| Asset liability management - rewarding risky business |
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| Successfully controlling liquidity risk and interest risk is key to a bank's survival and profitability. NIALL CUDDIHY discusses the importance of asset and liability management (ALM), describes its mechanics and demonstrates how traders assimilate information from the capital markets to leverage a bank's cash position. |
Banking is essentially the business of risk management. Whereas credit risk is key, liquidity risk and interest rate risk are also extremely important for any bank. These risks are not only managed through asset and liability management (ALM), but used as a source of profit for the bank. | | Niall Cuddihy |
In managing the bank's assets and liabilities in light of uncertainties in cash flows, cost of funds and return on investments, a bank must determine its optimal trade-off between risk, return and liquidity. In simple terms, when a bank lends to its customers, the bank funds the loan by borrowing from banks, corporates, and financial institutions. The maturity of the bank's loan is synchronized with the customer's loan so that funds from the borrower arrive just in time for the lender to meet its obligations at maturity (This is the case where the bank runs a matched book, without employing gapping techniques). This is commonly known as asset and liability management.
All of these activities result in concentration of liquidity and interest rate risk in a bank's book. Bankers have been managing these risks since the evolution of banking. It is only in the recent past that the complexities of liquidity and interest rate risk management have increased. Several factors have led to this increased complexity, most notably the increased sophistication of banking products, the volatility of financial markets and the increased complexity of both accounting and legal regulations.
Corporate lending portfolios are far more complex in an ALM context. Lenders offer credit lines with significant uncertainty as to what proportion of customers will actually accept the offer (i.e. most corporates have multiple offers from various banks) and to what extent and at what speed customers will utilize the credit lines that are offered. Add to this the uncertainty of repayment profiles, variations in credit quality, and the fact that customer demand can drive funding requirements up very quickly - literally in days (M&A is a typical example) - and at any point after the credit line is granted, and the funding dilemma is clear.
Interest rate risk and liquidity risk are significant risks in a bank's balance sheet, and it is vital that the bank's ALM department monitors and manages them in a proactive and comprehensive manner. In effect, the ALM department hedges the bank's interest rate risk and therefore has control over the following:
* The risk and liquidity profile of the bank's asset/liability mix
* The volatility of its margin
* The bank's profitability
Liquidity risk
This funding tightrope that banks continually walk is impacted by the seasonality of companies funding requirements as well as month/year end and reporting dates. This balancing act has a direct effect on the pricing of ALM's financial products. An example would be funding the banks assets, because a lot of corporate treasury departments have irregular cash flows and like to keep their cash very liquid. This means placing deposits in the overnight and one week. Banks are left with the job of continually funding large overnight positions.
Therefore, liquidity risk management has increasingly become a challenge. Liquidity risk is related to bank's ability to pay its depositors as maturities fall due. However, a bank's inability to pay its depositors is the ultimate manifestation of liquidity risk. Liquidity risk, at initial stages, may lead to distress pricing of assets and liabilities. A bank with high degree of liquidity risk may be forced to borrow funds from the inter-bank market at exorbitant rates and/or to increase its deposit rates. As the bank may not be able to transfer these increased costs to borrowers, its net interest income is affected. Furthermore, as the bank's cost of funds goes up, increasingly it looks for risky avenues to increase its earnings. The process may lead to poor selection of borrowers as well as venturing into riskier areas that will increase the overall risk profile of the bank.
While funding the banks overnight positions, ALM will take into account the yield curve. With a positive yield curve, it suits to fund the long-term assets with short-term liabilities. However we sometimes have a negative or even a flat yield curve. Typically, a bank positions its assets and liabilities into a funding book but they also have a trading book. Interest rate movements cause price changes in the trading and funding book. While the trading book uses off-balance sheet instruments such as interest rate swaps, interest rate futures and forward rate agreements to take positions in the market, they are usually held on a short-term basis to exploit anticipated price movements and are marked to market. However, the funding book's (on balance sheet) assets and liabilities provide accrual income to a bank.
Gapping
The funding book focuses on gapping, or 'mismatch risk', arising from holding assets and liabilities with different principle amounts and maturity dates thereby creating exposure to unexpected changes in the level of market interest rates. As seen in Table 1, we have the EUR 12 month gapping exposure for Bank ABC. In the period 0-1 month there is a net asset (short) position of -1.5 b.illion. In a rising rate scenario earnings will increase as a result of this asset position. However, the reverse will occur in a falling interest rate scenario. This demonstrates the relationship between a bank's net interest income, periodic gapping exposure and the direction of interest rate movements. Therefore a bank may strategically position its gaps to anticipate interest rate movements, thus increasing its net income.
However, the gap management might be hampered by the objectives of the customers. In rising interest rate scenarios gap management recommends shifting out of fixed rate assets to floating rate assets. The customers may however demand fixed rate assets. Additionally, such adjustments in assets/liabilities may have to be accomplished at the cost of trading off lower interest rate risk for greater credit and default risk.
A bank's approach to its funding requirement will therefore have a direct effect on its pricing. Many banks are willing to forgo a margin and quote their rates flat for short-dated cash. Many banks fund their position from the interbank market (i.e. other banks). However banks who wish to optimise their liquidity will usually seek to obtain most of their funding from their commercial customers. This may require the payment of a small premium (i.e. two basis points). This is effectively an insurance premium to insure the bank against any liquidity crisis as corporate cash is more 'sticky' than interbank cash. This constant need for turnover or volume results in some banks focusing more on volumes at the expense of margins or profits.
ALM involves viewing the balance sheet as a complex interest rate arbitrage where funds are obtained from many sources at various interest rates and employed in a wide variety of assets at rates high enough to cover the interest paid on the liabilities and the operating expenses and most importantly to produce a profit. By not meeting its appetite for cash at the right price, the bank can sustain losses and in a worst case scenario a bank that gets its asset and liability management wrong may fail. |
Niall Cuddihy is a senior dealer in treasury ALM at BNP Paribas, Dublin.
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