in'Asset Liability Management
Asset Liability Management processes and responsibility are guided by formal policies that are needed for the smooth operation of any organization. Ensuring standard reports, risk profile evaluations, liquidity risk management, measuring and managing risk return and ‘what-if’ scenario simulations are a must for any Financial institution.
Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting assets. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating).
A comprehensive ALM policy framework focuses on bank profitability and long term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital.
An insightful view of ALM is that it simply combines portfolio management techniques (that is, asset, liability and spread management) into a coordinated process. Thus, the central theme of ALM is the coordinated, and not piecemeal, management of a bank’s entire balance sheet.
ALM has evolved from the simple idea of maturity-matching of assets and liabilities across various time horizons into a framework that includes sophisticated concepts such as duration matching, variable rate pricing, and the use of static and dynamic simulation.
VALOORES ALM provides complete multidimensional analysis of the balance sheet, incorporating interest rate risk, income simulation and market valuation using deterministic and stochastic modeling.
It measures and models every loan, deposit, investment, and portfolio individually, using both deterministic and stochastic methods.
It’s a consistent framework for gathering data, measuring risks, monitoring changes, and acting on decisions.
Actively measuring and managing the interest rate and FX risk in the banking book (asset/liability management).
HOW CAN ALM BE MANAGED?
Business cycles are becoming aggressive, and global ecosystems and third-party risks are becoming increasingly complex. Regulations are rapidly changing, and compliance enforcement is becoming more stringent. All these factors will continue to create the perfect storm for ALM. In light of these dynamics, adopting an agile ALM framework with a broader perspective is an important step in its management. The framework should set out the broad objectives of the bank’s asset/liability portfolio, as established by the Board. This framework governs all ALM policy constraints and helps address new situations where a policy does not yet exist.
Although objectives may differ depending on the circumstances, environment or political dynamics of the bank, the ALM framework had to address the following minimum strategic objectives:
- The bank should manage its asset cash flows in relation to its liability cash flows in a manner that contributes adequately to earnings and limits the risk to the financial margin, to the economic value of equity (EVE) (by managing both mark to market and net interest income) and to liquidity.
- Product terms, pricing and balance sheet mix must help manage banks’ product demands and the need to protect the equity of the bank.
- Most importantly, financial derivatives instruments must only be used to limit interest/profit rate risk and must never be used for speculative investment purposes.
Governance and review system for ALM
With Valoores in’ALM, any Bank can establish the required governance structure to manage risks emanating from ALM in accordance with the RAF limits. It also ensures that the bank maintains sufficient liquidity, to continuously review the bank’s liquidity developments, which are reported to the Board on a quarterly basis. A bank’s Board should annually review and approve the strategies, policies and practices related to the management of ALM as part of the Internal Capital and Liquidity Adequacy Assessment Process (ICLAAP). Based on the industry’s best practices, Valoores in’ALM tackles all Basel Pillar 1 and Pillar 2 (including IRRBB) risks, along with Stress Testing, at an enterprise level, and the Treasury middle office function. By taking this approach, it augments the vision of a CRO to provide a holistic view of risks at the enterprise level.
MISMATCH OF ASSETS AND LIABILITIES
Banks manage the risks arising from ALM by matching various assets and liabilities according to the maturity pattern, or by matching the duration, by hedging and by securities. Valoores in’ ALM framework manages the risks related to changes in interest rates, the mix of balance sheet assets and liabilities, the holding of foreign currencies, and the use of derivatives. These risks are managed in a manner that contributes adequately to earnings while limiting risks to the financial margin.
Valoores in’ALM helps banks to proactively manage asset–liability risk through an enterprise-wide Risk Appetite Framework, which sets limits on the asset and liability mix, as well as the level of interest rate and foreign currency risk to which the financial institution is willing to be exposed. Valooores in’ALM provides guidelines for the pricing, term and maturity of loans and deposits. The use of derivatives, if any, is also controlled, which should state among other things that derivatives must only be used to limit interest/profit rate risk and must never be used for speculative investment purposes, otherwise there is a potential risk of using them for short-term gains, where the risk versus reward is not justified. The banks should ensure they have sound business and financial practices by having risk and performance measurement techniques, and risk-based compensation practices, as well as risk management procedures that are repeatable, sustainable and can be implemented during stressed scenarios, and that are appropriate to the size and complexity of the bank’s balance sheet and operations.
KEY RISKS MANAGED BY ALCO
With Valoores in’ALM, Banks will have a holistic view on the liquidity situation and the mean to report the evaluation results to the Board, with adequate feedback to the relevant management frameworks.
The following sections describe some of the key risks that are managed by ALCO within Valoores in’ALM. These objectives shall be pursued within the framework of the bank’s policies.
- Monitor the liquidity position and the management activities of the bank, including wholesale funding activities, contingency funding and any other relevant liquidity measurements the ALCO deems advisable or appropriate.
- Approve liquidity risk tolerances by reviewing how the bank’s inability to meet its obligations when due may affect the bank’s earnings, capital and/or operations.
- Monitor the management of interest rate risk activities and the bank’s overall interest rate risk Profile
- Monitor the sensitivity of the bank’s earnings under varying interest rate scenarios and potential changes in market interest rates
- Monitor trends in the economy in general and interest rates in particular with a view to limiting any potential adverse impact on the bank’s earnings.
- Approve interest rate risk tolerances by reviewing how movements in interest rates may adversely affect the bank’s earnings and capital using the bank’s projected earnings and capital as a benchmark.
- Monitor the capital position of the bank and the capital management activities undertaken by the bank to ensure that capital levels are maintained in accordance with regulatory requirements and management directives.
- Monitor capital allocation to various lines of business
- Monitor the management’s investment activities, such as purchase, sale, exchange and other disposition of the investments of the bank, including a review of management reports concerning current equity and debt security investment positions.
- Monitor compliance with both external regulations and the ALM Policy governing the bank’s investments and categories of investments, including requirements relating to composition, diversification, credit risk and yield.
- Review the status of the securities portfolios, including performance, appreciation or depreciation, quality, maturity profile and any actions taken by management with respect thereof.
- Review and determine whether to approve the holdings of investment securities (including prudent investments) that are subject to the ALCO’s authority to approve under the ALM Policy or Board of Directors’ resolutions.
- Review significant financial risk exposures facing the bank generally, and in its investment portfolios in particular, and the steps management is taking to monitor and control such exposures.
- Monitor compliance with the provisions of the ALM Policy and applicable standards relating to the management of counterparty credit risk, including, but not limited to, reviewing limits on counterparty exposure and reviewing limits on individual transactions based on risk.
- Approve objectives for the composition of on- and off-balance sheet positions.
- Review and approve procedures and systems the management has established to implement the Board’s objectives and limits for each portfolio, taking into account applicable laws, regulations and current accounting standards for each part of the portfolio.
With Valoores in’ALM, Banks will ensure that the FTP mechanism is well understood by all stakeholders, particularly by the relevant Lines of Business in the context of interest rate and liquidity risk. It will also ensure that the borrowing rates of Treasury remain within the established RAF Policy limits and that borrowing is not taking place at rates that make the lending business unviable for the bank.
The Treasurer will be asked to explain his view on the overall market liquidity in the financial market and how this is expected to impact the bank’s borrowing cost and eventually the FTP.
Valoores in’ALM ensures that the FTP mechanism used by the bank also takes into consideration the off-balance sheet exposures.
With Valoores in’ALM, Banks will ensure that stress testing is carried out on multiple scenarios ranging from mild to severe impacts. It will allow reverse-stress testing based analysis of the bank’s portfolio to assess the levels at which the Business Model would become unviable. Valoores in’ALM will ensure that the stress scenarios have taken into consideration the possibility of continued negative net interest income for a period of two to three years and its impact on the bank’s ability to sustain such a scenario for a small subsection of the balance sheet
- Provides a modelling and simulation environment in which to interactively run, manage and compare a large number of ‘what-if’ scenario simulations
- Allows users to build balance sheet models that measure and forecast all drivers of business profitability
- Offers standard reports for effective and timely reporting of data
- Manage risk effectively, model customer behavior, economic valuation, interest rate scenarios and a wide range of other variables quickly, easily and accurately.
- Measure and manage interest rate, foreign exchange and liquidity risk more precisely and efficiently
- Model customer behavior and market movements to more effectively stabilize and increase earnings, precisely forecast future earnings, measure profitability, and comply with regulatory requirements including IFRS 9 and Basel III
- Support a wide variety of balance and off-balance-sheet products, including non-maturing accounts, amortizing loans (various amortization types), and derivatives (interest rates/FX swaps, quanto swaps, trigger Swaps, FRA, futures, swaptions, binary options, digital options, etc.)
- Deterministic and Stochastic modeling of the balance sheet
- Stress the balance sheet under Interest rate, currency, or economic indicator Shocks/Scenarios
- Allows multiple analysts to work collaboratively and efficiently to measure and manage the risk return profile of the balance sheet
- Facilitates risk profile evaluation and proactive strategies, optimizing the Bank’s risk/return trade-off
- Allows earnings simulation and valuation routines to naturally produce accurate results for positions with virtually any sequence of events and for any reporting interval
- Reduces the time needed for simulation processing
- Assists users to understand the relative impact of changes, balance sheet composition and model parameterization
- Operates on transaction-level data; each account, as well as all forecasted new-business activity, is modeled independently on a daily cash flow basis