1. Chapter 81 CHAPTER 8 RISK MANAGEMENT: ASSET-LIABILITY MANAGEMENT (ALM) AND INTEREST-RATE RISK

2. Chapter 82 LEARNING OBJECTIVES TO UNDERSTAND… Risk management as driven by the R in TRICK – risk exposure Asset-liability management (ALM) as the coordinated management of a bank’s on- and off-balance sheet activities driven by interest- rate risk and its two components: price risk and reinvestment risk Accounting and economic measures of ALM performance

3. Chapter 83 LEARNING OBJECTIVES (continued) TO UNDERSTAND… The duration or maturity imbalance (“gap”) in banks’ balance sheets in terms of rate- sensitive assets (RSAs) and rate-sensitive liabilities (RSLs) ALM risk profiles as pictures of banks’ exposure to interest-rate risk and how to hedge that risk using on- and off-balance sheet methods

4. Chapter 84 CHAPTER THEME The business of banking involves the measuring, managing, and accepting of risk This chapter focuses on asset-liability management (ALM) and interest-rate risk ALM is the coordinated management of a bank’s balance sheet to take account of alternative interest-rate, liquidity, and prepayment scenarios

5. Chapter 85 Asset-Liability Management (ALM) Three techniques of ALM: On-balance sheet matching of the repricing of assets and liabilities Off-balance sheet hedging of on- balance sheet risks, and Securitization, which removes risk from the balance sheet

6. Chapter 86 R in Trick – Risk Exposure Risk Exposure calls for Risk Management Basic Exposures Banks Face Arise From: Credit Risk Interest-rate Risk Liquidity Risk

7. Chapter 87 ALM As Coordinated Balance- Sheet Financial Management Three Stage Approach: Stage I – Reflects a global or general approach that focuses on the coordinated management of a bank’s assets, liabilities, capital, and off-balance sheet activities Stage II – Identifies specific components of a bank’s balance sheet used in coordinating its overall portfolio management Stage III – Shows that, given interest rate and prices, a bank’s balance sheet generates its income- expense statement and free cash flow

8. Chapter 88 Balance Sheet Generates the Income-Expense Statement Policies to achieve objectives: 1. Spread management 2. Loan quality 3. Generating fee income and service charges 4. Control of noninterest operating expenses 5. Tax management 6. Capital adequacy 7. Hedging practices

9. Chapter 89 Rate Sensitivity An important distinction should be made between assets and liabilities that are rate sensitive and those that are not (RSA, RSL) Sensitivity can be described in terms of the effective time to repricing or duration Reserves and other liquid assets reprice quickly while long-term, fixed-rate securities and loans do not; since most deposits are short term, they reprice quickly

10. Chapter 810 Liability-Management (LM) Aspect of ALM Two Functions: Reserve-Position LM Generalized or Loan-Position LM

11. Chapter 811 Target Net Interest Income (NII) Minimization of the variability of NII Most critical determinant of a bank’s profitability is credit risk. Viewed in terms of a bank’s risk index (RI): RI = [E(ROA) + CAP]/s ROA

12. Chapter 812 Net Interest Margin (NIM) NIM can be viewed as the “spread” on earning assets, hence the term “spread management” and “spread model” NIM = Net Interest Income/Average Total Assets Where NII = Interest Income – Interest Expense

13. Chapter 813 Why Does NIM Vary Inversely With Bank Size? Competitiveness of the loan-and-deposit markets are a major factor Differences in the volumes, mixes, and pricing (interest rates) of the balance sheet Banks with more variable-rate loans will experience greater fluctuations in interest revenue

14. Chapter 814 Variability of NIM Versus ROA Time period: 1985-2000 NIMROA Mean3.64%0.88% S.D.0.18%0.38% CV0.050.43

15. Chapter 815 Effects of Interest- Rate Risk on Loans Effects on the Loan Portfolio  Interest Rates (Up) Adverse Price Effect Favorable Reinvestment Effect  Interest Rates (Down) Favorable Price Effect Adverse Reinvestment Effect Old Loans Worth Less New Loans Worth More Old Loans Worth More New Loans Worth Less

16. Chapter 816 Effects of Interest- Rate Risk on Deposits Effects on Deposits  Interest Rates (Up) Early Withdrawal (Depositors Seek Higher Rates) Banks Must Attract New Depositors at Higher Rate or Face Liquidity Problems  Interest Rates (Down) Loan Prepayments Due to Refinancing Banks Must Issue New Loans at Lower Rates or Face Shrinking Balance Sheet

17. Chapter 817 Risk Profiles and Embedded Options Loan contracts: When interest rates decline, borrowers tend to refinance – prepayment risk Deposit contracts: When interest rates rise, lenders might be willing to take penalties for early withdrawal – liquidity risk See Figure 8-1, p. 225

18. Chapter 818 Two Faces of ALM: Accounting and Economic Perspectives The accounting model focuses on NII and NIM vis-à-vis measures of maturity gap The focal variable of the economic model is a bank’s market value of equity (MVE)

19. Chapter 819 Relationship Between Change in Interest Rate and Change in NII Δ NII = Δ r[GAP]= Δ r[RSA-RSL] GAP is the difference between rate-sensitive assets (RSA) and rate-sensitive liabilities (RSL). When RSA – RSL > 0, bank has positive maturity gap When RSA – RSL < 0, bank has negative maturity gap

20. Chapter 820 General Illustration of the Accounting Model Δ r +GAP=[RSA-RSL]= Δ NII Pos+Neg=Neg Pos+Pos=Pos Neg+Pos=Neg Neg+Neg=Pos

21. Chapter 821 The Economic Model and a Bank’s MVE Table 8-4, p. 229 MVE reduced to 1.8 = 10 – 8.2 The duration approach approximates this change at –8.5, that is, [89.4(-4.17) – 87.6(-1)]0.03 = -8.5 The next slide explains duration

22. Chapter 822 Duration (Box 8-2, p. 230) Duration can be viewed as the “effective time to repricing”. Take the difference between the market value of assets and the market value of liabilities with each component weighted by its respective duration multiplied by change in interest rate: Δ V ≈ [PV(A)x(-D A ) Δ r A -[PV(L)x(-D L )] Δ r L

23. Chapter 823 Variable-Rate Pricing as an ALM Tool If the loan reprices annually, then the bank has a built-in hedge against rates rising The hedge, however, is not perfect as MVE is not immunized To achieve this a solvent bank must be slightly asset sensitive

24. Chapter 824 Determinants of the Change in MVE (see eqn 8.4b, p. 232) Duration gap adjusted for leverage – the first term below Scale (size) of a bank’s operations – the second term Magnitude of the change in interest rates – the third term ΔV ~ -[D A - λD L ][A][Δr/(1+r)]

25. Chapter 825 The Tactical Versus the Strategic Bank and Yield Curves See Box 8-3 (p. 233), Figures 8-2 (p. 234) and 8-3 (p. 235), and Table 8-5 (p. 236) Exploit a positively shaped yield curve by borrowing short and lending longer, but not too long – avoid the old S&L problem Tactical Bank (LRBA) + Strategic Bank (ARBL) = Overall Bank (ARBL)

26. Chapter 826 Interest-Rate Derivatives (IRDs) Off-Balance sheet activities (OBSAs) that ALM managers use for hedging or trading. Includes forwards, futures, options, and swaps. Four or five of the largest banks/BHCs dominate the IRD market.

27. Chapter 827 Examples of Interest- Rate Derivatives Interest-rate swap (“plain vanilla”) Interest-rate futures Interest-rate cap Interest-rate floor Interest-rate collar See Glossary in Box 8-4, p. 238

28. Chapter 828 Citigroup’s IRDs (30 September 2000) TypeNotional value ($ mils) Swaps3,655,151 Forwards 926,933 OTC Options 538,634 Futures 285,765 Exchange options 37,754 Total5,444,237 Net Fair Value: 306 Ratio of Notional to Fair Value: 17,792 to 1

29. Chapter 829 Relationships between IRDs and Cash- Market Instruments and Among IRDs Figure 8-4 (p. 239) Credit risk and performance period Forward: pure credit instrument with performance at maturity Futures: Guaranteed contract with daily performance (mark-to-market) Swaps: Interval performance

30. Chapter 830 Swap Building Blocks A swap can be viewed as a portfolio of forward contracts A swap can be viewed as a portfolio of cash-market contracts, e.g., a pay fixed-receive floating swap is the same as borrowing at a fixed rate and lending at a floating rate

31. Chapter 831 RISK PROFILES AND HEDGING A LRBA bank has a negatively sloped risk profile An ARBL bank has a positively sloped risk profile Hedging profiles depend on the type of contract. Futures, forwards, and swaps are “linear” while options (caps, floors, collars) are “nonlinear”

32. Chapter 832 Micro and Macro Hedges Macro => hedge the balance sheet’s MVE Micro => hedge a particular transaction Examples of micro hedges (pp. 242- 243) 1. Convert a fixed-rate loan to floating 2. Convert a floating-rate loan to fixed 3. Convert a fixed-rate deposit to floating 4. Convert a floating-rate deposit to fixed

33. Chapter 833 Swaps: Comparative Advantage and Arbitrage Potential Analyze the following situations: 1.AAABBB 10% fixed12% fixed LIBOR + 0.1%LIBOR + 1% 2.LICBank AssetT-bill+1% (6mos.) 8% (fixed,5yrs) Liability7% (GIC,5yrs)T-bill+0.25% (6 mos. CD) Construct swaps for both situations (pp. 244-245) and assume A, L = $50 million

34. Chapter 834 Caps, Floors, and Collars See Figures 8-7, 8-8, 8-9 (pp. 246-248) Buy cap + sell floor = collar (Fig. 8-7) Buy floor + sell cap = collar (Fig. 8-9) The use of collars by LRBA and ARBL banks

35. Chapter 835 Asset Securitization Technique for managing interest-rate risk by removing risky assets from the balance sheet. Pass-through finance – banks either (1) originates and sells loans or (2) originates, sells, and services loans

36. Chapter 836 Building Blocks of ALM Four key building blocks of ALM: Measurement of dollar gaps based on maturity buckets (0-90 days, 91-180 days, etc.) to determine the amount of assets and liabilities being repriced; Estimating the interest rate at which these funds will be repriced; Projecting future interest income and interest expense (rate x volume); Exploring alternative interest-rate scenarios to estimate the bank’s downside vulnerability.

37. Chapter 837 Risk Management Quotes The fact is that bankers are in the business of managing risk. Pure and simple that is the business of banking, Walter Wriston, former Chairman of Citicorp Risk management is perhaps the central topic of the 1990s among managers of financial institutions and their regulators, The Economist

38. Chapter 838 Modern Risk Management Key actions of bank risk management can be highlighted by five action verbs: identify, measure, price, monitor, and control. Two important concepts: Value-at risk (VAR) – A comprehensive measure of risk. Capital-at-risk (KAR) – KAR tolerance level captures the default probability of the bank in terms of its insolvency risk or risk of ruin.

39. Chapter 839 Criticism of ALM ALM is balance-sheet oriented and therefore not easily adapted to OBSAs. ALM measures, which are interest-rate based (gaps and duration) are not necessarily easy to translate across other asset classes. ALM provides little mechanism for arriving at an overall risk level for a firm and is not easily adapted to a risk-adjusted-return framework.

40. Chapter 840 CHAPTER SUMMARY Risk management is the heart of bank financial management and ALM is one of the most important risk-management functions in a bank ALM techniques include 1. Maturity or duration matching of on-balance sheet items 2. Off-balance sheet hedging using IRDs 3. Securitization