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Asset Liability Management

ALM
asit

Basel III vs Basel II

Basel II
Pillar 1 Capital Adequacy Ratio =
Regulatory Capital Funds
-------------------------------------------------Risk Weighted Assets (On & Off B/S)
9%
Total Risk Weighted Assets =
[Mkt RWA + Operational RWA+ Credit RWA]

Non-Equity Capital Instruments in


Basel II
Recognized as part of regulatory capital funds by
RBI
As Part of Lower Tier 1 Capital
Innovative perpetual debt instruments (IPDI)
Perpetual, Non cumulative Preference Shares (PNCPS)

As Part of Tier 2 Capital

Perpetual Cumulative Preference Shares (PCPS)


Redeemable, Cumulative or Non-Cumulative Preference
Shares (RCPS or RNCPS)
Long Dated debt instruments (UT II)
Subordinated Debt

The cost of hybrid capital, varied over time, and depended


on the strength of the issuer bank and on the nature of
securities issued

A combination of regulatory change, strong bank asset


growth and a favourable market environment contributed to
the evolution of the market of hybrid bank capital securities
in India

Basel III
In Dec 2010, BCBS issued the Basel III guidelines on the
new regulatory standards for bank capital adequacy
and liquidity
The Reserve Bank of India issued the final Basel III
Capital Regulations in May 2012 which came into force
from 1st of April 2013 in a phased manner over 5 years
In Mar 2014, RBI extended the deadline for full
implementation of Basel III capital ratios to 31 st March
2019.
Basel III is not a replacement of Basel II but a series of
amendments and enhancements to the existing Basel II
framework (NCAF in India) with the objective of
improving the banking sectors ability to absorb shocks
arising from financial and economic stress.

Basel III Building Blocks


Capital Reforms

Liquidity
Standards

Higher Minimum
Equity Capital

Short Term: Liquidity


Coverage Ratio

Better Quality,
Consistency and
Transparency of
Capital

Long Term: Net


Stable Funding Ratio

Higher Capital
Requirement via
Capital Conservation
Buffer

Minimum Leverage
Ratio

Systemic Risk

Enhanced
Risk Cover

Less Capital for OTC


Derivatives cleared
through Central
Counterparty

CVA Capital
Charge for OTC
Derivatives

Higher Capital for


Inter-financial
Exposures

Higher Capital
Charge for
Securitisation
Exposures

Procyclical Capital
Buffer

Capital Surcharge
for Systemic Banks

Bank Capital Levels during Financial


Crisis
As reported in an IMF paper,, the reported Tier 1
ratios were significantly higher at 7-8% during
financial crisis
Tangible common equity ratios for some banks
had fallen to below 2% of RWA whereas

Quantum of good quality capital (primarily,


Common Equity) required under Basel II was too
low

Minimum Capital Adequacy


Requirements: Basel II Vs Basel III
Basel II
Regulatory Pillar 1 Capital
Components
Tier 1 Capital (Core Capital) (Min)
- Common Equity Tier 1 (Min)
- IPDI (max)
- PNCPS + IPDI (max)
Tier 2 Capital (Supplementary
Capital) (Max)
- Subordinated Debt (max)
- Upper Tier 2 Debt
CAR Pillar 1 (Min)

% of
RWA
6.0%
3.6%
0.9%
2.4%

Basel III
Regulatory Pillar 1 Capital
Components
Tier 1 Capital (Going Concern Capital)
(Min)
- Common Equity Tier 1 (Min)
- Additional Tier 1 (Max)
Tier 2 Capital (Gone Concern Capital)
(Max)
CAR Pillar 1 (Min)

% of
RWA
7.0%
5.5%
1.5%

2.0%
3.0%
9.0%
2.50
3.0% Capital Conservation Buffer (Min)
%
11.5
9.0%
CAR + CCB (Min)
%

Min. Contribution of Common Equity has gone up


Max. Contribution of AT 1 has gone done down
Max. Contribution of T2 has gone down
Only if bank has complied with minimum CET1 ratio and T1
ratio, can excess AT1 capital be admitted for compliance with

Transitional Arrangements
Transitional Arrangements - Scheduled Commercial Banks

(% of RWAs)

311-Apr- Mar3131313131Minimum Capital Ratios


13
14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19
Minimum Common
Equity Tier 1 (CET1)

4.5

4.5

Minimum Tier 1 Capital

6.5

Minimum Total Capital

Capital Conservation
Buffer (CCB)
Minimum CET 1 + CCB

5.5

5.5

5.5

5.5

5.5

0 0.625

1.25 1.875

2.5

5.5 6.125

6.75 7.375

Components of Regulatory Capital


Funds under Basel II
Regulatory
Constraints

Cost to
Bank

Regulatory Capital

High
Common Equity,
Reserves &
Surplus,
Retained Earnings
Lower Tier I
Upper Tier II

Lower Tier II
Subordinated debt
(Dated)

Tier I
50% at least
of minimum
capital ratio
of 8%
Max up to 100% of
Tier I (along with
Lower Tier II)

Max up to 50% of
Tier I

Loss
Risk to
Absorption investor
High

High

Low

Low

ROE:14% - 16%

9.25% - 11.15%

9.10% - 10.85%

7. 5% - 9.45%

Low

Capital Conservation Buffer


The additional requirement of common equity to the
extent of 2.5% of RWA over and above the minimum
5.5% of CET1 in the CRAR
To ensure the availability of tangible equity funds
which can absorb losses during a stressed period
(systemic or bank specific), without causing the bank
to breach minimum capital requirements and continue
normal business activities
A bank must first use available common equity (post
deductions) to demonstrate that it meets the
minimum CET1 requirements, T1 requirements and
overall capital adequacy requirements (9%) before it
can demonstrate adequacy of CCB
Lower CCB equity relative to the specified threshold
would place restrictions on dividend distribution

Why Capital Planning under Basel


III?
Basel III will result in less available capital to
cover higher RWA requirements and more
stringent minimum coverage for quantity and
quality of bank capital
More capital will be required to continue to
operate above higher minimum buffers, but then,
Capital is scarce
Capital is costly
Capital is not continuously available

Global Banks have already


Reacted
European, American, Asian, Australian banks have already issued
Basel III compliant capital instruments

Banks such as UBS, Socit Gnrale, Credit


Suisse, Deutsche Bank and Royal Bank of Scotland
have issued about 91 billion ($102 billion) of
CoCo Bonds from April 2013 until early 2016.
UBS issued bonds in 2011 that will be written down in case CET1
ratio falls below 5% and intends to reduce RWAs closer to 300
billions francs under Basel III rules and wont pay dividends till 2013
14 till reserves build up
HSBC lowered its growth plans by 3% in response to stricter capital
rules
Credit Suisse cut its 2010 dividend by 35 percent and lowered
growth plans in next 3 to 5 years by 3 percent

ASSET- LIABILITY MANAGEMENT

Asit Mohanty

Outline

Basel III and ALM


ALM as Career Option
Objectives of ALM
Interest Risk Management in Banking Book
Deposit and Loan Pricing
Liquidity Risk Management
Hands On (Proof of Concept)
New Generation ALM
Interest Rate Forecasting Techniques
ALM & Economics of Securitization of Assets
Valuation of Banks
De-monetisation and ALM

OBJECTIVES OF ALM

TO MANAGE THE LIQUIDITY OF A BANK EFFICIENTLY


Through the Outflow /Inflow of the existing liability / asset
Creation of New Business

TO MANAGE THE INTEREST RATE RISK

BY PROTECTING NII / NIM (SHORT TERM GOAL)


NET INTEREST INCOME IS THE EXCESS OF INTEREST EARNINGS OVER
INTEREST EXPENSES
NIM IS THE RATIO OF NII TO TOTAL INTEREST BEARING ASSETS
Therefore, to decide about the BENCHMARK PLR

TO IMPROVE THE NETWORTH OF A BANK


Compute Market Value of Equity (MVE)

Compute Economic Value Addition (EVA)

Deposit and Loan Pricing


Securitization

(LONG TERM GOAL)

Scope of ALM

Liquidity Risk

Liquidity Profile of
Assets & Liabilities
across time Buckets

Static Liquidity Ratio


Analysis
Dynamic Liquidity
Position
Liquidity Index
Cash flow model for
Perpetual products

Interest Rate
Risk
Interest Rate Sensitive
Position of Assets &
Liabilities
Modified Duration at
Product Level
Modified Duration Gap
of the Balance Sheet
Risk Based Pricing of
Loans

Earnings/MV
E Analysis
EaR Analysis
MVE Analysis
EVA Analysis

Value at Risk
Both Asset &
Liability

Mean Reversion
Interest Rate Model for
forecasting of Interest
Rate

Pre Payment
Modelsprepayment
rate of the Retail
Mortgage Loan

Monte Carlo Simulation


for Interest Rate Risk

Valuation of
Banks

Non Market Related


Off Balance Sheet
Model

NPV Method to
measure Interest Rate
Risk in Banking Book

Scenario Manager
Worst Case

ALM

& Best Case


Scenario

ALM Process
Flow
Common
Inputs

ALM Computations

(CBS)

(Cash Flow Engine)

ALM Output

Contractual
Perpetual
OBS
Residual &
GL based

Cash Flow Engine

Simulations
Periodic

Contractual Positions
IAS 39

IRR

LR

Simulations
Daily Liquidity
Periodic

Behavioral Models

Scenario Manager

Scenarios

NII

IRR

LR

NII

MD

ALM

MVE

Gap

Ratios

EaR

Projected Balance
Sheet
Projected P&L

ALM Process Flow

3 Tier hierarchy for ALM Process Flow

IBM - Algo Asset Liability


Management
Algo Asset Liability Management features
include:

Sophisticated analytics and reporting tools help


assess earning sensitivity, future market valuation and
liquidity risk.
Comprehensive regulatory compliance supports Basel
III, IAS 39 and FAS 133 international accounting rules and
more.
Scenario-based
Optimizer
enables
risk-informed
assessment of the trade-off between earnings and values.
Comprehensive asset and liabilities coverage spans
off-balance sheet items, with measures such as NIM and
FTP.
Internal limits support enables forecasts of future
business to take into account corporate limits for liquidity
and hedging policies.

Asset Liability Management


Moodys Analytics

Accurate Balance Sheet Risk


Management

Oracle Financial Services Asset-Liability


Management

Analyze and forecast interest


rate risk through deterministic
and stochastic simulation
results
Monitor Liquidity Gaps,
Funding Concentrations,
Marketable Assets and
Liquidity Ratios on a daily
basis
Access to granular and
actionable ALM insight
directly within operational processes

Sungard ALM
Kamakura Risk Manager (KRM)
FERMAT ALM

Piper
TruView
Fermat ALM
RV Limits
FXAT

MeasuRisk
Askari
Fermat
MKIRisk
Alphametrics

Findur Asset Liability Management

OpenLink

IPS-Sendero A/L Systems,


Asset/Liability Budget Management
(ALBUM)
BARRA TotalRisk (TM) for Asset
Management

IPS-Sendero
BARRA, Inc.

KRM-ni: Net income simulation,


The Kamakura Cor
KRM-tp: Transfer pricing, KRM-dc:
poration
Deposit valuation
RiskPro(TM) Value Exposure
Analysis, RiskPro(TM) Funds
Transfer Pricing FTP
BancWare Convergence, BancWare
Insight

IRIS integrated ri
sk management
ag
SunGard Trading a
nd Risk Systems

Risk Trade

RiskBox.com Ltd

http://www.bobsguide.com/guide/ass
et-and-liability-managementsolutions-2.html

Introduction to ALM ALM InstrumentsGlobal


Practices
There are two
Primary Risks associated with ALM
Interest Rate Risk and Liquidity Risk
Interest Risk arises from the possibility that profits will
change if rate of interest change.
The Liquidity Risk arises from the possibility of losses due
to bank having insufficient cash on hand to pay customers.
ALM is different from management of Market Risk because
Market risk deal with trading operation and ALM Positions
are relatively illiquid..takes care of Banking Book
After origination, the assets and liabilities are typically held
by the bank until they mature, although it is becoming
increasingly common to bundle banking products such as
loans into securitization and sell or trade them with other
banks.

Introduction to ALM ALM Instruments..Contd


U.S Saving & Loan Crises

The best illustration of ALM Risks is given by U.S


(S&L) crisis (Thrift and Building Society)
The Commercial Banks in US were mandated by
FED to take Retail deposits at 4% and can lend
to 30 year mortgage loans at 8%.....the rate are
fixed and regulated by the FED. This gives 4%
spread.
In 1980, FED deregulated the rate of interestas a
result the short term rate rose to 16%....many
depositors withdrew their fund..re priced at
higher ratehowever loans were locked at 8%
for 30 years.
The spread became negative..most of the Banks
went Bankrupt
By the end of 1982, massive losses had driven the
tangible capital of the industry down to 0.5% of
total assets

This ALM Risk is combination of


Interest Risk and Liquidity Risk.

The measurement of ALM Risk is


made more difficult than the
management of a simple bond
portfolio
as
the
indeterminate
maturities of assets and liabilities.

The indeterminate maturities of


Assets and Liabilities leads to
uncertainty of as to when borrower
will make or the depositors ask for
payment

ALM Instruments.Contd

Therefore, the ALM positions makes to measure the risk in


the banking book as well as trading Book.

ALM products are mainly driven by the customer behavior


such as mortgages and deposits have many implicit or
embedded options that makes the values dependent not
only on market rates but also on customer behavior.

For Example, the depositors can any time withdraw their


deposits and borrower can prepay the loansif the
borrower find a cheaper rate else where.

Introduction to ALM ALM Instruments..Contd


Global Practice

Assets

Retail Personal Loans


Retail Mortgages
Credit Card Receivables
Commercial Loans
Long Term Investments
Traded Bonds
DerivativesOff Balance Sheet Item

Liabilities

Retail Checking accounts


Retail Saving Accounts
Retail fixed Deposits accounts
Deposits from Commercial Customers
Bonds issued by Bank

Asset Liability
Management

Interest Rate Risk (IRR)


Management

Interest Rate Risk (IRR)


Management

Rate Sensitive Assets


Rate Sensitive Assets: These are those
assets that are sensitive to changes in
interest rate movements.
Non Sensitive Assets
Cash
Fixed Assets
Other Assets

Sensitive Assets:
Loans
Investments
Balances with other banks (except Current Account)

Rate sensitivity .Based upon.. Re pricing time bucket

Time Buckets.8 Time Buckets based upon Re pricing


Re pricing Buckets
1.
2.
3.
4.
5.
6.
7.
8.

1 to 28 days
29 days and up to 3 months
Over 3 months and up to 6 months
Over 6 months and up to 1 year
Over 1 year and up to 3 years
Over 3 years and up to 5 years
Over 5 years
Non -Sensitive

Re Pricing of Asset or Liabilities in different time bucket

Interest Rate Sensitivityof Asset

Interest Rate Sensitivity of Liability

Liability
Rate sensitivity and Re pricing time bucket

Capital, Reserves and Surplus


Non-sensitive

Demand Deposits (CASA)

Current Account.Non-sensitive.

SB RSL

Liability
Rate sensitivity and Re pricing time bucket

Term Deposits & CD.fixed rate of Interest

Sensitive.is re priced on maturity. The


amounts should be distributed to different
buckets on the basis of remaining term to
maturity.

Term Deposits.floating rate of Interest

the amounts may be shown under the time


bucket when it is due for re pricing.

Liability
Rate sensitivity and Re pricing time bucket

Borrowings. Includes..Refinances, Inter Bank Borrowing, Call


Money Borrowing, Zero Coupon

Borrowings Fixed Rate

Sensitive and re prices on maturity. The amounts should be


distributed to different buckets on the basis of remaining maturity.

Borrowings.Floating Rate

Sensitive and re prices when interest rate is reset.. distributed to


the appropriate bucket which refers to the re pricing date.

Borrowings Zero Coupon

Sensitive and re prices on maturity. The amounts should be


distributed to the respective maturity buckets.

Provisions other than for loan loss and depreciation in


investments
Non-sensitive
Repo.. Sensitivefirst Time Bucketat the maturity

Asset
Rate sensitivity and Re pricing time bucket

CashNon - sensitive.
Balances with RBI
.Non - sensitive

Balances with other Banks

Current AccountNon - sensitive


Call Money.sensitive. 1-14 days
bucket

Asset
Rate sensitivity and Re pricing time bucket

Investments Fixed Rate / Zero Coupon

Sensitive on maturity

Investments Floating Rate

Sensitive at the next re pricing date

Shares/ Mutual Funds


Non Sensitive
Cash Credits / Overdrafts/ Loans repayable on demand and
Term Loans
Sensitive only when Base Rate is changed.Re
pricing Date.
If there is anticipation of frequent changes in Base
rate, then time bucket for rate sensitive positions
will coincide with future change in Base
Rate/MCLR
For Loan with fixed Rate of Interestthe rate
sensitive position will be reflected at maturity.

Asset
Rate sensitivity and Re pricing time bucket
Net NPA
Sub-standard Asset(SA). Over 3-5 years
bucket..sensitive during the Recovery
period
Doubtful and Loss Over 5 years
bucket sensitive during Recovery the
period

Fixed Assets..Non Sensitive


Reverse Reposensitive in 1-14 days bucket

Sample Interest Rate Statement(IRS )


Rs. in Crores
1 3 months 3 6 months 6 12 months
RSA

200

300

200

RSL

100

500

300

RS Net Gap

100(AS)

-200(LS)

-100(LS)

RS Cumulative Gap

100

-100(LS)

-200(LS)

Observations:
One year cumulative gap is liability sensitive.
The increase in interest rate would result in reduction of NII.
For 1% change the interest rate, NII will decline by Rs.2 crore.

A TYPICAL INTEREST RATE SENSITIVITY ANALYSIS.interpret


(Rs. in Crores)

RESIDUAL MATURITY

TOTAL
LIABILITIES
(A)

TOTAL ASSETS
(B)

GAP
(C=B-A)

1 TO 28 DAYS

2188

2481

293

29 DAYS TO 3 MONTHS

565

978

413

OVER 3 MON. TO 6 MONTHS

1557

4256

2699

OVER 6 MON. TO 1 YEAR

1544

789

-755

OVER 1 YEAR TO 3 YEARS

2995

2980

-15

OVER 3 YEARS TO 5 YEARS

11023

7895

-3128

OVER 5 YEARS

4349

3361

-988

NON SENSITIVE

5870

7680

1810

TOTAL

30091

30420

329

Types of Interest rate risks


RS Gap
Basis
Yield curve

Gap risk- example


(In a particular Bucket)
Up to 3 months Time bucket
Rate Sensitive Liabilities
Borrowings
Term Deposits

Rate Sensitive Assets


30

Investment

10

70
100

Advances

80
90

Gap = RSA - RSL =


-10
Interst rate falls by 1%, NII will change by

0.025

Gap Analysis
Take a view on change in ROI for
different RSA & RSL
Multiply the value of RSA & RSL in a
time bucket by expected interest rate
change
Compute gap

Gap risk
Rate Sensitive Asset & Liability
Position are different in a particular
Re pricing time bucket
Lead to gap risk

Gap report

RSA> RSL= POSITIVE Rate sensitive GAP


RSL> RSA= NEGATIVE Rate sensitive GAP
RSA=RSL= NEUTRAL GAP
Compute
individual gaps for different time buckets and
cumulative gaps

Gap Analysis
Challenge
Identify Rate Sensitive Position and
re pricing date
Limitation
Assumes Parallel shift in yield
curveignores basis risk
Ignores time value of money

Gap Risk
Basis Risk

Basis Risk Example.Rise in ROI


Interest rates on assets and liabilities do not
change in same proportion..in 1 year Time
Bucket
--------------------------------------------------------------------RSL
RS LiabilityInterest Expenses
Total
200
Call ( 50 ) goes up by 5% = (2.5)
Variable Repo ( 50 ) goes up by 3% = (1.5)
Deposit ( 100 ) rate goes up by 4% = (4.0)
--------------------------------------------------------------------RSA
RS AssetInterest Income
Total
150
TB (30) yield goes up by 2% = 0.6
Base rate for advances (120) goes up by 2%
=2.4
----------------------------------------------------------------------

No Gap Risk
But Basis Risk

Basis risk
Change in Interest rate on assets and liabilities is not in
the same proportion
If Repo is Rs. 50 crore & deposits is Rs.75 crore, whereas
loans = Rs 125 cr
When Repo Rate declines by 50 bps, deposit rates is
declined by 1.5%. and Lending Rate by.. 1.0%
NII & NIM ?
Therefore, basis risk arises when interest rates of different
assets and liabilities change in different magnitudes

Basis risk
What happens to NII?
Fall in NII by Rs 0.48 crore.
Change in NII is -0.48 crore

Yield curve Risk


If the floating rates are based on different
benchmarks for assets and liabilities
A 2 year loan is funded through a 91 day
deposit
Deposit is taken at 100 basis points above
91 day T-bill (= 100 cr)
Loan is priced 300 basis points above 364
T-bill.( 70 cr)
Spread is 200 basis points

Yield curve risk- contd..

70*10%

-100*6.25% = 0.75 cr rise in NII

Earning @ Risk

EaR for negative change in NIM


The impact of adverse movements in Interest rate
on NII .Earnings at Risk (EaR).
In order to evaluate the earnings exposure,
Interest Rate Sensitive Assets (RSAs) and RSL in
each time band are to be identified.
IR Gap is to be measured in each time bucket.
Both Basis Risk and Yield Curve Risk are need to
be captured

The EaR method facilitates to


estimate how much the earnings
might
be
impacted
by
an
adverse/favorable
movement
in
interest rates.

The changes in interest rate could be


estimated on the basis of past
trends, forecasting of interest rates,
etc.

Elasticity-based Pricing

Elasticity Based Pricing


The pricing rule captures the impact of changes in deposit rates
on the volume of deposits.
For instance, if the deposit volume goes up from 100 to 115 as the
rate increases from 10% to 11%, the elasticity of the deposit is
1.5.
The rule suggests that deposit rates vary directly with the (i) H.O.
rate and (ii) price elasticity of deposits.
The H.O. rate reflects the general level of interest rates in the
economy. As market rates rise, customers demand higher deposit rates.

Determining elasticity
A regression equation might be set up to examine the
historical relationship between deposit volumes, GNP
levels, rates offered by bank, rates offered by
competitors, rates offered on similar non-bank
products and number of branches.
Past volumes of deposits should also be considered.
The strength of the relationship between own rates
and deposit balances captures the price elasticity
of deposits.
Opinions of branch mangers should also be factored.

Interpretation
Elasticity captures the degree of interbank
competition higher elasticity makes customers more
jittery and may result in a loss of deposit supply or
fall in demand for loans..
It may push up deposit rates when market rates are
rising, or push up lending rates when rates are rising..

DR = c - b1 log(deposit volume)
+ b2 GDP + b3 competitors rate
+ b4 rates offered on similar non-bank products
+ b5 log(deposit volume(-1))
+ residuals

Stress Testing of EaR - I


Positive Gap = Rs. 850 cr.
Present ROI = 7.95%.....91 T Bill
99.90% C.I. that ROI during the
month will be less than 4.57% in
coming month
ROI will be down by 3.38%
NII. (3.38%)*850/12 = -2.40 cr

Stress Testing of EaR - II


Negative Gap = Rs. 850 cr.
Present ROI = 7.95%.....91 T Bill
99% chance that ROI during the
month will be more than 11.67% in
coming month
ROI will be down by 3.38%
NII. (3.72%)*- 850/12 = -2.63 cr