Asset liability management (ALM) / Dynamic Financial Analysis (DFA)

Understanding risk is the basis of every insurance company.

By carefully coordinating its management of assets and liabilities, a financial

institution can operate more soundly and profitably. This coordination, or large-

scale simulation of an entire company, is known as Asset Liability Management

(ALM) in the life insurance industry and as Dynamic Financial Analysis (DFA)

within the property/casualty industry.

ALM helps in:-

1. Define its strategic asset allocation

2. Better manage its financial uncertainty

3. Identify opportunities to improve its financial results

Asset liability management process

An integral phase in process is gaining an understanding of

1. How the company operates,

2. How the company intends to operate in the future and

3. The steps the company will take to achieve its overall goals.

A thorough evaluation of process allows life insurance companies to:

Identify key financial risks

1. Interest rates, inflation, defaults and liquidity

2. Liabilities and expenses

3. GDP, adverse timing of payouts.

Quantify key financial risks and interactions between risks

Probability and prospective

Projected financial statements

Compare alternative financial solutions

Investment strategy, crediting strategy, business plan, etc.

Asset liability management - Efficient frontier analysis

The Asset liability management frontier illustrates the efficient economic asset

strategies given a company's liability profile and business plan.

Why is Asset liability management important?

variety of issues both life and property/casualty companies face.

Life Companies Asset Allocation

1. What is the appropriate distribution of maturities for the fixed income

portfolio?

2. What degree of duration mismatch is adjustable?

Business Plan

1. What is the impact of the new business plan on the optimal asset allocation?

2. How will changes in planned business mix impact financial results?

3. How can you effectively communicate your business plan and investment

strategies to rating agencies?

Product Design

1. What is the best crediting strategy for a new product?

2. What are the costs associated with policyholder options?

3. Are there ways to combine different product lines and get better results?

Property/Casualty companies

Asset Allocation

1. Is the current asset allocation efficient?

2. What is the appropriate duration of the fixed income portfolio?

3. What is the optimal split between taxable and tax-exempt securities?

Business Plan

1. What is the relationship between business mix and asset allocation?

2. How will variations in the planned business mix impact the budgeted financial

results?

3. Are the premiums, claims and expenses sensitive to inflation?

Capital Management

1. What is the optimal level of capital for the company and by line of business?

2. Is the capital level adequate to sustain downside exposures and to maintain your

financial rating?

3. Can adding/deleting a line of business improve your return on capital?

ASSET- LIABILITY MANAGEMENT

The emergence of this concept can be traced to the mid 1970s in the US when

deregulation of the interest rates compelled the banks to undertake active planning

for the structure of the balance sheet. The uncertainty of interest rate movements

gave rise to interest rate risk thereby causing banks to look for processes to manage

their risk. In the wake of interest rate risk came liquidity risk and credit risk as

inherent components of risk for banks. The recognition of these risks brought Asset

Liability Management to the center-stage of financial intermediation.

The Indian economy has witnessed a similar scenario. The post-reform banking

scenario is marked by interest rate deregulation, entry of new private banks, new

products and greater use of information technology. To cope with these pressures

banks were required to evolve strategies rather than ad hoc fire fighting solutions.

These strategies are executed in the form of ALM practices. An efficient ALM

technique aims to manage the volume, mix, maturity, rate sensitivity, quality and

liquidity of the assets and liabilities as a whole so as to earn a predetermined,

acceptable risk/reward ratio.

Recognizing the need for a strong and sound banking system, the RBI has come

out with ALM guidelines for banks and FIs in April 1999.

ALM framework rests on three pillars

ALM Organization:

It consist of the banks senior management including CEO who is responsible

for deciding the business strategy of the bank in line with the banks budget

and decided risk management objectives.

ALM Information System

For the collection of information accurately, adequately and expeditiously.

Information is the key to the ALM process.

ALM Process

The basic ALM process involves identification, measurement and

management of risk parameters.

ALM process:

Gap Analysis

Duration

Simulation

VaR

Value at Risk

Formally defined VAR is a measure of the worst expected loss over a given time

interval under normal market conditions at a given confidence level.

For Example, you are holding USD 1,000. We have got probability distribution

curve showing the percentage daily change in the USD / INR rate in the forex

market. At 95 % confidence level we say that it will not fall by more than 1 %. In

essence, we say that you will not lose more than USD 10 in a day. When

measuring VaR, we consider only potential losses and not profits. Hence only the

left tail representing loss is considered.

This was for only single instrument, but generally banks hold a portfolio of

instruments. Hence we need VaR of a portfolio. Portfolio diversification describes

the risk in the portfolio that is reduced by holding a diversity of assets. Correlation

between assets is used to describe how the price changes in assets are related to

each other.

For example, consider a simple case where a bank holds two zero coupon bonds

with different maturities; say 1 yr. and 2-yr. They have very high correlation in

terms of change in price. This way bank can calculate VaR for entire portfolio,

which summarizes the bank's exposure to market risk as well as the probability of

an adverse move.

While there is various method of computing VaR, the most preferred method is

using the Monte Carlo simulation.

In a Monte Carlo simulation a set of randomly generated market prices of the basic

instruments is used to construct a distribution of portfolio returns from a series of

returns from a portfolio values instead of the historical prices. It avoids the type of

criticism such as driving by looking in the rear view mirror.

Implied volatility currently traded in the market place may be utilised for the

structured random numbers generating in the computation process. It is viewed as a

better choice over the historical volatility. However due to lack of liquid

correlation derivative products market and computational difficulties, the

correlation cannot easily be implied from any market prices. The major drawback

of the structured Monte Carlo simulation is the computational complexity.

Today, banks mark-to-market their trading items. Hence risk in the trading

portfolio can be easily quantified using market prices and VaR.

It is desirable that the VaR be applied to the entire balance sheet. However, the

application of VaR to the accrued portfolio is a difficult exercise as accrued items

typically generate numerous cash flows, each one occurring at a unique time. This

gives rise to an unwieldy number of combinations of cash flow dates when many

instruments are considered. As a result, one is faced with the impractical task of

having to compute an intractable number of volatilities and correlations for the

VaR calculation.

To more easily estimate the risks associated with instruments’ cash flows, one

needs to simplify the time structure of these cash flows. The students showed how

the cash flow mapping and a zero coupon yield curve can be used to obtain the

correlations and volatilities of all the cash flows. The method of simplifying time

structure involves redistributing (mapping) the observed cash flows onto so-called

representative vertices, to produce mapped cash flows. Thus the idea here is to

have all cash flows to occur at the specified vertices.

The adoption of VaR was strongly recommended by the students in light of the

various advantages of this method.

VaR measures risk, expressed as a potential loss, and in so called normal markets,

i.e. when price changes follow normal distribution. However all financial assets are

subject to very large price changes, that fall outside the normal distribution i.e.

beyond 3-sigma.

Hence the use of Var is not sufficient. VaR has to be complemented by using stress

testing to identify extreme events that would cause significant loss. The job of

ALCO is to strategically think of about these scenarios and to decide whether they

are willing to accept the level of risk implied by the losses that would result, given

the current market conditions.

All said and done, every model however sophisticated has to be tested in real life

situations. Hence every VaR model used for ALM, needs to be back tested. The

back testing simply means that for a given number of days, the loss on portfolio is

compared to the previous day's estimated VaR. The students recommended that the

RBI should make such back-testing mandatory, when it comes out with guidelines

for VaR for Indian banks.

After having looked at the methods by which one can monitor the effects of

interest fluctuations, the presentation then moved on to the different techniques

that can be used to hedge the various risks that the banks are exposed to in a free-

market environment.

Introduction to derivatives

Derivatives have become increasingly important in the field of finance. Options

and futures are traded actively on many exchanges. Forward contracts, swaps and

different types of options are regularly traded outside exchanges by financial

institutions, banks and their corporate clients in what are termed as over-the-

counter markets. Some of the instruments that were discussed in the presentation

included securitisation, forwards and swaps, and credit derivatives.

Securitisation:

It refers to the process of imparting liquidity to highly illiquid assets. It involves

repackaging of future cash flows from advances into securities and issuing them to

the investors. In the process of enhancing liquidity, securitisation also reduces the

interest rate exposure for the financial intermediary since risk associated to rate

fluctuations will also be eliminated.

The securities are usually liquid, negotiable and highly rated and include bonds,

floating rate notes and commercial papers. The securities are designated 'asset

backed securities' as each security is backed by a specific pool of assets rather than

being a general corporate obligation of an issuer.

Securitisation can also be used to plug GAPs as per ALM requirements.

IRS & FRAs (Interest Rate Swap and Forward Rate Agreements):

An IRS is a financial contract between two parties exchanging or swapping a

stream of interest payment for a notional principal amount. Such contracts

generally involve exchange of a "fixed to floating" or "floating to fixed" rates of

interest. Accordingly on each payment date - which occurs during the swap period

- cash payments based on fixed/floating rates, are made by the parties to one

another.

A FRA is a financial contract between two parties to exchange interest for a

notional principal amount on settlement date for a specified period from a start date

to maturity date. Accordingly, on the settlement date, the parties make cash

payments based on contracts and the settlement rate to one another.

Credit Derivatives:

The role of a bank in any economic system is financial intermediation. This

essentially involves borrowing and lending of funds and assuming the risk of

lending in the process. Current banking practices view the management of credit

risk outside the scope of the ALM framework. Credit risk, as most bankers claim,

is taken care of by having stringent lending preconditions and diligent monitoring

of the loan portfolio. The regulators are happy with stringent reporting norms with

reference to provisions for non-performing assets.

However, in a banking system where 40% of the loan able funds are locked in the

priority sector and competitive pressures often driving the banks to compromise on

the self-devised stringent lending norms, the fact that banks carry substantial credit

risk on their balance sheets cannot be ignored.

When one talks of lending, the first issue that should come up is the borrower's

credibility. Credit risk management is not a new concept. Exposure to credit risk

has long been hedged or reduced through portfolio diversification, collateral and

by making provisions against possible defaults. In today’s global market, these

tools seem inefficient and the time- honored view of the credit market needs re-

examining.

Credit risk differs from market risk in that the default risk of an individual

company is tied to its own performance and not to the performance of other

companies. In fact, there is a low correlation between the default risk of an

individual counterparty and any aggregate index of corporate performance such as

the market index. So, default risk cannot be hedged by means of a market index,

future contracts or by matching within the existing book. The only way actually to

lay off default risk is by means of some instrument that is directly related to the

specific company. Credit derivatives are exactly that.

Broadly speaking, a credit derivative is an instrument that allows credit risk to be

priced and traded independently of other features of a financial instrument. Credit

derivatives can be tailored to layoff any part of the credit risk exposure: amount,

recovery rate and maturity. They may even be constructed for events such as a

rating downgrade that do not involve default. A credit derivative is a bilateral

financial contract that derives its value from an underlying event that is credit

sensitive. The intent of the derivative is to provide default protection to the risk

seller and compensation for taking risk to the risk buyer.

Market development

Though number of tools has been developed for the purpose of risk management

they haven't had the kind of exponential growth, which was expected. This was

mainly because of the lack of well-developed market for these instruments.

The reasons for this have been highlighted below:

Absence of a benchmark rate:

Normally a benchmark is unbiased, representative, objective, acceptable,

accessible and constantly updated. As of today only the overnight MIBOR satisfies

the above mentioned criteria and thus qualifies to be a benchmark rate. Though we

see the existence of other rates like the 14-day, 1 month and 3 month MIBOR,

these cannot be considered to be benchmark rates as the markets in these tenures

are not deep and liquid enough.

Also there is an ongoing debate on whether the t-bill rate and/or the PLR should be

used as a benchmark rate. The option of PLR can be dismissed on the fact that each

bank has its own PLR and thus pricing of instruments becomes difficult. As

regards the t-bill rate, not all the t-bills have a deep and liquid market and this

reduces their chances of becoming representative rates. Also t-bill rates are not

market representative because of frequent devolvements.

Absence of public sector participation:

It is common knowledge that public sector banks constitute the bulk of banking

volumes. However these very banks, inspite of their huge risk exposures fight shy

of active market participation. The reasons could be manifold:

Being brought up in a controlled interest regime these banks have not realised the

importance of risk management.

These instruments require expertise and skill. This commands a premium in the

market which public sector banks cannot afford.

However the size of these public sector banks cannot be ignored and any market

development effort without their participation is futile.

Integrated ALM Approach:

Traditionally only interest rate risk and liquidity risks have been considered in the

ALM framework. A bank would have managed a major portion of its risks by

having in place a proper ALM policy attending to its interest rate risk and liquidity

risk. These two risks when managed properly lead to enhanced profitability and

adequate liquidity.

ALM is an important tool in the overall risk management process for any bank.

ALM should be used strategically for deciding the pricing and structure of assets

and liabilities in such a way that profitability, liquidity and credit exposure is

maintained. Hence one cannot neglect credit risk in the ALM process. Based on

this rationale, the students presented a qualitative argument why credit risk should

be incorporated in the overall ALM framework.

Consider the procedure for sanctioning a loan. The borrower who approaches the

bank, is appraised by the credit department on various parameters like industry

prospects, operational efficiency, financial efficiency, management evaluation and

others which influence the working of the client company. On the basis of this

appraisal the borrower is charged certain rate of interest to cover the credit risk.

For example, a client with credit appraisal AAA will be charged PLR. While

somebody with BBB rating will be charged PLR + 2.5 %, say. Naturally, there will

be certain cut-off for credit appraisal, below which the bank will not lend e.g. Bank

will not like to lend to D rated client even at a higher rate of interest. The

guidelines for the loan sanctioning procedure are decided in the ALCO meetings

with targets set and goals established. The role-played by the treasury in the loan

sanctioning process is limited to satisfying the demands for funds. All exceptional

cases however, are referred to the treasury, which looks at the gaps created by the

proposal and based on the policies of the bank and its long-term objectives the

proposal is either rejected or sanctioned with appropriate pricing.

The students proposed that all the three parameters viz. Interest rate, credit risk and

liquidity positions should be dynamically looked at simultaneously for better

decision making.

In the proposed approach, the credit appraisal comes out with a credit score, the

treasury comes up with a liquidity score, the corporate banking division comes up

with a interest rate score. This information is used to arrive at a composite score to

evaluate the proposal.

Risk Scores

Now let us see on what basis the scores are arrived at.

The credit score is the result of the credit appraisal process. It is at this stage that

the credit risk is quantified in terms of default probabilities. The interest rate score

reflects the spread earned by the corporate bank over and above the transfer price.

The liquidity score reflects the impact of the proposal on the liquidity profile of the

bank. Every bank would have certain target Gaps. Every proposal either takes the

bank away from the target Gap or brings it closer to the same. This score reflects

the impact of the proposal on the Gap profile of the bank. The score also is a

reflection of the cost of funding the liquidity mismatch that it might create. This

looks at the possibility of a credit default. This kind of arrangement, however,

demands, diligent monitoring of the asset to keep the bank updated with its

liquidity profile.

Asset Evaluation

Once the three performance scores are available, the entire evaluation of the asset

can be condensed to a one-page report. Here the performance measures are graded

on a scale of 1-5. The weighted average of these scores will give us the

COMPOSITE SCORE of the loan, the weights being assigned on the basis of the

relative strategic importance of each of these three parameters specific to the bank.

Higher the composite score, better is the chance of the loan being accepted

The calculation of the composite score has certain underlying requirements:

Every bank should have a minimum composite score based on its risk appetite.

Eg., if we fix a minimum composite score of 2, then any loan with a score below 2

should be rejected, no questions asked.

A bank might have a minimum composite score of two, but care should be taken to

see to it that most of the loans in the portfolio do not fall very close to the

minimum composite score as this would worsen its risk profile.

Weights should be assigned to the different performance scores based on the

bank’s future strategies and the current balance sheet status. Eg., a bank with heavy

focus on the control of already high NPAs should give higher weights to credit

performance score.

Advantages of the integrated ALM approach

A bank will price the loan even taking the liquidity risk. Incorporating the default

probabilities helps the bank to price the loan appropriately in line with its risk

profile. Hence bank would also look at the impact of such a loan on its liquidity

along with the credit risk and not in isolation.

The bank would now have flexibility in accepting and rejecting the loan only after

having considered all parameters.It will provide the necessary direction to the bank

in structuring the loan in such a way, that liquidity profile of the bank is improved.

If the liquidity profile of the portfolio is improved the loan can be priced

favourably for the borrower.

This model helps us to identify those loans that contribute to the ROA and Roe of

the bank. This puts the bank on the road to SHAREHOLDER VALUE

CREATION. By identifying the acceptable risk limits, the bank achieves greater

stability thus ensuring higher returns for the shareholders.

While a similar system might already be in use in several competitive banks in one

form or the other, other banks that do not employ such a system in totality might

Lessor

Loan Participant

Trustee

Lessee

find it useful to adopt the integrated ALM approach which has been presented as a

conceptual argument.

At the end of the presentation, students emphasised on the need of a strong ALM

for all banks if the were to survive in the next century.

Advantages of Leasing:

To The Lessee:

Full Financing:

Generally, leasing is 100% financing –the lessor buys the equipment and lends it to

the lessee. However, 100% funding is not always recommended from the lessor’s

point of view- therefore it is common for the lessor to insist upon an upfront

payment either as a security deposit or as initial rentals

Better pricing:

Leasing as a method of acquiring capital assets may cost less than other

alternatives available. This is primarily because the lessor gets the benefit of

depreciation and hence passes on a better rate to the lessee.

Flexible, fast and negotiable:

Leasing is believed to be more flexible than any other method of financing. A lease

plan can always be tailor made to suit the requirements of the lessee with renewal,

termination and purchase options.

Increases the borrowing capacity of the lessee:

A lease helps to maintain a low debt equity ratio of the lessee so that his borrowing

capacity is kept intact even after the lease has been taken. A lease obligation is not

recorded as a debt on the balance sheet of the lessee.

Improved Liquidity

Leasing ensures that the lessee does not have to block capital in purchasing the

asset thereby giving him greater liquidity.

To The Lessor:

Better security:

The lessor maintains his title over the asset, which acts as powerful collateral for

him. Repossession of the leased asset is simpler than of assets secured against a

loan.

Disadvantages of Leasing:

Rentals preceding cash generation:

Rental payments start even during the gestation period when there is no cash

generation.

Loss of Inflational advantage:

The lessee is not the owner of the asset and hence the appreciation of the asset due

to inflation is of no advantage to the lessee.

Inflexible production line:

Since a financial lease agreement cannot be cancelled in the primary lease period,

the lessee cannot discontinue a line of production if several inter linked assets are

leased in a phased term.

Difficulty in accounting:

Traditional financial analysis cannot evaluate leasing decisions and so the lessee

has to be well versed with the techniques of lease accounting to appreciate the cost

of the lease.

Complicated rights against the vendor:

Protection against express and implied warranties available to the buyer is not

available to the lessee. The defective supplies if any are can be remedied only

through the lessor.

Salvage value:

Since salvage value realisation is uncertain, traditional financial lessors pass on the

risk of this uncertainty as higher rentals to the lessee.

Difficulty in taxation:

Taxation on lease rentals and lease asset capital expenditure are dependent on the

type and text of the contract. A contract with the option of purchase of the leased

asset at the end of the term of the lease is a hire purchase. The expenditure

allowable is different in both cases. Similarly, for the lessor tax rebate is allowed

on the depreciation.