ALM Materials Eng

8/3/2019 ALM Materials Eng

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Funds Management

for

Financial Institutions

February 8-10, 2006


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Welcome

1. Introduction

2. Overview of Risk and Risk Management

3. ALM Overview

4. Funds (Liquidity risk) Management

5. IRR Management

6. FX Risk Management

7. Credit Risk Management

8. Summary and Review


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1. Workshop Introduction


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Sarah W. Hargrove

Native of North Carolina

Wharton MBA, CFA

Thirty years of experience in investment and commercialbanking in NY, NC and PA

Top bank regulator in Commonwealth of PA with supervision

of banks, savings institutions, licensed lenders,pawnbrokers..aggregate assets of USD 90 billion

Consulting for past 10 years in emerging markets (Russia andother CIS, Thailand, Turkey, China, Jordan) ranging frombank appraisals, bank supervision and bank technicalassistance

Special expertise in bank supervision, bank valuation, risk

management and corporate governance


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Objectives of Workshop

To understand the role of ALM and itsrelationship to strategic and annual profit

planning To be able to define and measure different

risks involved in financial intermediation

To understand how ALM decisions affectchanges in net interest margin, ROA and ROE

To be able to design ALM strategies indifferent interest rate environments

To understand the role of capital in ALM

decisions


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There are some administrative matters toreview

Hours 9:00 am 5:00 pm

Breaks: 10:30 am 10:45 am

12:00 pm 1:00 pm

3:00 pm 3:15 pm Summary and feedback at end of each session

No cell phones!


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We will first review some basic principlesof risk and risk management

Definition of risk and risk/reward trade-off

Purpose of capital and role of risk

management

The road to Basel 2

Major risks faced by financial institutions Credit risk

Market risk

Operational risk

RAROC/RORAC principles


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We will then look at an overview of AssetLiability Management

Management of non-credit financial risks

Objectives of ALM Framework for ALM decision-making

Determining risk appetite

Business strategies in different interest rateenvironments


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We will review funds management

Tools of funds management

Application of tools

Asset liquidity vs liability liquidity

Determination of minimum liquidity needs


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We will then examine how gap analysis isused to measure and manage IRR

Periodic and cumulative gaps

Static and dynamic gaps

Data needed for a gap report

Steps in preparation of a gap report


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We will look at another aspect of ALM: FXrisk management

Definition of FX risk

Identification of FX risk: Long vs shortpositions

Measurement of FX risk

Management of FX risk


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We will look at risk valuation methods

Value at risk and earnings at risk

Inverse relationship

Capital Asset Pricing Model

Systematic vs diversifiable risk Standard deviation

Correlation and covariance


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We will look at credit risk valuationmethods

Individual vs Portfolio risk

Default factors

Marginal risk

Expected loss Probability of default

Loss given default

Exposure at default

Unexpected loss


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We will then apply the risk managementprinciples to business planning

Sensitivity analysis

Flexible budget allocation

Volatility of earnings and EVE

Application of Models Dangers of Models

Limitations of Models


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The last day will be devoted to review

Putting it all together with case study

Final review


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2. Overview of Risk and RiskManagement

Fi i l i tit ti i t di t it l


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Financial institutions intermediate capitalflows between savers and borrowers

Sources of Funds

(Surplus accounts orSavings)

Users of Funds

(Deficit accounts orBorrowings)

Fi i l i tit ti i k i th


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Financial institutions assume risks in theintermediation process

Economic Sectors Intermediaries

Assets Liabilities

Insurance Companies

Pension Funds

Businesses

Governments

Households

Banks, Savings Assoc.,Investment Banks,Leasing Cos.

Stock Exchange

Other markets

Liabilities Assets

Certain principles rule financial


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Certain principles rule financialintermediation in free markets

Supply and demand Interest rate as the clearing price

Opportunity cost of consumption/investment

Rational investors Risk averse

Maximize return/Minimize risk

Efficient markets Allocation of resources

Information impounded in prices Competition

Economies of scale

Accumulation/protection of capital is the


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Accumulation/protection of capital is thegoal of risk taking and risk management

Capital represents net assets or shareholderownership

Capital serves to absorb losses

Operating or financial losses

Protects other creditors

Permits growth

Equity is the most costly source of capital


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What is risk?

The concept of financial risk underlies modern portfoliotheory with roots in capital market and investment

theory

Risk aversion

Risk premiums

Historical and expected returns

Probability distributions

Variance and standard deviation

Systematic vs diversifiable risk

P i d i k i b d hi t i l


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Perceived risk is based on historical orexpected volatility

020

40

6080

100

120

140

160

1 2 3 4 5 6 7 8 9 10

Series1

Series2


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What is return?

Cash flows

Net income

Dividends

Capital appreciation/gains

Time value

of money

PV = Cn=o-t (1+r)n

FV = C (1+r) nn=o-t

Th hi h th i k th hi h th


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The higher the risk, the higher therequired rate of return

Required rate of return determines the price

Current income stream

Capital appreciation

Based on perceived risk The greater the historical volatility the greater

the risk

The greater the uncertainty the greater the

risk The longer the horizon the greater the risk

Ri k i i d b th di t t


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Risk is priced by the discount rate:absolute and relative

Rate of Return

RiskPremium

Risk FreeRate

MV=PV = C + TVt=0-n (1+r)t (1+r)t

Treasury Bonds

First Mortgage Bonds

2nd Mortgage BondsSubordinated Debentures

Income Bonds

Preferred Stock

Conv. PreferredCommon Stock

AAA

AAA

BBB

BBB

CCC

Level of Risk

There is risk reward trade off inherent in


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There is risk-reward trade-off inherent infinancial intermediation

Short-term vs longer-term Liquidity

Floating vs fixed rates

Credit

Leverage

Risk is theuncertainty or thestandard deviationof probable returns

H h i l d b k d?


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How much capital does a bank need?

Enoughbut not too much.


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What is enoughcapital?

Capital protects depositors and other creditors

Safety and soundness

Supports growth

Is a buffer against losses

Can be in the form of non-equity

Equity capital represents owners interestsLast creditors to be paid in liquidation

Requires a return in cash income and appreciation

Retained earnings are a good source of capital


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What is too muchcapital?

Capital is a non-interest bearing source of funds

Equity capital is the most expensivesource offunds

Must earn a required rate of return (ROE)

Is a scarce resource

Managements goal is to maximize risk-adjustedreturns

Rational investor theory

Competes with risk-free rate and alternativeinvestments

Affects pricing and competitive position if too much

Bank management must satisfy different


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Bank management must satisfy differentstakeholders with different objectives

Owners

Regulators/Rating Agencies Employees

Return

Pricing

Safety andSoundness

Compensation

Customers

Capital adequacy is in the eyes of the


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Capital adequacy is in the eyes of thebeholder

Focus is historical cost ofassets and recognition ofimpairment (fair value)

Focus is historical cost ofassets and recognition ofimpairment (fair value)

Accounting capital

Market capital

Economic capital

Regulatory capital

Focus is income, the

markets expectationsand required return

Focus is income, themarkets expectationsand required return

Focus is market value(PV of cash flows) ofassets/liabilities

Focus is market value

(PV of cash flows) ofassets/liabilities

Focus is balance sheetand income risk and

capital components

Focus is balance sheetand income risk and

capital components

BIS II attempts a more precise calibration of economic andregulatory capital

In a perfect market the different capital


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In a perfect market the different capitaldefinitions would theoretically be equal

Book values represent present values of futurecash flows discounted at current required rates of

return

Market values of capital stock reflect net presentvalues

Economic capital is the same as net book value

Regulatory capital would be a realizable value of

assets in excess of liabilities

But financial markets are neither perfect


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But financial markets are neither perfectnor efficient

Different expectations

Abnormal profits Asymmetrical and imperfect information

Information not instantaneously impounded inprices

Transactions costs

Etc.

Banking regulation has historically


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Banking regulation has historicallyprotected the industry from undue risks

Restricted licenses

Geographical limitations

Interest rate ceilings

Product line uniqueness

Limited competition

Lets look at how regulation has evolved as theseprotections eroded and market structures changed

World-wide trends have changed the nature


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World wide trends have changed the natureof banking

Deregulation and liberalization of markets

Globalization and interdependence of markets Technological advances

Product innovation and increased complexity Increased size and speed of financial transactions

Increased competition

Increased volatility and risk

Bank regulatory trends have followed


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Bank regulatory trends have followed but with a lag

Prim

aryca

pital

reg

ula

tion

Risk-b

ased

Capit

al

Reg

ulatory

/ac

coun

ting

stan

dards

conve

rgen

ce

Risk

man

agem

entvs.

ris

kav

oid

ance

Inte

rest

ratean

d

marke

tdereg

ulati

on

New rules follow every financial crash, almostalways with unintended consequences.

Economist, October 5, 2002

The introduction of primary capital led to


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unintended consequences

Reduction in liquid assets

Gains trading to create capital

Explosion of off-balance sheet items

Overcapitalized banks and disintermediation

Undercapitalized banks in emerging markets

Unfair competition

Inte

rest

rate

and

marke

t

dereg

ula

tion

Primary

capit

al

regula

tion

Different capital requirements allowedb k i k h


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some banks to gain market share

Japanese Bank US Bank

Loan USD 100 million USD 100 million

Net interest margin .6% 1.25%

Income USD 600,000 USD 1,250,000

Capital 2% 6%

USD 2 million USD 6 million

ROE 30% 20.8%

The 1988 BIS Capital Accord created


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an international level playing field

Harmonized capital standards with risk-based capital

Addressed off-balance sheet assets

Distinguished among riskiness of different assetclasses

Applied to large, internationally active banks

Risk-b

ased

Capit

al

Inte

rest

rate

and

marke

t

dereg

ula

tion

Primary

capit

al

regula

tion

Regulation of capital has become the


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primary tool to limit bank risk-taking

Tier I: Shareholders equity (Paid-in capital and R/E)

Tier II: Supplementary capital

Tier III: Add on capital to support market risk only

Risk-b

ased

Capit

al

Interest

ratean

d

market

dereg

ula

tion

Prim

aryca

pit

al

reg

ula

tion

Since 1988, other banking standards


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ghave converged with capital standards

Core Principles of Effective Supervision (1995)

Amendments .to Incorporate Market Risk (1996,1998)

Principles for the Management of Interest Rate Risk (1997) Framework for Internal Control Systems (1998)

Guidelines for Corporate Governance (2000)

Principles for Internal Audit (2001)

BIS II

Primary

capit

al

regula

tion

Risk-bas

ed

Capital

Inte

rest

rate

and

marke

t

dereg

ulatio

n

Reg

ula

tory/

acco

unting

stan

dards

conve

rgen

ce

BIS II permits banks to customize


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capital adequacy assessment

New guidelines intend to align regulatory capitalrequirements more closely with underlying risk

Emphasis is on banks risk management andeconomic capital allocations

There is flexibility in assessing capital adequacy:standardized vs. IRB approaches

Primary

capit

al

regula

tion

Risk-ba

sed

Capital

Risk

man

ageme

nt

vs.

Risk

avoid

ance

Inte

restra

teand

marke

t

dereg

ulati

on

Reg

ulato

ry/

acco

untin

g

stan

dards

conve

rgen

ce

Capital adequacy should be a function of a


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banks mission, strategy and risk tolerance

Mission

Bank Strategy

Capital AllocationPricing

Business Plans for PriorityBusiness Segments

Target Customers, Products/Services Objectives and Business / Financial Plans

Support Infrastructure

Performance ManagementFunding and Liquidity

Capital should be set to meet a banks


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target credit rating

S & P RATING MOODYSEQUIVALENT

DEFAULT PROBABILITY(SUBSEQUENT YEAR)

AAA Aaa 0.01%

AA Aa3/A1 0.03%

A As/A3 0.10%

BBB Baa2 0.30%

BB Ba1/Ba2 0.81%

B Ba3/B1 2.21%

CCC B2/B3 6.00%

CC B3/Caa 11.68%

C Caa/Ca 16.29%

The higher the rating the more unexpected lossesthat need to be covered by capital

Capital must be allocated to cover major


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risks to the appropriate confidence level

Credit Risk Standardized Approach IRB Approach

Foundation Advanced

Market Risk Standardized Approach Internal Models Approach

Operational Risk Basic Indicator Approach Standardized Approach Internal Measurement Approach

Minimum

8% of Capital toRisk-WeightedAssets

Capital adequacy is a function of threeill


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pillars

Mutuallyreinforcingfactors that

determine capitaladequacy

Pillar 3: Market Discipline Formal disclosure policy Describe risk profile, capital levels, risk

management process and capitaladequacy

Pillar 1: Minimum Capital Internal capital assessment process

and control environment

Capital f (how sound the process is)

Pillar 2: Supervisory Review

Review assessment process Evaluate IRR in banking book

Ultimately the financial market is theh h t l t


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harshest regulator

Market Discipline

Quantitative Requirement Qualitative Requirement

Public Disclosure

Minimum CapitalRequirement

SupervisoryReview Process

Many players

Self interested,rational

Independent

Real time

Many players Self interested,

rational

Independent

Real time

The level of capital required is a function ofth lit f i f ti


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the quality of information

The less the history, the less reliable the data

The less certain or transparent, the greater the risk

The more the risk, the more capital needed

All the above implies higher capital levels for somebanks in less mature markets

BIS II guidelines are guidelines only b t h b b t ti


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but have become best practice

The quality of bank management,

particularly the risk management

process, is the key concern inensuring the safety and stability of

both individual banks and the system

as a whole.

The purpose of capital is to absorbt d l d t th


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unexpected losses and support growth

Capital is not a substitute for inadequateCapital is not a substitute for inadequate

control or for risk managementcontrol or for risk management

processes.processes.- Bank for International Settlements

Assumption of risk is the raison detreof banking


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of banking

Banks make money by assuming risk

Banks lose money by not managing risk or

by not getting paid for the risk assumed

Banks manage what they measure

A formalized risk managementframework is best practice


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framework is best practice

Risk Management is the deliberateacceptance of risk for profit makinginformed decisionson the trade-offs betweenrisk and reward and using various financialand other tools to maximize risk-adjusted

returns within pre-established limits.

A Risk Management frameworkfacilitates informed decision-making


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g

Identify

Measure

Manage

Monitor

Risk Management is now basic tofinancial management


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g

The nature of Risk Management in banks is changingfundamentally. Until recently, it has been an exercise

in damage limitation. Now it is becoming animportant weapon in the competitive strugglebetween financial institutions.

Those who can manage and control their risks best

will be the most profitable, lowest priced producers.Those who misjudge or mis-price will be out on theirear.

The Risk GameThe Economist, Survey ofInternational Banking (1996)

Risk management permits the optimizationof the risk-reward trade-offs


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of the risk-reward trade-offs

The primary objective is to minimize the

volatility of earnings and capital (hence therisk as perceived by investors) and at thesame time earn a ROE to maintain the value

of the common equity.

Different risks affect different parts of theincome stream and capital levels


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income stream and capital levels

Net Interest IncomeAverage Assets

Non Interest IncomeAverage Assets

OverheadAverage Assets

Income TaxesAverage Assets

Return onAverage Total

Assets

Leverage

Multiplier

Return onAverage

Equity

(x)

(+)

(-)

(-)

Provisions

Average Assets

(-)

Credit risk

Operating risk

Market risk

Interest rate risk

ALM Focus

ALM Concern

Rational shareholders require a returncommensurate with risk


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Balance Sheet

EquityAssets Liabilities

Equity



OverheadAverage Assets


Return onAverage TotalAssets

LeverageMultiplier

Return onAverageEquity

x

+

-

-

ProvisionsAverage Assets

-

Income Statement

RAROC rigorously calculates returns recognizing the capital cost of risk


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recognizing the capital cost of risk

RAROC: Risk-adjusted return on capital

RAROC = Profit

Economic Capital

Provisions

_

Revenue less funding andother costs

Predictable losses areexpensed

The cushion needed tosupport Unexpected Losses

RAROC allows bank management tomake proper risk-reward trade-offs


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Interest and fee income xxx

Less cost-of-funds (xxx)Net interest income xxxLess expected loss (xxx)Less non interest expenses (xxx)Pretax income xxx

Less tax (xxx)xxx

Divided by Economic xxxCapital

RAROC X%

Interest and fee income xxx

Less cost-of-funds (xxx)Net interest income xxxLess expected loss (xxx)Less non interest expenses (xxx)Pretax income xxx

Less tax (xxx)xxx

Divided by Economic xxxCapital

RAROC X%

Pricing guidelines

FTP

Credit analysis

Allocated capital

Direct and allocated

indirect costs

Applied to hurdle rate

Loan/Product/Branch

RAROC drives BIS Pillar 1: Depends on abanks own capital charge given risks


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Risk

Risk

FreeRate

Return

Business Units,Sub-Portfolios,

Transactions

EfficientFrontier

RAROC

One of the most difficult aspects ofRAROC is the assignment of EC


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RAROC uses a banks own allocation

RORAC uses BIS assigned weights The more the capital the more the perceived

risk of the asset.but more conservative and

less risky the bank

The more the capital the higher the requiredreturn from the asset

Which bank is the better bank?


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A B

ROE 20% 20%

ROA 2% 1%

Net Int. Income 2% 6%

Other Income 6% 1%

Spread 6% 6%

NIM 4% 7%

How do we explain the differences in measures of profitability?


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3. Asset Liability ManagementOverview

ALM is one component of a broader riskmanagement framework


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Credit Risk Management

Internal Audit

Treasury

Management

ALM

ALMs focus is non-credit financial risks


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Interest rate risk

Capital risk

Liquidity risk

Foreign currency risk

Market risk is due to movements inmarket prices or interest rates


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Liquidity risk

Interest rate risk

Foreign currency risk

Equity price risk

Commodity price risk

Banking Book

Trading Book

ALM is the process of managing theinterest spread while insuring liquidity


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The ultimate viability of a bankdepends on managements ability tomanage both assets and liabilities toprovide adequate liquidity and

adequate protection of both earningsand capital against significant marketinterest rate fluctuations

It is a balancing act to achieve the banksobjectives within risk limits


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Net Interest Income

Market Valueof Equity

ALM is a process of making risk/rewardtrade-offs.


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Expected

Return

Risk/Standard Deviation

A

C

B

ALM manages the structural balancesheet to satisfy the different stakeholders


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Market Value

Return on Equity

Return on Assets

Net interest marginCapital Adequacy

Liquidity

ALM is an integrated function of strategic,profit and capital planning


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Set Policies and Objectives (including FTP rules)

GatherExternal

Information

Develop andAssess

Scenarios

Collect andAnalyzeInternal

data

SetLiquidity

Policy

SetInterest

rateposition

SetFX

Exposureposition

Setinvestment

and earningsmanagement

guidelines

Execute

Interest RatesFX ratesEconomyReg .trendsCompetition

Businessstrategy &

creditpolicy

Drives strategy and credit risk management

ALM manages the banking book usuallythrough an ALCO


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Targets

ALCO

Balance sheet composition

Funding requirements

Interest rate risk management

Capital planning Profit planning

Loan pipeline

Treasury

Execution arm for ALCO

Customer transactions

Issue bonds

FX trading

Cash management

Derivatives/hedging

Funds transfer pricing

BusinessUnits

FISReports

MonitorFTP

RAROC

ALCO monitors economic environment,actual vs plan and adjusts accordingly


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Planning/Budgeting

Yield and spread analysis

Capital allocations

Executes ALCOs Transactions Funding/FTP

Cash Management

Investment Portfolio

Hedging/Derivatives

Manages Trading Risk Securities

Derivatives

Foreign Currency

Treasury

FAD

Reports

ALCO Targets

FIS

AssetPipeline

Customer Relationships

Loan originations

Deposit gathering

Business Units

ALM risks arise due to a mismatchbetween assets and liabilities capital


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Contractual differences between assets andliabilities

Yield curve

Exchange rates

Customer preferences

The objectives are a predictable level ofearnings and growth


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Financial Objectives

Short-term: Net income

Long-term: Market Value of Equity

Balance Sheet Objectives

Balance Sheet growth targetsCapital Growth and Dividends

Markets served and markets ignored

Product offerings and Pricing

Desired image of bank

ALM seeks to maximize ROE within givenrisk limits


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Overhead

Average Assets


Return on

Average Total

Assets

Leverage

Multiplier

Return onAverage

Equity

(x)

(+)

(-)

(-)

ProvisionsAverage Assets

(-)

Net interest income is usually the mostpredicable source of earnings


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Cost ofInterest-paying

Liabilities

Net Interest Spread

Gain (Loss)

Net InterestMargin on

EarningAssets

Earning Assets

Total Assets

(x)

Earning Assets -

Interest Bearing

Liabilities

Cost of

Interest-paying

Liabilities

Interest Yield onEarning Assets

(-)

(+/-)

(x)

NIM

Interest margin objective worksheet

Determined Required Return on Assets


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Determining Interest MarginRequired Net Income plus operating expenses plus loan and security losses plus taxes

Net Income OperatingExpenses

Loan andSecurity Loss

Taxes

5 + 6 + 7 + 8

Determined Required Return on Assets

Desired Return on Equity times Required Equity to Assets Ratio equals % Return on Assets

ROE Capital Ratio ROA

1x

2=

3

Determined Required Net Income

Decimal Required Return on Assets Times Total Assets equals net income

ROA Assets Net Income

3ax

4=

5

Less fees equals desired margin

Fees Interest Margin

-9

=10

Target ROE can be achieved if each assetproduces its return on allocated equity


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Required ROE of 20% with Capital Ratio of 10%

NetAssets Income Capital Return

Cash 10 0 0 0%

Investments 20 0.6 3 20%

Loans 70 1.4 7 20%

Total 100 2.0 10 20%

Capital is a scarce resource and itseffective utilization is a focus of ALM


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Bank Profits

Business Unit Profits

ProductProfitability

ClientProfitability

StaffProductivity

The goal of ALM is to maximize returns toshareholders over the long run


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Strategic andfinancial planning

Earnings andcapital

guidelines

Business &balance sheet mix Other key ratios

and targets

A banks strategy is the backdrop for anyALM policy


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Performance-driven

Mission

Bank Strategy

Capital AllocationPricing

Business Plans for PriorityBusiness Segments

Target Customers, Products/Services Objectives and Business / Financial Plans

Support Infrastructure

Performance ManagementFunding and Liquidity

Consider whether all a banks assetsshould be allocated to interbank loans?


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Commercial Interbank

Loan Amount 100 million 100 million

NIM 1.25% .5%

Income 1,250,000 500,000

Capital 8 million 1.6 million

ROE 15.6% 31.25%


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4. Funds Management

Funds management is concerned withfunding assets and managing liquidity risk


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Cost of funds

Diversified sources of funds Diversified tenors

Asset Sales

Roll over risk

Capital planning

What is Liquidity Risk?


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The volatility in income or economic capital

of the bank due to an inability to meet cash

needs for payments/withdrawals or to

support credit demands and growth in a

timely and cost-effective manner.

What Does Liquidity Mean?

bili


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Liquidity is a banks abilityto meet all cash

demands (withdrawing deposits, borrowing money,

operational demands, etc.) anytime and entirely at

a reasonable cost

It is not

Cash or other types of assets

A ratio

Earnings of a bank

Liquidity Risk: Deposit withdrawals androll-over risk

C i i f li bili i d i i i


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Composition of liabilities and sensitivity tochanges in interest rates and credit rating

Funding from money traders, publicinstitutions, foreign investors, and largecorporations

Large funding held by any single group orindividual

Seasonal or cyclical patterns

The higher the asset quality and the greater theliquidity ... the better a banks perceivedcreditworthiness and access to refinancingsources at reasonable prices

The higher the asset quality and the greater theliquidity ... the better a banks perceivedcreditworthiness and access to refinancingsources at reasonable prices

BUT

Liquidity Risk: Asset Growth


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Unused credit lines outstanding

Business activity in banks trade area Demographic changes in market

Aggressiveness of marketing efforts--strategies to expand market share and pricingdecisions

Funding under letters of credit and bankguarantees

There is a trade-off between liquidity vs.profitability


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Cash holdings provide no interest income

Short-term securities normally carry lower yieldsShort-term loans normally carry lower rates

Less liquid assets provide more income

But


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The better the quality assets and the greater theliquidity the better a banks perceivedcreditworthiness and access to refinancing

sources at reasonable prices

A banks liquidity risk closely follows its credit,capital and interest rate risk

Banks large deposit outflow often traced to creditproblems or interest rate gambles that failed

Liquidity risk is identified by maturity gaps

Liquidity risk is identified by maturity gaps


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Assets O/N 2-30 days 31-90 91-180 181-360 Over Total

Cash 35 35

Interbank loans 97 70 43 210

Investments 118 257 100 108 219 802

Loans 62 158 275 288 102 885

REPOs 4 126 77 105 312

Other assets 20 194 30 131 375

Total 218 666 639 205 396 495 2619

Liabilities

Deposits 327 327

Notes 20 75 101 31 14 241

Interbank Loans 214 89 183 153 71 4 714

Debentures 43 391 187 151 772

Other 85 46 16 147

Capital 102 102

Total 689 601 471 184 236 122 2303

GAP (A-L) -471 65 168 21 160 373

Cumulative GAP -471 -406 -238 -217 -57

GAP Ratio(A/L) 0.32 0.69 0.86 0.89 0.97 1.14

Limits Board Limits Actual

30 day Assets/overnight liabilities > .7 1.28

90 day Assets/overnight liabilities >1 2.21

90 day Assets/90 day liabilities >=1 0.86

The key to liquidity risk management isplanning


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93

To guarantee permanent liquidity, the Liquidity Planhas to accurately project all cash flows

However, the longer the planning horizon, the moreinaccurate the cash flow prediction

Need for good data bases and communicationsystems to estimate future cash flows basedon historical behavior

Plan should include worst case scenario

Examples of Asset Liquidity


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94

Cash and due from banks in excess of requiredreserves or compensating balances

Federal funds sold and repurchase agreements

Government securities that mature within oneyear

Loans that can be readily sold or securitized

Collateral for borrowings

Concerns with Asset Liquidity

Some assets cannot be sold because they are


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95

Some assets cannot be sold because they arealready pledged as collateral

Market risk Target loan to deposit ratio

Loans are among the least liquid assets

Deposits represent the primary source of fund

High (low) ratio indicates illiquidity (strongliquidity)

There are measures of liquidity thatindicate borrowing capacity

Equity to asset ratio ( well capitalized )


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96

Risk assets to total assets

Loan losses to net loans

Reserve for loan losses to non-performingloans

Core deposits to total assets Volatile (purchased) liabilities to liquid assets

Composition of deposits (diversified customerbase)

Market access

Liquidity risk management is a dailyresponsibility


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97

Monitor balance sheet trends

Forecast funding needs Identify alternative sources of funds

Asset liquidity vs liability liquidity Stress testing

Peer analysis

Liquidity Risk Monitoring: MinimumMIS/Reports

Li idit li it


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98

Liquidity gap limits

Sources of funds

Maturity distribution

Volatile funds dependency

Stress testing using assumptions of fundingattrition

Contingency plan

Liquidity risk management is a continuousprocess


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99

.Quantity of Risk

Identify:What kind ofrisks?Where do they

exist in ourbank?How much risk?

Quality ofLiquidity Risk

Management

Determine:How diversifiedare our sourcesof funds

assets andliabilities?

Strategies forManaging Risk

Assure:That plans aresufficient toavert funding

crises and togain a fair returnfor liquid assets

Monitor Risks

Continue:Regular,ongoingevaluation of

quantity andquality ofliquidity andmanagementpractices

Liquidity Risk Identification

Assets


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100

Assets

O/N 2-30 31-180 181-360 Over Total

Cash 35 35

Interbank 220 70 43 333

Securities 118 357 108 219 802

Investments 60 36 96Loans 62 158 275 288 102 885

Other 24 330 107 131 687

Total 341 726 880 396 495 2838


Li biliti


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101

Liabilities

O/N 2-30 31-180 181-360 Over Total

Deposits 327 327Interbank 33 33

Term Deposits 4 109 233 142 14 502

Notes 20 75 132 14 241

Other Borrow. 257 480 523 222 4 1486

Other 85 46 107 118 249

Total 726 710 888 378 136 2838


Net Liquidity Gap


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102

Net Liquidity Gap

O/N 2-30 31-180 181-360 Over Total

Assets 341 726 880 396 495 2838

Liabilities 726 710 888 378 136 2838

Gap(A-L) -385 16 -8 18 359

Cumulative -385 -369 -377 -359

Short-Term Liquidity Plan

Liquidity Plan from .... to .... TDM

Expected

Amount

Worst

Case


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103

0. Initial Liquid Assets1. Inflows

1.1 Certain cash inflows

1.2 Uncertain cash inflows2. Outflows2.1 Certain outflows2.2 Uncertain outflows

3. Assets - Level 1 (= 0. + 1. - 2.)4. Minimum required reserves

4.1 Required reserves at Central Bank4.2 Required internal reserves

5. Excess or Gap (=3. - 4.)6. Used sources7. Funds - Level 11 (=5. + 6.)

8. Funding sources6. Used sources9. Potential funding sources (= 8. - 6.)4.2 Required internal reserves10. Excess Potential Funding Sources (9. +4.2.)


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104

5. Interest Rate RiskManagement

Assume gap in previous exercise reflectsrepricing schedules

Net Liquidity GapO/N 2 30 31 180 181 360 Over Total


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105

What happens if interest rates increase/decrease?

Interest rate risk occurs because interest

rates change, and there is a yield curve

O/N 2-30 31-180 181-360 Over Total

Assets 341 726 880 396 495 2838

Liabilities 726 710 401 378 136 2838

Gap(A-L) -385 16 -8 18 359

Cumulative -385 -369 -377 -359

The Yield Curve Positively Sloped--Normal


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Generally implies: Growing economy Moderate Central

Bank policy Expectation of some

future rate increases

22.5

33.5

4

4.55

5.56

6.5

77.5

8

3 6 12 24 36 60 120 360

Maturity (in months)

Int

erestRates

The Yield Curve Positively Sloped-Steep


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22.5

33.5

44.5

55.5

66.5

77.5

8

3 6 12 24 36 60 120 360


InterestRates

Generally implies: Economy rebounding

from recession Easy Central Bank policy Expectation of significant

future rate increases

The Yield Curve A Flat Yield Curve

8


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22.5

33.5

44.5

55.5

66.5

77.5

8

3 6 12 24 36 60 120 360


InterestRate

s Generally implies:

High growth economy CB tightening to

reduce growth andinflation

Expectation of falling

future rates

The Yield Curve Inverted Yield Curve

12 5


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66.5

77.5

88.5

99.510

10.511

11.512

12.5

3 12 36 120

In

terestRates

Generally implies:

Unsustainably highgrowth economy

Aggressive CentralBank tightening

Expectation ofsignificantly lowerfuture rates


Relative interest rates reflect a risk-rewardtradeoff

Compounding


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p g Benefit of compounding available in shorter maturities

must be incorporated in the rate for longer maturities

Liquidity Price Risk Investors will accept a lower yield over time to have access

to their money more often

Credit Risk Longer the maturity of a loan, the higher the uncertainty as

to the borrowers ability to repay the debt Investors believe that the risk of a company defaulting on

its debt grows over time

The Yield Curve - Credit Differences


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33.5

44.5

55.5

66.5

77.5

88.5

9

3 6 12 24 36 60 120 360


InterestRates

US Treasury

A Rated

What is interest rate risk?


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112

The volatility in earnings or economic capital

of the bank due to a change in the level ofinterest rates, interest rate spreads or shifts

in the yield curve.

Volatility in earnings or economic capitalare inversely related

Changes in market rates cause a change in interest


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113

g gincome and expense of the portfolio

Changes in market rates cause a change in theopposite direction in market value of assets andliabilities

Increase in asset values mean reinvestmentoffunds at lower rates

Interest income is lower

Maturing values must be reinvested Asset sales look good, but future income could be lower

Examples of interest rate risk on earnings

Earnings are affected if assets and liabilities have different interest


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114

Earnings are affected if assets and liabilities have different interest

ases if the variable rate

rate sensitivity.

Example: 10 million loan @ 8% fixed for one year10 million 3-month deposit at variable rate currently4%

Interest margin of 4% or 400,000 decre

increases during the year.

Examples of interest rate risk on EVE


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115

Capital or EVE is affected if fixed rate assets are marked-to-marketand interest rates change.

Example: 10 million 6% due 2006 currently selling at par (ie.,market yield is 6%)

If interest rates increase 1% (100 basis points), the market

value of the bond decreases to 9.59 million for a loss of410,000.

Interest Rate Risk is identified by gaps

GAP = Rate Sensitive Assets - Rate Sensitive Liabilities


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116

Assets which reprice in agiven time period if interestrates change

maturing assetsprincipal payments on

assets

variable rate assets

Rate Sensitive Assets

Liabilities which reprice in agiven time period if interestrates change

maturing liabilitiesprincipal payments on

liabilities

variable rate liabilities

Rate Sensitive Liabilities

Positive Gap exists when sensitive assetsexceed sensitive liabilities

Example

(RSA) Assets = 400,000


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117

(RSL) Liabilities = 350,000Repricing Gap = 50,000

If interest rates rise, more assets will reprice than liabilities.

Therefore, expect interest income to increase in the short runmore quickly than interest expense.

If rates fall, the reverse will occur. Therefore, when rates rise,expect profits to rise; and when rates fall, expect profits to fall.

Negative Gap exists when sensitive assetsare less than sensitive liabilities

Example


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118

(RSA) Assets = 350,000(RSL) Liabilities = 400,000

Funding Gap = -50,000

If interest rates rise, more liabilities will reprice than f assets.

Therefore, expect interest expense to increase in the short runmore quickly than interest income.

If rates fall, the reverse will occur. Therefore, when rates rise,expect profits to fall; and when rates fall, expect profits to rise.

Interest Mismatch Ladder

PERIOD TO MATURITY

OR ROLLOVER DATE

LIABILITIES ASSETS MISMATCH

Non-interest


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119

Non interestbearing

Up to 1 month

1-3 months

3-6 months

An analysis of the mismatches (gaps) between assets and liabilitiesat each value date will show the banks exposure to both liquidityrisk (i.e., the risk of being unable to raise funds to meet paymentobligations at a future date) and interest risk.

(1,500)-

18,000

9,000

22,000

(1,500)

(9,600)

(18,000)

(17,000) 1,000

(600)

4,000

Interest Rate Risk Measurement: Exercise

Measuring the impact of different % of Rate Sensitive Assets

on Interest Revenue With an Increase in the General Level of Interest Rates

Earning Assets Interest Revenue% of AssetsGeneral Level of Interest Rates


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120

g

(000)

15,50915,509

15,509

Interest Revenue

Beginning After increase

129,241 155,091

129,241 142,166

129,241 135,704

% Change

20%

10%

5%

% of AssetsRepriced

10050

25

Rate Sensitive (%)Beginning

(%)

After increase

(%)

Change

(%)

10 12 2010 12 20

10 12 20

Measuring the impact of different % of Rate Sensitive Liabilities

on Interest Expense With an Increase in the General Level of Interest Rates

General Level of Interest Rates Liabilities

(000)

10 12 20

10 12 20

10 12 20

14,011

14,011

14,011

Beginning

(%)

After increase

(%)

Change

(%)

100

50

25

% of LiabilitiesRepriced

Rate Sensitive (%)

Interest Expense

Beginning % Change

116,758 140,110 20%

116,758 128,434 10%

116,758 122,596 5%

After increase

Interest Rate Risk Measurement:Exercise

Beginning Level of Rates (Base Case)

Interest Income 129,241Interest Expense 116,758


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121

Interest Expense 116,758Net Interest Income 12,483

Interest Rates Increase 20% RSA 50% RSA 100%RSL 100% RSL 50%

Interest Income 142,166 155,091Interest Expense 140,110 128,434

Net Interest Income 2,056 26,657Change from Base (85)% 114%

Interest Rates Decrease 20% RSA 50% RSA 100%RSL 100% RSL 50%

Interest Income ________ _______ Interest Expense ________ _______ Net Interest Income ________ _______ Change from Base ____% ____%

Losing Money with Gap Strategies

Consider the following maturity/rate structure

Interest RatesAssets: Liabilities:


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122

1-year maturity

2-year maturity

3-year maturity

Loans

8.5%

9.5%

10.5%

Deposits

5.5%

6.5%

7.5% Interest rates are expected to increase in the future

Appropriate Gap strategy for a rising rate environment

Hold positive Gap

Invest in short-term assets

Fund with long-term liabilities

Losing Money with Gap Strategies

Suppose rates do increase One-year rates one year from now have increased 1.5%


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123

One-year rates two years from now have increasedanother 1%, or 2.5% higher than current rates

Assume that the yield curves for assets and liabilitiesincrease by equal amounts

Calculate the three-year income performance for

this bank for a strategy of a positive Gap.

What is the performance with a zero Gap ornegative Gap?

StrategyInterestIncome

InterestExpense

Net InterestIncome


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124

Zero Gap:(1-yr assets &1-yr liabilities) ____.__ ____.__

____.______.__

Negative Gap:(3-yr assets &

1-yr liabilities)

____.__

____.__

Duration is a common measure of interestrate risk from a capital perspectiveChange in Price

from Initial

Price at 10%

Interest Rate(Percent)


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125

10%, 2 year

Zero Coupon, 2 year

0

+3.90

+3.63

-3.46

-3.72

8.0 10.0 12.0 Required Yield (Percent)

Market Rate

8.0%10.0%

12.0%

Price of 10% Bonds$1,036.301,000.00

965.36

Price of Zero Coupon

$854.80822.70

792.09

Simulation is used to test IRR limitsRate Shock Exposure

Net Interest Income Current Market Value

Change inRates (b.p.)

EstimatedValue

ChangeFrom Base

% Changefrom Base

EstimatedValue

ChangeFrom Base

% Changefrom Base

+ 400 6,155 476 8.4 10,812 (2,875) (21.0)

+ 200 5,969 290 5.1 12,741 (946) (6.9)

Base 5,679 0 0.0 13,686 0 0.0


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126

-200 5,401 (278) (4.9) 14,565 879 6.4

-400 4,978 (701 ) (12.3) 16,426 2,740 20.0

Rate Cycle Exposure


Y/CurveType

EstimatedValue

ChangeFrom Base

% Changefrom Base

EstimatedValue

ChangeFrom Base

% Changefrom Base

FullyInverted

7,111 1,414 24.8 9,409 (4,277) (31.3)

SemiInverted

6,641 944 16.6 11,052 (2,634) (19.2)

Flattening 5,762 65 1.1 13,237 (449) (3.3)

Base 5,697 0 0.0 13,686 0 0.0

Steepening 5,148 (549) (9.6) 14,790 1,103 8.1

Rate Forecast Exposure


Change inRates (b.p.)

EstimatedValue

ChangeFrom Base

% Changefrom Base

EstimatedValue

ChangeFrom Base

% Changefrom Base

Rising 5,829 129 2.3 17,102 (1,043) (5.7)

Most Likely 5,691 (9) (0.2) 18,461 316 1.7

Base 5,700 0 0.0 18,145 0 0.0

Declining 5,536 (164) (2.9) 19,412 1,267 7.0

Interest rate risk management hasevolved

STATIC GAPANALYSIS Stage 1 Develop Gap analysis - basic approach


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127

Stage 2 Create historyof rates and data base

DYNAMIC GAPANALYSIS

SIMULATIONMODELING

VALUE ATRISK

ANALYSIS

HISTORY OFRATE

VOLATILITY

DATA BASESUPPORT

DETERMINERISK

TOLERANCE

SET TRADINGLIMITS

DETERMINEBALANCE SHEET

TARGETS

Stage 3 Create modelsand begin VaR analysis

State 4 Utilize all of thetools to manage limits andbalance sheet

Interest Risk Management: Difficulties

Forecast the direction and magnitude of interestrate changes


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128

GAP measures do not accurately indicate interest

rate and do not recognize the timing differences incash flows for assets and liabilities within thesame maturity groupings

Duration is a good measure only for smallchanges in interest rates

What is ideal for the customers is not ideal for the

bank

Interest Rate Risk Management:Monitoring of MIS/Reports

Asset yields, liability costs

NIM variances from prior period and


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129

NIM, variances from prior period andbudget

Longer term interest margin trends

Rate sensitivity position

Static and dynamic gap

Exceptions to policy guidelines

ABC DEF GHI JKL MNO

19 14 33 22 1

30 18 42 26 24

49 32 75 48 25

19 14 33 22 1

11 4 9 4 23

5 4 4 4 5

133 86 196 126 79

19 14 33 22 1

ABC DEF GHI JKL MNO

19 14 33 22 1

30 18 42 26 24

49 32 75 48 25

19 14 33 22 1

11 4 9 4 23

5 4 4 4 5

133 86 196 126 79

19 14 33 22 1

ABC DEF GHI JKL MNO

19 14 33 22 1

30 18 42 26 24

49 32 75 48 25

19 14 33 22 1

11 4 9 4 23

5 4 4 4 5

133 86 196 126 79

19 14 33 22 1

ABC DEF GHI JKL MNO

19 14 33 22 1

30 18 42 26 24

49 32 75 48 25

19 14 33 22 1

11 4 9 4 23

5 4 4 4 5

133 86 196 126 79

19 14 33 22 1

ABC DEF GHI JKL MNO

19 14 33 22 1

30 18 42 26 24

49 32 75 48 2519 14 33 22 1

11 4 9 4 23

5 4 4 4 5

133 86 196 126 79

19 14 33 22 1

ABC DEF GHI JKL MNO

19 14 33 22 1

30 18 42 26 24

49 32 75 48 25

19 14 33 22 1

11 4 9 4 23

5 4 4 4 5

133 86 196 126 79

19 14 33 22 1


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130

6. Foreign Exchange RiskManagement

What is foreign currency risk?


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131

The volatility in income or economic value of

equity due to movements in foreign currencyexchange rates



Foreign currency risk arises frommovements in exchange rates

Forward

t

Spot

rate


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132

Cash

Market

Derivative

Market

raterate

Transaction Translation

Economic

FX risk comes in two forms

Translation risk:

Balance sheet assets and liabilities translated at FX rateprevailing on date of the balance sheet. Income statements

l d FX ili h


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translated at an average FX rate prevailing over themeasurement period

Measures impact of a change in exchange rates on a

companys financial statements

Transaction risk:

Potential gains or losses on future settlements of outstanding

obligations denominated in a foreign currency, ie., booked

sales may be paid in different actual amounts

Measures impact of a change in exchange rates on actualcollections (the difference between receivables and payables)

Like interest rates, risk arises from amismatch of assets and liabilities

ASSETS LIABILITIES


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Foreigncurrencyappreciates

Foreigncurrencydepreciates

gain loss

gainloss

What is an institutions FX Position

The Balance Sheetposition in a particularcurrency is a function of total assets and totalliabilities in that currency


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liabilities in that currency

When assets in a currency exceed liabilities inthat currency, there is a long (or overbought)position in the currency

When liabilities in a currency exceed assets inthat currency, there is a short (or oversold)position in the currency

FX position can be determined byanalyzing the balance sheet

The total of :


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(A) FX Assets + contingent FX boughtLess

(B) FX Liabilities + contingent FX sold

Equals the Foreign Exchange Position


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The FX position includes the ForwardPosition

Forward contracts represent the obligations to

purchase or sell a specific amount of a currency


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at a specific future date

When a bank dealer executes a forward FX deal,

the bank's actual assets and liabilities in the dealcurrencies do not change until the deal is settled

on the specified date (typically in 1, 2, 3, 6, 9 or

12 months)

What is the exposure effect?

A Chinese company sells hospital diagnosticequipment. Most of its revenues are in China, butb t h lf it i EUR b th


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about half its expenses are in EUR, because the

company buys many components abroad. Itsprimary competition is from Chinese companieswith no international business at all.

How will a strengthening of the EUR affect thiscompany?

Another example: Japanese TVs

A Japanese firm sells television sets to anAmerican importer for JPY 1 billion payable in 90


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American importer for JPY 1 billion payable in 90

days.

What is the importers risk?

How should the importer protect against it?

FX risk is measured like interest rate risk

Foreign exchange gap analysis

F i h d ti l i


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Foreign exchange duration analysis

Foreign exchange rate simulation

Rate volatility analysis

FX risk is managed with effective policies

Objectives and principles of FX risk management

Measurement of risk


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142

Risk exposure limits

Net open position limits

Currency position limits

Other position limits

Stop-loss provisions

Concentration limits

Revaluation procedures

FX risk management tools are available insome markets

Contractual hedges Forwards

M


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Money

Futures Options

Natural hedges Payment leads and lags

Matching

Forward exchange rates are derived fromrelative interest rates

The spot USD/CHF rate is 1.40. Six monthinterest rates are 6% on the dollar and 4% onthe Swiss Franc. (The six month interest periodi 184 d )


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is 184 days.)

An organization with USD 1 million and arequirement for Swiss Francs in six monthsshould be indifferent, financially speaking, as to

whether it: Invests the USD 1 million for six months and

converts the dollars (plus interest) into CHF atthe end of this time

Sells the USD 1 million spot for CHF, andinvests the CHF for six months until they areneeded

Derivation of Forward Exchange Rates

Invest USD 1 million at 6%for 6 months (184 days)

Sell USD 1 million spot at 1.40Buy CHF 1.4 million

Invest CHF for 6 months at 4%

OPTION 1 OPTION 2


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Interest earned USD30,666.67

Value after 6 monthsUSD 1,030,666.67

Interest earned CHF28,622.22

(1.4 million x 4% x 184/360)

Value after 6 monthsCHF 1,428,622.22

Exchange Rate: 1.3861

Value at risk (VaR) is a common marketrisk measure

Position size

Value sensitivity to

Captures

Captures


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146

0

Tail Probability =2.5%

Value at Risk

Value sensitivity toprice movements

Probability distributionof price movements

Daily Changes in Position Value

The historical volatility of exchange ratesdetermines the risk

015

0.2

/$ RETURNS


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Aug-8

7

Jan-8

8

Jul-8

8

Dec-8

8

Jun-8

9

Nov-8

9

May-9

0

Oct-9

0

Apr-9

1

Sep-9

1

Mar-9

2

Aug-9

2

Feb-9

3

Jul-9

3

Jan-9

4

Jun-9

4

Dec-9

4

May-9

5

Nov-9

5

May-9

6

Oct-9

6

Apr-9

7-0.1

-0.05

0

0.05

0.1

0.15

R

ateofReturn(%)

Aug-8

7

Jan-8

8

Jul-8

8

Dec-8

8

Jun-8

9

Nov-8

9

May-9

0

Oct-9

0

Apr-9

1

Sep-9

1

Mar-9

2

Aug-9

2

Feb-9

3

Jul-9

3

Jan-9

4

Jun-9

4

Dec-9

4

May-9

5

Nov-9

5

May-9

6

Oct-9

6

Apr-9

7

The returns can then be plotted in ahistogram

DM/$ RETURNS

HISTOGRAM

/$ RETURNS

35

Frequency


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Price Change (%)

Frequenc

0

5

10

15

20

25

30

-5.43% -3.46% -1.48% 0.49% 2.47% 4.45% 6.42% 8.40% More

Price Change (%)

The greater the number of observations, themore normal the distribution


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-4 -3 -2 -1 0 1 2 3 4

Change in Portfolio Value

StandardDeviation

2.5% of Distribution

The standard deviation is a measure ofdispersion

Assume an asset returns the following over threeperiods:


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periods:

10% 15% 20%

What is the standard deviation/volatility?

(10% - 15%)2 + (15% - 15%)2 + (20% - 15%) 2 = 5%

2

The number of standard deviations variesdepending on how sure you want to be

How much we can expect to lose over a givenperiod of time at a certain confidence level?


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VaR = Position in Portfolio (i.e., $100) * Volatility (i.e.,standard deviation) * No. of Standard Deviations specified(i.e., 95% = 2)

Note:The 95% confidence is for a +/- 2 standarddeviations. For a one-tailed test (- 2 standard deviations),we are 97.5% (or rounding 98%) confident.

An example of VAR

Assume: Monthly Volatility of $/Sterling is 3.3% Current Spot Rate = $1.6/Sterling

C t P iti GBP 10 Milli


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Current Position = GBP 10 Million

The most we can lose over the next month with98% confidence is 10*1.6*3.3*2 is $1,056,000

Exercise

AssumeMonthly volatility of $/EUR is 2%

Current spot rate = .9 EUR/$


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Current position = EUR 20 million

What is the most we can lose in $s over the

next month with 98% confidence? What is the most we can lose in $s over the

next month with 99% confidence?

VaR can be calculated for individual asset orportfolio of assets

JPMorganChases RiskMetricsNon-simulation variance/covariance approach

Uses daily volatility and correlation estimates


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System implementation from 3rd

parties

Historical simulation

Portfolio aggregation Monte Carlo simulation

The best VaR models use a combination ofmethods

HistoricalSimulation

HistoricalSimulation

Parametric VAR

Parametric VAR

Normal distribution

assumption

Normal distribution

assumption

Monte CarloSimulation

Monte CarloSimulation

Can simulate many

price paths

Can simulate many

price pathsCan test current

portfolio over pasti d ( h

Can test currentportfolio over pastperiods (e en crash


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155

Easy to calculate

No event risk

capabilities

No compensation for

fat tails

No ability to fully

calculate non-linear

instruments

Easy to calculateNo event risk

capabilities

No compensation for

fat tails

No ability to fully

calculate non-linear

instruments

Limits model riskAccounts for non-

linearity and non-

normality

Computationally

expensive

Limits model riskAccounts for non-

linearity and non-

normality

Computationally

expensive

periods (even crash

conditions)

Relies on theexistence ofhistorical price series

Incorporates non-linearities and non-normal distributions

Doesnt necessarilyreflect futureconditions

periods (even crash

conditions)

Relies on theexistence ofhistorical price series

Incorporates non-linearities and non-normal distributions

Doesnt necessarilyreflect futureconditions

Jan-Peter Onstwedder, The Royal Bank ofScotland

Judgment still must be applied to the VaR process ofsetting limits and watching or forecasting changing

economic conditions. Changes in fundamental economic

conditions (even less dramatic than the 1991 events in


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156

conditions (even less dramatic than the 1991 events in

Eastern Europe) can cause losses that exceed the levels of

risk tolerancesuch as the unwinding of the Asian

economies and its impact on the securities of developing

economies. VaR is a valuable tool because it attempts toquantify a process that would otherwise be purely

judgmental. It should be used along with interest

sensitivity dynamic Gap analysis.


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157

7. Credit Risk Management

What is credit risk?




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158


equity due to non-performance by a debtoror counter-party

That means a number of things

The risk that a borrower will not pay what was lent in fulland on time


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159

The potential that a bank borrower or counterparty will failto meet its obligations in accordance with agreed terms

Principles for the Management of Credit Risk - BIS 1999

Must also include allthreats to value, in a probability / net

present value sense; e.g. deterioration in qualitythroughout the life of the loan is a credit risk in itself

Credit risk is typically the greatest threat tocapital health in the banking business

plus

Net Int. Income

Other income

Int. Income

Int. Expense


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160

ROE

less

less

less

Other income

Op. Expense

Provisions

Tax

Credit risk

Successful credit risk is a competitiveadvantage

Identify

And price appropriately!


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161

Measure

Monitor

Control

And price appropriately!

There are two major factors to consider

with as much confidence as possible

What is the likelihood a borrower will default?

Probability [%]


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If the borrower defaults, how much are we likely to lose?

Amount [$ / / $ or%]

Credit analysis, ratings, pricing andcontrols focus on these two factors


Probability [%]


Likelihood that cash flow will sustainthrough life of credit:


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Amount [$ / / $ or%]

Financial strength

Management quality

Market and economy

Other factors

Exposure at default Compromised financial strength

Guarantees or security

Other factors

Value of distressed credit:


Credit risk affects both capital andearnings

Foregone Interest and provisions

And mark-to-market losses


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The primary objective is to minimize the volatilityof earnings and capital (hence the risk asperceived by investors) and at the same time earna ROE to maintain the value of the common

equity.

Losses in economic capital

Financial success in any enterprisemeans at the least breaking even

Breakeven

Manufacturern

Other costs

Profit


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OperatingCosts

Cost ofGoods

Sold

How is a FinancialInstitution different

from a manufacturer?

For a financial institution, this meanseffectively managing credit risks . . .

Profit

Reserves forUnexpected

Losses

Losses resulting fromvolatility true risk


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Why weneedcapital

Margin forExpected

Credit Losses

OperatingCosts

FinancialInstitution

Predictable losses thatcan be built into pricing

Cost of Funds

Credit risk measurement takes differentforms

Expert systems

Credit scoring models


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Rating systems

CAMELS

Pass, OLEM, Substandard, Doubtful, Loss

Public bond ratings

Credit analysis drives the credit riskassessment of all methods


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Both the ability and thewillingness to pay are key

There are several indicators of future abilityand willingness to pay

Past record of meeting debt payments, particularlyin stress situation like a recession

Proven record of careful financial management


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Adequate financial reserves or other liquid assets

Fiscal flexibility .or the ability to

Raise funds or sell assetsAccess bank lines on short notice

Draw on cash reserves

Cut discretionary spending

Alter the business plan or delay capital expenditures

Credit risk analysis is an evolving fieldusing basic quantitative methods

Basic algebra Equations define relationship among variables

Solving 2 unknowns with 2 equations

Expected value


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Present value vs future value Opportunity cost of $ today

Inverse relationship between rates and prices

Statistics

Variables describing a sample

Measures of central tendency (Median, mean andmode)

Measures of dispersion (Range and std deviation)

Regression analysis and correlation

There are two basic aspects of credit risk

Standalone risks Default probability

Loss given default

Migration risk


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Portfolio risks Default correlations

Exposure

Credit risk management means

diversifying and transferring risk

Standalone creditworthiness depends onmany factors

n h v.n


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Industrysector

Competitivepositio

Financi

alstrengt

Cashflow

/debtser

Mgmt./o

rganizatio

Data drives the credit analysis

Category

Industry Industry profile -- 3 years Size, growth Concentrations Cyclicality/seasonality Explanation of trends

Industry outlook Profiles of key competitors (top two) Regulatory profile -- current, recent changes,

expected changes

Data Required Data Sources

Internal Files Research department Other managers familiar with industry

Third parties Ministries Multilateral agencies -- World Bank,

IADB, etc.

Other government organizations


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SAMPLE DATA COLLECTION

examples

FinancialCondition

expected changes Borrowers strategy Key alliances:

With government With private sector With other influential players

Company financials -- 3 years

Profit & loss statements, balancesheets

Supplementary statements --reconciliation of net worth, fixed assets\

Audited where possible Creditor facilities

Banks Suppliers

Other government organizations Trade associations Other banks Other companies in industries

External -- customer calls Business press

Internal

Files Other managers familiar with borrower

Issuer In person calls Site visits

amounts and conditionof facilities

Financial ratio analysis provides the basisfor ability to pay

RATIOS

RATIOS

Liquidity (Cash/Current Liabilities)

Cashflow-Measures (Repayment)

(e g CF/interest CF/liabilities)

SELECTION

SELECTION

Financial statements relevant (even) inemerging economies

Depending on maturity of economy and


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(e.g. CF/interest, CF/liabilities)

Profitability (e.g. pre-tax profit/assets)

Activity (e.g. Revenues/Assets)

Leverage (e.g. equity/liabilities)

Size (e.g. Sales)

Growth (e.g. Revenue growth)

Depending on maturity of economy andreporting systems different factors aredominant

Liquidity and Cashflow measures likely todominate a rating

Precise definition of factor will depend onconsistent availability of data

Need to test numerous ratios given sufficientdata

Both quantitative and qualitative analysesare required

Financial factors

Financial factors Non-financial

factors

Non-financial

factors

Warning signals /

Behavioral factors

Warning signals /

Behavioral factors


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factorsfactors Behavioral factorsBehavioral factors

Financial ratingFinancial rating Warning signal ratingWarning signal ratingNon-financial ratingNon-financial rating

Issurer ratingIssurer rating

Their relative importance typically variesaccording to the issuer segment

- ILLUSTRATIVE -

FACTOR WEIGHTS

Financial Non-Financial Behavioural

Large Corporate Profitability


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Small Business

Leverage

Growth

Liquidity

Mgt quality

Industry

outlook

Insidertransactions

Evergreenloans

SIZE

SEGMENT

Credit ratings are an assessment ofmanagementa leading indicator

Management (not external conditions) drivesperformance

How cope in periods of rapid change

Attitudes toward risk a focus on fundamentals


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Attitudes toward risk, a focus on fundamentals

Corporate culture: how motivated and promoted

Collegial versus dictatorial decision making

Quality of management information systems

Realism of long-term strategies and goals

Ratios are tools in the rating process

Absolute and relative trend

Peer group comparisons

Not the final step or whole answer


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Not the final step or whole answer Ratios put you in the right neighborhood, but you

need the right address

Non-quantifiable (subjective) side of the analysis

just as important as the numbers

A credit analysis is essentially a bottom-up pyramid analysis

AAA?

Qualitative Analysis


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Qualitative Analysis-Management

-Financial Flexibility

Quantitative Analysis

-Financial Statements-Past/Future Performance

Market Position

Competitive Trends (domestic/global)

Regulatory Environment

Industry Analysis

Sovereign Macroeconomic Analysis

BIS II has led to a new generation ofstatistical rating models

Capital required to support risk-weightedassets

Three measures for credit risk

Standardized using external ratings for risk weights


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Standardized using external ratings for risk weights

IRB: Foundation and Advanced

IRB uses banks own rating systems withrequired features

Provisions should equal expected losses

Capital must be held for UL

Traditional credit risk measurement hasnot been discriminate

Not compensating for risk

Evolved to KMV Credit Monitor Model

Loans as options using Black-Scholes


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Loans as options using Black-Scholes

JP Morgans CreditMetrics and other models

Risk neutral valuation approach Differ in terms of definition of risk (MTM or

DM); risk drivers; volatility and correlation of

credit events; recovery rates; simulation oranalytic

BIS IIs objective is to have same level ofcapital in the system as a whole


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Source: Bank of England Spring Quarterly Report, 2001

Probability of Default (PD) is based onhistorical experience

X Corporate Loans

Y Credit Cards


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-4 -3 -2 -1 0 1 2 3 4StandardDeviation

X = 2%

Y = 4%

X = 4%

Y = 5%

Which loan type is more risky.X or Y?

X Corporate Loans

Y Credit Cards


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-4 -3 -2 -1 0 1 2 3 4StandardDeviation

X = 2%

Y = 4%

X = 4%

Y = 5%

Databases of historical defaults aremaintained by international CRAs

S&P Moodys

Fitch


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Dun & Bradstreet

Others

Default histories drive PD

S & P RATING MOODYSEQUIVALENT

DEFAULT PROBABILITY(SUBSEQUENT YEAR)

AAA Aaa 0.01%

AA Aa3/A1 0.03%

A As/A3 0.10%BBB Baa2 0 30%


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BBB Baa2 0.30%

BB Ba1/Ba2 0.81%

B Ba3/B1 2.21%

CCC B2/B3 6.00%

CC B3/Caa 11.68%C Caa/Ca 16.29%

Raw data

Raw data Individual

Scores

IndividualScores

EconomicInterpretation

EconomicInterpretation

Calibrated

Rating (PD)

Calibrated

Rating (PD)

Aggregation to

overall Score

Aggregation tooverall Score

Input Calculation Output

Quantitative modeling provides the basis ofthe analysis


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Financials Assessment of

qualitativeFactors

Ratios Scalecomparablefor all factors

Weights fixed(e.g. linearalgorithm)

Calibrationfixed

May be different by segment(size, state -owned /private, industry, available information)

The oldest and simplest model is Altmans ZScore

Overall profitability (ROA)Sales to Total Assets

Leverage (Market Value of Equity to Debt)

Working Capital to Total Assets


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Working Capital to Total Assets

Cumulative profitability (Retained

earnings/Total Assets)

A Z score below 2.99 could be an earlywarning sign of default

RATIO FORMULA WEIGHT FACTOR WEIGHTED RATIO

Return on Total Assets

Earnings Before Interest andTaxes

-----------------------------------------

Total Assets

x. 3.3 -4 to +8.0

Sales to Total AssetsNet Sales

-----------------------------------------

Total Assetsx 0.999 -4 to +8.0

Equity to DebtMarket Value of Equity

----------------------------------------- x 0.6 -4 to +8.0


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Total Liabilities

Working Capital to TotalAssets

Working Capital----------------------------------------

-Total Assets

x 1.2 -4 to +8.0

Retained Earnings to TotalAssets

Retained Earnings

-----------------------------------------

Total Assetsx1.4 -4 to +8.0

Hindsight is perfect.but how do wepredict default


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If we have the data, we can begin togeneralize about a similar population

Example: Life insurance company

How we can we classifyindividuals into broad risk bands

to manage our actuarial risk?


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?

What would be a logical process fordiscerning the predictive risk variables?

Example: Life insurance company

Sethypothesis

Examine

experience

Age Male / female Smoker / non-smoker Obesity

Family history


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Selectvariables

Testpredictability

Test andCalibrate

Family history

What would be a logical process fordiscerning the predictive risk variables?

Risk factor: Obesity

Sethypothesis

Examine

experience

0

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Selectvariables

Testpredictability

Test andCalibrate

0

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50

60

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40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

0

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40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

The larger the data population, and themore reliable the data, the more confident


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and the easier to test the predictability ofour data points

20.00

30.00

40.00

50.00

60.00


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The most reliable credit risk models are from

consumer credit scoring models

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Example:

CreditCards


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Examples ofpredictive factorsfor credit cards

Not surprisingly, for such credits, the

models drive the whole credit process

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