ALM Structure of Interest Rates and THEORIES

ASSET LIABILITY MANAGEMENTwith specific focus on

TERM Structure and relevant Theories

Forex Banking

ASSET LIABILITY MANAGEMENT

Areas covered for Banking Entities

Interest rate risk Foreign exchange rate risk Liquidity risk Linkages between credit risk and market risks ALM organization (e.g., ALCO, i.e., Asset Liability

Management Committee) Tools and systems for ALM

Source: www.iciciresearchcentre.org/user/research/subtheme_13.asp?level2ID=t10&level3ID=13

Banking Sector in India: Asset Management to Liability Management

In the 1940s and the 1950s, there was an abundance of funds in banks in the form of demand and savings deposits.

Because of the low cost of deposits, banks had to develop mechanisms by which they could make efficient use of these funds.

Hence, the focus then was mainly on asset management. But as the availability of low cost funds started to decline,

liability management became the focus of bank management efforts.

Source: R. Vaidyanathan, “Asset-liability management: Issues and trends in Indian context”, ASCI (Administrative Staff College of India) JOURNAL OF MANAGEMENT 29(1). 39-48 (1999).

(Available on: http://www.iimb.ernet.in/~vaidya/Asset-liability.pdf

Banking Sector in India: Asset Management to Liability Management and shift towards ALM Approach

Liability management essentially refers to the practice of buying money through cumulative deposits, federal funds and commercial paper in order to fund profitable loan opportunities.

But with an increase in volatility in interest rates and with a severe recession damaging several economies, banks started to concentrate more on the management of both sides of the balance sheet.

Source: R. Vaidyanathan, “Asset-liability management: Issues and trends in Indian context”, ASCI (Administrative Staff College of India) JOURNAL OF MANAGEMENT 29(1). 39-48 (1999).

(Available on: http://www.iimb.ernet.in/~vaidya/Asset-liability.pdf

Asset/Liability Management

11th Plan Approach Paper: The target of finding and investing $320 billion in Infrastructure development in the next five years.

IDFC Chairman Deepak Parekh to head the Committee and submission of a quick report within six weeks in a run-up to the budget.

As a measure to raise long-term capital funds, FM Chidambaram to push pension and insurance reforms.

Long-pending proposal of the Planning Commission to use the country’s booming forex reserves for infrastructure.

India Infrastructure Finance Company Ltd. (IIFCL) to tap the debt market to raise funds to the tune of Rs. 10,000 crore.

Source: “Parekh to Head Panel on Infrastructure Funding”, the FW, Dec. 21, 2006


Applicability to depository institutions (commercial banks, savings and loan associations, mutual savings banks, and credit unions), non-bank financial corporations (insurance companies, pension funds, finance companies, mortgage banks, brokerage firms, and investment banks) and MNCs.

Depository institutions and NBFCs primarily concerned with the return on their portfolios and the risk associated with holding these portfolios.

A principal source of earnings for depository institutions and NBFCs: The difference between interest received and interest paid, and the source of the risk is primarily the volatility of these same interest rates.

Maxim: Never borrow short to lend long!


For MNCs: The additional problem of exchange-rate risk from holding assets denominated in one currency that are funded by liabilities denominated in another currency. (Even otherwise some residual translation exposure associated with financial statement consolidation)

ALM as a treasury function of a commercial bank – Asset allocation issues – ALM and hedging as closely related activities (complementary to one another) – ALM techniques include techniques for managing interest-rate risk and exchange-rate risk.


The Evolution of Asset/Liability Management Early 1960s: Depository institutions derived the bulk of their

funding from customer deposits, long-term debt, and equity. The terms on the deposit accounts (demand and/or time

deposits) were fixed. And the outcome: An Institution’s short-term funding mix was determined, primarily, by decisions made by the institution’s depositors. (Little control over deposits)

Institutions could not attract depositors from outside their immediate geographic region by offering higher rates. (So little art or science involved in liability management and the principal focus was on asset management).


Role of the treasury department: Use the funds provided by depositors to structure an asset portfolio that was appropriate for the given liability portfolio.

Alternatives: A portion to be set aside as non interest earning reserves (deposits with Central Banker) or invest in loan/securities portfolio.

Highly regulated deposit taking industries – limited competition – stable interest rates

Early 1960s USA: Demand for funds by corporate customers outstripped banks’ traditional funding sources. (Citibank experiment with 14 days negotiable certificate of deposit)

CD as a tool to manipulate the mix of liabilities that supported asset portfolios (stage was set for active management of asset and liability portfolios as against management of the asset portfolio alone)


The first Asset/Liability strategy…….management of interest margin (interest received on earning assets and the interest paid on liabilities)

Interest margin management led to the concept of the gap and subsequently, to gap management (The term, “Spread” in banking)

Aggressiveness and complexity in ALM: Contributory factors such as Volatile interest rates, the introduction of money market mutual funds (MMMFs), the development of overseas markets as both funding and lending sources, deregulation of financial services.

In US alone, PLR changed – 16 times in 1950s and the 1960s, 139 times in 1970s, between Oct. 1979 and Dec. 1980, about 50 times.

Rung the death knell for the old way of doing the business.


Traditional source of low-cost financing – the demand and time deposits – dried up as savers gradually turned to more lucrative, equally liquid, unregulated alternatives.

Disintermediation – The process by which the traditional customers of depository institutions, small savers, pull their funds out in order to earn higher returns elsewhere.

MMMF (first in US in 1973) as the main driving force behind the disintermediation process – investment pattern of MMMFs – Cheque writing facility as another innovation – Shift of funds from banks and thrifts to MMMFs.


December 16, 2006 (Business Line)

Improved net interest margins (NIM) despite the hike in the CRR. (NIM in excess of three per cent)

Large PSBs and private sector banks tweaked their deposit rates for raising medium term funds instead of short-term funds.

Many banks contained acceptance of bulk deposits, to avert possible liquidity mismatches.

Bulk deposits cost 8 per cent – No longer seen as profitable in view of the short tenure – Mostly deployed in 91-day T-Bills.

Yields on T-bills ranged 6.65 per cent for almost five weeks in a row. Hence effective returns from such investments were negative.

A banker: We would prefer to have bulk deposits for at least one year as it allows for deployment of funds in longer dated assets.


At least, 50 per cent of the banks deposits’ mix came from savings accounts.

Weighted average cost of funds remained under control and allowed for parking in long-term assets, including credit.

Increased costs largely neutralized by increased yields on credit that moved up to over 11 per cent from about 10 per cent in Q2.

The industry average yield on assets was upwards of 8.5 per cent, neutralizing the increased cost of liabilities.

Source: “Banks’ profits for Q3 may remain buoyant”, BL, Dec. 16, 2006


RBI notification on Dec. 14: More leeway for banks in capital market exposure and guidelines to come into effect from April 1

Aggregate capital market exposure to 40 per cent of its net worth on a solo and consolidated basis and the direct capital market exposure to 20 per cent of its consolidated net worth.

Aggregate exposure would include direct investment in equity shares, convertible bonds, convertible debentures, units of equity-oriented mutual funds, advances against shares, bonds, debentures or other securities to individuals for investment in shares, including IPOs or ESOPs or for other purposes, secured and unsecured advances to stock brokers and guarantees issued on behalf of stockbrokers, loans to corporates against bonds/debentures, bridge loans against expected equity flows or issues and all exposure to Venture Capital funds.

Source: “More leeway for banks in capital market exposure”, BL, Dec. 17, 2006.


Foundation concepts

(Applicable to all asset/liability management strategies)

(a) Liquidity(b) Term Structure(c) Interest Rate Sensitivity(d) Maturity Composition(e) Default Risk

Foundation Concept: LIQUIDITY

Liquidity Ease in Conversion: The ease with which assets can be

converted into cash. (Sudden withdrawal by depositors – News item regarding BoP, now CBoP and ICICI)

Cash required to meet any such liquidity demands. Two dimensions of liquidity: The first one is maturity

liquidity (maturity within a very short period of time, e.g., overnight repos and multi-year commercial loans as highly illiquid assets) and the second dimension is marketability (An asset is liquid if it can be easily sold in the secondary market without a major price concession – Treasury Security vs. Junk Bond)

Trade-off between liquidity and profitability.

Foundation Concept: TERM STRUCTURE

Term StructureTerm StructureRelationship between debt instrument yields and

their maturities (depiction by the yield curve). Draw Relationship for securities having a

similar credit rating. The shape of the yield curve. Expectations of the asset/liability manager

about the future shape of the curve and its’ role in his/her strategy.


The Yield-to-maturity: On any fixed-income security is the single interest rate (with interest compounded at some specified interval) that, if paid by a bank on the amount invested, would enable the investor to obtain all the payments promised by the security in question.

Yield Curve: A graph that shows the yields-to-maturity (on the vertical axis) for Treasury securities of various maturities (on the horizontal axis) as of a particular date.

Often the one-year spot rate is less than the two-year spot rate, which in turn is less than the three-year spot rate and so on.

Typical Yield Curve Shapes: Upward Sloping, Flat, Downward Sloping Yield curve provides an estimate of the current term structure of interest

rates, and will change daily as yields-to-maturity change.


Term Structure Theories

(a) The Unbiased Expectations Theory

(b) The Liquidity Preference Theory

(c) The Market Segmentation Theory

(d) The Preferred Habitat Theory

Source: “Fundamentals of Investments” by Alexander, Sharpe and Bailey, 2003


(a) The Unbiased Expectations Theory (or Pure Expectations Theory)

The forward rate represents the average opinion regarding the level of the expected future spot rate for the period in question.

An investor does not know what the one-year spot rate will be one year from now, the investor has an expectation about what it will be.

What if the expected future spot rate is 6% instead of 10% and an option to invest for one year and two years?

Two strategies: Maturity strategy vs. Roll over strategy (1 x 1.10 x 1.10) vs. (1 x 1.10 x 1.06).

Naive Strategy: Two-year security could be purchased now and sold after one year.


(b) The Liquidity Preference Theory The notion that investors are primarily interested in purchasing short-term

securities. Investors realize that they may need their funds sooner than anticipated and

recognize that they face less “price risk” (interest rate risk) if they invest in shorter term securities.

Investors will agree to follow a maturity strategy only if the expected return from doing so is higher than the expected return from following the rollover strategy.

The difference between the forward rate and the expected future spot rate is known as the liquidity premium.

Downward-sloping yield curve will be observed only when the marketplace believes that interest rates are going to decline substantially.

Flat Yield curve to mean that the marketplace expected interest rates to remain at the same level.


© The Market Segmentation Theory A third explanation for the determination of the term structure rests on the

assumption that there is market segmentation. Various investors and borrowers are thought to be restricted by law,

preference, or custom in certain maturities. (Investment in China by residents and foreigners – H-Shares vs. A-shares)

There is a market for short-term securities, another for intermediate-term securities, and a third for long-term securities.

As per the theory, spot rates are determined by supply and demand conditions in each market.

Investors and borrowers will not leave their market and enter a different one even when the current rates suggest to them that there is a substantially higher expected return available if they make such a move.


An upward-sloping term structure exists when the intersection of the supply and demand curves for shorter term funds is at a lower interest rate than the intersection for longer tem funds

Reason: Either a relatively greater demand for longer term funds by borrowers or a relatively greater supply of shorter term funds by investors, or some combination of the two)

A downward-sloping term structure would exist when the intersection for shorter term funds was at a higher interest rate than the intersection for longer term funds.


(d) The Preferred Habitat Theory A more moderate and realistic version of the market segmentation theory

is the preferred habitat theory. Investors and borrowers have segments of the market in which they

prefer to operate, similar to the market segmentation theory. However, they are willing to leave their desired maturity segments if

there are significant differences in yields between the various segments. Yield differences are determined by the supply and demand for funds

within the segments The term structure reflects both expectations of future spot rates and a

risk premium. Risk premium does not necessarily rise directly with maturity and is a

function of the extra yield required to induce borrowers and investors to shift out of their preferred habitat.

Foundation Concept: Interest Rate Sensitivity

Interest Rate Sensitivity The degree to which an instrument’s price will

change when the instrument’s yield (a reflection of the current market rate) changes.

To focus on the variable or floating-rate assets and liabilities. (Being Interest rate sensitive instruments and if market rates rise then the return on int. rate sensitive assets and the cost of the interest-sensitive liabilities will also rise).

The degree to which an instrument’s interest rate adjusts and the speed of this adjustment.

Gap or Mismatch Risk

A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or re-pricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.

0-6 6M-1Y >1Y Total

Assets 100 1000 5000 6100

Liabilities 2000 1000 2500 5500

Gap - 1900 0 2500 600

(Note: the difference of Rs 600 cr between assets and liabilities, re-present non-sensitive liabilities e.g. Capital, Reserves, Current deposits etc).

Gap or Mismatch Risk: Implications

As the bank has negative mismatch in the first year (i.e. its maturing liabilities are more than assets), its net interest margin or earnings will decline in a rising rate scenario.

The reverse will happen in a falling interest rate scenario.

Direction

of

Interest Rates

Position

of

Gaps

Impact on Net Interest Income

(NII)

Increasing Positive Positive

Decreasing Positive Negative

Increasing Negative Negative

Decreasing Negative Positive

Relationship between a bank’s net interest income, gap and direction of interest rate movements

Foundation Concept: Maturity Composition

Maturity Composition The maturities of assets and liabilities can be

matched or unmatched. If the maturity and the interest-rate sensitivity of an

asset and a liability are matched, then the institution has a spread lock on that portion of the principals that are also matched.

Maturity composition and term structure interact to determine interest-rate sensitivity.

Foundation Concept: Maturity Composition and Asset-Liability Mismatch

An asset-liability mismatch occurs when the financial terms of the assets and liabilities do not correspond.

Example: A bank that chose to borrow entirely in U.S. dollars and lend in Indian Rupee would have a significant mismatch if the value of the Indian Rupee were to fall dramatically (depreciation as well as devaluation), the bank would lose money.

In extreme cases, such movements in the value of the assets and liabilities could lead to bankruptcy or liquidity problems.


The Changing Face of Liquidity Management Unpredictable element in deposits and withdrawals:

Depositors could withdraw funds on relatively short notice in case of depository institutions (Festival season for individuals, payrolls for commercial accounts, harvest cycle for agriculturalists)

Depositor behaviors of such types had to be planned for through asset management. (so as to liquidate assets to meet the liquidity needs) – Holding of cash equivalent assets.

CDs allowed FIs a tool by which to manage their liquidity on the liability side. (By managing liquidity on the liability side of the B/S, the institution could reduce its holding of low-return cash equivalents in favour of higher-return, longer-maturity, less liquid assets).


Decline in holding of cash and cash equivalents Holding composition of banks and NBFCs Ability to manage liquidity on the liability side of

the balance sheet: Enhanced by repo/reverse repo market.

CD Approach to manage depository institution liquidity replicated on the corporate side with the introduction of commercial paper.

Liquidity Risk Management

Approaches to Measure Liquidity risk(a) Stock Approach (b) Flow Approach

Stock Approach

Certain standard ratios are computed. Some of the ratios widely used in banks are Liquid assets to short-term liabilities, Core assets to core liabilities, Inter bank borrowings to total assets, Overnight borrowings to total assets etc.

However, management of liquidity through ratios suffers from some drawbacks, as it does not factor market liquidity aspect of assets and liabilities.

For example, presence of some short-term investments may show the improved liquidity risk of the bank whereas the investment itself may be highly illiquid.

Further, the ratio, though good indicator of liquidity, may be valid good for a point of time only as balance sheet profile constantly changes.

Liquidity Risk Management

Flow Approach

The alternative model for measuring and managing liquidity has been accepted by most of the banks.

Under flow approach, cash flows are segregated into different maturity ladders and net funding requirement for a given time horizon is estimated.

The net funding requirement over a given time horizon gives a fair idea of liquidity risk faced by an institution.

Flow Approach: RBI has prescribed some statutory returns for submission of data on liquidity risk and interest rate risk by banks. There are limits for liquidity mismatches in the first two buckets prescribed by RBI. The mismatches as percentage to outflows should not exceed negative 20% in the time buckets of 1-14 days and 15-28 days.

Source: Vaidya, Pramod, and Arvind Shahi, “ALM in Indian Banks”. www.iimk.ac.in/archives/events/spandan/Spandan (Nov 20, 2005)

PERFORMA LIQUIDITY RISK PROFILE OF A BANK


Spread-lock Strategy

Lock-in spread by matching both the type and the maturity of its assets and liabilities.

All fixed-rate assets would be funded by fixed-rate liabilities and all floating-rate assets would be funded by floating-rate liabilities.

Pros and Cons: Relatively safe strategy, barring loan and securities defaults – Not necessarily produce spreads sufficient to cover the institution’s overhead expenses.

The spread can be increased by holding higher-risk assets, but this exposes the institution to greater default risk.


Gap Management as aggressive strategy

The institution varies the gap in response to its expectations about the future course of interest rates and the shape of the yield curve.

To increase the gap when interest rates are expected to rise and to decrease the gap (negative gaps included) when interest rates are expected to fall.

An increase in the gap will increase the spread when rates rise since the return on the variable-rate assets will rise but the cost of the fixed-rate liabilities used to fund the assets will not rise. (The reverse argument applies when rates fall)

Gap vs. Spread: Expectation of rising rate market

Upper Limit to spread fromUnexpected but favourableInterest rate movements

Expected Spread

Spread

GapLower Limit to spreadFrom unexpected unfavourableInterest rate movements

NHB on ALM for Housing Finance Companies

TRIAD OF

ALMPROCESS

ALMInformation

System

ALMOrganization

ALMProcess

ALM Structure of Interest Rates and THEORIES

Documents

administrative

preferred

net funding

market segmentation

unbiased expectations

interest rate

shorter term

year spot