligned} \frac{\text{HQLA}}{\text{Stressed net cash outflows over a 30-day period}} > \text{100%} \end{aligned}\]

2. The Net Stable Funding Ratio (NSFR)

Compared to LCR, NSFR promotes resilience over a longer term.

\[\begin{aligned} \frac{\text{Available Stable Funding}}{\text{Required Stable Funding}} > \text{100%} \end{aligned}\]

NSFR is typically used to monitor and control the level of dependency on short-term wholesale market. A low ratio indicates concentration of shorter term funding.

Introduction

In the banking business, there is a mismatch in the asset (loans) and liability (deposit) side of the balance sheet. Managing the liquidity and market rish arising from this mismatch is the primary role of ALM.

Banks tailor the loans to corporate borrowers cashflow plannning. Similarly, retail clients have their particular request as well. With a wide range of clients, the bank’s balance sheet will have many mismatches. ALM focuses on managing the capital, funding, liquidity, and interest rate risks.

ALM comprises high level strategic management and on the tactical level, daily cash management. The high level aggregate policy is set by the bank’s Asset-Liability Committee (ALCO).

Traditional ALM is divided into following key areas:

Funding Liquidity is the continuous ability to maintain funding
Trading Liquidity is the ease of converting assets into cash
Term Structure of Interst Rates
Maturity Profile
Interest-Rate Risk

Interest Rate Risk

Changes in interest would impact the cash flow of assets and liabilities due to maturity mismatch. In other words, NII is sensitive to changes in interest. Also interest rate affects net present value (NPV) which affects the valuation of assets and liabilities. A rise in rates would lower the NPV as the opportunity cost would be higher.

The primary risk arise from fixing of interest rate for floating-rate assets and liabilities. The secondary risk arise from funding mismatch aka interest-rate gap.

The interest rate gap quantifies the difference between the interest rate of assets and liabilities at each tenor. The ALM profile can be plotted which consists of tenors on the x-axis and assets/liabilities on the y-axis.

Gap Risk

Gap risk is the risk due to the difference in maturity profile of assets, liabilities and off-balance sheet instruments. The gap risk is exposed ro changes in the parallel shift of the yield curve or a change in the shape of the yield curve.

Yield Curve Risk

Is the risk that a non-parallel or shift in the shape of the yield curve that cuases a reduction in NII. ALM manager might change the structure of the book to take into account the view on the yield curve. For example, borrowing short-term and lending out long-term is a risk from a yield curve inversion (known as the twist).

Basis Risk

The difference arising from different interest rates from assets (loans) and funding interest rate. For example loans charged at prime rate and funded at libor has basis risk. Prime rate is correlated with Libor but does not change on a daily basis.

Run-Off Risk

A risk that depositors might withdraw funds during rising interest rate environment giving no notice.

Liquidity Risk

Banks need to be able to obtain funding (roll over) when existing funding expires. Liquidity risk is bank not able to refinance their assets as liabities become due.

Banks reserve a significant portion of the assets in liquid form in case they need to liquidate quickly in a crisis. A surplus of assets over liabilities at a specific tenor creates a funding requirement. Likewise, a surplus of liabilities over assets creates a funding surplus and banks need to find use for the extra funds. A bank will a surplus of long-term assets over short-term liabilities will always have an ongoing requirement to fund the assets continuously.

The liquidty gap is the difference in assets and liabilities across each tenor in the term structure. It is risky to concentrate funding in just one tenor bucket and better to spread the funding profile across a number of tenors and avoid period of low liquidity like Christmas and New Year.

The liquidity risk by itself also generates interest rate risk due to the uncertainty of future interest rates.

The Funding Gap

We will illustrate handling the funding gap using two basic examples.

Example 1: Decreasing Funding Gap

Time	\(t_{1}\)	\(t_{2}\)	t_{3}
Assets	970	840	1,250
Liabilities	380	430	1,120
Gap	-590	-410	-130
Borrow 3-periods	130	130	130
Borrow 2-periods	280	280	280
Borrow 1-period	180	0	0
Total Funding	590	410	130

Example 2: Increasing and Decreasing Gap

In the “Borrow 2-period”, there is a forward start loan.

Time	\(t_{1}\)	\(t_{2}\)	t_{3}
Assets	970	840	1,250
Liabilities	720	200	1,200
Gap	-250	-640	-50
Borrow 3-periods	50	50	50
Borrow 2-periods	200	200	0
Borrow 1-period	0	390	0
Total Funding	250	640	50

In general, the bank would ideally increase the gap when interest rates are expected to fall and decrease the gap when interest rates are expected to rise. But this would assume the ALM manager is able to predict the future direction of rates. There must be a tradeoff between risk and return. Also the liquidity of loans have to be taken into consideration and most cannot be liquidated with ease.

Asset-Liability Committee (ALCO)

The Asset-Liability Committee (ALCO) is responsible for managing the bank’s balance sheet taking into account balance sheet risk, regulatory capital requirement and liquidity.

The formulation of interest-rate risk policy is usually done by the ALCO, which is made up of senior management. ALCO is the governance forum responsible for setting the bank policy for balance sheet management and scenario analysis. It is also known as the Blanance Sheet Risk and Management Committee (BRMC), Asset-Liability Policy Committee (ALPC) or Asset, Liability and Capital Management Committee (ALCMCO).

ALCO will normally take review the MI reporting from Treasury during regular monthly meetings. The monthly meeting presentation may include:

Analysis of the difference between previous month actual NII vs forecast from last month
Review the assumptions from last month scenario analysis

The balance sheet is solely the responsibility of ALCO and ensuring the balance sheet is long-term viable. ALCO needs to work with the Executive Committee and have an oversigh role over the Credit Committee.

Most bank failures can be sourced to problems with capital and liquidty managment.

Traditional ALCO

The ALCO is usually comprised of the CEO, heads of the business lines, head of Treasury, and Risk Management. They will discuss:

Management Reporting

Analyze various management reports and signing off and coming to term action items such as lending margin, intereswt income, variance from last projection, etc.

Business Planning

Review existing balance sheet for existing business and discussing future business.

Hedging Policy

Review risk exposure and existing risk limits and the use of hedging instruments. Hedging policy takes into account the overall cost of hedging and that certain exposures may be left unhedged.

ALM Desk

The ALM process is delegated to the Treasury desk. There are three major stages of ALM.

First stage is that the ALM desk does not have a profit target. It is operated as a cost center and look to minimize operating cost. It’s main goal is to hedge interest-rate and liquidity risk.

The next stage is looking to minimize the cost of funding. Core banking activities result in an excess or shortage of funds. Hedging interest-rate eliminates interest rate risk but also eliminates any potential gain from market movement.

The final stage is to turn the ALM desk into a profit centre. This includes optimizing the funding policy. If the ALM desk actively manage interest-rate risk, limits such as gap and VAR limits are set to ensure adequate risk management.

Traditional ALM

We can summarize the role of traditional ALM desk as follows:

Interest-Rate Risk Management

This includes income sensitivity analysis and duration gap analysis. The desk will monitor the interest-rate exposure with the view of the market within the risk limits.

Liquidity and Funding Management

There are regulatory requirements that a proportion of banking assets must be held as short-term instruments.

Setting Up Risk Limits

The ALM desk will set risk limits and ensure it is enforced.

Capital Requirement Reporting

The reporting of capital usage and position limits to regulatory authorities.

Funding

Funding cost refers to the interest cost that is incurred when cash is borrowed to finance other trading assets. Banks are usually structured with a dedicated Treasury department that is responsible for the managing of the cash flow of the business. This include arranging borrowing of cash to fund other trading desks. Those funding costs are then internally charge to the business that generated the funding requirement by lending internally to them.

Strategic ALM

Traditonal ALM is essentially a reactive process. Each of the business lines will have little interaction with Treasury. Treasury which is tasked to manage the balance sheet have little influence in the creation of the balance sheet. For example, the bank would not want to be in a situation where illiquid long-dated assets are mainly funded by wholesale overnight deposits that is treated puntively by Basell III liquidity requirements. In the post Basel III environment, there are benefits to having a more proactive method to manage the balance sheet risk.

3D Optimization Challenge

Balance sheet optimization post Basel III is no longer to maximize return on capital, but to structure the balance sheet to meet the needs of regulators, clients, and shareholders.

Regulator Requirements

Banks must adhere to the capital, liquidity and leverage ratio requirements of the regulator which consists of the Basel III guidelines. An example is the minimum size requirements of HQLA. Generally having more HQLA is a drag on the bank’s balance sheet.

Clients Requirements

The requirements from clients could be not optimum when viewed from a regulator requiement. For example, deposits from large corporate clients carry a greater liquidity cost to banks and accepting these deposits might be unavoidable to retain clients.

Shareholder Requirements (NII Requirements)

Similarly, shareholder requirements might be unoptimal from the other two requirements. For example, from a NII perspective, bank would want to maximize its funding base in NIBLs which carry a higher liquidity cost.

Implementing strategic ALM has to be undertaken from top down and with Board approval. The bank will come up with a Risk Appetite Statement (RAS) from the Board incorporating qualitative and quantitative metrics and limits which is regularly reviewed.

ALM optimization is done by minimizing the objective function which in this case is the cost of funding. If the objective and constraint functions are linear, we can use the method of solving for Linear Programming Problem (LPP). An example would be the simplex algorithm. However, if the functions are not linear, other techniques such as Lagrange mutliplier method and interior-point algorithm are used.

Treasury Operating Model

Capital and Balance Sheet Operating Functions

Capital Management (Strategic Management Functions)

Risk Limits (RWA)
Cost of Capital
Budget Forecasting
Setting Capital Policy
Setting Return Metrics
Define Capital Structure and Ratios
Capital Allocation

Term Liabilities Issuance (Market Facing Functions)

Senior Unsecured Debt
Subordinated Debt
Equity Instruments
Securitization
Secured ABS/MBS
Covered Bonds

Liquidity Operating Functions

Liquidity Risk Management (Strategic Management Functions)

Liquidity Limits
Liquidity Stress Tests
Liquidity Policy
Contingency Funding Plan
LAB Policy
Liquidity Cost Calculation
Funding Strategy
Internal Funds Pricing Policy (FTP)

Money Markets Desk (Market Facing Functions)

Depos, CD/CP (MM)
Repo
Collateral Management
Counterparty Risk Management

NII/NIM Operating Functions

Banking Book Interest-Rate Risk (Strategic Management Functions)

Interest-Rate Risk Management
Interest-Rate Risk Modelling
Forecasting NII/NIM

Swaps and Derivatives Desks (Market Facing Functions)

Banking Book
Trading Book
Market Risk Hedging

Example 1: Encompass Both Market Facing and Policy Functions

Consists of:

Term Liabilities Issuance
Liquidity Risk Management
Money Markets Desk
Banking Book Interest-Rate Risk

Example 2: “Middle Office” Treasury

No market facing function and responsible for policy setting and implementation.

Capital Management
Liquidity Risk Management
Banking Book Interest-Rate Risk
Finance and Risk Managment (Regulatory Reporting)

Example 3: Market Facing Functions but No Cash Managmement

Capital Management
Liquidity Risk Management
Term Liabilities Issuance
Investor Relations

Example 4: Market Facing and Governance Functions

Capital Management
Liquidity Risk Management
Banking Book Interest-Rate Risk
Money Markets Desk
Investory Relations
Finance and Risk Managment (Regulatory Reporting)

Liquidity Management

To undertake banking, it is to assume a continuous ability to roll over funding. Banks need to set in place infrastructure to ensure that liquidity is always available.

Financial crisis are often a result of liquidity crisis. The UK FSA has identified the following failures in the liquidity management for the GFC:

inconsistent reporting to senior management or the regulator
excessive relaince on short-term wholesale funding and securitization market
funding long-dated illiquid assets with short-term wholesale liabilities
excessive reliance on parent banks for funds
lack of a sufficiently diverse funding base

Sound principles to Liquidity Management:

1. Fund illiquid assets with core customer deposits

Custommer deposits are generally more stable than wholesale funds and also at a lower risk of sudden withdrawal unless there is a bank run.

2. Use long-term wholesale funding where possible

When there is insufficient core deposits, try to fund illiquid assets with long-dated wholesale funds (at least a year).

3. No over-reliance on short-term wholesale funding

Perhaps no more than 20% to 30% of the balance sheet should be funded by anything less than 3M.

4. Maintain liquidity buffers of HQLA

Regulators have mandated this under the Basel III guidelines on minimum liquidity buffer size.

Traditionally, a bank’s capital is invested in shorter-dated government bills, but because of the low yield, banks began to extend the portfoio to agency bonds, bank CDs, FRNs, and corporate bonds. The alot of these higher yielding securities became illiquid in a crisis and the only liquid securities are government bills.

5. Establish a liquidity contingency plan

Bank funding should be sourced from multiple sources so as to avoid concentration risk. This may include setting up facilities at the central bank .

6. Beware of liquidity facilities offered to other banks

In a stressed situation, it has to be assumed that facitilies line would be drawn.

7. FTP must be set correctly

An incorrect FTP will result in inapproriate business decision making and incorrect profits.

8. Liquidity risk management policy iw owned by the Group

Policy should be centralized. Individual exceptions must be authorized by the Group Board.

Liquidity Asset Buffer (LAB)

Following Basel III guidance, the minimum size of the LAB is set by the regulator in the form of the Liquidity Coverage Ratio (LCR). Banks have to hold and HQLF portfolio that returns anLCR value of at least 100%.

Maintaining an LAB is like levying a tax on the business as it takes up space on the balance sheet that would otherwise be holding higher paying assets. The cost of the LAB can be calculated as a sum o fthe funding cost of the business porftfolio and the opportunity cost of holding lower yielding risk-free assets.

The businesses that generate the greatest need for liquidity protection (large asset-liability gaps that is funded by shot-term wholesale funds) will pay the larger share of the LAB.

References

Choudhry, M. (2022), The Principles of Banking

Asset Liability Management (ALM)

Contents:

Funds Transfer Pricing (FTP)