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**RISK MANAGEMENT-MODULE B**

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MARKET RISK The risk that the value of “on” or “off” balance sheet positions will be adversely affected by movements in equity, interest rate markets, currency exchange rates and commodity prices.

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A L M CONCEPT The fundamental objectives of ALM are to maximise Net Interest Income (NII) or Net Interest Margin (NIM) and Market Value of Equity (MVE)

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A L M CONCEPT Earnings Perspective involves analysing the impact of changes on earnings in near term. Economic Value Perspective involves analysing the impact of interest on expected cash flows from assets minus expected cash flows from liabilities in long term and its impact on equity or net worth of the bank.

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FOREIGN EXCHANGE RISK The risk that the BANK may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two in an individual foreign currency.

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LIQUIDITY RISK Ability of an organisation to meet its commitments as and when they fall due. Liquidity needs can be met by Creation/assumption of fresh liability - Liability management. Conversion of an existing asset - Asset management.

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**MEASUREMENT OF LIQUIDITY RISK**

Stock approach - fixing Balance Sheet ratios Flow approach - Liquidity Ladder or Gap Method

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**STOCK APPROACH Volatile Liability Dependence Ratio**

Volatile Liabilities minus Temporary Investments to Earning Assets net of Temporary investments Shows the extent to which bank’s reliance on volatile funds to support LT assets Growth in Core Deposits to growth in assets Higher the ratio the better Purchased Funds to Total Assets Loan losses to Net Loans

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**LIQUIDITY PARAMETERS Cap on daily Call Lending**

Allowed to lend maximum 50 % of Capital funds on any given day during the fortnight. Cap on average Call Lending on a fortnightly basis Average basis not to exceed 25 % of capital funds. Cap on Daily Borrowing Allowed to borrow upto 125 % of capital funds on any day during the fortnight. Cap on average Borrowing Average basis not to exceed 100 % of capital funds

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**LIQUIDITY PARAMETERS Cap on Purchased funds**

Gross borrowings from Banks, RBI and other FI including Certificate of Deposits and Institutional deposit should not exceed 25 % of Cash, balances with Banks, lending in call money market and total investments. Cap on Gross Credit to Core Deposit. Gross credit should not exceed 85 % of the core deposits (total deposits less interbank deposits and bulk deposits of Rs. 10 cr and above.) Cap on Gross Credit to Total Assets. Maximum total credit to total assets will be 65 %.

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**INTEREST RATE RISK Basle committee:**

Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. Changes in Interest rates is a threat to: Earnings Capital base

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**INTEREST RATE RISKS Repricing Risk. Basis Risk. Yield Curve Risk.**

Embedded Option risk.

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**REPRICING RISK Arises on account of mismatches in rates**

Can be measured by the measure of risk in different time buckets Information needed Balance sheet -on & off on a particular day Business plan & expected income/ exp. ignored Static vs Dynamic

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BASIS RISK Interest rates on assets and liabilities do not change in the same proportion. When Bank Rate was raised by 2%, PLR was raised by 1% and deposit rates by 1.5% Interest rates movement is based on market perception of risk and also market imperfections. Therefore, basis risk arises when interest rates of different assets and liabilities change in different magnitudes.

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YIELD CURVE RISK Even if interest rates on liabilities and assets are of floating nature, there is danger of Interest Rate Risk If the floating rates are based on different benchmarks for assets and liabilities Bank prices its liabilities linked to 100 bp above 91-day TREASURY BILLS and assets to 300 bp above 364-day TREASURY BILLS

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YIELD CURVE RISK Assume funding a 2 year loan through a 91 day deposit - Deposit interest related to 100 basis points over 91 day T-bill Loan was priced 300 basis points above 364 days T-bill resetting quarterly If the Yield Curve is flat NII is 200 basis points

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**YIELD CURVE RISK - contd..**

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EMBEDDED OPTION RISK Pre-payment of loans in a falling interest rate scenario ( for contracting new loan at low rate ) Premature withdrawal of deposits in rising interest rate scenario ( for reinvestment at higher rate ) In either case, bank will receive lower than anticipated NII

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**MEASUREMENT OF IRR Maturity Gap Analysis**

– to measure interest rate sensitivity of earnings or NII Duration Gap Analysis – to measure interest rate sensitivity of equity Simulation Value at Risk

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MATURITY GAP ANALYSIS A maturity/repricing schedule –distribute all interest sensitive assets & liabilities into time bands. Time bands Related to maturities-if fixed interest Related to next repricing- if floating interest Relative differences in each time band – represents the sensitivity in that band.

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DURATION GAP ANALYSIS Duration of a bond effective maturity/weighted average life of a bond calculated based on present value of the cash flows Apply sensitivity weight to each time band The same concept can be used for any kind of asset if the timing and volume of cash flows and prevailing interest rate is known

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WHAT IS DURATION

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**Duration Gap DURgap = DURa – (L x DURl)/A Where**

DURgap = Duration of the gap DURa = Duration of the assets DURl = Duration of the liabilities A = Market value of assets L = Market value of liabilities NW/A = - DURgap x i/(1+I)

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Simulation Simulate performance under alternative interest rate scenarios and assess the resulting volatility in NII / NIM / ROA / ROE / MVE A financial model incorporating inter-relationship of assets, liabilities, prices, costs, volume, mix and other business related variables Computer generated scenarios about future and response to that in a dynamic way

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**Simulation - Data Requirement**

Maturity and repricing Rate scenarios Alternative management response under different scenarios Yield curves Prepayment tables Behavioural pattern of assets and liabilities Consistency of assumptions

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**Simulation- other information**

Risk-Return policies - management appetite for risk taking Regulatory framework – Ward against practices which are considered unsafe and unsound Capital strength and profitability Experience and track record of management Other risks embedded in the balance sheet - Liquidity / Credit / Forex risks Business plan

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**Simulation -advantages**

Forward looking Dynamic Lessens the role of crisis management Increases the value of strategic planning Enhances capability of analysis Interpretation easy Timing of cash flows captured accurately

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**Disadvantages of Simulation**

Accuracy depends on quality of data, strength of the model and validity of assumptions Time consuming Huge investment in computer Requires highly skilled personnel Analysis paralysis

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**VaR VaR is a risk measurement and management concept**

It “statistically” estimates the potential loss in a position over a given holding position at a given level of certainty due to adverse movement in market variables such as interest rates, exchange rates, equity prices or commodity prices. Mostly used for trading portfolios, and also for strategic balance sheet management

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**VaR & Modified Duration for ALM**

Modified duration essentially measures the interest rate sensitivity of a bond We can calculate the Duration of Equity Duration of Equity={(DA*A - DL*L)/A-L} Modified Duration of Equity = DE/(1+i) For 1% change in interest rate, equity value of bank will change by modified duration percentage

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VaR- contd.. If we know the Modified duration of Equity and standard deviation of interest rate movements (volatility), we can compute MVE at different levels of confidence Example : MVE is 50. Modified duration of equity is 2.5. Standard deviation of interest rate for 1 year period is 1%. What will be MVE at the end of 1 year ?

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**VaR- contd.. Solution MVE at 84.15% loc={50-(50*2.5*1%}=48.75**

Asset-Liability Managers have thus begun to follow this healthy approach of marrying the two most insightful techniques in ALM for strategic balance sheet management

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**Weaknesses of VaR Approach**

Relies on simplifying statistical assumptions like normal distribution, etc.. Past may not be a good approximation of future - volatilities and correlations can change abruptly VaR captures end-of-day rates and not intra-day rates which is important for trading Does not capture “event risk”

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Thank You

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