Risk Management in Banking Unit 3 ASSET LIABILITY MANAGEMENT Unit 3

Learning Objectives By the end of this unit, you should be able to: Explain Asset-Liability Management Describe liquidity gaps Discuss the term structure of interest rates Describe interest rate gaps Explain amount hedging and the use of derivatives Discuss the hedging issues Unit 3

Recap SCENARIOS A < L A > L Examples: Key risk drivers Rate sensitive assets $50m higher than rate sensitive liabilities (liquidity gap /get emergency funding) $2m of 1 year loans v only $1m amount of 1 year deposits (term mismatch) $10m of fixed rate loans at 5% v $5m of variable rate deposits at LIBOR+2% (interest rate mismatch) Variable rate loans of $50m v variable rate deposits of $30m (interest rate gap) Fixed rate loans of $30m v variable rate deposits of $20m interest rate gap) A > L A < L Positive gap Deficit Negative gap Surplus Key risk drivers Liquidity gap / solvency risk Interest rate / Income risk Risk factors Maturity or term structure mismatch Fixed v variable rate mismatch Mixture of both

Types of Interest Rate Risk (VIDEO) Task: take notes for further discussion, Q&A Unit 3

Interest rate risks Unit 3

Impact of Changes in Interest Rates Unit 3

Discussion Q & A Unit 3

Cash Matching between assets and liabilities Cash matching is a fundamental concept applied to manage liquidity and interest rate risks. It implies that the time profiles of amortization of assets and liabilities are identical. FINDING A NATURAL HEDGE: Fixed rates funding are matched with fixed rates lending; floating rate funding reset periodically with floating rate lending based on the same reset dates using the same reference rates. Unit 3

Liquidity Management Liquidity management is a continuous process of raising new funds when there are deficits or investing funds when there are surpluses. The Cost of the Liquidity Ratio Typical commercial banks transactions comprise of borrowing short and lending long, leads to deteriorating liquidity ratio. Borrowing long and lending short is one method to improve the liquidity ratio but there are costs involved. It is a component of the ‘all-in’ cost of funds including: Spread between long-term and short-term rates Cost of the swap plus the credit spread of borrowing plus the bid-ask spread. Unit 3

Issues in determining the liquidity gap time profiles Demand deposits (hard to predict outflows over longer term) Contingencies (Off-balance sheet) – hard to predict net settlement values Prepayment options embedded in loans – adds additional uncertainty and cost Unit 3

Term Structure of Interest Rates Interest rates are essential for the banking business because: Fluctuating interest rates impact the bank’s interest income Future interest rates of borrowing or lending/investing are unknown Typical commercial banks lend long-term and borrow short-term. All funding and investing decisions resulting from liquidity gaps have an impact on interest rate risks. Unit 3

Interest Rate Expectation and Forward Rates Unit 3

Task: take notes for further discussion, Q&A Price-Yield curve (VIDEO) Task: take notes for further discussion, Q&A Unit 3

Expectation of steepening/flattening of Price-Yield Curve (VIDEO) Task: take notes for further discussion, Q&A Unit 3

(for all term US gov. bonds) Yield Curve data (for all term US gov. bonds) Unit 3

https://www.bis.org/bcbs/basel3.htm Unit 3

Hedging Issues An upward sloping yield curve benefits the typical commercial bank who pay short-term deposit rates and earn long-term interest rates from loans Capture the positive maturity spread Sensitive to shifts and steepness of the yield curve. Net lender banks with large deposit base: Adversely affected by interest rate declines. High long-term interest rates increases the bank’s income. Adversely exposed to decline in the steepness of the yield curve. Unit 3

Week 1. Chapters (Sections) 2 and 3 Week 2. Chapter (Sections) 4 Bessis, 2nd edition Week 1. Chapters (Sections) 2 and 3 Week 2. Chapter (Sections) 4 Week 3. Chapters (Sections) 5 and 6 Week 4 (next week) Chapter 7 Bessis 3rd edition Sections Unit 3

ALM Models ALM decisions which manages interest rate risks and business risks, involves: business decisions (on-balance sheet); hedging decisions (off-balance sheet). ALM simulations are required to evaluate the behaviour of the balance sheet under different interest rate assumptions and determine the future profitability and risk faced by the bank. Unit 3

Interest Rate Risk Measurement (VIDEO) Task: take notes for further discussion, Q&A Unit 3

ALM Simulation Select the target variables, interest income and the balance sheet NPV Define the interest rate scenarios. Build business projections of the future balance sheet. Project the margins and net income. Consider optional risk by valuing options Combine all the steps with hedging scenarios to view the entire set of feasible risk and return combinations. Jointly select the optimum business and hedging scenarios based on the risk and return goals of the ALCO. Unit 3

Hedging Issues The sensitivity of the bank’s exposure to parallel shifts of the yield curve depends on: the sign of the variable interest rate gap the average reset period of assets and liabilities. If variable rate gap is positive, the bank behaves as net lenders. If variable rate gap is negative, the bank behaves as net borrowers. Unit 3

Variable Rate Gaps Variable rate gaps increase with the gap between the asset reset rate period and the liability reset period. Variable rate assets > Variable rate liabilities: the reset period for assets become shorter than the reset period for liabilities. Variable rate liabilities > Variable rate assets: the reset period for liabilities become shorter than the reset period for assets. Unit 3

Variable Rate Gaps With Variable rate gaps and reset date gaps having the same sign, the position of the bank would be as follows: Positive variable rate gap The asset average reset period is shorter than the liabilities average reset period. Bank borrows long-term and lend short-term. With an upward sloping yield curve, the bank’s interest income will suffer negative market spread between the short and long rates. Unit 3

Variable Rate Gaps Negative variable rate gap The liabilities average reset period is shorter than the asset average reset period. Bank borrows short-term and lend long-term. With an upward sloping yield curve, the bank’s interest income will benefit positive market spread between the short and long rates. Unit 3

Hedging Policy Banks with positive variable rate gaps have increasing interest income with increasing interest rates – behave as net lenders: Expect interest rates to increase: benefit by maintaining gaps open Expect interest rates to decrease: benefit by closing gaps. Banks with negative variable rate gaps have increasing interest income with decreasing interest rates – behave as net borrowers: Expect interest rates to increase: benefit by closing gaps. Expect interest rates to decrease: benefit by maintaining gaps open. Unit 3

Natural exposure of a bank Unit 3

Forward Rates Applications As Breakeven Rates for Interest Rate Arbitrage. Lock-in forward rate as of today. Provide lending-borrowing opportunities instead of only lending-borrowing cash at the current spot rates. Unit 3

Interest Rate Gaps There are 2 types of interest rate gaps: Fixed interest rate gap the difference between fixed rate assets and fixed rate liabilities. Variable interest rate gap the difference between interest rate sensitive assets and interest sensitive liabilities. Unit 3

Limitations of Interest Rate Gaps Volume and maturity uncertainties Dealing with options which create ‘convexity risk’ Mapping assets and liabilities to selected interest rates as opposed to using the actual rates of individual assets and liabilities. Dealing with intermediate flows within time bands selected for determining gaps. Unit 3

Interest Rate Risk Management In a prudent management which aims to hedge interest rate risks, policies aim to: Lock in interest rates over a given time horizon with the use of forward contracts or derivatives such as futures or swaps. Hedge adverse movements only, while having the option to benefit from other favourable market movements with the use of options Unit 3

Interest Rate Swaps Interest rate swaps allow for the exchange of a floating rate for a fixed rate or vice versa. The cost of the swap is the spread earned by the counterparty which is a spread deducted from the rate received by the swap. In the case of a bank: Positive variable gap (Variable rate asset > Variable rate debt): Bank is adversely exposed to interest rate declines Negative variable gap (Variable rate asset < Variable rate debt): Bank is adversely exposed to an increase in interest rates. Unit 3

Forward Contracts Forward contract enables the rates to be locked in. The cost of the forward contract is the spread between the 9-month interest rates and the 3-month interest rates. A future borrower can purchase a forward rate agreement (FRA) hedge the risk of an interest rate increase. A future lender can enter into a forward rate agreement (FRA) to hedge an interest rate decline. Unit 3

Interest Rate Options A call option is the right, but not the obligation, to buy the underlying asset at a fixed exercise price for a fixed period of time. The buyer of the option has to pay a premium for the right, irrespective of whether it is subsequently exercised or not. A put option is the right, but not the obligation, to sell the underlying asset. In-the-money: underlying value of the asset is higher than the exercise price and it provides a gain to the option holder. Out-of-the-money: underlying value of the asset is below the exercise price Unit 3

Caps and Floors A cap sets up a guaranteed maximum rate which protects the borrower from any increase in interest rate but allows the borrower to take advantage of cheaper interest rates. A floor set a guaranteed minimum rate which protects a lender from any interest rate decreases while allowing the lender to benefit from any interest rate increases. Caps and floors are more costly than forward hedges as it allows for upside benefits. As a result, it is common to minimize the cost of options by using a collar: Borrower at floating rate buys a cap for protection and sells a floor to minimize the cost of the hedge. Lender at floating rate buys a floor for protection and sells a cap to minimize the cost of the hedge. Unit 3

Futures Contract Futures contracts requires the hedger to: Commit the price and delivery quantity at maturity of a given asset. Close-out the position (settle the transaction) at the committed date as per the agreed terms. The futures market is a standardized exchange that uses standard contracts. The clearinghouse acts at the intermediary to the counterparties. Unit 3

Futures Contract To hedge against a decrease in interest rates: Lender buys a futures contract A gain is earned in the futures market when interest rates decrease To hedge against an increase in interest rates: Borrower sells a futures contract A gain is earned when interest rate increase. Unit 3

Asset-Liability Management (ALM) The unit responsible for managing interest rate risk and bank liquidity is the Asset-Liability Management (ALM). It addresses 2 types of interest rate risk as follows: Interest income fluctuates due to interest rate movement. Embedded options in the banking products which may be exercised when interest rate change. ALM reviews 2 major areas of risk: Standalone risk Portfolio risk Unit 3

Liquidity Gaps Liquidity gaps are the differences between assets and liabilities of the banking portfolio at all future dates. The gaps create liquidity risks which is the risk that the bank is not able to raise funds without incurring excess costs. Unit 3

Liquidity Gaps Controlling liquidity risk implies: Spreading funding amounts over time. Avoiding unexpected important market funding. Maintaining a buffer of liquid short-term assets. Two types of liquidity gaps: Static liquidity gap – result from existing assets and liabilities Dynamic liquidity gap – includes projected new loans and deposits. Unit 3

Liquidity Gaps Liquidity risk exists when there are deficit of funds but surplus funds results in interest rate risks – the risk of an unknown rate of lending or investment. A > L: Positive gap – deficit which require funding A < L: Negative gap – surplus which is an excess resource that needs to be invested. Unit 3

Fixed rates versus Floating rates With fixed rates, any liquidity gap generates interest rate risk. A projected deficit will require raising funds at an unknown rate in the future. A projected surplus will require lending or investment at an unknown rate as well. With deficits, margin decrease when interest rates increase, With surplus, margin decrease when interest rates decrease. Unit 3