Asset & Liability Management Introduction

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

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

ALM, business units, and relevant issues

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)

Organising ALMAC The Asset and Liability Management Committee

The Balance Sheet, The Regulator and Bank Capital

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

Risk Weights

Examples of Capital Adequacy Calculation 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

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

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

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

Tiers of Capital (Continued) 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

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

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

Liquidity Risk Measurement and Management

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

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

A Maturity Ladder Expected Maturity

Net Funding Requirement Expected Maturity

A Liquidity Ladder Contractual Maturity

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

Funding Requirement Contractual Maturity

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

Interest Rate Risk Classification and Measurement

Parallel Shift

Steepening

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

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

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

Interest Rate Derivatives

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

Interest Rate Swap Bank Swap Provider LIBOR Fixed Rate

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

Balance Sheet Management Long-Term Funding

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

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

Standard Market Interest Rate Swap Issuer Swap Provider LIBOR 4.90%

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

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

Balance Sheet Management Securitisation

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

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

Credit Enhancement Overcollateralisation Tranching Reserves Credit Insurance

Mortgage Pass-through Mortgages Originator SPV Cash Cash Securities Investor

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

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

Credit Derivatives Basic Instruments and Issues

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

Credit Default Options Fee (BP) Bank A Bank B Zero No credit event Credit event CEP

Total Return Swaps Bank B Bank A Bond C (Reference credit) Total positive returns on Bond C Bank B Bank A LIBOR + Spread + Losses on Bond C Bond C (Reference credit)

Credit-Linked Note Non-Principal Protected Coupon Issuer (Bank B) Principal Investor (Bank A) No credit event Credit event Principal Less CEP Bond C (Reference credit)

Credit Derivatives and ALM Can reduce credit risk concentrations Can provide funding opportunities Can be used in securitisation transactions Under some circumstances, can reduce regulatory capital usage

A Typical CLO $100M in loans 50 senior secured bank loans Average rating B1 Diversified by industry & obligor LIBOR + 275 5 Year Average Life Class A $85M 12 year maturity LIBOR + 50 Aa3 Class B $7M 12 year maturity LIBOR + 120 Baa3 Equity $8M 12 Year maturity subordinated