Asset & Liability Management

1. Asset & Liability Management Introduction

2. What is ALM about ? • Liquidity • Interest rate risk (in the main portfolio, not in trading books) • Balance sheet management

3. Balance Sheet Management • Capital • Funding • Bond issues • Deposit pricing • Portfolio Composition • Securitisation • Credit concentrations and their solution

4. ALM, business units, and relevant issues

5. Why do we need ALM ? • Maturity Transformation (banks borrow short and lend long) • Bank portfolios generate interest rate risk • Capital needs to be allocated and managed • Portfolio imbalances (eg. All retail deposits from one country)

6. Organising ALMACThe Asset and Liability Management Committee

7. The Balance Sheet, The Regulator and Bank Capital

8. Capital Adequacy Requirements • Capital Must Exceed 8% of Risk-Weighted Assets • Risk Weighted Assets calculated by applying factors (Risk Weights) to on & off-balance sheet items

9. Risk Weights

10. Examples of Capital Adequacy Calculation Example 1 Asset = $100M GECC Bond Risk Weight = 100% Capital Required = 8% x 100% x $100M = $8M Example 2 Asset = $100M Deutsche Bank Bond Risk Weight = 20% Capital Required = 8% x 20% x $100M = $1.6M

11. Other Developments • BIS 1996 • Capital required for market risk • BIS 2000+ • Three New Approaches to Credit Risk • Capital needed for liquidity risk, operational risk etc.

12. Three Approaches Approaches Internal Standardised Credit - Risk Ratings - based Approach Modelling Approaches

13. Tiers of Capital • Tier 1 • Shareholders funds • Can be used to support trading and banking • Tier 2 • Perpetual, medium, long-term subordinated debt, general provisions, fixed asset revaluation reserves • Can be used to support trading and banking

14. Tiers of Capital (Continued) • Tier 3 • Short-term Subordinated Debt • Can be used to support trading activities • Aggregate Rule • Tier 2 + Tier 3 can only be used up to the level of Tier 1

15. Regulatory vs Economic • Economic capital is not the same as regulatory capital • Regulatory calculation basically flawed • Economic capital should be used for return on capital calculations

16. ALM Decisions and Capital Concerns • Portfolio Composition • Interest Rate (and other market risks) • Long-term funding

17. Liquidity Risk • Measurement and Management

18. Liquidity Risk Measurement • Measurement • Construct a maturity ladder, and net funding requirement. • Assumptions on maturity are needed • Maturities can be contractual or expected or worst-case.

19. Assumptions for an Expected Mismatch • Likely maturity of retail deposits • Drawdowns of committed facilities • Seasonality • Discount to be applied to marketable securities

20. A Maturity Ladder Expected Maturity

21. Net Funding RequirementExpected Maturity

22. A Liquidity Ladder Contractual Maturity

23. Liquidity Management • Tools of Liquidity Management • Standby Facilities • Marketable Securities • Can be used as collateral for loans through repos etc. • In the last resort …… • Central Bank facilities

24. Funding RequirementContractual Maturity

25. Types of Interest Rate Risk • Repricing Risk • Exposure to changes in the absolute level of interest rates • Yield Curve Risk • Basis Risk • Optionality

26. Interest Rate Risk • Classification and Measurement

27. Parallel Shift

28. Steepening

29. Effects of Interest Rate Risk • Net Interest Income may fall • Net Asset Value (Portfolio) Value may fall

30. Measurement Techniques • Bucket and Gap analysis • Duration • Price Value of a Basis Point • Large Exposure Reporting

31. Measurement Techniques • More Advanced Techniques • VaR and Related Techniques • Monte Carlo Simulation • Historical Simulation • Dynamic Simulation including strategy and business changes

32. Interest Rate Derivatives

33. Interest Rate Derivatives • Interest rate swaps • FRAs • Eurodollar futures • Overnight Index Swaps • Caps & Floors • IROs

34. Interest Rate Swap Bank Swap Provider LIBOR Fixed Rate

35. Exposure Currency swap Interest rate swap Time Credit Exposure Profiles for Interest Rate and Currency Swaps

36. Balance Sheet Management • Long-Term Funding

37. Long Term Funding - The Key Issues • Currency, Amount, Maturity • Investor concerns: Market Access • Hedging: Hidden costs of credit and capital • MIS

38. A Typical Long-Term Funding Process Appoint Lead Manager: Advises on Timing, Swaps, Documentation Set target, maturity, required currency Assess Proposals Appoint Paying Agent, Get tax advice, listing Sale to Investors Syndication

39. Standard Market Interest Rate Swap Issuer Swap Provider LIBOR 4.90%

40. Interest Rate Swap for a New Issue LIBOR - 12.5BP • 5 Year Issue • 4.75% Coupon • Issue Price 100.00 • Fees 0.1% Issuer Swap Provider 4.75% Fees

41. Sterling Principal Start Issuer Swap Provider Euro Principal Sterling Interest Interest Exchange Issuer Swap Provider Euro Interest Euro Principal Issuer Swap Provider Maturity Sterling Principal Currency Swaps

42. Balance Sheet Management • Securitisation

43. Securitisation : Key Issues • Vehicle must be bankruptcy remote • Must be off balance sheet • Credit Enhancement

44. Securitisation Examples • Mortgage pass-throughs & CMOs • Credit Card Receivables • Collateralised Loan Obligations

45. Credit Enhancement • Overcollateralisation • Tranching • Reserves • Credit Insurance

46. Mortgage Pass-through Mortgages Originator SPV Cash Cash Securities Investor

47. Cashflow Details Credit Support Mortgagor Note Holder SPV Principal Plus Interest Mortgage payments less servicing fee Note Holder Servicer Mortgage Payments Collects payments

48. Tranching Principal Cashflows Time Medium Pay Fast Pay Slow Pay Tranche B Tranche C Tranche A

49. Credit Derivatives • Basic Instruments and Issues

50. Types of Credit Derivative • Credit Default Swaps & Options • Total Rate of Return Swaps • Credit-Linked Notes • Various Spread Products