1 / 40

CHAPTER 8

CHAPTER 8. RISK MANAGEMENT: ASSET-LIABILITY MANAGEMENT (ALM) AND INTEREST-RATE RISK. LEARNING OBJECTIVES. TO UNDERSTAND… Risk management as driven by the R in TRICK – risk exposure

collin
Download Presentation

CHAPTER 8

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. CHAPTER 8 • RISK MANAGEMENT: ASSET-LIABILITY MANAGEMENT (ALM) AND INTEREST-RATE RISK Chapter 8

  2. LEARNING OBJECTIVES TO UNDERSTAND… • Risk management as driven by the R in TRICK – risk exposure • Asset-liability management (ALM) as the coordinated management of a bank’s on- and off-balance sheet activities driven by interest-rate risk and its two components: price risk and reinvestment risk • Accounting and economic measures of ALM performance Chapter 8

  3. LEARNING OBJECTIVES (continued) TO UNDERSTAND… • The duration or maturity imbalance (“gap”) in banks’ balance sheets in terms of rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSLs) • ALM risk profiles as pictures of banks’ exposure to interest-rate risk and how to hedge that risk using on- and off-balance sheet methods Chapter 8

  4. CHAPTER THEME • The business of banking involves the measuring, managing, and accepting of risk • This chapter focuses on asset-liability management (ALM) and interest-rate risk • ALM is the coordinated management of a bank’s balance sheet to take account of alternative interest-rate, liquidity, and prepayment scenarios Chapter 8

  5. Asset-Liability Management (ALM) Three techniques of ALM: • On-balance sheet matching of the repricing of assets and liabilities • Off-balance sheet hedging of on-balance sheet risks, and • Securitization, which removes risk from the balance sheet Chapter 8

  6. R in Trick – Risk Exposure • Risk Exposure calls for Risk Management • Basic Exposures Banks Face Arise From: • Credit Risk • Interest-rate Risk • Liquidity Risk Chapter 8

  7. ALM As Coordinated Balance-Sheet Financial Management Three Stage Approach: • Stage I – Reflects a global or general approach that focuses on the coordinated management of a bank’s assets, liabilities, capital, and off-balance sheet activities • Stage II – Identifies specific components of a bank’s balance sheet used in coordinating its overall portfolio management • Stage III – Shows that, given interest rate and prices, a bank’s balance sheet generates its income-expense statement and free cash flow Chapter 8

  8. Balance Sheet Generates the Income-Expense Statement • Policies to achieve objectives: • 1. Spread management • 2. Loan quality • 3. Generating fee income and service charges • 4. Control of noninterest operating expenses • 5. Tax management • 6. Capital adequacy • 7. Hedging practices Chapter 8

  9. Rate Sensitivity • An important distinction should be made between assets and liabilities that are rate sensitive and those that are not (RSA, RSL) • Sensitivity can be described in terms of the effective time to repricing or duration • Reserves and other liquid assets reprice quickly while long-term, fixed-rate securities and loans do not; since most deposits are short term, they reprice quickly Chapter 8

  10. Liability-Management (LM)Aspect of ALM Two Functions: • Reserve-Position LM • Generalized or Loan-Position LM Chapter 8

  11. Target Net Interest Income (NII) • Minimization of the variability of NII • Most critical determinant of a bank’s profitability is credit risk. Viewed in terms of a bank’s risk index (RI): RI = [E(ROA) + CAP]/sROA Chapter 8

  12. Net Interest Margin (NIM) • NIM can be viewed as the “spread” on earning assets, hence the term “spread management” and “spread model” NIM = Net Interest Income/Average Total Assets Where NII = Interest Income – Interest Expense Chapter 8

  13. Why Does NIM Vary InverselyWith Bank Size? • Competitiveness of the loan-and-deposit markets are a major factor • Differences in the volumes, mixes, and pricing (interest rates) of the balance sheet • Banks with more variable-rate loans will experience greater fluctuations in interest revenue Chapter 8

  14. Variability of NIM Versus ROA • Time period: 1985-2000 NIMROA • Mean 3.64% 0.88% • S.D. 0.18% 0.38% • CV 0.05 0.43 Chapter 8

  15. Effects of Interest- Rate Risk on Loans • Effects on the Loan Portfolio • Interest Rates (Up) • Adverse Price Effect • Favorable Reinvestment Effect • Interest Rates (Down) • Favorable Price Effect • Adverse Reinvestment Effect Old Loans Worth Less New Loans Worth More Old Loans Worth More New Loans Worth Less Chapter 8

  16. Effects of Interest- Rate Risk on Deposits • Effects on Deposits • Interest Rates (Up) • Early Withdrawal (Depositors Seek Higher Rates) • Banks Must Attract New Depositors at Higher Rate or Face Liquidity Problems • Interest Rates (Down) • Loan Prepayments Due to Refinancing • Banks Must Issue New Loans at Lower Rates or Face Shrinking Balance Sheet Chapter 8

  17. Risk Profiles and Embedded Options • Loan contracts: When interest rates decline, borrowers tend to refinance – prepayment risk • Deposit contracts: When interest rates rise, lenders might be willing to take penalties for early withdrawal – liquidity risk • See Figure 8-1, p. 225 Chapter 8

  18. Two Faces of ALM: Accounting and Economic Perspectives • The accounting model focuses on NII and NIM vis-à-vis measures of maturity gap • The focal variable of the economic model is a bank’s market value of equity (MVE) Chapter 8

  19. Relationship Between Change in Interest Rate and Change in NII ΔNII = Δr[GAP]= Δr[RSA-RSL] • GAP is the difference between rate-sensitive assets (RSA) and rate-sensitive liabilities (RSL). • When RSA – RSL > 0, bank has positive maturity gap • When RSA – RSL < 0, bank has negative maturity gap Chapter 8

  20. General Illustration of the Accounting Model Δr + GAP=[RSA-RSL] = ΔNII Pos + Neg = Neg Pos + Pos = Pos Neg + Pos = Neg Neg + Neg = Pos Chapter 8

  21. The Economic Model and a Bank’s MVE • Table 8-4, p. 229 • MVE reduced to 1.8 = 10 – 8.2 • The duration approach approximates this change at –8.5, that is, • [89.4(-4.17) – 87.6(-1)]0.03 = -8.5 • The next slide explains duration Chapter 8

  22. Duration (Box 8-2, p. 230) • Duration can be viewed as the “effective time to repricing”. • Take the difference between the market value of assets and the market value of liabilities with each component weighted by its respective duration multiplied by change in interest rate: ΔV ≈ [PV(A)x(-DA) ΔrA-[PV(L)x(-DL)] ΔrL Chapter 8

  23. Variable-Rate Pricing as an ALM Tool • If the loan reprices annually, then the bank has a built-in hedge against rates rising • The hedge, however, is not perfect as MVE is not immunized • To achieve this a solvent bank must be slightly asset sensitive Chapter 8

  24. Determinants of the Change in MVE (see eqn 8.4b, p. 232) • Duration gap adjusted for leverage – the first term below • Scale (size) of a bank’s operations – the second term • Magnitude of the change in interest rates – the third term • ΔV ~ -[DA - λDL][A][Δr/(1+r)] Chapter 8

  25. The Tactical Versus the Strategic Bank and Yield Curves • See Box 8-3 (p. 233), Figures 8-2 (p. 234) and 8-3 (p. 235), and Table 8-5 (p. 236) • Exploit a positively shaped yield curve by borrowing short and lending longer, but not too long – avoid the old S&L problem • Tactical Bank (LRBA) + Strategic Bank (ARBL) = Overall Bank (ARBL) Chapter 8

  26. Interest-Rate Derivatives (IRDs) • Off-Balance sheet activities (OBSAs) that ALM managers use for hedging or trading. • Includes forwards, futures, options, and swaps. • Four or five of the largest banks/BHCs dominate the IRD market. Chapter 8

  27. Examples of Interest-Rate Derivatives • Interest-rate swap (“plain vanilla”) • Interest-rate futures • Interest-rate cap • Interest-rate floor • Interest-rate collar • See Glossary in Box 8-4, p. 238 Chapter 8

  28. Citigroup’s IRDs(30 September 2000) • TypeNotional value ($ mils) • Swaps 3,655,151 • Forwards 926,933 • OTC Options 538,634 • Futures 285,765 • Exchange options 37,754 • Total 5,444,237 • Net Fair Value: 306 • Ratio of Notional to Fair Value: 17,792 to 1 Chapter 8

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

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

  31. RISK PROFILES AND HEDGING • A LRBA bank has a negatively sloped risk profile • An ARBL bank has a positively sloped risk profile • Hedging profiles depend on the type of contract. Futures, forwards, and swaps are “linear” while options (caps, floors, collars) are “nonlinear” Chapter 8

  32. Micro and Macro Hedges • Macro => hedge the balance sheet’s MVE • Micro => hedge a particular transaction • Examples of micro hedges (pp. 242-243) • 1. Convert a fixed-rate loan to floating • 2. Convert a floating-rate loan to fixed • 3. Convert a fixed-rate deposit to floating • 4. Convert a floating-rate deposit to fixed Chapter 8

  33. Swaps: Comparative Advantage and Arbitrage Potential • Analyze the following situations: • 1. AAABBB 10% fixed 12% fixed LIBOR + 0.1% LIBOR + 1% • 2. LICBank Asset T-bill+1% (6mos.) 8% (fixed,5yrs) Liability 7% (GIC,5yrs) T-bill+0.25% (6 mos. CD) • Construct swaps for both situations (pp. 244-245) and assume A, L = $50 million Chapter 8

  34. Caps, Floors, and Collars • See Figures 8-7, 8-8, 8-9 (pp. 246-248) • Buy cap + sell floor = collar (Fig. 8-7) • Buy floor + sell cap = collar (Fig. 8-9) • The use of collars by LRBA and ARBL banks Chapter 8

  35. Asset Securitization • Technique for managing interest-rate risk by removing risky assets from the balance sheet. • Pass-through finance – banks either • (1) originates and sells loans or • (2) originates, sells, and services loans Chapter 8

  36. Building Blocks of ALM Four key building blocks of ALM: • Measurement of dollar gaps based on maturity buckets (0-90 days, 91-180 days, etc.) to determine the amount of assets and liabilities being repriced; • Estimating the interest rate at which these funds will be repriced; • Projecting future interest income and interest expense (rate x volume); • Exploring alternative interest-rate scenarios to estimate the bank’s downside vulnerability. Chapter 8

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

  38. Modern Risk Management • Key actions of bank risk management can be highlighted by five action verbs: identify, measure, price, monitor, and control. • Two important concepts: • Value-at risk (VAR) – A comprehensive measure of risk. • Capital-at-risk (KAR) – KAR tolerance level captures the default probability of the bank in terms of its insolvency risk or risk of ruin. Chapter 8

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

  40. CHAPTER SUMMARY • Risk management is the heart of bank financial management and ALM is one of the most important risk-management functions in a bank • ALM techniques include • 1. Maturity or duration matching of on-balance sheet items • 2. Off-balance sheet hedging using IRDs • 3. Securitization Chapter 8

More Related