assets and liabilities management – risks

8/13/2019 ASSETS AND LIABILITIES MANAGEMENT RISKS

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ASSETS AND LIABILITIES

MANAGEMENTRISKS

Carl Abruquah

Consultant


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Agenda

Introduction

Risk in financial markets

Strategic risks

Interest rate risks

Foreign Exchange Risks

Liquidity risks

Credit portfolio risks

Summary/Conclusion

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Introduction

The key to bank management is managing the

Spread the difference between interest

income on assets and interest cost of liabilities.

This is supplemented by strategies to reduce the

burden on net interest incomereducing

operating costs and increasing non interest

income In managing the spread, the bank is faced with

the risk of volatility in its expected revenue

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ALM Risks

The risks that must be dealt with in ALM arethose factors that cause variation in the Banksnet interest income.

These include: Strategic risks

Interest rate risks

Liquidity risks Foreign exchange risks

Credit portfolio risks

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Strategic Risks

Strategic risk refers to the probability that achosen strategy will not have the desiredimpact on the achievement of objectives.

Strategic risk may arise from outcomes thatare a variance with the forecasts on which thestrategies were based.

A critical tool that may be used in ALM forevaluation of achievement of objectives isfinancial performance evaluation.

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Financial Report Analysis

Analysis of financial reports may be divided

under the following headings:

Capital

Assets Quality

Management

Earnings

Liquidity

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Capital Management

Capital management ratios measure the

banks ability to withstand a financial crisis

Capital indicators include the following:

Capital adequacy Ratio

Leverage

Profit retention

Dividend payout

Growth in fixed assets

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Capital Adequacy Ratio

CAR is defined as risk weighted assets divided

by adjusted capital base.

A high CAR of say 25% connotes inefficient

utilization of capital and loss of opportunities

to make profits

A very low CAR connotes a reckless

deployment of capital without regard to

eventualities resulting from impaired assets.

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Leverage (Multiplier) ratio

Financial leverage represents the Assets to Capitalturnover.

It shows how much assets have been generated withthe aid of external funds.

It indicates the level to which the bank is willing to takerisk.

Cost of equity is high compared to deposits, whichimplies that a higher leverage is cheaper to the bank

than a lower leverage. It is possible for a bank to have a high leverage but

good CAR if it deploys more of its assets in low riskweight assets.

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Erosion of Capital

Losses caused e.g. by lack of control of

overheads and mismanagement

Exogenous factors such as competition,

decline in the economy, natural disasters, staff

strike

Fraud by bank employees.

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Measures to Improve Capital

Increase profitability

Cost control

Efficient deployment of funds Strong internal controls to prevent fraud

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Assets Quality

In financial institutions, the main assets thatgenerate revenue are the monetary assets,primarily advances and investments.

The amount of revenue a bank earns hingessignificantly on the quality of the assets it hascreated.

Bad loans are written off as an expense in afinancial institutions income statementreducing the bottom-line

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Risk/Return Trade Off of Assets

Apart from the problem of collectability ofassets, there exists a risk return trade offthehigher the risk associated with a monetary

asset, the higher the earnings the asset pay. On the other hand, low risk assets like

government securities will normally havelower interest rates.

The bank should therefore select a portfolio inwhich the risk/return trade off is balanced.

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Asset Quality Ratios

Total Loan Provision (TPL) to Advances TPL =balance of loan provision account includingcurrent and previous provision

Risk Adjusted Margin = Net Interest Incomeless Impairment charge divided by AverageTotal Assets

Non performing Loans to Loans The risk adjusted margin shows the impact of

credit risk on profitability of a bank.

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Management Ratios

Management of a bank may be assessed by

observing the trend in certain parameters

including:

Growth in assets

Growth in number of branches

Market share of deposits

Market share of advances

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Assessment of Management with

Balanced Score Card

Customer related measures:

Number of customers per employee

Number of borrowers per employee

Market share by segment Customer satisfaction survey

Internal processes

Losses through fraud as a percentage of Net profit

after tax Investments in technology

Number of complaints

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Balanced Score Bard

Learning and Growth

Revenues from new products

Product development cycle

Employee survey

Revenue per employee

Employee turnover

Training hours per employee

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Earnings Ratios

Return on Equity = NPAT/Equity

Return on Assets = NPAT/Total Assets

Net Interest Margin = NII/ Average Total Assets

Net Operating Margin = Net OperatingIncome/Average Total Assets

Net Operating Income = Total Operating IncomeLess Total Non Interest Operating Expenses

(including depreciation) Less impairment charge) Total Operating Income = Net Interest Income

plus Non-Interest Operating Income

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Cost Management Ratios

Efficiency Ratio (Cost Income) = OperatingExpense divided by Total Operating Income

Overhead Burden Ratio = Non Interest Expenses

(Operating Expense) Less Other Income dividedby Net Interest Income

The overhead burden shows what percentage ofNet Interest Income is consumed by operating

expenses. The higher the burden the less efficient the

business is

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Interest Rate Risk

Assets Interest Yield = Interest Revenue / TotalAssets

Break Even Yield = Interest Expenses / TotalAssets

Cumulative gap = Rate Sensitive Assets/RateSensitive Liabilities

Change in NII = Gap X Expected change in interestrate.

A shrinking NIM is an indication of poor interestrate risk management.

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Liquidity Risk

Liquidity risk is the likelihood that a bank

would not be able to meet its commitments as

they fall due.

A bank must be able to strike the right balance

between avoiding the problem of excess cash

whilst ensuring that the bank does not run

into the problem of deficit cash.

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Liquidity Ratios

Liquid Assets Ratio = Total Cash Reserves/Total

Assets, where

Total cash reserves = cash + Government

Securities + placement with other banks

Advances Deposit Ratio = Total

Advances/Deposits

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ALM and Performance Evaluation

A key role of ALM is to evaluate the financial

performance of a bank in order to establish

whether a bank is achieving its strategic

objectives.

Financial report analysis and balanced score

card are key tools that are employed in playing

this role

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Interest Rate Risk

Interest rate risk is the probability that the

banks profits and capital would fall due to

variation in the level of interest rates.

Interest rate risks may arise due to the Assets

and Liabilities positions taken by the bank

Positions relate to the composition and

maturity structure of Assets and Liabilities,

including advances, investments and deposits

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Types of Interest Rate Risk

There are three main types of Interest rate

Risk:

Basis Risk

Repricing Risk

Yield Curve Risk

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Basis Risk

Basis risk arises when different basis are used inthe pricing of a banks assets and liabilities.

The upshot of this is that NII changes because of

differential changes in interest rates on assetsand liabilities.

For example, if deposits are priced relative toTreasury Bills whilst advances are priced relative

to the Bank of Ghana Prime rate, interest rate riskcould arise if Treasury Bills change at a differentrate than the prime rate.

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Repricing Risk

Repricing risk arises when assets and liabilitiesare repriced at different times leading to declinein interest income and NIM for that matter.

In the 1980s the Savings and Loans Companiesfaced repricing risk because they granted longterm facilities at a fixed rate which were fundedby short term wholesale deposits.

When deposit rates started going up it affectedmany of these institutions some of whichcollapsed.

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Yield Curve Risk

Yield curve risk arises due to unequal shifts in

the yield curve of assets and liabilities.

The yield curve is the maturity structure of

interest rates.

For example if the yield of government

securities change relative to the yield curve of

a banks fixed deposits, there would be

implications on NII

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Management of Interest Rate Risks

Banks have a number of tools that could be

used to manage interest rate risks. These

include:

Repricing schedules

Duration

Simulation

Hedging Futures

swaps

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Strategies for Controlling Interest Rate

Risks

Interest rate risk management should encompassstrategies that changes the banks interest ratesensitivity by altering various components of thebalance sheet

Theoretically, the actual ALM strategies shouldfocus on controlling the gap between interestsensitive assets and interest sensitive liabilities.

The rate sensitive gap could be varied in tune

with interest rate forecasts. If the bank is expecting interest rates to increase,

they widen the gap and vice versa.

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Strategies for Reducing Assets

Sensitivity

Extending investment portfolio maturity

Increase floating rate deposits

Increase fixed rate lending

Sell floating rate notes

Increase short term borrowing

Increase long term lending

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Strategies for Reducing Liabilities

Sensitivity

Reduce investment portfolio maturities

Increase floating rate lending

Increase long term deposits

Increase short term lending.

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Other Strategies

Matching of assets and liabilitiese.g.matching long term assets with long termliabilities

Match repriceable assets with repriceableliabilities

Use forward rate agreements, swaps optionsand financial futures to construct syntheticsecurities and thus hedge against anyexposure to interest rate risk.

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Other Strategies

The bank may set tolerance limits on interestsensitivity gapsthese should be smaller in theproximate time bands

The bank can do this by constantly reviewing therepricing structure of all new debt raised or newassets financed with a view to protecting interestrate margins.

Other tactics include investing short term whenrates are rapidly rising and long term when ratesare falling

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Forecasting

It is very critical that the bank develop suitable

in-house expertise for forecasting interest

rates to guide interest rate risk management

strategy at the Assets and LiabilitiesManagement Committee (ALCO)

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Control and Monitoring

An effective system of internal control for themanagement of interest rate risks include: A strong control environment

Adequate processes for identifying and evaluating

risks The establishment of control activities such as policies

and procedures and methodologies

Adequate MIS

Continual review of adherence to policy Continuous monitoring and evaluation of

performance.

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Sound Interest Rate Risk Management

Practices

Appropriate board supervision, management

and oversight

Appropriate risk management policies and

procedures

Appropriate risk measurement monitoring and

control function

Comprehensive interest rate controls and

independent audit.

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Foreign Exchange Risk

Foreign exchange risk is the risk that changes

in foreign exchange rate will cause some

variability in the banks earnings and capital.

Foreign exchange risk is a type of market risk

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Foreign Exchange Risk

There are three main types of foreign

exchange risks:

Transactions exposure

Translation exposure

Economic exposure

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Transactions Exposure

Transactions exposure measures the riskinvolved due to a change in foreign exchangerates between the time of a transaction is

executed and the time it is settled Examples:

Purchase and sale of goods and services in foreigncurrency

Loan repayment in foreign currency

Dividends paid or received in foreign currency

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Economic Exposure

Economic exposure, otherwise termed

operating exposure is the sensitivity of future

cash flows and profits of a bank to

unanticipated exchange rate changes.

Due to its nature, it is a less significant risk

considering the nature of banking activities.

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Management of Foreign Exchange

Risks

Open foreign exchange positions

Foreign exchange portfolio management

Hedging tools

Forwards

Options

Swaps

Currency futures

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Liquidity Risk Management

Liquidity is defined as the ability of a bank tomeet its day to day commitments as they fall due

Day to day commitments of a bank include fuel,

bills, payment of salaries, drawdown of loans andwithdrawal by depositors

A bank must have its own source of liquidityotherwise it must incur a cost to meet its liquidity

needs. Costs include interest expenses to be incurred

and the expense incurred in sourcing funds.

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Liquidity Risk

Liquidity risk is the probability that a bank will

not have sufficient funds to meet day to day

commitments as they fall due.

It has a negative impact on bank earnings due

to cost of borrowing to make up the liquidity

shortfall.

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f i idi i k


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Impact of Liquidity Risk

The bank would have to borrow the required

resources at a cost

The bank would not be able to secure the

required amount of liquidity needed.

There could be a run on the bank if a liquidity

crisis is not well managed.

The ultimate impact would be bank failure

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Component of Bank Liquidity

Branch cash

Reserve account

Near cash investments

Nostro account

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Causes of Liquidity Risk

Excessive expenditure

Executive abuse of power

Overambitious projects

Overtradingtoo much loans with very little

capital

Poor services leading to withdrawal ofdeposits and closing of accounts

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Liquidity Management

Liquidity risk management policy and liquidity

contingency planning

Liquidity forecasting

Investments in liquid assets

Setting of financial liquidity ratio targets

Reserve account management

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Liquidity Risk Management

Branch cash management

Nostro account management

Diversification of funding sources

Scenario planning

MIS

Centralized liquidity control

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Credit Portfolio Management

Whilst day to day management of credit is theresponsibility of the Risk management Division, ALM isconcerned with management of the advances portfolio as awhole.

Credit portfolio management is the process by which risks

that are inherent in the credit process are managed andcontrolled. Because review of the LPM process is soimportant, it is a primary supervisory activity.

It involves evaluating the steps bank management takes toidentify and control risk throughout the credit process. The

assessment focuses on what management does to identifyissues before they become problems.

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A h t C dit P tf li


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Approaches to Credit Portfolio

Management

Define the Portfolio to be managed

Identify the role and mandate of the Credit PortfolioManagement function

Standardize risk measures and models

Portfolio segmentation and Risk Diversificationmeasures

Deal with data issues and MIS

Understand economic value and accounting value Stress test portfolio

Rebalance portfolio to achieve strategic objectives

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Summary/Conclusion

ALM involves dealing with the foregoing risks on aholistic, enterprise wide basis.

Due to the correlations involved in ALM risks, it ispertinent to deal with them on a centralized basis

through a cross functional senior managementcommittee.

The Assets and Liabilities management Committee(ALCO) is normally charge with the responsibility ofspearheading the banks assets and liabilities

management policies procedures and practices. The ALM is the dashboard of a bank and neglecting it

would have inevitable dire consequences on a bank.

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THE END

THANK YOU

assets and liabilities management – risks

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