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I Abstract
The State Bank of Pakistan (SBP) promulgated prudential regulations for banking
and non-banking financial institutions in July 1992, with a view to ensuring their smooth
functioning. However, these regulations focus mainly on the assets side of the balance
sheet. Recent discussions with commercial bankers reveal that SBP is now directing it’s
attention towards liabilities management also. It is analyzing the liabilities management
function of the banks and suggesting steps for improvement. It is therefore quite likely
that in the near future, SBP might issue specific guidelines and outline limits/ bench
marks for commercial banks to follow, in respect of liabilities management.
Huzier concludes that the benefits of the ALCO approach are: better control over the
balance of income and risk; and consequently lower cost of capital. The costs for the
organization as a whole, are small: a few meetings, some extra reports and start-up effort
of a process. However, ALCO decisions may sometimes be at variance with the desires
of individual business units within the banks. Huzier therefore emphasizes that ALCO
structure should be added to the bank’s bureaucracy only if the business unit managers
participating in the process support ALCO decisions in practice.
Maximilan J.B. Hall (1988) has emphasized the linkage between a bank’s profit and
interest rate changes, and exposure to interest rate risk, which is dependent on the
maturity profiles of its assets and liabilities. His view is that all banks to a greater or a
lesser degree, will deliberately adopt a maturity mismatched position in order to ‘play the
yield curve’ with a view to raising profits, should the anticipated interest rate adjustment
materialize. Having decided on the appropriate mismatched position, banks in practice,
will then diversify between liquidity sources according to the nature of their business
operations, the purpose for which liquidity is needed and the costs and constraints
associated with their usage. The interest rate risk management tools identified by Hall
include:
a) Close monitoring of ‘gap’ (i.e. the amount by which interest–earning assets exceed
interest-bearing liabilities).
b) Interest rate volatility analysis (employing historical data to predict future rate
movements and accordingly taking position in individual markets/ instruments).
c) ‘Immunization approach’ or ‘duration gap analysis’, which aims to construct the
balance sheet in such a way that returns at a specified future date are at least as much
as they would have been had the interest rates remained constant.
d) Financial futures and interest rate swaps, which can be employed by banks as hedging
devices to reduce interest rate risk.
Price Waterhouse (1991) enumerates the following interest rate exposure measurement
techniques:
a) ‘Gap’ analysis. The premise underlying this approach is that if an asset matures or
reprices at the same time as a matching liability, then no risk exists.
b) ‘Duration analysis’. This technique quantifies the interest rate risk exposure of a
bank’s balance sheet into a single number, measured in years.
David Gilbert (1988) underlines the usefulness of computer modelling in interest rate
risk management. He views modelling techniques as central to the control of interest rate
risk because they provide a framework for measuring current exposure and show the
effects of future management actions and changes in the financial environment.
Diagram 1
The Risk Management Process
Diagram 1 represents the complete decision support system for interest rate risk
management. It has three major components: the data; the computer models, which
permit the application of current analytical techniques; and lastly, the reports that provide
for management analysis and action.
The model provides the facility of simulation of results of various alternate management
strategies. However, the modelling framework is only as sound as the its fundamental
structure, the data provided and most importantly, the assumptions on management
actions. The key to a superior modelling framework is the flexibility it can offer to
realistically portray the structure of the bank, the financial environment and management
Liquidity risk refers to the possibility of a bank not having enough funds available to
meet a payment obligation on a contractual due date. The reasons for shortfall in funds
could be:
Interest rate risk relates to the chance of variation in a bank’s profitability due to
changes in interest rates. Of particular importance in this respect would be the maturity
profiles of assets and liabilities contracted by the bank. In other words, the higher is the
difference in the average maturates of assets and liabilities, the larger would be the
fluctuation in profitability due to upward or downward movements in interest rates.
Even though liquidity and interest rate risks can be viewed as conceptually
different from each other, as shown above, they are in effect two sides of the same coin
when a bank is evaluating its own balance sheet. This is so because when a bank attempts
to fine tune its liquidity, any action taken on either side of the balance sheet is bound to
affect its interest rate exposure. When liquidity management decisions are motivated by
anticipated future interest rate movements, with the aim of profit maximization, both
liquidity and interest rate risks would increase. For instance, if a bank has strong reasons
to believe that short-term interest rates would fall significantly in the near future, it may
decide to minimize liquidity to the maximum possible extent. For this it may switch from
short-term assets to marketable securities of a longer term and restrict its borrowings so
that it could gain from lower borrowing costs or higher security prices in the future.
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III.1 Managing Liquidity Risk
As is the case in managing any other type of risk, diversification plays a key role
in liquidity risk management of a bank. Diversification for the bank on the liabilities side
would primarily be in two forms:
On the assets side, liquidity would be affected by the mix of the asset holdings i.e.
cash, readily encashable short term investments/securities, interest payments and
principal repayments against loans and advances, and interest or dividend payments
against debt or equity instruments held as long term investments by the bank.
While deciding on the optimal mix of deposits, the relatively low cost of readily
withdrawable saving accounts and current accounts has to be compared with the higher
cost but also higher stability of term deposits. On the assets composition front, cash,
short-term investments or readily encashable securities contribute towards high liquidity
but at the cost of giving relatively low returns. However, cash flows from loans and
advances as well as from long term investments though promising a higher return, suffer
from some uncertainty since the timing and/or amount of cash receipts may differ from
schedules or expectations. In other words, it cannot be said with high certainty that
borrowers would pay interest or principal dues on time or a particular stock would
declare an expected dividend. Further, the difficulty in predicting the cash flows from
new deposits and the market demand for new loans and advances adds more complexity
to liquidity management.
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floating rate basis. However, this is practically not possible because one of the main roles
of a deposit-taking bank is to reconcile the conflicting requirements of borrowers and
lenders by accepting variable rate deposits and giving loans on a fixed rate basis. The
monitoring of interest rate risk on the balance sheet requires regular evaluation of
changes in balance sheet composition, as market interest rates change. After identifying
the exposure, the bank can chart out a plan to deal with it.
The net exposure to interest rate risk depends on the relative timing of when
interest rate sensitive assets and liabilities reprice. Repricing refers to the point in time at
which the interest rate attached to an asset or a liability can be reset. This occurs:
Two of the main techniques for assessing interest rate exposure are:
i) Gap analysis
ii) Duration Analysis
The direction of the gap in each period will govern the type of exposure:
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Assets greater than liabilities in the period (positive gap) implies exposure to
reduction in interest rates in the period.
Assets less than liabilities in the period (negative gap) implies exposure to increase in
interest rates in the period.
Gap analysis is simple to apply and relatively easy to understand, however, it has the
following limitations:
It does not consider the timing of maturity or repricing within the periods and
therefore its accuracy is restricted to the length of each ‘time bucket’.
It does not quantify the total risk, as it only analyses it by ‘time bucket’.
Gap analysis can be modified to measure ‘cumulative gap’. This is the summation of
the periodic gaps, which occur in each time bucket. The cumulative gap provides an
indication of the interest rate position over the longer term.
As a result of the stated shortcomings of gap analysis, its use is recommended for
exposure measurement of assets and liabilities, which mature within six month to a
maximum of one year. This is because the impact of the shortcomings increases with
increase in length of the time bucket. Besides providing an assessment of exposure to
interest rate risk, a close monitoring of the ‘gap’ (i.e. the amount of interest earning assets
less interest bearing liabilities) can help in improving a bank’s profitability by making
requisite changes in balance sheet composition. For instance, if interest rates are
anticipated to rise in future, the bank may try to increase the proportion of such interest
earning assets held, whose yield moves in line with market rates and/or reduce the
proportion of interest bearing liabilities, whose yield is also linked to market rate
movements. Thus, if interest rates actually rise as expected, the yield on assets would
increase at a faster rate as compared to the rate of increase of yield on liabilities, thereby
increasing interest spreads at least temporarily. An exactly reverse strategy would be
appropriate if market interest rates were expected to fall in future and result in increasing
interest spreads, if the market interest rates fall as anticipated. However, the practical
implementation of the strategy in each of the preceding situations, would be subject to the
degree of interest rate risk, the bank is willing to bear, as well as on the degree of
flexibility available to it to adjust its balance sheet, as it desires.
III.4 Duration Analysis
To understand the concept of duration, it would be simple to look at only one
asset e.g. a five-year bond of $ 1000 face value with a 10 percent annual coupon interest.
The duration calculation for such a bond is shown below:
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Table 2: Duration Analysis Illustrated
Year 1 2 3 4 5
___________________________
Cash inflow ($) 100 100 100 100 1100
The above concept can be extended to the entire balance sheet of a bank i.e. if a
bank is able to exactly match duration of its rate sensitive assets and liabilities, there
would be no exposure to interest rate risk.
In the case of a bank, the duration concept can be applied through estimation of
‘duration of equity’. Sample calculations based on assumed market values and duration
of assets and liabilities are exhibited below:
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The interpretation of the duration of equity is as follows:
∆ Market value of equity = ∆ Market interest rate x duration of equity
This means that for a + 1% change in market interest rate, there would be a +
3.4% change in the market value of the bank. Thus, the higher the duration number, the
higher would be the bank’s exposure to interest rate risk. Conversely, the bank would be
completely insulated from interest rate risk if the duration of equity is zero i.e. the market
value of the bank’s equity would not change with changes in interest rates.
The market value of assets is simply the present value of estimated case flows
from these assets. The present value calculations for fixed rates advances would be
simple. However, for variable rate assets like investment in stocks, appropriate discount
rates would have to be estimated, for computation of present value of projected cash
flows. The appropriate discount rates would depend on the assessment of riskiness of the
assets in question. A similar process will apply to the present value calculations
pertaining to liabilities.
IV. Scope and Methodology:
A sample of eight commercial banks was chosen from the commercial banks
operating in Pakistan. They were requested to provide information as per questionnaire
given below:
Table 3
Q.1. Is there a formal set up available at your bank to look after the ALM function e.g.
an Assets/Liabilities Management Committee (ALCO).
a) Yes
b) No
c) Presently being planned
Q.2. If the answer to Q.1 is ‘Yes’, how many of your executives/officers are members
of ALCO ?
------------ members
Q.3. Which functional executives are represented on ALCO ? Please give designations
below:
i)
ii)
iii)
iv)
v)
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Q.4. How often does the committee meet?
a) Weekly
b) Fortnightly
c) Monthly
d) Quarterly
e) Other (pl. specify)
Q.6. What are the analysis techniques used at your bank to help in ALM:
Q.7. What percentage of gap between market rate assets/liabilities on your balance
sheet, do you consider to be acceptable:
a) Upto 10%
b) Upto 15%
c) Upto 20%
d) Other (pl. specify)
a) Reactive
b) Pro-active
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Q.10. Do you think that our financial markets provide enough financing, investment and
risk management opportunities to enable following a pro-active ALM policy?
a) Yes
b) No
Q.11. Are you presently using any computer based tool or models to assist you in the
ALM function?
a) Yes
b) No
a) Yes
b) No
a) Yes
b) No
Q.14. If your answer to Q.12 is Yes, are you satisfied with the guidelines?
a) Yes
b) No
Q.15. If your answer to Q.14 is ‘No’, please specify the changes you desire in SBP’s
guidelines for liabilities management.
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.
Since most of the banks approached were reluctant to permit quoting their names,
the information has been obtained on the understanding that specific cross reference
between the information given and the bank’s name would not be disclosed in this paper.
V. Analysis of Results
Based on the responses to the questionnaire by the eight banks in our sample the
following picture emerges:
i) Six out of eight banks have a formal management committee concerned with
ALM. In one other bank the Executive Committee, also looks after ALM matters.
Thus, ALM issues are formally being handled in seven out of eight sample banks.
ii) The number of senior executives on ALCOs ranges from five to eight members
and the CEO heads the committee in five out of the seven banks with formal
ALM.
iii) At all the seven relevant banks, ALCO is a decision making body and not merely
an advisory body.
iv) Amongst ALM analysis techniques, three banks use static “gap” analysis and two
use duration analysis. One bank conducts both gap and duration analysis, while
the remaining one bank could not specify any analysis technique it was using.
v) The three banks, which conduct “gap” analysis, agree that ideally, the gap
between market rate assets and liabilities on their balance sheet should be a
maximum of 10%.
vi) Only one bank is utilizing computer based models for assisting in their ALM
function.
vii) ALM’s chief objective is identified as ‘managing liquidity risk’ by three banks, a
combination of ‘managing liquidity risk’ and ‘capital adequacy’ by one bank,
‘achieving a target net income’ by two banks, while one of the banks was unable
to specify the chief objective of its ALM.
viii) Six banks claim that they are following a pro-active ALM policy, while one bank
could not specify whether their ALM policy was pro-active or reactive.
ix) Five banks feel that our financial markets offer enough financing, investment and
risk management opportunities for pursuing a pro-active ALM policy. One
respondent thinks otherwise while one did not respond to this question.
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xi) Six banks say that the State Bank of Pakistan (SBP) has not provided them any
guidelines in respect of liabilities management.
xii) The only bank which says that SBP has provided guidelines for liabilities
management, has not given its opinion on whether or not it is satisfied with these
guidelines.
Table 4
Summary of responses to questionnaires, given to 8 sample banks.
1. No. of sample banks with formal ALM setup. 7 (88%)
No. of sample banks with no formal ALM setup. 1 (12%)
8 (100%)
2. No. of sample banks out of 7 in which CEO heads the ALM setup. 5 (71%)
3. ALM techniques used by the 7 banks:
a) ‘Gap’ analysis 3 banks (43%)
b) Duration analysis 2 banks (29%)
c) Combination of a) & b) 1 bank (14%)
d) No response 1 bank (14%)
7 banks (100%)
4. Use of computer modelling for ALM: 1 bank (14%)
5. ALM objectives specified by 7 banks :
a) Managing liquidity risk 3 banks (43%)
b) Combination of a) & capital adequacy 1 bank (14%)
c) Achieving a target net income 2 banks (29%)
d) No response 1 bank (14%)
Total 7 banks (100%)
6. Type of ALM policy (pro-active or re-active)
a) Pro-active 6 banks (86%)
b) No response 1 bank (14%)
Total 7 banks (100%)
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VI. Conclusions and Recommmendations:
i) Most of the banks have set up ALCOs, not out of realization for the need of such
a committee, but because of SBP’s recommendations in the course of SBP’s audit
and inspection of banks.
ii) There is a general lack of in-depth awareness of ALM issues and analysis
techniques pertaining thereto. The banks do not even agree on the chief goal of an
ALM policy.
iii) While most banks claim that they are following a pro-active ALM policy, only
one bank is utilizing computer-based models as an aid for the required analysis. It
is therefore unlikely that ALCO meetings would presently be discussing projected
balance sheets based on alternate scenarios of different assumptions of
management actions. Thus, most of the banks are very far from the stage of using
computer modeling and simulation, without which a dynamic policy is difficult to
pursue in today’s competitive world.
iv) SBP has started raising queries and giving observations on liabilities management
aspects of banks, without providing clear cut guidelines, bench marks or
permissible limits for parameters it would like to monitor.
The importance of the ALM function for commercial banks cannot be over
emphasized. The concerned bankers have become aware about asset management issues,
since they have to comply with SBP’s prudential regulations, which focus mainly on the
asset side of a bank’s balance sheet. However, the same is not true about liability
management aspects for which SBP is yet to issue guidelines.
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The overall picture that emerges from the information obtained through the
questionnaires is that the ALM function is generally not being performed properly by the
commercial banks in Pakistan. In particular the management of liabilities leaves a lot to
be desired. An efficient ALM function would not only enhance the profitability of banks
but also result in a better return for the depositors and share holders. Following are some
recommendations for bringing about improvement in the ALM function:
(i) SBP should expand the scope of its prudential regulations to encompass liability
management aspects and develop guidelines to be followed by banks. This should
be done in consultation with representatives of the banks. Sufficient time would
need to be given for implementation of these guidelines, considering that some of
the large banks have a substantial infected loans portfolio, which greatly reduces
their flexibility to readjust their balance sheets.
(ii) Alongwith developing benchmarks for ALM, SBP should also look at related
issues such as provisioning against non-performing loans (NPL). Despite SBP’s
specific guidelines for provisioning, a number of banks appear to get away with
under provisioning. This aspect is important for a meaningful monitoring of ALM
by SBP.
(iii) Without waiting for SBP’s guidelines, the banks should themselves take steps to
strengthen the ALM function by providing adequate training to their concerned
staff.
(iv) Banks should try to make their ALCOs more dynamic. As a first step, the monthly
ALCO meetings can start discussing quarterly projected balance sheets developed
on the basis of inputs from the various operating divisions. A projected balance
sheet would provide early warning signals, enabling the bank management to take
timely corrective action, of course within the flexibility constraints imposed by
internal factors as well as the external environment.
(v) Implementing (iv) would gradually lead to development of computer models and
simulation of the internal and external environment. This would enable
development of projected balance sheets under various scenarios or sets of
assumptions, thereby allowing the management to choose the optimum course of
action.
(vi) The efficacy of the ALM function would depend on the ability of a bank to
identify the critical ingredients of inputs for their model for preparing a projected
balance sheet. With experience and development of ALM expertise, the inputs
can be modified from time to time. However, the main input areas can be
identified as:
a) Economic forecasts.
b) Financial markets performance forecasts.
c) Impact of tax, accounting or regulatory changes.
d) Analysis of likely net additions to assets and liabilities.
e) Conformity with limits imposed by regulatory authorities.
f) Interest rate risk exposure positions.
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References
David Gilbert (1988), The tools of Interest Rate Risk Management, Euromoney Books p.
205-236.
M.C Huizer (1988), The ALM Function: Development and Strategy, Euromoney Books
p. 85-110.
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