© IMaCS 2010 Printed 26-May-11 1 Training Session 2: Asset Liability Management May 2011 Dhaka ICRA Management Consulting Services Limited TRAINING ON CORE RISK MANAGEMENT FOR BANGLADESH BANK
Jan 22, 2015
© IMaCS 2010
Printed 26-May-11
1
Training Session 2:
Asset Liability Management
May 2011
Dhaka
ICRA Management Consulting Services Limited
TRAINING ON CORE RISK
MANAGEMENT FOR BANGLADESH BANK
© IMaCS 2010
Printed 26-May-11
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CONFIDENTIAL
All the contents of the presentation are confidential and should
not be published, reproduced or circulated without the written
consent of World Bank, Central Bank of Bangladesh and IMaCS
© IMaCS 2010
Printed 26-May-11
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Agenda of the presentation
Understanding requirement for training on Asset
Liability Management
Introducing key concepts and tools for Asset Liability
Management
Outlining the current guidelines issued by Bangladesh
Bank and suggesting improvements, if any
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Agenda for Day 1
Introduction to Asset Liability Management
ALM basic concepts
Lunch Break
Liquidity Risk
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Agenda for Day 2
Liquidity risk Continued
Lunch Break
Liquidity risk Continued
Liquidity risk Continued
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Agenda for Day 3
Liquidity risk Continued
Lunch Break
Liquidity risk Continued
Interest rate risk
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Agenda for Day 4
Interest rate risk
Lunch Break
Interest rate risk continued
Interest rate risk continued
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Agenda for Day 5
Interest Rate risk Continued
Lunch Break
Interest Rate risk Continued
Basel Guidelines, current guidelines in
Bangladesh and wrap up session
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In this session, we will understand what constitutes assets and
liabilities in a Bank and why asset liability management is important
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Components of Balance Sheet
Liabilities Assets
Capital Cash and Balances at Central Bank
Reserves and Surplus
Deposits
Borrow ings Investments
Other Liabilities and Provisions Advances
Contingent Liabilities Fixed Assets
Other Assets
Balance w ith banks and money at call
and short notice
Balance Sheet of a Bank
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Components of Liabilities … 1
1. Capital:
Capital represents owner‟s contribution/stake in the bank.
- It serves as a cushion for depositors and creditors.
- It is considered to be a long term sources for the bank.
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Components of Liabilities … 2
2. Reserves & Surplus
Components under this head includes:
I. Statutory Reserves
II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Revenue and Other Reserves
V. Balance in Profit and Loss Account
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Components of Liabilities … 3
3. Deposits
This is the main source of bank‟s funds. The deposits are
classified as deposits payable on „demand‟ and „time‟. They
are reflected in balance sheet as under:
I. Demand Deposits
II. Savings Bank Deposits
III. Term Deposits
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Components of Liabilities … 4
4. Borrowings
(Borrowings include Refinance / Borrowings from central
bank, Inter-bank & other institutions)
I. Borrowings in Bangladesh
i) Bangladesh Bank
ii) Other Banks
iii) Other Institutions & Agencies
II. Borrowings outside Bangladesh
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Components of Liabilities … 5
5. Other Liabilities & Provisions
It is grouped as under:
I. Bills Payable
II. Inter Office Adjustments (Net)
III. Interest Accrued
IV. Unsecured Redeemable Bonds
(Subordinated Debt for Tier-II Capital)
V. Others(including provisions)
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Components of Assets … 1
1. Cash & Bank Balances
I. Cash in hand
(including foreign currency notes)
II. Balances with Bangladesh Bank
In Current Accounts
In Other Accounts
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Components of Assets … 2
2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE
I. In Bangladesh
i) Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. Outside Bangladesh
a) In Current Accounts
b) In Other Deposit Accounts
c) Money at Call & Short Notice
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Components of Assets … 3
3. InvestmentsA major asset item in the bank‟s balance sheet. Reflected under 6 buckets as under:
I. Investments in Bangladesh in:
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (Commercial Papers, COD & Mutual Fund Units etc.)
II. Investments outside Bangladesh in
Subsidiaries and/or Associates abroad
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Components of Assets … 4
4. Advances
The most important assets for a bank.
A. i) Bills Purchased and Discounted
ii) Cash Credits, Overdrafts & Loans repayable on demand
iii) Term Loans
B. Particulars of Advances :
i) Secured by tangible assets (including advances against
Book Debts)
ii) Covered by Bank/ Government Guarantees
iii) Unsecured
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Components of Assets … 5
5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture and fixtures)
6. Other Assets
I. Interest accrued
II. Tax paid in advance/tax deducted at source (Net of Provisions)
III. Stationery and Stamps
IV. Non-banking assets acquired in satisfaction of claims
V. Deferred Tax Asset (Net)
VI. Others
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Contingent Liability
Bank‟s obligations under LCs, Guarantees, Acceptances on
behalf of constituents and Bills accepted by the bank are
reflected under this heads.
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Banks Profit & Loss Account
A bank’s profit & Loss Account has the following
components:
I. Income: This includes Interest Income and Other
Income.
II. Expenses: This includes Interest Expended, Operating
Expenses and Provisions & contingencies.
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Components of Income … 1
1. INTEREST EARNED
I. Interest/Discount on Advances / Bills
II. Income on Investments
III. Interest on balances Central Bank and other inter-bank
funds
IV. Others
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Components of Income … 2
2. OTHER INCOME
I. Commission and Brokerage
II. Profit on sale of Investments (Net)
III. Profit/(Loss) on Revaluation of Investments
IV. Profit on sale of land, buildings and other
assets (Net)
V. Profit on exchange transactions (Net)
VI. Income earned by way of dividends etc. from
subsidiaries and Associates abroad/in Bangladesh
VII. Miscellaneous Income
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Components of Expenses … 1
1. INTEREST EXPENDED
I. Interest on Deposits
II. Interest on Central Bank of Bangladesh/ Inter-Bank
borrowings
III. Others
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Components of Expenses … 2
2. OPERATING EXPENSES
I. Payments to and Provisions for employees
II. Rent, Taxes and Lighting
III. Printing and Stationery
IV. Advertisement and Publicity
V. Depreciation on Bank's property
VI. Directors' Fees, Allowances and Expenses
VII. Auditors' Fees and Expenses (including Branch Auditors)
VIII. Law Charges
IX. Postages, Telegrams, Telephones etc.
X. Repairs and Maintenance
XI. Insurance
XII. Other Expenditure
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Reclassification of liabilities
Liabilities/outflows
1&2. Capital funds
a) Equity capital, Non-redeemable or perpetual preference capital, Reserves, Funds and Surplus
b) Preference capital - redeemable/non-perpetual
3. Grants, donations and benefactions
4. Bonds and debentures
a) Plain vanilla bonds/debentures
b) Bonds/debentures with embedded call/put options (including zero-coupon/deep discount bonds)
5. Inter Corporate Deposits:
6. Borrowings
a) Short Term borrowings
b) Long Term Borrowings
7. Current liabilities and provisions:
a) Sundry creditors
b) Expenses payable (other than interest)
c) Advance income received, receipts from borrowers pending adjustment
d) Interest payable on bonds/deposits
e) Provisions for NPAs
f) Provision for Investments portfolio
g) Other provisions
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Reclassification of Assets … 1
Inflows
1. Cash
2. Remittance in transit
3. Balances with banks (in Bangladesh only)
a) Current account
b) Deposit accounts/short term deposits
4. Investments (net of provisions)
a) Approved Trustee securities, government securities, bonds, debentures and other instruments
b) Unlisted securities (e.g. shares, etc.)
c) Unlisted securities having a fixed term maturity
d) Venture capital units
e) Equity shares, convertible preference shares, non-redeemable/perpetual preference shares, shares of
subsidiaries/joint ventures and units in open ended mutual funds and other investments.
5. Advances (performing)
a) Bill of Exchange and promissory notes discounted and rediscounted
b) Term loans (rupee loans only)
c) Corporate loans/short term loans
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Reclassification of Assets … 2
6. Non-performing loans
(May be shown net of the provisions, interest suspense held )
a) Sub-standard
i) All overdues and instalments of principal falling due during the next three years
ii) Entire principal amount due beyond the next three years
b) Doubtful and loss
i) All instalments of principal falling due during the next five years as also all overdues
ii) Entire principal amount due beyond the next five years
7. Assets on lease
8. Fixed assets (excluding leased assets)
9. Other assets
(a) Intangible assets and items not representing cash inflows.
(b)Other items (such as accrued income, other receivables, staff loans, etc.)
C. Contingent liabilities
(a) Letters of credit/guarantees (outflow through devolvement)
(b) Loan commitments pending disbursal (outflow)
(c) Lines of credit committed to/by other Institutions (outflow/inflow)
Overdue for less than one month.
Interest overdue for more than one month but less than seven months (i.e. before the relative amount
becomes NPA)
Principal installments overdue for 7 months but less than one year
In this session, we will understand what constitutes assets and
liabilities in a Bank and why asset liability management is important
Asset Liability Management is concerned with strategic balance sheet management involving risks caused by changes in interest rates, exchange rate and the liquidity position of bank
Asset liability
management is a
strategic management
tool to measure and
manage liquidity risk,
interest rate risk and
interest rate risk faced
by Banks and Financial
Institutions. ALM is
about matching of the
assets and liabilities of
the balance sheet based
on maturity or re-pricing
for liquidity risk and
interest rate risk
respectively
ALM is the process involving decision making about the composition of assets and liabilities including off balance sheet items of the bank / FI and conducting the risk assessment
It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII
Globalization of financial markets._ Deregulation of Interest Rates._ Multi-currency Balance Sheet.
_ Prevalence of Basis Risk and Embedded Option Risk._ Integration of Markets – Money Market, FOREX Market,
Government Securities Market._ Narrowing NII / NIM
_ Mismatches in the maturity profile of assets and liabilities_ Banks borrow short term and lend long term-basis of
profitability_ Mismatches in interest rates
Liquidity mismatch→
Interest rate mismatch →
May lead to liquidation
Affects profitability
An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.
It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are:
Net Interest Income (NII)
Net Interest Margin (NIM)
Economic Equity Ratio
Bank’s liquidity management is the
process of generating funds to meet
contractual or relationship obligations
at reasonable prices at all times.
New loan demands, existing
commitments, and deposit withdrawals
are the basic contractual or relationship
obligations that a bank must meet.
Liquidity Management
FLOW APPROACH STOCK APPROACH
Measuring &
Managing net
funding requirement
Managing market
access
Contingency planning
Based on the level of
Assets & Liabilities as
well as Off balance
Sheet exposures on a
particular date and
calculating certain
ratios to assess the
liquidity position
COMPONENTS OF BALANCE SHEET
Liabilities Capital
Reserves and Surplus
Deposits
Borrowings
Other Liabilities and Provisions
Contingent Liabilities
Assets Cash and Balances
at Central Bank
Investments
Advances
Fixed Assets
Other Assets
Components of Liabilities … 1
1. Capital:Capital represents owner’s
contribution/stake in the bank.
- It serves as a cushion for
depositors and creditors.
- It is considered to be a long term
sources for the bank.
Components of Liabilities … 2
2. Reserves & Surplus
Components under this head
includes:
I. Statutory Reserves
II. Capital Reserves
III. Investment Fluctuation Reserve
IV. Revenue and Other Reserves
V. Balance in Profit and Loss
Account
Components of Liabilities … 3
3. Deposits
This is the main source of bank’s
funds. The deposits are
classified as deposits payable on
‘demand’ and ‘time’. They
are reflected in balance sheet as
under:
I. Demand Deposits
II. Savings Bank Deposits
III. Term Deposits
Components of Liabilities … 4
4. Borrowings
(Borrowings include Refinance / Borrowings from RBI,
Inter-bank& other institutions)I. Borrowings in India
i) Bangladesh Bank
ii) Other Banks
iii) Other Institutions & Agencies
II. Borrowings outside India
5. Other Liabilities & Provisions
It is grouped as under:
I. Bills Payable
II. Inter Office Adjustments (Net)
III. Interest Accrued
IV. Unsecured Redeemable Bonds
(Subordinated Debt for Tier-II Capital)
V. Others(including provisions)
Components of Assets … 1
1. Cash & Bank Balances
I. Cash in hand
(including foreign currency
notes)
II. Balances with Bangladesh
Bank
In Current Accounts
In Other Accounts
Components of Assets … 2
2. BALANCES WITH BANKS AND
MONEY AT CALL & SHORT NOTICE
I. In Bangladesh
i) Balances with Banks
a) In Current Accounts
b) In Other Deposit Accounts
ii) Money at Call and Short Notice
a) With Banks
b) With Other Institutions
II. Outside Bangladesh
a) In Current Accounts
b) In Other Deposit Accounts
c) Money at Call & Short Notice
Components of Assets … 3
3. Investments
A major asset item in the bank’s balance sheet. Reflected
under 6 buckets as under:
I. Investments in Bangladesh in:
i) Government Securities
ii) Other approved Securities
iii) Shares
iv) Debentures and Bonds
v) Subsidiaries and Sponsored Institutions
vi) Others (Commercial Papers, COD & Mutual
Fund Units
etc.)
II. Investments outside Bangladesh in
Subsidiaries and/or Associates abroad
Components of Assets … 4
4. AdvancesThe most important assets for a bank.
A. i) Bills Purchased and Discounted
ii) Cash Credits, Overdrafts & Loans
repayable on demand
iii) Term Loans
B. Particulars of Advances :
i) Secured by tangible assets (including
advances against
Book Debts)
ii) Covered by Bank/ Government
Guarantees
iii) Unsecured
Components of Assets … 5
5. Fixed Asset
I. Premises
II. Other Fixed Assets (Including furniture
and fixtures)
6. Other Assets
I. Interest accrued
II. Tax paid in advance/tax deducted at
source (Net of Provisions)
III. Stationery and Stamps
IV. Non-banking assets acquired in
satisfaction of claims
V. Deferred Tax Asset (Net)
VI. Others
Contingent
Liability
Bank’s obligations under LCs, Guarantees, Acceptances on
behalf of constituents and Bills accepted by the bank are
reflected under this heads.
1&2. Capital funds
a) Equity capital, Non-redeemable or perpetual preference capital, Reserves, Funds and Surplus
b) Preference capital -redeemable/non-perpetual
3. Grants, donations and benefactions
4. Bonds and debentures
a) Plain vanilla bonds/debentures
b) Bonds/debentures with embedded call/put options (including zero-coupon/deep discount bonds)
5. Inter Corporate Deposits:
6. Borrowings
a) Short Term borrowings
b) Long Term Borrowings
7. Current liabilities and provisions:
a) Sundry creditors
b) Expenses payable (other than interest)
c) Advance income received, receipts from borrowers pending adjustment
d) Interest payable on bonds/deposits
e) Provisions for NPAs
f) Provision for Investments portfolio
g) Other provisions
1. Cash
2. Remittance in transit
3. Balances with banks (in India only)
a) Current account
b) Deposit accounts/short term deposits
4. Investments (net of provisions) a) Approved Trustee securities, government securities, bonds, debentures and other instruments b) Unlisted securities (e.g. shares, etc.) c) Unlisted securities having a fixed term maturity d) Venture capital units e) Equity shares, convertible preference shares, non-redeemable/perpetual preference shares, shares of subsidiaries/joint ventures and units in open ended mutual funds and other investments.
5. Advances (performing)
a) Bill of Exchange and
promissory notes discounted and
rediscounted
b) Term loans (rupee loans only)
c) Corporate loans/short term
loans
6. Non-performing loans
(May be shown net of the provisions, interest suspense held )
a) Sub-standard
i) All overdues and instalments of principal falling due during the next three years
ii) Entire principal amount due beyond the next three years
b) Doubtful and loss
i) All instalments of principal falling due during the next five years as also all overdues
ii) Entire principal amount due beyond the next five years
7. Assets on lease
8. Fixed assets (excluding leased assets)
9. Other assets
(a) Intangible assets and items not representing cash inflows.
(b)Other items (such as accrued income, other receivables, staff
loans, etc.)
C. Contingent liabilities
(a) Letters of credit/guarantees (outflow through devolvement)
(b) Loan commitments pending disbursal (outflow)
(c) Lines of credit committed to/by other Institutions (outflow/inflow)
Overdue for less than one month.
Interest overdue for more than one month but less than seven months (i.e. before the relative amount
becomes NPA)
Principal installments overdue for 7 months but less than one year
Managing Currency risk is one more
dimension of Asset - Liability
Management. Mismatched currency
position besides exposing the
balance sheet to movements in
exchange rate also exposes it to
country risk and settlement risk.
It is the current or prospective risk to earnings andcapital arising from adverse movements in currencyexchange rates.It refers to the impact of adverse movement incurrency exchange rates on the value of open foreigncurrency.The banks are also exposed to interest rate risk,which arises from the maturity mismatching of foreigncurrency positions. Even in cases where spot andforward positions in individual currencies arebalanced, the maturity pattern of forward transactionsmay produce mismatches. As a result, banks maysuffer losses due to changes in discounts of thecurrencies concerned
Banks also face another risk called
time-zone risk, which arises out of time
lags in settlement of one currency in
one center and the settlement of
another currency in another time zone.
The forex transactions with counter
parties situated outside Bangladesh
also involve sovereign or country risk.
LIQUIDITY COVERAGE RATIO
NET STABLE FUNDING RATIO
Objective is to examineshort term resiliency ofliquidity risk profile toensure they havesufficient high qualityresources to surviveone month in acutestress condition
Objective is to ensurelonger term resiliencyby funding activitieswith more stablefunding on an on goingstructural basis
The liquidity coverage ratio identifies theamount of unencumbered, high quality liquidassets an institution holds that can be used tooffset the net cash outflows it would encounterunder an acute short-term stress scenariospecified by supervisors. The specified scenarioentails both institution-specific and systemicshocks built upon actual circumstancesexperienced in the global financial crisis
The scenario entails:
• a significant downgrade of the institution’s public credit rating;
• a partial loss of deposits;
• a loss of unsecured wholesale funding;
• a significant increase in secured funding haircuts; and
• increases in derivative collateral calls and substantial calls on contractual and noncontractual off-balance sheet exposures, including committed credit and liquidity facilities.
The net stable funding (NSF) ratio measures the
amount of longer-term, stable sources of funding
employed by an institution relative to the liquidity
profiles of the assets funded and the potential for
contingent calls on funding liquidity arising from off-
balance sheet commitments and obligations.
The NSF ratio is intended to promote longer-term
structural funding of banks’ balance sheets, off-
balance sheet exposures and capital markets
activities.
Throughout the global financial crisis
which began in mid-2007, many banks
struggled to maintain adequate liquidity.
Unprecedented levels of liquidity support
were required from central banks in order
to sustain the financial system and even
with such extensive support a number of
banks failed, were forced into mergers or
required resolution.
These circumstances and events were
preceded by several years of ample liquidity
in the financial system, during which
liquidity risk and its management did not
receive the same level of scrutiny and
priority as other risk areas. The crisis
illustrated how quickly and severely
liquidity risks can crystallise and certain
sources of funding can evaporate,
compounding concerns related to the
valuation of assets and capital adequacy.
Banks should have in place
contingency and business
continuity plans to ensure their
ability to operate as going
concerns and minimize losses
in the event of severe business
disruption.
does management have a strategy for handling a crisis?
does management have procedures in place for accessing funds in an emergency?
A contingency plan needs to spellout procedures to ensure thatinformation flows remain timelyand uninterrupted, and that theyprovide senior management withthe precise information it needs inorder to make quick decisions.
Another major element in the planshould be a strategy for takingcertain actions toalter asset and liability behaviours.
Other components of the contingency plan involve
maintaining customer relationships with liability-
holders, borrowers, and trading and off-balance-sheet
counterparties.
Contingency plans should also includeprocedures for making up cash flowshortfalls in adverse situations. Banks haveavailable to them several sources of suchfunds, including previously unused creditfacilities. The plan should spell out asclearly as possible the amount of funds abank has available from these sources, andunder what scenarios a bank could usethem.
The plan should spell out as clearly as
possible the amount of funds a bank has
available from these sources, and under
what scenarios a bank could use them.
Holding readily marketable securities
(financial assets). The sub-prime crisis has
exposed the shortcomings in such a strategy
for coping with market wide liquidity crises.
Holding securities which can be
pledged as collateral for short term
borrowings. The repurchase (repo)
market has become an important tool for
liquidity management of this sort.
Having in place lines of credit or other
arranged borrowing facilities. The Having
in place lines of credit or other arranged
borrowing facilities.
Having at-call or short term loans
outstanding to other entities which can be
called to provide cash when needed. The
risk here is that such loans involve
counterparty risk – and calling such loans
may increase the likelihood of default if
there is widespread stress in the financial
market.
For banks, the ability to access
“Lender of Last Resort” loans or
use discount window facilities at
Central Banks provide further
potential
new issues of short- and long-
term debt instruments
new capital issues, the sale of
subsidiaries or lines of business
asset securitisation
rapid asset growth, especially when funded with potentially volatile liabilities
• growing concentrations in assets or liabilities
• increases in currency mismatches
• a decrease of weighted average maturity of liabilities
• repeated incidents of positions approaching or breaching internal or regulatory limits
• negative trends or heightened risk associated with a particular product line, such as rising delinquencies
• significant deterioration in the bank’s earnings, asset quality, and overall
financial condition
• negative publicity
• a credit rating downgrade
• stock price declines or rising debt costs
• widening debt or credit-default-swap spreads
• rising wholesale or retail funding costs
• correspondent banks that eliminate or decrease their credit lines
• increasing retail deposit outflows
• increasing redemptions of CDs before maturity
• difficulty accessing longer-term funding
• difficulty placing short-term liabilities (eg commercial paper)
All banks are
required to
produce a
Contingency
Funding Plan
(CFP). These
plans are to be
approved by
ALCO
CFP are liquidity
stress tests designed
to quantify the likely
impact of an event on
the balance sheet
and the net potential
cumulative gap over a
3-month period.
The bank's CFP
should reflect the
funding needs of
the bank
Reports of CFPs
should be
prepared at least
quarterly and
reported to ALCO
If a CFP results in
a funding gap within
a 3-month time
frame, the ALCO
must establish an
action plan to
address this
situation. The Risk
Management
Committee should
approve the action
plan.
CFPs under each
scenario must
consider the impact
of accelerated run off
of large funds
providers.
The plans must
consider the impact
of a progressive,
tiered deterioration,
as well as sudden,
drastic events.
Balance sheet
actions and
incremental sources
of funding should be
dimensioned with
sources, time frame
and incremental
marginal cost and
included in the CFPs
for each scenario.
Assumptions underlying the CFPs, consistent with each scenario, must be reviewed and approved by ALCO. The Chief Executive/Chairman must be advised as soon as a decision has been made to activate or implement a CFP.
The ALCO will implement the CFP, amending it necessary, to meet changing conditions daily reports are to be submitted to the Treasury Head, comparing actual cash flows with the assumptions of the CFP.
© IMaCS 2009
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Risks
• Various sources of risk that investors are exposed to when investing in fixed income securities
– Interest Rate Risk: Sensitivity of bond prices to changes in interest rates
– Yield Curve Risk: Changes in the shape of the yield curve will negatively impact bond values
– Call Risk: Bond redeemed (called) before maturity & have to reinvest at lower yields
– Prepayment Risk: Principal on amortizing securities is prepaid, and have to reinvest at lower yields
– Reinvestment Risk: Risk of reinvesting in new security with lower yields
– Credit Risk: The risk of default and the risk of decrease in bond value due to a downgrade
– Liquidity Risk: immediate sale of security will result in a price below fair value
– Exchange-Rate Risk: Foreign exchange value of the currency that a foreign bond is denominated in will fall relative to the home currency of the investor.
– Inflation Risk: Higher inflation erodes the purchasing power of the cash flows from a fixed income security.
– Event Risk: Decrease in a security's value from disasters, corporate restructurings, or regulatory changes that negatively impact the firm.
– Sovereign Risk: Govt. may repudiate debt, prohibit debt repayment by private borrowers, or impose general restrictions on currency flows
– Credit spread risk: The default risk premium required in the market for a given rating can increase, even while the yield on Treasury securities of similar maturity remains unchanged
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Basic Concepts-Bonds
Fixed Income Securities (FIS): An investment that provides a return in the
form of fixed periodic payments and the eventual return of principal at
maturity. Eg. Bonds
Bond Indenture: Contract that specifies all rights and obligations of issuer and
owners of FIS.
Covenants: are the contracts provisions including both affirmative and
negative covenants
Affirmative Covenants: (actions that borrower promises to perform)
1. Maintenance of certain financial ratios.
2. Timely payments of principal & interests.
Negative Covenants: (prohibitions on the borrower)
1. Restrictions on assets sales
2. Negative pledge of collateral
3. Restrictions on additional borrowings
© IMaCS 2009
Printed 26-May-11
144
Key terminologies
Interest/coupon: The charge for the privilege of borrowing money, typically
expressed as an annual percentage rate.
Frequency: The coupon frequency
Principal: The original amount invested, separate from earnings.
Maturity: The length of time until the principal amount of a bond must be
repaid.
YTM: Yield to maturity is defined as the one discount rate at which all the
coupons needs to be discounted to arrive at the market price of the bond
Day count: The number of days to be taken in a year for computation of
interest.
Face Value: Value of bond stated in indenture (denominated in currency in
which payments will be made).
Issue Price: Price at which security is issued in the market.
Market Price: Price at which bond is traded in the market.
© IMaCS 2009
Printed 26-May-11
145
Bonds
Bonds: A debt investment in which an investor loans money to an
entity (corporate or governmental) that borrows the funds for a
defined period of time at a fixed interest rate.
Types of bonds:
1. Zero Coupon Bonds -no periodic interest payments
2. Accrual bonds - interest payments at maturity
3. Step up notes -coupon rate increase over time at specified rate
4. Deferred coupon bonds- coupon payments starts after some specified
period
5. Floating Rate Securities- coupon payments varies based on specified
interest rate or index.
1. Inflation indexed bond
2. Caps, floors, collar
© IMaCS 2009
Printed 26-May-11
146
Redemption Provisions
Redemption Provisions: Refers to how, when, and under what
circumstances the principal will be repaid.
Non Amortizing: Pay only interest until maturity, at which time the entire
par or face value is repaid
Amortizing securities: Make periodic interest and principal payments over
the life of the bond.
Prepayment options: Give the issuer/borrower the right to accelerate the
principal repayment on a loan.
Call provisions: Give the issuer the right (but not the obligation) to retire
all or a part of an issue prior to maturity.
Nonrefundable bonds: Prohibit the call of an issue using the proceeds
from a lower coupon bond issue.
Sinking fund provisions: Provide for the repayment of principal through a
series of payments over the life of the issue
© IMaCS 2009
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147
Embedded Options
Security owner options: gives additional value to the security, compared to
an otherwise-identical straight (option free) security.
A conversion option: Right to convert the bond into a fixed number of common shares
of the issuer.
Put provisions: Right to sell (put) the bond to the issuer at a specified price prior to
maturity.
Floors: Set a minimum on the coupon rate for a floating-rate bond.
Security issuer options: will be priced less (or with a higher coupon) than
otherwise identical option free securities.
Call provisions: Right to redeem (payoff) the issue prior to maturity.
Prepayment option: Right to prepay the loan balance prior to maturity, in whole or in
part, without penalty.
Accelerated sinking fund provisions: Allow the issuer to (annually) retire a larger
proportion of the issue than is required by the sinking fund provision, up to a specified
limit.
Caps: Set a maximum on the coupon rate for a floating-rate bond.
© IMaCS 2009
Printed 26-May-11
148
Treasury Securities
Type Maturity Coupon payments
T bills Less than 1 yr
(usually 4 weeks, 3, 6 months)
Similar to Zero
coupon bonds
T Notes 2,3,5,10 yrs Semiannual coupons
Bonds 20 or 30 years Semiannual coupons
Treasury Inflation
Protected Securities (TIPS)
5,10 year notes, 20 year bonds Semiannual coupons
•TIPS : The par value is adjusted semiannually for changes in the Consumer Price Index.
•If there is deflation, the adjusted par value is reduced for that period.
•The fixed coupon rate is paid semiannually as a % of the inflation adjusted par value.
•TIPS coupon payment = (Inflation adjusted coupon value)*(stated coupon rate/2)
•On-the-run issues are the most recently auctioned Treasury issues.
•Off-the-run issues are older issues replaced by a more recently auctioned issue.
•STRIPS: Strip the coupons from the principal, repackage the cash flows, and sell them
separately as zero-coupon bonds, at discounts to par value.
•Coupon Strips: Created from coupon payments stripped from the original security
•Principal Strips: Bond and note principal payments with the coupons stripped off
© IMaCS 2009
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149
Contd.
Medium-term notes (MTN):
Issued periodically by corporations under a shelf registration
Sold by agents on a best efforts basis
Have maturities ranging from 9 months to over 30 years.
Commercial paper :
Short-term corporate financing vehicle
Does not require registration with the SEC if its maturity is less than 270 days.
• Directly-placed paper-sold directly by the issuer
• Dealer-placed paper-sold to investors through agents/brokers.
Negotiable CDs
Issued in a wide range of maturities by banks
Trade in a secondary market
Are backed by bank assets.
Bankers acceptances:
Issued by banks to guarantee a future payment for goods shipped
Sold at a discount to the future payment they promise
Short term, and have limited liquidity
Asset-backed securities :
Debt that is supported by an underlying pool of mortgages, auto loans, credit card receivables
Collateralized debt obligations (CDOs)
Backed by an underlying pool of debt securities like corporate bonds, loans etc
© IMaCS 2009
Printed 26-May-11
150
Yield Curve
Yield Curve: curve depicting relation between yield on
bonds of same credit quality but different maturities.
4 types of yield curves
© IMaCS 2009
Printed 26-May-11
151
Theories of the Yield Curve
The pure expectations theory
Rates at longer maturities depend only on expectations of
future short-term rates
Consistent with any yield curve shape.
The liquidity preference theory
Longer term rates reflect investors expectations about future
short-term rates as well as a liquidity premium
Consistent with a downward sloping curve if an expected
decrease in short-term rates outweighs the term premium.
The market segmentation theory
Lenders and borrowers have preferred maturity ranges
Shape of the yield curve is determined by the supply and
demand for securities within each maturity range,
independent of the yield in other maturity ranges.
Consistent with any yield curve shape
© IMaCS 2009
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Bonds Valuation
3 major steps in bonds valuations are
Estimate the cash flows over the life of the security.
1. The coupon payments
2. The return of principal
Arbitrage-free valuation approach: discount each cash flow using spot rates.
Determine the appropriate discount rate based on the risk of the receipt of
the estimated cash flows.
3 main kinds of discount rates used are
1. Yield to maturity: The rate of return anticipated on a bond if it is held until
the maturity
2. Spot rates : appropriate discount rates for individual future payments
3. Forward rates: current lending rates for loans to be made in future periods
Calculate the present value of the estimated cash flows by multiplying the
bond„s expected cash flows by the appropriate discount factors.
© IMaCS 2009
Printed 26-May-11
153
Price Volatility Characteristics of FIS
Price/Yield relationship for option-free bonds
Price of bond changes inversely to the change in yield
Yield % 8%/ 5-year
6 108.9826
7 104.3760
7.5 102.16
7.9 100.4276
7.99 100.0427
8 100
8.01 99.9574
8.1 99.57462
8.5 97.8944
9 95.8417
© IMaCS 2009
Printed 26-May-11
154
Observation from graphs
Relationship is not linear (its convex).
Slope gives measure of sensitivity of price for variation in yield (Duration)
Higher the market yield, lower the interest rate risk (curve less steep at higher
yields).
As yield increases, price of option-free bond decreases.
For discount and premium bonds, the price changes even if the yield remains the
same as we move towards maturity.
Price of discount (premium) bond increases (decreases) as it moves towards
maturity, reaching at par value at maturity.
Absolute dollar price change and absolute % price change are different for an
equal increase and decrease in yields
Volatility can be measured in terms of dollar price change and percentage price
change . It depends on maturity, coupon rate, YTM
© IMaCS 2009
Printed 26-May-11
155
Bonds with options
Negative convexity in putable and callable bonds
Price of callable bond can not exceed the call price (negative convexity).
Value of callable bond = (value of option free bond - call premium)
(Value of callable bond) < (value of option free bond)
Value of putable bond cannot decline more than put price (negative convexity).
Value of putable bond= (value of option free bond+ value of put)
Value of putable bond > value of option free bond
© IMaCS 2009
Printed 26-May-11
156
Discounting curves
Time to Maturity
YieldPar Curve
ZCYC Curve
Forward Curve
© IMaCS 2009
Printed 26-May-11
157
Debt Market in India
60% of AAA securities accounted for 80% of the total trade in past 2 years
1%0% 1%
8%1%
10%
79%
Distribution of number of trades
A
A-
A+
AA
AA-
AA+
AAA
1%1%
2%
14%
3%
17%62%
Distribution of securities
A
A-
A+
AA
AA-
AA+
AAA
© IMaCS 2009
Printed 26-May-11
158
Interest rate movement in India
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
3M
6M
9M
12M
© IMaCS 2009
Printed 26-May-11
159
Yield curve structure-India –current scenario
7.00%
7.50%
8.00%
8.50%
9.00%
9.50%
10.00%
0.25-0.5 0.5-1 1.0-2.0 2.0-3.0 3.0-4.0 4.0-5.0 5.0-6.0 6.0-8.0 8.0-10.0 >10.0
© IMaCS 2009
Printed 26-May-11
160
EXERCISE
Pricing of bonds
© IMaCS 2009
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Introduction to Interest rate risk
Risk due to variation in financial condition of the Bank due to
variation in interest rates
Reprising risk
Yield curve risk
Option risk
Basis risk
The immediate impact of variation in interest rates is on the
earning of the Bank
A long term impact of change in interest rates is on the net
worth, since the economic value of assets and liabilities get
affected
© IMaCS 2009
Printed 26-May-11
162
Types of interest rate risk … 1
Re-pricing risk
Risk due to timing difference in the maturity (for fixed rate) and
repricing (for floating rate) of assets and liabilities and off balance
sheet (OBS) position
Banks usually have assets deployed at fixed rates (pre-determined at
the time of contract) and also at variable rates (changes with change in
benchmark interest rates), which get run down in the EMI structures
regularly.
On the other hand the liabilities have varying structures that include
repayment in installments and bullets. This leads to reprising risk
© IMaCS 2009
Printed 26-May-11
163
Types of interest rate risk … 2
Yield curve risk
Yield curve risk is the risk of change in the shape or slope of the yield
curve
Usually banks borrow short term and lend long term, thus flattening
of the yield curve increases the cost of funds, whereas the interest
earned does not increase proportionately. Thereby leading to pressure
on the profitability of the Bank
© IMaCS 2009
Printed 26-May-11
164
Example of yield curve risk
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
15-Feb-10 15-Mar-10 15-Apr-10 15-May-10 15-Jun-10 15-Jul-10 15-Aug-10 15-Sep-10 15-Oct-10 15-Nov-10
3M
6M
9M
12M
© IMaCS 2009
Printed 26-May-11
165
Types of interest rate risk … 3
Basis risk
Assets and liabilities are linked to different benchmark yield curves
Movement in the benchmark yield curves are seldom same in
direction and magnitude
Any variance in the direction and magnitude of different benchmark
yield curves would lead to volatility in the profitability of the bank
The risk that value of assets and liabilities change by the same
magnitude by change in interest rates is termed as basis risk
© IMaCS 2009
Printed 26-May-11
166
Types of interest rate risk … 4
Option risk
Change in interest rate that could lead to funds being withdrawn by
the exercise of the option embedded with the product
Also change in interest rate could lead to cash flows being received
earlier than expected as a result of options being exercised
Thus option risk is the risk that a change in prevailing interest rates
will lead to an adverse impact on the earnings or capital by change in
timing of the cash-flows of assets or liabilities
© IMaCS 2009
Printed 26-May-11
167
Reasons for interest rate risk
On account of asset transformation
Many deposits are used for one big loan
Non-periodical review of assets and liabilities
Due to mismatches between maturity / reprising dates as well
as maturity amounts between assets and liabilities
Depositors and borrowers may pre-close their accounts
© IMaCS 2009
Printed 26-May-11
168
Earnings vs. economic value
Earnings perspective: It involves the impact of changes in
interest rates on accrual or reported earnings in the near term.
This is measured by measuring the changes in NII and NIM
Economic value perspective: It involves the impact of interest
rates on the expected cash-flows on assets minus the expected
cash-flows on liabilities. It focuses on the risk to net worth
arising from all reprising mismatches and other interest rate
sensitive positions. It identifies the risk arising from long
term interest rate gaps
© IMaCS 2009
Printed 26-May-11
169
Factors Affecting NII.
Changes in the level of interest rates.
Changes in the volume of assets and liabilities.
Change in the composition of assets and liabilities.
Changes in the relationship between asset yields and
liabilities. cost of funds.
© IMaCS 2009
Printed 26-May-11
170
Example-impact of interest rate on profitability
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.0% 600 4.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.08x500+0.11x350) - (0.04x600+0.06x220)
78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
© IMaCS 2009
Printed 26-May-11
171
Exhibit 1
1% increase in the level of all short-term rates.
1% decrease in spread between assets yields and interest cost.
RSA increase to 8.5%
RSL increase to 5.5%
Proportionate doubling in size.
Increase in RSAs and decrease in RSL‟s
RSA = 540, fixed rate = 310
RSL = 560, fixed rate = 260.
© IMaCS 2009
Printed 26-May-11
172
1% Increase in Short-Term Rates
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 9.0% 600 5.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.09x500+0.11x350) - (0.05x600+0.06x220)
83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74%
GAP = 500 - 600 = -100
© IMaCS 2009
Printed 26-May-11
173
1% Decrease in Spread
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.5% 600 5.5%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.085x500+0.11x350) - (0.055x600+0.06x220)
81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09%
GAP = 500 - 600 = -100
© IMaCS 2009
Printed 26-May-11
174
Proportionate Doubling in Size
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 1000 8.0% 1200 4.0%
Fixed rate 700 11.0% 440 6.0%
Non earning 300 200
1840
Equity
160
Total 2000 2000
NII = (0.08x1000+0.11x700) - (0.04x1200+0.06x440)
157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
© IMaCS 2009
Printed 26-May-11
175
Increase in RSAs and Decrease in RSLs
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 540 8.0% 560 4.0%
Fixed rate 310 11.0% 260 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.08x540+0.11x310) - (0.04x560+0.06x260)
77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
© IMaCS 2009
Printed 26-May-11
176
There are four methods for measuring Interest
Rate Risk
Gap Analysis method
Duration and Convexity method
Simulation and Scenario analysis method
Value at Risk method
Each method has its advantages, disadvantages and
complexities which is explained subsequently. For this
workshop, we will limit our discussions to Gap method and
duration method.
© IMaCS 2009
Printed 26-May-11
177
What is a Gap?
1. Risk Sensitive Assets and Liabilities are those whose values are
affected by interest rate movement
2. For interest risk analysis, gap is calculated for each bucket
according to repricing or residual maturity, whichever earlier
3. If they do not have contractual maturity, behaviourial maturities
to be used
4. Gap analysis, though simple, forms the basis of calculations
based on which Asset-Liability Mismatch limits are set
Gap = Risk Sensitive Assets (RSA) - Risk Sensitive Liabilities (RSL)
© IMaCS 2009
Printed 26-May-11
178
Gap Report: Key concepts
A gap report calculates the gap over different time intervals
and the cumulative gap of a period
Gap report based on reprising maturities is used for analysis of Interest Rate
Risk
Gap report based on actual maturities is used for analysis of Liquidity Risk
Gap reports can be Static or Dynamic:
Static Gap report is based on actual data on assets, liabilities and hedges on
a particular day
Dynamic Gap report is based on projections of assets, liabilities and hedges
on a particular day taking into account bank‟s business plans
© IMaCS 2009
Printed 26-May-11
179
Bucketing
1 to 14 days
15 day to 30 / 31 days (one month)
Over one month and up to 2 months
Over 2 months and up to 3 months
Over 3 months and up to 6 months
Over 6 months and up to 1 year
Over 1 year and up to 3 years
Over 3 years and up to 5 years
Over 5 years
© IMaCS 2009
Printed 26-May-11
180
Bucketing of assets and liabilities
Liabilities
1. Capital Non-sensitive
a) Equity and perpetual preference
shares Non-sensitive
b) Non-perpetual preference shares Non-sensitive
2. Reserves & surplus Non-sensitive
3. Gifts, grants, donations &
benefactions Non-sensitive
4. Notes, bonds & debentures
a) Plain vanilla bonds/debentures
Sensitive; reprice on the roll- over/repricing date should
be slotted in respective time buckets as per the
repricing dates.
b) Bonds Debunture with embedded options
Sensitive; could reprice on the exercise date of the
option particularly in rising interest rate scenario. To be
placed in respective time buckets as per the next
exercise date.
c) Fixed rate notes
Sensitive; reprice on maturity. To be placed in
respective time buckets as per the residual maturity of
such instruments.
© IMaCS 2009
Printed 26-May-11
181
Bucketing of assets and liabilities(contd.)
5. Deposits
a) Term deposits from public
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
b) ICDs
Sensitive; reprice on maturity. To be placed in respective
time buckets as per the residual maturity of such
instruments.
c) Certificate of Deposit
Sensitive; reprice on maturity. To be placed in respective
time buckets as per the residual maturity of such
instruments.
6.Borrowings
a) Term money borrowings from
Banks
Sensitive; reprice on maturity. To be placed in respective
time buckets as per the residual maturity of such
instruments.
b) From Bangladesh Bank, Govt., &
others
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
c) Bank Borrowings in the nature of
WCDL, CC etc
Sensitive: could reprise on the reprising date in case of
floating or reprise on maturity if fixed
© IMaCS 2009
Printed 26-May-11
182
Bucketing of assets and liabilities(contd.)
7. Current Liabilities & provisions:
a) Sundry creditors Non-sensitive
b) Expenses payable (other than
interest) Non-sensitive
c) Advance income received, receipts
from borrowers pending adjustment Non-sensitive
d) Interest payable on bonds/deposits Non-sensitive
e) Provisions (other than for NPAs) Non-sensitive
8. Contingent Liabilities
a) Letters of credit/guarantees Non-sensitive
b) Loan commitments pending
disbursal (outflows) NA
c) Lines of credit committed to other
institutions (outflows) NA
d) Outflows on account of forward
exchange contracts, rupee/dollar swap
Sensitive: should be bucketed according to the maturity of
the contract
9. Commercial Paper
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
10. Others (Subordinate Debt)
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
© IMaCS 2009
Printed 26-May-11
183
Bucketing of assets and liabilities(contd.)
Assets
1. Cash Non-sensitive
2. Remittance in transit NA
3. Balances with banks
a) Current account Non-sensitive
b) Deposit /short-term deposits
Sensitive; reprice on maturity. To be placed in respective
time buckets as per the residual maturity of such
instruments.
4. Investments (net of provisions)
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
5. Advances (performing)
a)Bills of exchange and promissory
notes discounted & rediscounted
Sensitive; reprice on maturity. To be placed in respective
time buckets as per the residual maturity of such
instruments.
b) Term loans (only rupee loans)
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
c) Corporate loans/short term loans
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
© IMaCS 2009
Printed 26-May-11
184
Bucketing of assets and liabilities(contd.)
6. Non-performing loans Same as Bucketing criteria of SLG
7. Inflows from assets on lease
Sensitive on cash flows. The amounts should be
distributed to the respective maturity buckets
corresponding to the cash flow dates.
8. Fixed assets (excluding assets on
lease) Non-sensitive
9. Other assets :
a) Intangible assets & other non-cash
flow items Non-sensitive
b) Interest and other income receivable
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
c) Others
In respective maturity buckets as per the timing of the
cashflows.
10. Lines of credit committed by
other institutions (inflows) 1-14 day time bucket
11. Bills rediscounted (inflow)
Sensitive: could reprice on the repricing date in case of
floating or reprice on maturity if fixed
12. Inflows on account of forward
exchange contracts, dollar/rupee
swaps
In the respective time buckets as per the residual maturity
of the underlying bills/transactions.
13. Others NA
© IMaCS 2009
Printed 26-May-11
185
Important points to be considered while auditing Gap
Statements for measuring interest rate risk
Number of time buckets
Choosing too few may not give meaningful results
Choosing too many will be difficult to interpret
5 to 12 time buckets may be ideal
Length of time buckets may depend on maturity mix of assets and liabilities
Length of bucket depends on the type of institution
It depends on the how developed the market for asset and liabilities are across
maturities
The first few buckets are generally shorter
Buckets should not be too heavy or light under “normal” conditions
A bucket having 30% or more of assets or liabilities should be split into two
buckets
Buckets containing less than 5% of the assets or liabilities are considered light
and should be combined
© IMaCS 2009
Printed 26-May-11
186
Important points to be considered while auditing slotting
of assets and liabilities for measuring interest rate risk
On and off- Balance sheet items are slotted into appropriate buckets as per
maturities. Maturities can be classified into three types:
Repricing
Contractual
Remaining
For estimating interest rate risk repricing maturities may be used.
For example: 5 year variable rate bond with a coupon of 6-months LIBOR will be
slotted in the 6-month bucket as the bond will reprice according to movements in
6-month LIBOR.
Non-interest sensitive items like capital are slotted into the last time bucket.
© IMaCS 2009
Printed 26-May-11
187
The bonds with following maturity details should be classified under which time
bucket. Options are: (a) Less than 1 month, (b) 1 to 3 months, (c) 3 to 6
months, (d) 6 months to 1 year, (e) 1 to 3 years and (f) 3 to 5 years
Group Exercise : Slotting of cash flows
i. Today: 1st February, 2005
ii. Issue Date: 1st January, 2000
iii. Maturity Date: 30th June,
2005
iv. Bond reprices on 1st January
© IMaCS 2009
Printed 26-May-11
188
Other important points to be considered while auditing slotting of
assets and liabilities for estimating interest rate risk
Principal vs.
Cash Flows
Amortizing Loans
Liabilities
The principal to be slotted in the contractual
maturity
Accrued interest, if shown in balance sheet, should
be slotted in the bucket it will be actually received
Calculate payments and segregate the principal and
interest components
Slot only the principal in the bucket
Liabilities with non-contractual maturities
• Core vs. Volatile
• Trend, seasonal and cyclical components
© IMaCS 2009
Printed 26-May-11
189
Gap report
Time Buckets RSA RSL GAP
Residual
Period
(Mid Point)
Impact of 1%
change in
Interest Rate
A B C=A-B D 1%*C*D/12
1 to 14 days 797 390 407 0.25 0.08
14 days to 30 / 31 days (one
month)297 349 -52 0.75 -0.03
Over one month to 2 months 202 168 34 1.50 0.04
Over 2 months to 3 months 1309 1240 69 2.50 0.14
Over 3 months and up to 6
months618 1051 -433 4.50 -1.63
Over 6 months and up to 1 year 1381 900 481 9.00 3.61
Total 4604 4098 506 2.22
© IMaCS 2009
Printed 26-May-11
190
Different types of Gap
Periodic Gap
Gap for each time bucket
Measures the income effects from interest rate changes
Cumulative Gap
– Sum of periodic Gaps
– Measures aggregate interest rate risk over the entire period
© IMaCS 2009
Printed 26-May-11
191
Types of Gap: Positive Gap & Negative Gap
A positive gap for a particular time
bucket is when the Rate Sensitive Assets
exceed Rate Sensitive Liabilities
A negative gap for a particular time
bucket is when the Rate Sensitive
Liabilities exceed Rate Sensitive Assets
An increase in interest rate leads to an
decrease in NII
An increase in interest rate leads to a
increase in NII
Liabilities reprice faster than assets
Long term assets funded with shorter
term liabilities
Assets reprice faster than liabilities
Short term assets funded with Long term
Liabilities
© IMaCS 2009
Printed 26-May-11
192
Illustration: A liability sensitive gap
1.Since there are more liabilities at the
shorter end, the institution is
borrowing short and lending long.
2. Therefore liabilities reprise faster
than assets
3. Increase in interest rates leads to a
decrease in the Net interest income.
4. This is called a negative gap.
Gap and Cumulative Gap
-250
-200
-150
-100
-50
0
50
100
150
1 2 3 4 5 6 7
Period 1 2 3 4 5 6 7
Assets 20 50 60 40 80 100 150
Liabilities 90 160 70 60 50 40 30
Gap -70 -110 -10 -20 30 60 120
Cum. Gap -70 -180 -190 -210 -180 -120 0
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Illustration: An asset sensitive gap
Period 1 2 3 4 5 6 7
Assets 100 150 70 60 50 50 30
Liabilities 30 50 60 40 80 100 150
Gap 70 100 10 20 -30 -50 -120
Cum. Gap 70 170 180 200 170 120 0
1.Since there are more assets at the
shorter end, the institution is
borrowing long and lending short
2. Therefore assets reprice faster than
liabilities
3. Increase in interest rates leads to an
increase in the Net interest income.
4. This is called a positive gap
Gap and Cumulative Gap
-150
-100
-50
0
50
100
150
200
250
1 2 3 4 5 6 7
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Management of gaps
Management should cap the gap for each time bucket and the
cumulative gap based on
Regulatory requirement
Risk appetite of the Bank
The gap can be adjusted to positive or negative based on the
interest rate perception of the bank
Should have more rate sensitive assets in case of interest rates are
perceived to go up
Should have more rate sensitive liabilities in case interest rates are
perceived to go down
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Group Exercise
Bank’s asset liability maturity profile is given below:
1. Does the Bank have a positive gap or a negative gap?
2. Find the interest rate sensitivity of the bank‟s NII to a 5% increase
in interest rates for (a) Quarter (b) Half year (c) Year
Assume all assets and liabilities as fixed rate.
Hint: If interest rates change and we are noticing the impact for a quarter, only the cash flows
relevant up to the quarter will be effected and for a quarter only
Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months
Total assets 97967 502495 71691 11519 44840 18937
Total liabilities 203567 285347 285302 30967 4513 3070
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Help guide for Exercise
Step 1: Calculate the Net Gap
Step 2: Calculate duration for repricing
Step 3: Calculate the impact of 5% rise in interest rate on the
NII by using the following formula:
[(Net Gap) * (duration for repricing) * (period/12) * (change in interest
rate)]
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Step 1: Calculate the Net Gap
Step 2: Calculate duration for reprising
= [(3 months/ 12) – (Reprising after how much time)]
Step 3: Calculate the impact of 5% rise in interest rate on the
NII by using the following formula:
= [(.25*-105600*.25*5%) + (.208*217148*.25*5%) + (.083*-
213611*.25*5%) ]
= 12.98
Solution : Impact of 5% increase in interest rate for
one Quarter
Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months
Total assets 97967 502495 71691 11519 44840 18937
Total liabilities 203567 285347 285302 30967 4513 3070
Gap -105600 217148 -213611 -19448 40327 15867
0.000 0.042 0.167 0.375 0.625 0.875
Demand 0 - 1 months 1 - 3 months 3 - 6 months 6 - 9 months 9 -12 months
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Solution: Impact of 5% increase in interest
rate for half year and full year
For a quarter- 12.98
For half year- 0.500 0.458 0.333 0.125
-105600 217148 -213611 -19448
x x 0. 5 x 5%= -672.7
For whole year-
1.000 0.958 0.833 0.625 0.375 0.125
-105600 217148 -213611 -19448 40327 15867
x x 1 x 5%= -3528
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Solution : Diagrammatic representation of the solution
13
-673
-3528-10.7%
0.0%
-2.0%
-4000
-3500
-3000
-2500
-2000
-1500
-1000
-500
0
500
Quarter Half-year Full-year
-12.0%
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
NII
% of PBT
Impact of a 5% upward shock on interest rate will be as follows:
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Relation between NII and interest rates
Asset Sensitive
Liability Sensitive
Fully Hedged
NII
Interest rates
NII
Interest rates
NII
Interest rates
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Stress testing
Analyse the impact of change in interest rate due to parallel
and non parallel shift in yield curve
Time Buckets RSA RSL GAP
Residual
Period
(Mid Point)
Non-Parallel
Shift
Impact of
change in
Interest
Rate
A B C=A-B D E E*C*D/12
1 to 14 days 797 390 407 0.25 1% 0.08
14 days to 30 / 31 days (one
month)297 349 -52 0.75 1% -0.03
Over one month to 2 months 202 168 34 1.5 0.75% 0.03
Over 2 months to 3 months 1309 1240 69 2.5 0.75% 0.11
Over 3 months and up to 6 months 618 1051 -433 4.5 0.50% -0.81
Over 6 months and up to 1 year 1381 900 481 9 0.50% 1.80
Total 4604 4098 506 1.18
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While Gap method is simple for estimating the
interest rate risk, it has a few limitations
Gap method does not capture the impact of non parallel shift
in yield curves, volatility, basis risk, mismatches within a
time bucket, dynamic positions and change in timing
differences
• Could lead to errors in risk quantification
• Limits the ability to do sensitivity analysis
Implications
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There are four methods for measuring Interest
Rate Risk
Gap Analysis method
Duration and Convexity method
Simulation and Scenario analysis method
Value at Risk method
Each method has its advantages, disadvantages and
complexities which is explained subsequently. For this
workshop, we will limit our discussions to Gap method and
duration method.
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What is Duration?
Duration is a quantitative technique to measure the “first
order” interest rate sensitivity of assets and liabilities
It is the weighted average maturity of a bond where the
present value of cash flows is used as weights (Macaulay
Duration)
Duration is also a interpreted as a measure of the price
elasticity of a bond (Modified Duration)
The concept of duration can be used for: all assets, liabilities
and off-balance sheet items, single asset, a portfolio of assets,
or the entire balance sheet.
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How to calculate Macaulay Duration?
Macaulay duration is a “time -weighted ” present value.
N
t
N
t
tPV
tPVtD
1
1
)(
)(
Macaulay Duration can be measured as follows:
Where t=Period, and PV(t)=PV of cash flows in period t
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How to calculate Modified Duration?
The Macaulay duration is easy to understand as an „average” maturity of
an instrument. However, the more important use of duration is to predict
“first order” price sensivity due to changes in the interest rate. Modified
duration, elasticity to interest changes, is the measure for this.
i
DP
di
dPMD
1
Where P = Price of the bond, and I = prevailing yield
i
DMD
1
It can be shown that:
Change in Price ≈ MD x Change in Yield
Modified Duration can be measured as follows:
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Mathematically duration is defined as follows
1. Taylor series is a mathematical expression of the extent to which price
changes with the change in interest rates
2. Mathematically duration is the first term of Taylor series
3. Convexity, is the rate of change of price owing to change in interest rates and
contributes to the non-linear shape of the price-yield relationship
Duration Convexity
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Five steps in calculating duration of an asset or
portfolio
Step 1
Step 2
Step 3
Step 4
Define timing and magnitude of cash flows
Calculate PV (t). Sum Present Value of all cash
flows
Calculate t PV (t). Sum time –weighted Present Value of all cash
flows
Divide t PV (t) by PV (t)
Step 5 Calculate Modified Duration
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Assumptions for Duration framework
Duration measures the “first order” approximation of price
sensitivity to interest changes and works exactly under the
following assumptions:
Change in
interest rates
Cash flows • Cash flows do not change with interest rates. Exceptions:
Collateralised Mortgage Obligations (CMOs), Callable Bonds
• Change in interest rates must be “small”.
Yield change • Yield changes are assumed to be instantaneous
Shift in curve • Parallel shift in the yield curve is assumed.
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Calculation of duration of fixed coupon bond
Serial No. Cash Flow Maturity Coupon Principal Cash Flows PV @8% PV*Maturity
1 1-Jan-09
2 1-Jul-09 0.50 3.75 3.75 3.61 1.80
3 1-Jan-10 1.00 3.75 3.75 3.47 3.47
4 1-Jul-10 1.50 3.75 3.75 3.34 5.01
5 1-Jan-11 2.00 3.75 3.75 3.22 6.43
6 1-Jul-11 2.50 3.75 3.75 3.09 7.73
7 1-Jan-12 3.00 3.75 3.75 2.98 8.93
8 1-Jul-12 3.50 3.75 3.75 2.86 10.03
9 1-Jan-13 4.00 3.75 3.75 2.76 11.03
10 1-Jul-13 4.50 3.75 3.75 2.65 11.94
11 1-Jan-14 5.00 3.75 100.00 103.75 70.61 353.05
Total 98.59 419.42
(a) (b)
Duration (b)/(a) 4.25
Modified Duration = Duration/(1+Discount factor of 8%/coupon frequency of 2) 4.09
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Calculation of duration of Floating rate bond
Serial No. Cash Flow Maturity Coupon Principal Cash Flows PV @8% PV*Maturity
1 1-Jan-09
2 1-Jul-09 0.50 3.75 3.75 3.61 1.80
3 1-Jan-10 1.00 3.75 100.00 103.75 96.06 96.06
4 1-Jul-10 1.50 0.00 0.00 0.00
5 1-Jan-11 2.00 0.00 0.00 0.00
6 1-Jul-11 2.50 0.00 0.00 0.00
7 1-Jan-12 3.00 0.00 0.00 0.00
8 1-Jul-12 3.50 0.00 0.00 0.00
9 1-Jan-13 4.00 0.00 0.00 0.00
10 1-Jul-13 4.50 0.00 0.00 0.00
11 1-Jan-14 5.00 0.00 0.00 0.00
Total 99.67 97.87
(a) (b)
Duration (b)/(a) 0.98
Modified Duration = Duration/(1+Discount factor of 8%/coupon frequency of 2) 0.94
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Weighted average duration
Serial No. Home Equity Loan Amount DurationWeighted Avg.
Duration
1 A 100000.00 2.00 200000.00
2 B 200000.00 2.30 460000.00
3 C 300000.00 5.00 1500000.00
4 D 400000.00 3.20 1280000.00
5 E 500000.00 2.10 1050000.00
6 F 600000.00 2.20 1320000.00
7 G 700000.00 2.30 1610000.00
8 H 800000.00 1.50 1200000.00
9 I 900000.00 1.80 1620000.00
10 J 1000000.00 2.00 2000000.00
Total 5500000.00 12240000.00
(a) (b)
Weighted Avg. Duration (b)/(a) 2.23
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Duration Gap analysis
Modified duration gap (DGAP) is derived as:
DGAP = Modified DA-W*Modified DL
Where
W = RSL/RSA
DA = Weighted average MD of Assets
DL = Weighted average MD of Liabilities
MD of equity = DGAP*Leverage
Where
Leverage = RSA/Net worth
Net Worth = Equity + reserves and surplus
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Example
Outflows Amount Mod. Duration DL
Capital 366.47 NS
Reserves & Surplus 341.96 NS
Bonds and Debentures 2071.5 4
Borrowings 3353.89 1
Current Liability &provisions 429.7 0.5
Others 146.43 1
Total outflow 6709.95
1.999689
Inflows
Cash 0.06
Balances with Banks 1553.66
Investment 405.22 0.5
Advances 4316.25 4
NPA 163.98 4
Total Assets 6439.17
3.709696
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Contd.
Duration of Equity of 8.64 means that an increase of interest rate by 1% would
result in a decrease in equity by 8.64%
RSA 4885.45
RSL 6001.52
DA 3.709696
DL 1.999689
Net worth 708.43 Equity + reserves and surplus
W 1.228447738 RSL/RSA
DGAP 1.253182572 DA-DL*W
Leverage 6.896164759 RSA/Net-worth
Duration of equity 8.642153489 Leverage*DGAP
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Duration Ratio
Duration ratio is defined as the ratio of the duration of assets to that of the
liabilities. The impact on Net Interest Income (profitability) is as follows:
Duration Ratio Net Sensitivity Interest rate ↑ Interest rate ↓
Less than 1 Liability Sensitive Adverse
Impact on NII
Favorable
Impact on NII
Equal to 1 Matched Insulated * Insulated*
Greater than 1 Asset Sensitive Favorable impact
on NII
Adverse Impact on
NII
* Assuming parallel shift
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MATURITY GAP METHOD(IRS)
THREE OPTIONS:
A) RSA>RSL= Positive Gap
B) RSL>RSA= Negative Gap
C) RSL=RSA= Zero Gap
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Management of gaps
Each bank to set its prudential limits on individual gaps with
approval of Board
Prudential limits set with respect to bearing on Total Assets,
Earning Assets or Equity
Bank‟s may work out their Earnings at Risk – 20-30% of last
year‟s NII or NIM
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Asset Liability Risk Mitigation Strategies
Business Strategy•product mix
•product pricing
Investment Strategy
•maturity mix•rate profile of
investments
Derivative
Strategy
•IRS
•options
• structured
products
ALM
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Business Strategy…Impact on NEV must be assessed
Risk Mitigation
Product mix Product Pricing
•How much long term/short
term?
•Advance portfolio
composition
•Charging a premium for
products not offered by
competitors?
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Investment Strategy…Impact on NEV must be
assessed
Risk Mitigation
Maturity mix Rate profile of investments
•How much long term/short
term •High risk-high return?
•Additional risk such as currency
risk?
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Exercise : Estimate duration of a bond
Face value of bond: Amount 100,000
Annual coupon rate: 12%
Remaining maturity: 4 years
Yield curve is flat at 11%
Find the duration and modified duration of the bond.
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Exercise : Help guide for measuring duration and
modified duration of a bond
Step 1
Step 2
Step 3
Step 4
Define timing and magnitude of cash flows
Calculate PV (t). Sum Present Value of all cash
flows
Calculate t PV (t). Sum time –weighted Present Value of all cash
flows
Divide t PV (t) by PV (t)
Step 5 Calculate Modified Duration
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Solution : Estimating duration of a bond
A B C D
Period CashflowPresent
ValueA*C
1 12000 10811 10811
2 12000 9739 19479
3 12000 8774 26323
4 112000 73778 295111
103102 351724Yield 11%
073.311.01
411.3.DurationM
1. The present value of cash flows
(column C) is obtained by discounting
the cash flows in column B with a
discount rate of 11%.
2. Last column (column D) is the product
of the discounted cash flows and time
periods.
3. Duration is calculated by dividing the
total of column D by that of column C
4. Duration divided by the discounting
gives Modified duration.
411.3C Col. of Sum
D Col. of Sum Duration
1. Modified Duration is an approximate measure of the price elasticity of a bond.
2. A more exact measure can be calculated by using both duration and convexity
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Exercise: Estimate the impact of change in
interest rate and coupon on duration
Consider the following 3 bonds
Maturity Coupon Yield
A 4 12% 11%
B 4 11% 11%
C 4 11% 10%
1. What is the impact on duration if coupon changes ? (Bond B)
2. What is the impact on duration if yield changes ? (Bond C)
Duration
3.411
M. Duration
3.073
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Solution: Impact of duration if coupon
changes
Consider the following 3 bonds
Maturity Coupon Yield
A 4 12% 11%
B 4 11% 11%
C 4 11% 10%
1. What is the impact on duration if coupon changes ? (Bond B)
D=3.444 MD=3.102
If the coupon decreases, the duration increases. In fact the duration of a
zero coupon bond is equal to its maturity
D=3.411 MD=3.073
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Exercise : Impact on duration if yield changes
Consider the following 3 bonds
Maturity Coupon Yield
A 4 12% 11%
B 4 11% 11%
C 4 11% 10%
2. What is the impact on duration if yield changes ? (Bond C)
D=3.453 MD=3.139
D=3.444 MD=3.102
If the yield decreases, the duration increases.
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Exercise: What is the duration of an portfolio
Assume there is an investment portfolio of 3 assets:
Mark-to-market valuation: Amount 90, Amount 125 and
Amount 65 respectively
Book values of the assets: Amount 80, Amount 130 and
Amount 40 respectively
The duration of these assets are 2, 3.5 and 6 respectively.
What is the duration of the portfolio?
Hint: The Duration of a portfolio is the weighted average of the Mark-to-Market value of the
portfolio.
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Solution: Duration of investment portfolio
Mark-to-market value of the investment portfolio is :
(90 + 125 + 65)= 280
Average duration of the portfolio is (in years) :
598.3280
6655.3125290
Duration of a portfolio of assets (for assets or liabilities)
V
vdD
i
n
i i
P1
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Exercises (1): Rapid fire questions
Q 1 Modified duration is a more accurate measure of interest rate sensitivity than duration.
1 True
2 False
Q 2 Duration of a bond generally increases with an increase in:
1 Coupon
2 Yield
3 Term to maturity
4 Frequency of coupon payments
Q 3 Assuming the following bonds has the same yield, which one has the shortest duration?
1 Zero coupon, 30-year maturity
2 10% coupon, 30-year maturity
3 Zero coupon, 5-year maturity
4 10% coupon, 5-year maturity
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Exercises (2): Rapid fire questions
Q 4 With a zero coupon bond, duration is
1 Less than maturity
2 Greater than maturity
3 Depends on yield
4 Equal to maturity
Q 5 Duration is a measure of
1 Length of time until a bond matures
2 Timing of cash flows weighted by the proportionate present value of cash flows
3 Timing of cash flows weighted by the magnitude of cash flows
4 Original maturity of the bond
Q 6 An investment is made in a bond. The credit rating of the bond has been upgraded by the rating
agency. How would duration of the bond react?
1 Increase
2 Decrease
3 Does not change
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Exercises (3): Rapid fire questions
Q 7 A bond's modified duration is 3.7. Its value is Rupees 100,000. If interest rates increase by 20
basis points, the price will:
1 Decrease by Rupees 740
2 Increase by Rupees740
3 Increase by Rupees 7400
4 Decrease by Rupees7400
Q 8 For regular coupon paying bonds (with no structured features), duration is:
1 Equal to maturity
2 Less than maturity
3 Greater than maturity
4 None of the above
Q 9 Assuming the following bonds has the same yield, which has the shortest duration?
1 10-year, 10% coupon
2 10-year, 8% coupon
3 10-year, 6% coupon
4 10-year, zero coupon
RISK MANAGEMENT
FRAMEWORK
ALM
ORGANISATION
RISK MANAGEMENT FRAMEWORK
A risk management framework encompasses the scope of risks to be managed, the
process/systems and procedures to manage risk and the roles and responsibilities of
individuals involved in the risk management.
Risk Management Framework
• It includes
A well constituted organisational structure defining clearly roles & resposibilities of individuals involved in risk taking & managing it
An effective Management Information System
Mechanism to ensure ongoing review of systems policies and procedures to adopt changes
BUSINESSLINE ACCOUNTABILITY
In every banking organization there arepeople who are dedicated to riskmanagement activities, such as risk review,internal audit etc. It must not be construedthat risk management is something to beperformed by a few individuals or adepartment. Business lines are equallyresponsible for the risks they are taking.Because line personnel, more than anyonee lse, understand the risks of the business,such a lack of accountability can lead toproblems.
Risk Evaluation/Measurement
To adequately capture institutions riskexposure, risk measurement should representaggregate exposure of institution both risk typeand business line and encompass short run aswell as long run impact on institution.
To the maximum possible extent institutions
should establish systems / models that quantify
their risk profile
Independent review.
One of the most important aspects in riskmanagement philosophy is to make sure thatthose who take or accept risk on behalf of theinstitution are not the ones who measure, monitorand evaluate the risks.To be effective the review functions should havesufficient authority, expertise and corporatestature so that the identification and reporting oftheir findings could be accomplished without anyhindrance.
Contingency planning
Institutions should have a mechanism toidentify stress situations ahead of timeand plans to deal with such unusualsituations in a timely and effectivemanner.
Board and Senior Management Oversight
To be effective, the concern and tone for risk
management must start at the top. While the
overall responsibility of risk management rests
with the BOD, it is the duty of senior
management to transform strategic direction set
by board in the shape of policies and procedures
and to institute an effective hierarchy to execute
and implement those policies.
The formulation of policies relating to risk management onlywould not solve the purpose unless these are clear andcommunicated down the line. Senior management has toensure that these policies are embedded in the culture oforganization. Risk tolerances relating to quantifiable risks aregenerally communicated as limits or sub-limits to those whoaccept risks on behalf of organization. However not all risksare quantifiable. Qualitative risk measures could becommunicated as guidelines and inferred from managementbusiness decisions.
Board and Senior Management Oversight
To ensure that risk taking remains within limits
set by senior management/BOD, any material
exception to the risk management policies
Introduction and tolerances should be reported
to the senior management/board who in turn
must trigger appropriate corrective measures.
Board and Senior Management Oversight
To keep these policies in line with significant changes in internal and external environment, BOD is expected to review these policies and make appropriate changes as and when deemed necessary.
Board and Senior Management Oversight
BANGLADESH BANK RECOMMENDATION
1. The Asset Liability Committee (ALCO) isresponsible for balance sheet (asset liability)risk management.
2. The responsibility of Asset Liabilitymanagement is on the Treasury Departmentof the bank.
3. Specifically, the Asset liability Management(ALM) desk of the Treasury Departmentmanages the balance sheet.
4. The results of balance sheet analysis alongwith recommendation is placed in the ALCOmeeting by the Treasurer where importantdecisions are made to minimise risk andmaximize returns.
BANGLADESH BANK RECOMMENDATION
BANGLADESH BANK RECOMMENDATION
BANGLADESH BANK RECOMMENDATION
BANGLADESH BANK RECOMMENDATION
BANGLADESH BANK RECOMMENDATION
BANGLADESH BANK RECOMMENDATION –POLICY STATEMENT
BANGLADESH BANK RECOMMENDATION –POLICY STATEMENT
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Basel I
Basel I was published in 1988 to set out a minimum capital
requirement for Banks
Basel I primarily focused on credit risk when published first,
though in subsequent issue in 1996 the minimum capital
requirement for market risk was introduced
Under Basel I assets were classified under 5 risk categories as
0%, 10%, 20%, 50% and upto 100% based on the risk profile
of the assets
Banks with international presence were required to maintain
capital of 8%.
Basel I is now outmoded and a more comprehensive
guidelines in the form of Basel II has been introduced
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Basel II
Basel II was intended to cover risk in a more comprehensive
manner as compared to Basel I
Basel II is a three pillar system
Minimum capital requirement
• Credit risk
• Market risk
• Operational risk
Supervisory review process
• Regulatory framework for banks
• Supervisory framework
Market discipline
• Disclosure requirements for banks
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Menu for estimating capital as per Basel II Accord
For Measuring Credit Risk
Standardized Approach
Foundation Internal Ratings-based Approach
Advanced Internal Ratings-based Approach
For Measuring Market Risk
Standardized Approach
Internal VaR Models
For Measuring Operational Risk
Basic Indicator Approach
Standardized Business Line Approach
Internal Measurement Approach
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Amendment to the Basel Accord to incorporate
Market Risk
In 1996, the Basel Committee amended the Basel Capital
Accord to incorporate market risks. The Amendment
separated the bank's assets into:
Trading Book
This is the bank portfolio
containing financial
instruments that are
internationally held for
short-term resale and are
marked-to-market.
Banking Book
This consists of other
instruments, mainly
loans.
Amendment required institutions to hold capital to cover their exposure to market risks,
associated with foreign exchange, commodity positions, debt and equity positions in the
trading account.
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To cover the capital charge for Market Risk, Basel
suggested “Tier III” capital
1. To cover market risks as well as credit risks, Basel suggested another tier of
eligible capital titled "Tier 3" capital.
2. Tier 3 capital can only be used to support the market risk capital charge and
will be limited to 250% of a bank's Tier 1 capital.
3. Only short-term subordinated debt with an original maturity of greater than two
years.
This implies that at least 28.5% of original Tier I capital has to be set aside for
supporting market risk
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Basel II approaches to measuring Market risk
Standardise
d
Internal
Models
Based
*Amendment to the Basel Accord to Incorporate Market Risk (1996/8)
Market Risk
Approaches
Covering SpecificGeneral Market
Yield curve sensitivity
(Duration) based.
Decided by the Regulator
VaR based- Bank‟s own
models stress- tested by
regulator
+
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Standardised Approach
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Standardised Approach - Capital Charge for General
Market Risk
General Market
Duration
MethodMaturity
Method
Risk weights specified by Basel
II, where Bank unable to
calculate duration
1. Yield curve shift specified,
and its impact on portfolio
calculated
2. Minor adjustments for non-
parallel shifts in yield curve
1.Time slotting of cash flows (on and off-balance sheet) into 15 categories.
2.The change in portfolio value as a result of yield changes in Duration method
“roughly” corresponds to the risk weights assumed
Or
© IMaCS 2009
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Standardised Approach: Capital charge for General Market risk by
Maturity Method
Residual Maturity buckets
Risk
Weig
hts
1 2 15
1.In the maturity method, the cash flows are slotted into time buckets as per their residual
maturities
2. Risk weights are applied as indicated in the table.
3
Normal Coupon
Low Coupon
© IMaCS 2009
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No. Mod. Duration
Assumed
yield
change
Zone 1
1 1 month or less 1%
2 1 to 3 months 1%
3 3 to 6 months 1%
4 6 to 12 months 1%
Zone 2
5 1.0 to 1.9 years 0.90%
6 1.9 to 2.8 years 0.80%
7 2.8 to 3.6 years 0.75%
Zone 3
8 3.6 to 4.3 years 0.75%
9 4.3 to 5.7 years 0.70%
10 5.7 to 7.3 years 0.65%
11 7.3 to 9.3 years 0.60%
12 9.3 to 10.6 years 0.60%
13 10.6 to 12 years 0.60%
14 12 to 20 years 0.60%
15 over 20 years 0.60%Residual Duration buckets
Yie
ld
1 2 4..
1%
158
0.75%0.6%
Current
ChangedZone 1
Zone 2Zone 3
Standardised Approach: Capital charge for
General Market risk by Duration Method
1. In duration method, instruments are slotted into time buckets as per their residual
duration and their sensitivities calculated. This is summed across to determine capital
charge
2. Minor adjustments to capture basis risk (vertical disallowance) and between “Zones”
(horizontal disallowance) are added to modify capital charge
© IMaCS 2009
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Standardised Approach: Capital Charge for Specific Risk
1.Govt. Securities•T-Bills•Govt. Securities
2.Qualifying Category•Public Sector Entities•Multilateral DevelopmentBanks•Investment Grade Securities
3.Other•Private Sector Entities
Maturity-
6m or less
Maturity -
6m - 24m
Maturity-
greater than 24
m
0%
0.25%
1.0%
1.60%
8.0%
Cap
ital Ch
arge
Govt.
SecuritiesOther
CategoriesQualifying Category
Specific Risk measures
price changes of
individual securities
owing to the factors
related to individual
issuer. No offsetting of
positions
© IMaCS 2009
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Internal Models Approach
© IMaCS 2009
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Basel market capital charge using VaR method
(Internal Models Approach)
1. Internally measured VaR with 99% confidence interval
2. A horizon of 10 days or two calendar weeks
3. An observation period of at least a year of historical data
and updated at once a quarter
Capital requirements will be the maximum of:
1. Previous day‟s 10 day 99% VaR
2. Average of daily VaR for the previous 60 days multiplied by a multiplication
factor (3+ where (0,1)
The alpha factor depends on the stress test of the VaR model and the discretion of
the national supervisor
© IMaCS 2009
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Use of the discretionary plus factor for
calculating capital requirements for Market risk
Less than 3 More than 9
This is the penalty component added to the multiplicative factor 'k', if
backtesting reveals that the internal model incorrectly forecasts risks. It
gives incentives to banks to improve predictive accuracy of models
3- 6 6- 9
0 0.5 1 Reject VaR
model
Specific risk is either the by the Standardized approach or that from internal
models (not to be less than 50% of the Standardized amount)
Specific Risk
Number of instances of breach of the daily VaR as stated by model
© IMaCS 2009
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Basel III
Basel III remains the same as Basel II with the major
difference as given below:
Tier I capital has been increased from 4% to 6%
Core tier I capital is increased from 2% to 4.5%
• Core tier I capital is common equity minus deductions
Capital conservation buffer is introduced in Basel III
• A buffer of 2.5% of core capital needs to be plugged in addition to
4.5% to withstand future periods of stress bringing the total common
equity requirements to 7%. This is to be implemented by 2019
• The purpose of the conservation buffer is to ensure that banks
maintain a buffer of capital that can be used to absorb losses during
periods of financial and economic stress.
© IMaCS 2009
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Contd.
Countercyclical capital buffer
• A countercyclical buffer within a range of 0% – 2.5% of common
equity or other fully loss absorbing capital will be implemented
according to national circumstances.
• Banks that have a capital ratio that is less than 2.5%, will face
restrictions on payouts of dividends, share buybacks and bonuses.
The buffer will be phased in from January 2016 and will be fully
effective in January 2019.
• Countercyclical Capital Buffer before 2016 = 0%, 1st January 2016 =
0.625%, 1st January 2017 = 1.25%, 1st January 2018 = 1.875%, 1st
January 2019 = 2.5%
© IMaCS 2009
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Current guidelines on ALM
The current guidelines looks at the following parameters to
be monitored
Loan to deposit ratio
• Loan to deposit ratio should not increase more than 80%
• Banks can also lend more than 80% by lending from capital or raise
funds from interbank market, but excessive lending could put the
bank under tremendous liquidity crisis in case liquidity in the
market tightens
Wholesale borrowing guidelines
• Set up guidelines for borrowing from the wholesale market
• Reduce dependency on wholesale market for funding
• Alternative products to borrow from the market
• Set limits to borrow from the wholesale market
© IMaCS 2009
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Contd.
• Number of parameters needs to be analyzed to determine the limit of
borrowing from the wholesale market
- Balance sheet size of the bank
- Historical trend of the market liquidity
- Credit rating of the bank
- Stability of liquidity and interest rates in the market
Commitments
• These are undrawn parts of the overdraft limit given to the
customers, which may be withdrawn at any point in time
• There should be limit to the undrawn part of the commitment
• The limit should be visa-a-via the undrawn part from the wholesale
borrowing limit
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Contd.
Medium term funding ratio
• Banks borrow sort term and lend long term, thereby there are
mismatches.
• Thus the Bank needs to have medium term sources of funds
• Medium term funding ratio is calculated as the ration of liabilities
with maturity more than 1 year to that of assets maturing in more
than 1 year
• This ratio shows the extent to which the bank is dependent on roll
over to fund medium term assets
Maximum cumulative outflow
• This can be calculated for different tenors, for example a month or a
year.
• The MCO should be limited to the maximum amount that could be
raised from the wholesale market and the amount of liquid assets
held by the bank
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Contd.
Swapped fund guidelines
• There should be cap on the maximum amount in absolute terms that
can be swapped from foreign currency liabilities in order to fund
domestic currency assets or vice-versa.
• This is to prevent excessive dependence on the foreign exchange
market
Local regulatory compliance
• Maintain CRR, SLR and capital adequacy ratios
Liquidity contingency plan
• Prepare a liquidity contingency plan to manage liquidity crisis
• Maintain liquid assets in the form of reserve assets, t-bills, specific
Government securities, open foreign currency position and specific
FDR’s
© IMaCS 2009
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Contd.
Maturity profile mismatches for liquidity risk and interest rate risk Classification of the balance sheet into different time buckets based on
the maturity profile and behavioral pattern for liquidity risk and based on re-pricing or maturity for interest rate risk
Calculation of mismatches between inflows and outflows for every bucket and also the cumulative outflow
Based on the mismatches the ALCO takes the following action points Deposit mobilization or growth in assets in the appropriate time
buckets
Cash-flow plan (long/short) based on market interest rates and liquidity
Change in FTP or customer rates
Address to the breach in limit and also provide plan to bridge the gap
Address all regulatory compliance
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Contd.
VaR
Calculation of expected loss at a confidence interval of 97.5% as to
loss due to change in market rates
Factor sensitivity
To estimate the change in value of the instruments with move in
interest rates by 1 bps (PV01)
Management action trigger (MAT)
Is equal to the current VaR + latest rolling monthly P/L (21 working
days)
It is a trigger point of a persistent loss making position
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Contd.
Other analysis done
Overall assessment of the market interest rates and liquidity
Peer group comparison on deposit and lending rates
Balance sheet performance as compared to the lat month
Three day liquidity stress, wherein it is assumed that more outflows
are there as compared to normal days for the next three days
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Organization structure
The responsibility of ALM is on the treasury department
Managed by the ALM desk of the treasury department
The roles and responsibilities of the ALM desk are as follows
• Assume overall responsibility of the money market activities
• Manage liquidity and interest rate risk of the Bank
• Comply with statutory requirement
• Understanding market dynamics, i.e. competition, potential target
markets, etc.
• Deal with dealer authorization limits
• Provide market views to the treasurer
The analysis and recommendation is presented to ALCO
ALCO is set up and is responsible for the overall
management of the balance sheet risk
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Recommendations … 1
Organization structure to be decided
Roles and responsibilities to be defined
Process flow has to be put in place for proper and smooth
functioning of the ALM
MIS
Define systems
Data flow
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Recommendations … 2
Liquidity risk management
Bucketing criteria to be defined
Set limits for each bucket as the tolerance limit (both positive and
negative gaps)
Set limit for cumulative gap
Analysis of detailed ratio analysis (some are covered but there are
other that also need to be monitored)
Dynamic liquidity statement to be done on a fortnightly basis
Resource planning to be done
Stress testing and models
Back testing
© IMaCS 2009
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Recommendations … 3
Interest rate risk
Define bucketing criteria
Define limits for gaps
Implement the entire process for NEV method for interest rate risk
management
Stress testing
In case of FOREX exposure the Banks should also implement
the ALM in managing Currency risk using the net open
position method
© IMaCS 2009
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282
IMaCS does not assume any liability, financial or otherwise, for any loss or injury that the user of the
recommendations in this report may experience in any transaction. All information contained herein is
obtained by IMaCS from sources believed by it to be accurate and reliable. Although reasonable care
has been taken to ensure that any information herein is true, such information is provided „as-is‟ without
any warranty of any kind and IMaCS, in particular, makes no representation or warranty, express or
implied, to the accuracy, timeliness or completeness of any such information. The analysis and
recommendations should not be construed to be a credit rating assigned by ICRA‟s rating division for
any of the company‟s debt instruments.
DISCLAIMER