Asset Liability

Management
Vikram Singh Sankhala

Topics
1. The definition and implications of
Liquidity Risk
2. The role of the ALCO
3. The concept of funding gaps
4. The concept and implications of duration
gaps
5. Some measures of liquidity risk
6. The concept of funds transfer pricing

Reading Materials
1.
2.
3.
4.
5.
6.

ALCO (The Essentials of Risk Management, pp. 185-188)

Gap Analysis (The Essentials of Risk Management, pp.
188-195)
Earnings at Risk (The Essentials of Risk Management, pp.
195-199)
Duration Gap (The Essentials of Risk Management, pp.
199-203)
Liquidity Measures (The Essentials of Risk Management,
pp. 203-205)
Funds Transfer Pricing (The Essentials of Risk
Management, pp. 205-206)

Case Studies
1. Continental Illinois: A Case Study
2. Daiwa Bank

Example
Consider a bank that borrows USD
100MM at 3.00% for a year and lends
the same money at 3.20% to a
highly-rated borrower for 5 years.
For simplicity, assume interest rates
are annually compounded and all
interest accumulates to the maturity
of the respective obligations.

 The net transaction appears profitable

the bank is earning a 20 basis point spread
but it entails considerable risk.
At the end of a year, the bank will have to
find new financing for the loan, which will
have 4 more years before it matures.
If interest rates have risen, the bank may
have to pay a higher rate of interest on the
new financing than the fixed 3.20 it is
earning on its loan.

 Suppose, at the end of a year, an

applicable 4-year interest rate is
6.00%.
The bank is in serious trouble.
It is going to be earning 3.20% on its
loan and paying 6.00% on its
financing.

 The problem in this example was

caused by a mismatch between assets
and liabilities.
Prior to the 1970's, such mismatches
tended not to be a significant problem.
Interest rates in developed countries
experienced only modest fluctuations,
so losses due to asset-liability
mismatches were small or trivial.

 Many firms intentionally mismatched their

balance sheets.
Because yield curves were generally upward
sloping, banks could earn a spread by
borrowing short and lending long.
Things started to change in the 1970s, which
ushered in a period of volatile interest rates
that continued into the early 1980s.

Some Concepts

Liquid Assets
Liquid assets are assets that can be
turned quickly into cash
Low transaction costs
Little or no loss in principle value
Traded in large market (trading does not
move the market)

Liquid Assets
Examples: T-bills, T-notes, T-bonds

Liquidity Ratios
Ratio of liquid assets to anticipated
short-term liability cash flows
Multiple time horizons might be
considered

Asset-Liability
Management

13

Duration
Measures the sensitivity of the value of a
series of cash flows to changes in interest
rates
Duration is approximately the average
point at which the projected cash flows
occur
For example, if a portfolio of assets has a
duration of 4, a 1% increase in interest
rates will cause a 4% decrease in its value
Asset-Liability
Management

14

Convexity
Measures the sensitivity of the duration
of a series of cash flows to changes in
interest rates
Convexity measures how rapidly
duration changes as interest rates
change

Compare duration and convexity of

assets with those of liabilities
Asset-Liability
Management

15

Hedging
Create portfolios with offsetting cash flows
Uses
Reduce systemic or non-diversifiable risk

Scope

For a business segment

Across business segments

Approaches

Static or dynamic
Rely on business cash flows or supplement with
derivatives

Asset-Liability
Management

16

Hedging Techniques
Cash flow matching
Structure portfolios to match asset and
liability cash flows

Immunization
Structure portfolios so that the impact of
a change in interest rates on the value
of liabilities offsets the corresponding
impact on asset values

Asset-Liability
Management

17

Other Measurement
Techniques
Cash flow testing
Project cash flows under various interest rate
scenarios
Examine the adequacy of asset cash flows to
meet liability cash flows under each scenario
Value at risk (VaR)
Probability-based boundary on losses
Used by banks to measure risk in trading portfolio
Economic capital
Assets required, in excess of liabilities, to avoid
ruin at a given confidence level
Asset-Liability
Management

18

LIQUIDITY RISK

LIQUIDITY RISK
What is liquidity risk?
Liquidity risk refers to the risk that the institution
might not be able to generate sufficient cash flow to
meet its financial obligations

WHAT ARE THE EFFECTS OF LIQUIDITY

CRUNCH

Risk to banks earnings

Reputational risk
Contagion effect
Liquidity crisis can lead to runs on institutions
Bank / FI failures affect economy

LIQUIDITY RISK
Factors affecting liquidity risk

Over extension of credit

High level of NPAs
Poor asset quality
Mismanagement
Reliance on a few wholesale depositors
Large undrawn loan commitments
Lack of appropriate liquidity policy &
contingent plan

TYPES OF LIQUIDITY RISKS

Broadly of three types:
Funding Risk: Due to withdrawal/nonrenewal of deposits
Time Risk: Non-receipt of inflows on
account of assets(loan installments)
Call Risk: contingent liabilities and new
demand for loans

TACKLING LIQUIDITY RISK

Tackling the liquidity problem
A sound liquidity policy
Funding strategies
Contingency funding strategies
Liquidity planning under alternate
scenarios
Measurement of mismatches through
gap statements

 Approaches

Traditional regulatory
approach

Broadly, regulators have developed 2

approaches to liquidity regulation:
The first is to monitor banks mismatch
between out-flows and inflows at short
maturities (e.g. 1 day, week or month).
Banks should measure the potential
outflows over the period & ensure that
they have sufficient liquidity to meet the
funding requirement.
The second requires banks to hold, at all
times, a stock of highly liquid assets that
can be used in the event that they
encounter problems raising liquidity.

Traditional regulatory
approach

For authorities, ensuring that banks hold

adequate liquid assets makes banks
individually, and the system as a whole, more
robust and better able to withstand shocks
without recourse to central bank support
But there is an obvious public policy trade-off
between risk and efficiency in the size of the
buffer banks hold.

Traditional regulatory
approach

This approach is fine as a starting point, but it

has a number of limitations:
It is a broad-brush, one size fits all
approach which is not tailored to the
circumstances of particular banks;
It places insufficient emphasis on qualitative
factors, particularly the adequacy of systems
& controls for managing liquidity risk; &
It does not reflect the latest liquidity risk
management practices of major banks.

LIQUIDITY RISK
METHODOLOGIES FOR MEASUREMENT

Liquidity index
Peer group comparison
Gap between sources and uses
Maturity ladder construction

1. Liquidity index
Liquidity index:
Weighted sum of fire sale price P to fair
market price, P*, where the portfolio
weights are the percent of the portfolio
value formed by the individual assets.
I = wi(Pi /Pi*)

2. Peer group comparisons :

Peer group comparisons: usual ratios
include borrowed funds/total assets,
loan commitments/assets etc.

Other Measures:
Peer group comparisons: usual ratios
include:
borrowed funds/total assets,
loan commitments/assets
Loan Losses / Net loans
Total Deposits./ Total Assets
Reserve for Loan losses / Net Loans

3. Sources and Uses

Net liquidity statement: shows sources
and uses of liquidity.
Sources: incoming deposits, revenue from
sale of non deposit services, Customer
Loan repayments, Sale of bank Assets,
Borrowing in money market
Uses include: Deposit Withdraws, Volume
of Acceptable loan requests, repayments
of bank borrowing, other operating
expenses, dividend payments

4. Maturity ladder
Construction
Maturity ladder/Scenario Analysis
For each maturity, assess all cash
inflows versus outflows
Daily and cumulative net funding
requirements can be determined in this
manner
Must also evaluate what if scenarios in
this framework

For Liquidity Planning

Important to know which types of
depositors are likely to withdraw first
in a crisis.
Allow for seasonal effects.
Delineate managerial responsibilities
clearly.

Liquidity Management
Liquidity can be managed from either the
asset side of the balance sheet or the
liability side.
Asset based management
Main goal is storing liquidity in the form of liquid
assets.
Less risky and often used by smaller institutions
Costs

Opportunity cost of foregone earnings if sold

Opportunity cost of liquid assets
Transaction Costs
Weakened Balance Sheet

Liquidity Management
Raising funds via borrowing if needed
Advantages
Only borrow if funds are needed
Volume and composition of asset portfolio is
unchanged
Can always attract funds (by increasing rate)

Disadvantages
Dependent upon market rate
Withdrawal risk (funding risk)

Balanced Liquidity
Management
Combination of Asset and Liability
Management
Borrow only for unanticipated
(usually short term needs)
Plan for long term liquidity needs via
asset management.

 Interest Rate Risk

Important Terms

Net Interest Income=

Interest Income-Interest Expenses.
Net Interest Margin=
Net Interest Income/Average Total Assets

Net Interest Margin

Interest Income - Interest Expenses

NIM
Total Earnings Assets

Net interest margin (NIM)

Example:
$100 million 5-year fixed-rate loans at 8% = $8
million interest
$90 million 30-day time deposits at 4%
= $3.6
million interest
$10 million equity
Net interest income = $4.4 million
Net interest margin (NIM) = ($8 - $3.6)/$100 = 4.4%
If interest rates rise 2%, deposit costs will rise in next
year but not loan interest. Now, NIM = ($8 - $5.4)/
$100 = 2.6%.

Interest Rate Risk

Interest rate risk refers to volatility in
Net
Interest
Income
(NII)
or
variations
in
Net
Interest
Margin(NIM).
Therefore,
an
effective
risk
management process that maintains
interest rate risk within prudent
levels is essential to safety and
soundness of the bank.

Sources of Interest Rate

Risk
Interest rate risk mainly arises from:
Gap Risk
Basis Risk
Net Interest Position Risk
Embedded Option Risk
Price Risk
Reinvestment Risk

 Interest rate risk is the volatility in net

interest income(NII) or in variations in net
interest margin(NIM).
Gap:The gap is the difference between the
amount of assets and liabilities on which
the interest rates are reset during a given
period.
Basis risk:The risk that the interest rate of
different assets and liabilities may change
in different magnitudes is called basis risk.
Embedded option:Prepayment of loans and
bonds and/or premature withdrawal of
deposits before their stated maturity
dates.

 Price Risk
When Interest Rates Rise, the Market
Value of the Bond or Asset Falls

Reinvestment Risk
When Interest Rates Fall, the Coupon
Payments on the Bond are
Reinvested at Lower Rates

Interest Rate Risk: GAP &

Earnings Sensitivity
When a banks assets and liabilities
do not reprice at the same time, the
result is a change in net interest
income.
The change in the value of assets and
the change in the value of liabilities will
also differ, causing a change in the
value of stockholders equity

How to mitigate the effect

To mitigate interest rate risk, the
structure of the balance sheet has to be
managed in such a way
that the effect on assets of any
movement in Interest rates
remains highly correlated with its effect
on Liabilities,
even in Volatile interest rate
environments.

Interest Rate Risk

Banks typically focus on either:
Net interest income or
The market value of stockholders' equity

GAP Analysis
A static measure of risk that is commonly
associated with net interest income (margin)
targeting

Earnings Sensitivity Analysis

Earnings sensitivity analysis extends GAP analysis
by focusing on changes in bank earnings due to
changes in interest rates and balance sheet
composition

How does it work?

FUNDAMENTALS OF ALM

Asset-Liability
Management

50

What is ALM
ALM or Asset Liability Management is
the
structured decision making process
for matching the mix of Assets and
Liabilities
on a firms Balance Sheet.

Asset-Liability Management
The Purpose of Asset-Liability
Management is to Control a
Banks Sensitivity to Changes in
Market Interest Rates and Limit
its Losses in its Net Income or
Equity

Techniques used by ALM to

control Risk
Gap Analysis
Duration Gap Analysis
Long Term Var

 ALM Strategy is the responsibility of

the treasurer of the company.
But the control of Risk in the Balance
Sheet is typically the mandate of the
risk management function.

 ALM is especially critical in the case

of Financial Institutions such as
commercial banks and Insurance
Companies.
Financial Intermediation generates
two types of imbalances.

First
An imbalance between the amount of
funds collected and Lent.

Second
An imbalance between the maturities
and interest rate sensitivities of the
sources of funding and the loans
extended to Clients.

 Deposits normally have lower

maturities than loans.
The rate of interest normally
increases with the term of the loan.

ALM is built on cash flows

Cash flows from both assets and
liabilities must be projected
The timing and amount of some cash
flows are highly predictable, but
many are not

Asset-Liability
Management

59

ALCO
The asset liability management committee
is the traditional name in the banking
industry for what is often known today as
the senior risk committee.
ALCO is typically chaired by the CEO and
composed of senior executive team of the
bank along with Senior executives of Risk
and Treasury.
It is co-chaired by the Chief Risk Officer
and the treasurer.

ALM must strike a balance

Asset-Liability
Management

61

An historical perspective
Before Oct. 1979, Fed monetary policy kept interest
rates stable.
Due to the above factors, banks concentrated on
asset management.
As loan demand increased in the 1960s during bouts
of inflation associated with the Vietnam War, banks
started to use liability management.
Under liability management, banks purchase funds
from the financial markets when needed. Unlike core
deposits that are not interest sensitive, purchased
funds are highly interest elastic.
Purchased funds have availability risk -- that is, these funds
can dry up quickly if the market perceives problems of bank
safety and soundness.

Liquidity Planning
Important to know which types of
depositors are likely to withdraw first in a
crisis.
Composition of the depositor base will
affect the severity of funding shortfalls.
Example: mutual funds/pension funds more
likely to withdraw than correspondent banks
and small businesses

Allow for seasonal effects.

Delineate managerial responsibilities
clearly.

Causes of Liquidity Risk

Asset side
May be forced to liquidate assets too
rapidly resulting n fire sale prices
May result from loan commitments

Traditional approach: reserve asset

management
Alternative: liability management.

Asset Side Liquidity Risk

Risk from loan commitments and
other credit lines:
met either by borrowing funds or
by running down reserves

Causes of Liquidity Risk

Liability side
Reliance on demand deposits
Core deposits (provide long term source
of funds)
Need to be able to predict the
distribution of net deposit drains.

Net Deposit Drains

Deposit withdraws are in part offset by the
inflow of new funds and income generated
by from both on and off balance sheet
activities.
The amount by which the cash withdraws
exceed the new cash inflows is the Net
Deposit Drain.
Positive NDD implies withdraws are greater
than inflows. Negative NDD implies that
inflows are greater than withdraws

Using Cash
The most obvious asset side
management technique is to use the
cash reserves of the firm.

Gap Analysis
Gap is defined as the difference
between the rate sensitive assets
and rate sensitive liabilities maturing
within a specific time period.

Gap Analysis
Gap Analysis- Simple maturity/re-pricing
Schedules can be used to generate simple
indicators of interest rate risk sensitivity of
both earnings and economic value to
changing interest rates.
- If a negative gap occurs (RSA<RSL) in
given time band, an increase in market
interest rates could cause a decline in NII.
- conversely, a positive gap (RSA>RSL) in a
given time band, an decrease in market
interest rates could cause a decline in NII.

Measuring Interest Rate Risk

with GAP
Traditional Static GAP Analysis
GAPt = RSAt -RSLt
RSAt
Rate Sensitive Assets
Those assets that will mature or reprice in a
given time period (t)

RSLt
Rate Sensitive Liabilities
Those liabilities that will mature or reprice in a
given time period (t)

MATURITY GAP METHOD

(IRS)

THREE OPTIONS:
A) RSA>RSL= Positive Gap
B) RSL>RSA= Negative Gap
C) RSL=RSA= Zero Gap

What Determines Rate

Sensitivity?
An asset or liability is considered rate
sensitivity if during the time interval:
It matures
It represents and interim, or partial, principal
payment
It can be repriced
The interest rate applied to the outstanding
principal changes contractually during the interval
The outstanding principal can be repriced when
some base rate of index changes and management
expects the base rate / index to change during the
interval

Interest-Sensitive Assets
Short-Term Securities Issued by
the Government and Private
Borrowers
Short-Term Loans Made by the
Bank to Borrowing Customers
Variable-Rate Loans Made by the
Bank to Borrowing Customers

Interest-Sensitive Liabilities

Borrowings from Money Markets

Short-Term Savings Accounts
Money-Market Deposits
Variable-Rate Deposits

Example
A bank makes a $10,000 four-year car loan to
a customer at fixed rate of 8.5%. The bank
initially funds the car loan with a one-year
$10,000 CD at a cost of 4.5%. The banks
initial spread is 4%.

What is the banks one year gap?

Example
Traditional Static GAP Analysis
What is the banks 1-year GAP with the
auto loan?
RSA1yr = $0
RSL1yr = $10,000
GAP1yr = $0 - $10,000 = -$10,000
The banks one year funding GAP is -10,000
If interest rates rise (fall) in 1 year, the banks
margin will fall (rise)

Measuring Interest Rate Risk

with GAP
Traditional Static GAP Analysis
Funding GAP
Focuses on managing net interest income in
the short-run
Assumes a parallel shift in the yield curve,
or that all rates change at the same time, in
the same direction and by the same amount.

Asset-Sensitive Bank Has:

Positive Dollar Interest-Sensitive
Gap
Positive Relative InterestSensitive Gap
Interest Sensitivity Ratio Greater
Than One

Liability Sensitive Bank Has:

Negative Dollar InterestSensitive Gap
Negative Relative InterestSensitive Gap
Interest Sensitivity Ratio Less
Than One

 Aim is to stabilise the short-term

profits,long-term earnings and longterm substance of the bank.
The parameters that are selected for
the purpose of stabilizing asset
liability management of banks are:
-Net Interest Income(NII)
-Net Interest Margin(NIM)
-Economic Equity Ratio

Net Interest IncomeInterest Income-Interest Expenses.

Net Interest MarginNet Interest Income/Average Total Assets

Economic Equity RatioThe ratio of the shareholders funds to the total
assets measures the shifts in the ratio of
owned
funds to total funds. The fact assesses the
sustenance capacity of the bank.

Net Interest Margin

Interest Income - Interest Expenses

NIM
Total Earnings Assets

Factors Affecting Net

Interest Income
Changes in the level of interest rates
Changes in the composition of assets
and liabilities
Changes in the volume of earning
assets and interest-bearing liabilities
outstanding
Changes in the relationship between the
yields on earning assets and rates paid
on interest-bearing liabilities

Example
Consider the following balance sheet:

Examine the impact of the

following changes
A 1% increase in the level of all short-term
rates?
A 1% decrease in the spread between
assets yields and interest costs such that
the rate on RSAs increases to 8.5% and the
rate on RSLs increase to 5.5%?
Changes in the relationship between shortterm asset yields and liability costs
A proportionate doubling in size of the
bank?

1% increase in short-term
rates

With a negative GAP, more

liabilities than assets reprice
higher; hence NII and NIM fall

1% decrease in the
spread

NII and NIM fall (rise) with a

decrease (increase) in the
spread.
Why the larger change?

Proportionate doubling in
size

NII and GAP double, but NIM

stays the same.
What has happened to risk?

Changes in the Volume of

Earning Assets and InterestBearing Liabilities
Net interest income varies directly
with changes in the volume of
earning assets and interest-bearing
liabilities, regardless of the level of
interest rates

RSAs increase to $540 while fixed-rate assets

decrease to $310 and RSLs decrease to $560
while fixed-rate liabilities increase to $260

Although the banks GAP

(and hence risk) is lower,
NII is also lower.

Changes in Portfolio Composition

and Risk
To reduce risk, a bank with a negative
GAP would try to increase RSAs
(variable rate loans or shorter
maturities on loans and investments)
and decrease RSLs (issue relatively
more longer-term CDs and fewer fed
funds purchased)
Changes in portfolio composition also
raise or lower interest income and
expense based on the type of change

Measuring interest rate

sensitivity and the dollar gap
Dollar gap:
RSA($) - RSL($) (or dollars of rate-sensitive assets
minus dollars of rate-sensitive liabilities, which normally
are less than one-year maturity).
To compare 2 or more banks, or make track a bank over
time, use the:
Relative gap ratio = Gap$/Total Assets
or
Interest rate sensitivity ratio = RSA$/$RSL$.

Positive dollar gap occurs when RSA$>RSL$. If interest

rates rise (fall), bank NIMs or profit will rise (fall). The
reverse happens in the case of a negative dollar gap
where RSA$<RSL$. A zero dollar gap would protect
bank profits from changes in interest rates.

Measuring interest rate

sensitivity and the dollar gap
Dollar Gap:
Interest rate forecasts can be important in earning bank
profit.
If interest rates are expected to increase in the near future,
the bank could use a positive dollar gap as an aggressive
approach to gap management.
If interest rates are expected to decrease in the near future,
the bank could use a negative dollar gap (so as rate
declined, bank deposit costs would fall more than bank
revenues, causing profit to rise).

Incremental and cumulative gaps

Incremental gaps measure the gaps for different
maturity buckets (e.g., 0-30 days, 30-90 days, 90-180
days, and 180-365 days).
Cumulative gaps add up the incremental gaps from
maturity bucket to bucket.

Measuring interest rate

sensitivity and the dollar gap

Gap, interest rates, and profitability:

The change in the dollar amount of net interest income (NII) is:
NII = RSA$( i) - RSL$( i) = GAP$( i)
Example: Assume that interest rates rise from 8% to 10%.
NII = $55 million (0.02) - $35 million (0.02) = $20 million (0.02)
= $400,000 expected change in NII

Defensive versus aggressive asset/liability

management:
Defensively guard against changes in NII (e.g., near zero gap).
Aggressively seek to increase NII in conjunction with interest
rate forecasts (e.g., positive or negative gaps).
Many times some gaps are driven by market demands (e.g.,
borrowers want long-term loans and depositors want short-term
maturities).

Measuring interest rate

sensitivity and the dollar gap

Three problems with dollar gap management:

Time horizon problems related to when assets and liabilities

are repriced. Dollar gap assumes they are all repriced on the
same day, which is not true.
For example, a bank could have a zero 30-day gap, but with daily
liabilities and 30-day assets NII would react to changes in interest
rates over time.
A solution is to divide the assets and liabilities into maturity
buckets (i.e., incremental gap).

Correlation with the market rates on assets and liabilities is

1.0. Of course, it is possible that liabilities are less correlated
with interest rate movements than assets, or vice versa.
A solution is the Standardized gap.
For example, assume GAP$ = RSA$ - RSL$ = $200 (coml paper) $500 (CDs) = -$300. Assume the CD rate is 105% as volatile as
90-day T-Bills, while the coml paper rate is 30% as volatile. Now
we calculate the Standardized Gap = 0.30($200) - 1.05($500)
= $60 - $525 = -$460, which is much more negative!

Measuring interest rate sensitivity

and the dollar gap
Three problems with dollar gap management:
Focus on net interest income rather than shareholder
wealth.
Dollar gap may be set to increase NIM if interest rates
increase, but equity values may decrease if the value of
assets fall more than liabilities fall (i.e., the duration of
assets is greater than the duration of liabilities).

Financial derivatives could be used to hedge dollar gap

effects on equity values.
While GAP$ can adjust NIM for changes in interest rates,
it does not consider effects of such changes on asset,
liability, and equity values.

Duration gap analysis

How do changes in interest rates affect asset,
liability, and equity values?
Duration gap analysis:
n general,V = -D x V x [i/(1 + i)]
For assets: = -D x A x [i/(1 + i)]
For liabilities: L = -D x L x [i/(1 + i)]
Change in equity value is: E = A - L
DGAP (duration gap) = DA - W DL, where DA is the average
duration of assets, DL is the average duration of liabilities,
and W is the ratio of total liabilities to total assets.
DGAP can be positive, negative, or zero.
The change in net worth or equity value (or E) here is
different from the market value of a banks stock (which is
based on future expectations of dividends). This new
value is based on changes in the market values of assets
and liabilities on the banks balance sheet.

Duration gap analysis

EXAMPLE: Balance Sheet Duration
Assets
$ Duration (yrs)
Cash
100
0
Business loans 400
1.25
Mortgage loans 500
$1,000

7.0
4.0

Liabilities
$
Duration (yrs)
CD, 1 year
600
1.0
CD, 5 year
300
5.0
Total liabilities $900
2.33
Equity
100
$1,000

DGAP = 4.0 - (.9)(2.33) = 1.90 years

Suppose interest rates increase from 11% to 12%. Now,
% E = (-1.90)(1/1.11) = -1.7%.
$ E = -1.7% x total assets = 1.7% x $1,000 = -$17.

Duration gap analysis

Defensive and aggressive duration gap
management:
If you think interest rates will decrease in the future, a
positive duration gap is desirable -- as rates decline,
asset values will increase more than liability values
increase (a positive equity effect).
If you predict an increase in interest rates, a negative
duration gap is desirable -- as rates rise, asset values will
decline less than the decline in liability values (a positive
equity effect).
Of course, zero gap protects equity from the valuation
effects of interest rate changes -- defensive
management.
Aggressive management adjusts duration gap in
anticipation of interest rate movements.

Earnings at Risk
On a periodic basis
The potential impact of the firms
various gap positions
On the income statement for the
current quarter and full year.

Duration of equity
Net worth = Market Value of Assets
Market Value of Liabilities.
Duration of Equity = (Market Value of
Assets * Duration of Assets Market
Value of Liabilities*Duration of
Liabilities) divided by Net Worth

Long Term Var

Can be achieved only by the Monte
Carlo Method.
Purpose is to generate statistical
distributions of Earnings at Risk and
Net worth at different time horizons
In order to produce the worst case
EAR and NW at a given confidence
level say 99%.

Input Parameters
Term structure of interest rates which will
include a random component.
Implied Volatilities
Interest rate sensitive prepayments
Loan defaults etc.
Simulation conducted at the pool level.
Pricing models need to be developed at each
stage of the simulation to assess the value
of assets and liabilities at that point of time.

Complex Relationship Model

Since the EAR and NW is a function of
the range of input parameters, one
needs a complex pricing model to
represent the function as well as
assumptions about the dynamics of
interest rates.
Inconsistent assumptions both on the
relationships and the interest rate
dynamics, can distort the results.

Liquidity Risk Measurement

Liquidity can be quantified by using a
symmetrical scale.
There is a rank score for the dollar
amount of the product.
The process is done both for liquidity
suppliers and Liquidity users.
The amount is multiplied by the rank
score.
The sum on both sides is netted out.

Funds Transfer Pricing

Here each business unit is taken separately.
If one business unit obtains funds and the
other applies them, instead of taking the
resultant profit margin,
We take an independent benchmark like the
LIBOR for each business unit and arrive at
the profit margin of each business unit
independently.
The independent margins of Business units
result in the overall margin of the Business.

Statements

Risk Management Profile

Report

V@R
Market
Report
V@R
Market
V@R
Market
Interest Rate Liquidity
Liquidity
Interest Rate
Liquidity
Report
Private Fund
Report
Report
Manageme
Report
Bankingnt
Report

Report

Report

Credit
Operational Credit
Operational
Behavior Income
Behavior Income

Report

Report

Corporate
Asset
Wealth
WealthReport
Management
Management
Management
Banking
Report

Report

Report

Report

Report

STATEMENT OF
STRUCTURAL LIQUIDITY
Placed all cash inflows and outflows in the
maturity ladder as per residual maturity
Maturing Liability: cash outflow
Maturing Assets : Cash Inflow
Classified in to 8 time buckets
Mismatches in the first two buckets not to
exceed 20% of outflows
Banks can fix higher tolerance level for
other maturity buckets.

Statement of Structural
Liquidity

All Assets & Liabilities to be reported as per their maturity

profile into 8 maturity Buckets:

i.

1 to 14 days

ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years

STATEMENT OF
STRUCTURAL LIQUIDITY
Places all cash inflows and outflows in the
maturity ladder as per residual maturity
Maturing Liability: cash outflow
Maturing Assets : Cash Inflow
Classified in to 8 time buckets
Mismatches in the first two buckets not to
exceed 20% of outflows
Shows the structure as of a particular date
Banks can fix higher tolerance level for other
maturity buckets.

An Example of Structural
Liquidity Statement
15-28
1-14Days Days

Capital
Liab-fixed Int
Liab-floating Int
Others
Total outflow
Investments
Loans-fixed Int
Loans - floating

300 200
350 400
50 50
700 650
200 150
50 50
200 150
Loans BPLR Linked
100 150
Others
50 50
Total Inflow
600 550
Gap
-100 -100
Cumulative Gap -100 -200
-14.29 -15.38
Gap % to Total Outflow

30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5

3 Month 6 Mths
1Year
Years
5 Years Years

200 600 600 300 200

350 450 500 450 450
0
550 1050 1100 750 650
250 250 300 100 350
0 100 150 50 100
200 150 150 150 50
200 500 350 500 100
0
0
0
0
0
650 1000 950 800 600
100 -50 -150 50 -50
-100 -150 -300 -250 -300
18.18

-4.76

-13.64

6.67

-7.69

200
200
450
200
1050
900
100
50
100
200
1350
300
0
28.57

Total

200
2600
3400
300
6500
2500
600
1100
2000
300
6500
0
0

STRATEGIES
To meet the mismatch in any maturity
bucket, the bank has to look into
taking deposit and invest it suitably
so as to mature in time bucket with
negative mismatch.

 Risk Management procedures vary vastly

from institution to institution as well as the
available data and environments
This implies Integrated Risk Management will
be both expensive and time consuming
Therefore, Integrated Risk Management
MUST be custom made according to the
institutions requirements

Liquidity Risk in Banks

Cash versus liquid assets

Banks own four types of cash assets:

1. vault cash,
2. demand deposit balances at Federal Reserve Banks,
3. demand deposit balances at private financial institutions,
and
4. cash items in the process of collection (CIPC).

Cash assets do not earn any interest, so the entire

allocation of funds represents a substantial
opportunity cost for banks.
Banks attempt to minimize the amount of cash
assets held and hold only those required by law or
for operational needs.

Why do banks hold cash assets?

1. Banks supply coin and currency to meet customers'
regular transactions needs.
2. Regulatory agencies mandate legal reserve
requirements that can only be met by holding
qualifying cash assets.
3. Banks serve as a clearinghouse for the nation's check
payment system.
4. Banks use cash balances to purchase services from
correspondent banks.

Cash assets are liquid assets

only to the extent that a bank holds more than the

minimum required.
Liquid assets are generally considered to be:
1.
2.
3.
4.

cash and due from banks in excess of requirements,

federal funds sold and reverse repurchase agreements,
short-term Treasury and agency obligations,
high quality short-term corporate and municipal
securities, and
5. some government-guaranteed loans that can be readily
sold.

Liquidity versus profitability

There is a short-run trade-off between liquidity and
profitability.
The more liquid a bank is, the lower its return on equity
and return on assets, all other things being equal.

Both asset and liability liquidity contribute to this

relationship.
Asset liquidity is influenced by the composition and
maturity of funds.
In terms of liability liquidity, banks with the best asset
quality and highest equity capital have greater access to
purchased funds. (They also pay lower interest rates and
generally report lower returns in the short run.)

Liquidity risk, credit risk, and interest rate risk

Liquidity management is a day-to-day responsibility.
Liquidity risk, for a poorly managed bank, closely
follows credit and interest rate risk.
Banks that experience large deposit outflows can often
trace the source to either credit problems or earnings
declines from interest rate gambles that backfired.

Few banks can replace lost deposits independently if

an outright run on the bank occurs.

Factors affecting certain liquidity needs:

New Loan Demand

Unused commercial credit lines outstanding

Consumer credit available on bank-issued cards
Business activity and growth in the banks trade area
The aggressiveness of the banks loan officer call programs

Potential deposit losses

The composition of liabilities
Insured versus uninsured deposits
Deposit ownership between: money fund traders, trust fund traders, public
institutions, commercial banks by size, corporations by size, individuals,
foreign investors, and Treasury tax and loan accounts
Large deposits held by any single entity
Seasonal or cyclical patterns in deposits
The sensitivity of deposits to changes in the level of interest rates

Asset liquidity measures

Asset liquidity
the ease of converting an asset to cash with a minimum loss.
The most liquid assets mature near term and are highly
marketable.
Liquidity measures are normally expressed in percentage terms as
a fraction of total assets.
Highly liquid assets include:
Cash and due from banks in excess of required holdings and due from banksinterest bearing, typically with short maturities
Federal funds sold and reverse RPs.
U.S. Treasury securities maturing within one year
U.S. agency obligations maturing within one year
Corporate obligations maturing within one year and rated Baa and above
Municipal securities maturing within one year and rated Baa and above
Loans that can be readily sold and/or securitized

Pledging requirements
Not all of a banks securities can be easily sold.
Like their credit customers, banks are required to
pledge collateral against certain types of
borrowings.
U.S. Treasuries or municipals normally constitute
the least-cost collateral and, if pledged against
debt, cannot be sold until the bank removes the
claim or substitutes other collateral.

What about loans?

Many banks and bank analysts monitor loan-todeposit ratios as a general measure of liquidity.
Loans are presumably the least liquid of assets,
while deposits are the primary sources of funds.
A high ratio indicates illiquidity because a bank is
fully extended relative to its stable funding.

The Loan-to-Deposit Ratio, continued

The loan-to-deposit ratio is not as meaningful a measure of
liquidity as it first appears.
Two banks with identical deposits and loan-to-deposit ratios
may have substantially different liquidity if one bank has highly
marketable loans while the other has risky, long-term loans.
An aggregate loan figure similarly ignores the timing of cash
flows from interest and principal payments.
The same is true for a banks deposit base.
Some deposits, such as long-term nonnegotiable time deposits,
are more stable than others, so there is less risk of withdrawal.
In summary, the best measures of asset liquidity identifies the
dollar amounts of unpledged liquid assets as a fraction of total
assets.

Purchased Liquidity and Asset Quality

A banks ability to borrow at reasonable rates of interest
is closely linked to the markets perception of asset
quality. Banks with high quality assets and a large capital
base can issue more debt at relatively low rates.
Banks with stable deposits generally have the same
widespread access to borrowed funds at relatively low
rates.
Those that rely heavily on purchased funds, in contrast,
must pay higher rates and experience greater volatility in
the composition and average cost of liabilities.
For this reason, most banks today compete aggressively
for retail core deposits.

Funding Avenues

a.
b.
c.
d.
e.

To satisfy funding needs, a bank

must perform one or a combination
of the following:
Dispose off liquid assets
Increase short term borrowings
Decrease holding of less liquid assets
Increase liability of a term nature
Increase Capital funds

Liquidity planning
Banks actively engage in liquidity planning
at two levels.
The first relates to managing the required
reserve position.
The second stage involves forecasting net funds
needs derived, seasonal or cyclical phenomena
and overall bank growth.

Liquidity planning: Monthly intervals

The second stage of liquidity planning involves

projecting funds needs over the coming year and
beyond, if necessary.
Projections are separated into three categories:
1. base trend,
2. short-term seasonal, and
3. cyclical values.

Management can supplement this analysis by

including projected changes in purchased funds and
in investments with specific loan and deposit flows.

Monthly liquidity needs

The banks monthly liquidity needs are
estimated as the forecasted change in loans
plus required reserves minus the forecast
change in deposits:
Liquidity needs =
Forecasted loans + required reserves
- forecasted deposits

Liquidity GAP measures

Management can supplement this information with
projected changes in purchased funds and
investments with specific loan and deposit flows.
The bank can calculate a liquidity GAP by
classifying potential uses and sources of funds into
separate time frames according to their cash flow
characteristics.
The Liquidity GAP for each time interval equals
the dollar value of uses of funds minus the dollar
value of sources of funds.

Considerations in selecting liquidity sources

The previous analysis focuses on estimating the
dollar magnitude of liquidity needs.
Implicit in the discussion is the assumption that the
bank has adequate liquidity sources.
Banks with options in meeting liquidity needs
evaluate the characteristics of various sources to
minimize costs.

Evaluating Asset sales:

Brokerage fees
Securities gains or losses
Foregone interest income
Any increase or decrease in taxes
Any increase or decrease in interest receipts

Evaluating New borrowings:

Brokerage fees
Required reserves
FDIC insurance premiums
Servicing or promotion costs
Interest expense.
The costs should be evaluated in present value terms
because interest income and expense may arise over
time.
The choice of one source over another often involves
an implicit interest rate forecast.

LIQUIDITY RISK: Effects

EFFECTS OF LIQUIDITY
CRUNCH

Risk to banks earnings

Reputational risk
Contagion effect
Liquidity crisis can lead to runs on institutions
Bank and Financial Institutions failures affect
economy

136

LIQUIDITY RISK: Factors

Factors affecting liquidity risk

137

Over extension of credit

High level of NPAs
Poor asset quality
Mismanagement
Non recognition of embedded option risk
Reliance on a few wholesale depositors
Large undrawn loan commitments
Lack of appropriate liquidity policy & contingent
plan

LIQUIDITY RISK: Solutions

Tackling the liquidity problem

138

A sound liquidity policy

Funding strategies
Contingency funding strategies
Liquidity planning under alternate scenarios
Measurement of mismatches through gap statements

What is a Liquidity
Contingency Plan?
A documented process to ensure that your
bank has the ability and means to obtain the
necessary funds to manage through a
liquidity crisis.
Creates a process to follow to utilize
management talent to expedite access to the
financial markets and to inform shareholders,
customers and the regulatory authorities
that you are taking the appropriate actions to
mitigate a liquidity crisis.

139

When could a liquidity crisis

occur?
Intraday fraud, large wire out,
etc
End of Day Market crisis, etc
Over several days.
Over a month.
Over several months.

Stems from Market, Credit and/or Operational Risk Events

Either Bank Specific or Systemic
140

Liquidity Contingency Plan:

Objectives
Ensure that a viable capability exists to respond to an
event.
Accomplish the LCP in an efficient, documented and orderly
way.
Minimize losses and reputational damage.
Protect the Balance Sheet and financial position, even if
the Balance Sheet moves to a new structure.
Minimize the risk of legal liabilities.
Ensure compliance with all applicable laws and regulations.
Maintain the confidence and good relations with the
shareholders, investment community, regulatory agencies,
customers, service providers and other involved parties.

141

How Do I know when the Liquidity

Contingency Plan should be
activated?

When a pre-determined set of

parameters are exceeded.
When a pre-determined number of
triggers are activated.
Note Targets are difficult to assess without parameters
Example A target rate of 2% - When is it way off?

142

LCP Activation When do I

do
this?
Level 1 Event Indicated
by minor
infringement on the liquidity
parameters and/or triggers. Handled in the normal course of
business.

Level 2 Event Indicated by additional triggers and parameter

violations. Additional executives become involved in addressing
the problem. Access to unsecured lines, pledging additional
collateral, brokered CDs, etc

Level 3 Event At level 3, the LCP is formally activated. A predetermined set of parameters/triggers are exceeded.
Not handled during the normal course of business.
Scope and duration could have a strong adverse effect on the
bank
Need to utilize multiple internal and external resources.
Could be as a result of a physical disaster (make sure this plan
is referenced in your Business Continuity Plan)

143

When should liquidity actions

be taken?

Below is an activation table that indicates when liquidity actions

should be taken. This table is a guidance table. To use this table,
add the parameters and triggers together. However, the plan may
be activated with fewer or no parameters or triggers exceeded,
especially in the case of a sudden event.
Level

of
Parameters
Exceeded

Number
of
Exceeded

Level I

Level II

Level III Full Plan Activation

144

Triggers

Parameter Examples
Liquidity and Funding Ratios

Low

High

Gross Loans to Total Deposits

70%

140%

Duration and Maturity Adjusted Liquidity

75%

90%

Fixed Liability Ratio

25%

100%

Pledgable Mortgage Loans to Total Residential Mortgage Loans

70%

80%

Net Short Term Non-core Fund Dependence (Short term non core
funding less short term investments divided by long term
assets)

50%

80%

Net Non-core Fund Dependence (Non core liabilities less short

term investments divided by long term assets)

50%

85%

Brokered Deposits to Deposits

0%

20%

145

Triggers for different events

Triggers are used as the basis for scenarios for review by the Bank. The triggers
are used in order to ensure their relevance to the liquidity situation at the Bank.
Systemic financial risk is the risk that an event will trigger a loss of economic value
or confidence in, and attendant increases of uncertainty about, a substantial
portion of the financial system that is serious enough to quite probably have
significant adverse effects on the real economy.
Systemic risk events can be sudden and unexpected, or the likelihood of their
occurrence can build up over time in the absence of appropriate policy
responses.
The adverse real economic effects from systemic problems are generally seen as
arising from disruptions to payment systems, to credit flows, and from the
disruption of asset values. This definition, from
The Group of Ten: Report on Consolidation in the Financial Sector , captures both
the timing and the scope of such an event.
Systemic risk is diversifiable and the events that trigger the LCP should match the
Banks exposures.

146

Triggers - Examples
Change/Cap/Flo
or

Probability/Seve
rity

Qualitative

Medium/Low

50% Change

Medium/Medium

Loss of confidence in a major capital markets participant by funds

providers that may spill over to others

Qualitative

Low/Medium

Indications of a potential asset bubble

Qualitative

Medium/High

Agency MBS spreads to the 5 year Swap 5 day moving average

150 bp increase

Low/High

3 month LIBOR to 3 Month T-Bills 5 day rolling average

100 bp increase

Low/Medium

50% decrease

Low/Medium

Description
Strong shift from accommodative to restrictive monetary policy
Unemployment rate changes to indicate a recession

Commercial Paper Issuance by Banks ($) year to year

147

Parameters and Triggers

Parameters are established for overall management.
Triggers are identified for three types of situations
Normal to Non-Normal Systemic
Normal to Non-Normal Bank Specific
Non-Normal with Further Deterioration Systemic
and Bank Specific
The most difficult triggers to identify
Reports should be developed that contain this
information and should be reviewed on a preidentified schedule. In a crisis, critical reporting
should be accelerated.
148

Who Gets Involved?

Liquidity Event Management Team (LEMT)
LEMT Members

Primary Responsibility

Chief Executive Officer

LEMT Leader

Activate LCP
Ensure necessary decisions are made by appropriate executives
LEMT Leader role can be delegated to another executive

Chief Risk Officer

Activate LCP (if necessary)

Ensure necessary decisions are made by appropriate executives (if necessary)

Chief Financial Officer

Coordinate all financial efforts related to the event

Coordinate communication with regulatory agencies

Chief Treasury Officer

Alternate LEMT Leader

Coordinate activities in Investments, Deposits and Lending

Coordinate actions to access and secure funds for the financial institution

LCP Coordinator

Coordinate all actions related to enacting the LCP

Coordinate communication up to the LEMT and down to the identified interested parties, including
the BCP if required

Treasury Operations/ALM

Provide data and run models to manage the event.

Coordinate scenario planning.

Corporate Communications

Coordinates all communications, with the exception of the Regulatory Agencies

Serve as the point of contact for the media and other outside parties (except regulatory agencies)
seeking information about the nature and status of the event and responses by the Bank

149

Key individuals who

support the LEMT
Other Executives

Primary Responsibility

Chief Credit Officer

Coordinate response for all lending area activities

SVP Retail Banking

Assist in coordination of response for all regional community bank activities

Assistant Treasurer

Coordinate all investment decisions

Senior Trust Officer

Coordinate response for all trust area activities

Legal Counsel

Identify legal issues as they arise and advise the LCP on liability issues
Expedite review of contracts for procurement of necessary funds
Coordinate insurance documentation and recordkeeping requirements for claims processing, if
necessary

Corporate Controller

Balance sheet accounting and budget forecasting.

Human Resources Director

Ensure officers and employees who are deemed to need to be exited are exited and access to
sensitive systems and information is discontinued.
Work with recruiters if key personnel are required with specific skill sets.

150

 FIVE STAGES OF LIQUIDITY CRISIS

MANAGEMENT

Stage 1
Declaration and Notification of
Liquidity Crisis

Declaration of Formal Liquidity Crisis, based on pre-defined triggers.

Notification of interested and involved individuals through use of
the Contact List.
Arranging the initial meeting to discuss actions to be taken to
mitigate the Liquidity Crisis
The LEMT Leader assumes control of the response activities.

Corporate Communications prepares

necessary employee notifications and
news releases for media, regulators and
counterparties.

152

Stage 2
Initial Meeting of the Liquidity
Event Management Team

Distribution of the LCP and the reasons for the declaration

of the need for contingent liquidity.
Establish meeting schedule, information requirements and
potential actions.
Arranging for full disclosure of issues to the LEMT.
Ensuring actionable items come out of the initial meeting,
enabling early intervention.
Developing communication to the appropriate regulatory
authorities regarding the reason for the activation and the
intended actions.

153

Stage 3
Subsequent Meetings and Actionable
Items
Provide updates regarding liquidity status and
projected needs.
Review updated information.
Determine how balance sheet, employees,
customers, shareholders and counterparties are
responding to draw downs of loan commitments,
additional collateralizations, securitizations, sales
and other actions.
Determine next steps, responsibilities and next
meeting.
154

Stage 4
Movement to Stabilized State of Liquidity
As liquidity stabilizes, determine methods to
pay down loans, unwind positions and other
steps to resume a stable liquidity state.
Reforecast upcoming months to develop
strategy.
Identify communications requirements

155

Stage 5
Forensic Review of Crisis
Conduct table top walk through
of crisis.
Amend plan as appropriate.
Communicate forensic activities
to appropriate personnel.

156

LCP: The Goal

It is important to remember that the goal is to bridge
the liquidity deficiency and not attempt to restructure
the balance sheet for long term profitability. In fact,
because of the liquidity issues, the profitability of the
Bank should expect to suffer. The goal is to focus on
short term solutions to enable the Bank to continue
operating until longer term stability can be achieved.

157

Actions to be taken during a Liquidity Crisis

In order of consideration

A liquidity crisis, whether a Level I, II, III, requires a concerted effort by the
Bank to manage through. Because each liquidity crisis is somewhat unique,
the actions outlined below are not specified as being required but are rather
presented in menu form.
1. In general, a financial institution should consider tapping funds that are readily
available, unsecured and can be termed longer than originally projected.
These types of funds will be made unavailable or priced out of range more
quickly than funds that require collateral to access.
2. Of secondary importance is the cost of these funds, as they are being used to
deal with a crisis and should be expected to have a higher cost associated with
them.
3. At the same time, some diversification is considered prudent because of the
message that is being sent to the market.
4. It is important to keep in mind that the funds being accessed are to address
the crisis until the Bank returns to a new level of stability, even if the new level
is of a significantly riskier institution. In other words, the goal is to survive.

The LCP Coordinator should keep a list of available sources of funds and
understand any covenants associated with their use. This list should be
updated at least monthly or more frequently in case of a crisis.
158

Examples of Actions
Action

Impact

Determine severity and duration of crisis

through current observations and estimates
of the short-term outlook.

Creates platform from which to build recovery strategy.

Have all Business Units that could have large

outflows of cash contact Treasury prior to
Outflow

Provides ability to negotiate on deposits or alerts Treasury

on wire activity. Reduces cash outflow.

Move maturing less liquid securities into more

liquid instruments.

Typically reduces yield but provides pledgable collateral.

Preferable to total liquidation because investments
remain after liquidity crisis subsides.

Acquire fed funds to cover liquidity shortfall.

Very short term strategy to cover intraday or interday

liquidity needs.

Reduce correspondent balances and move to

paying fees for services instead of
compensating balances.

Short term strategy to cover immediate cash needs.

Access unsecured lines. Counterparties noted

in Appendix I.

Accessing unsecured lines should be an early stage activity

and addresses short term needs. These funds will
typically not be available as the crisis unfolds. Early use
saves collateral for use at a later stage. However, a
blended approach should be used (unsecured and
secured).

Access unsecured term loans. Counterparties

noted in Appendix I.

Accessing unsecured term loans should be an early stage

activity and addresses the need to lengthen maturities.
These funds will typically not be available as the crisis
unfolds. Early use saves collateral for use at a later
stage.

Move customer repurchase agreements away

from pledged securities.

Pledged securities (repos) used for customer deposits may

159
need to be redirected to access market funds. While

LIQUIDITY RISK
RBI GUIDELINES
Structural liquidity statement
Dynamic liquidity statement
Board / ALCO
ALM Information System
ALM organisation
ALM process (Risk Mgt process)

Mismatch limits in the gap statement

Assumptions / Behavioural study

ALM - Funds Transfer

Pricing
Loan

Credit Spread

Rate

Maturity Mismatch

Funding Margin
Deposit

Maturity

LIBOR Curve

Questions for Revision

What are liquid assets ? What is a
liquidity crisis ? What is its impact on
an organization ? Illustrate with
examples ?
What is meant by liquidity Risk ? Why
is it so important ?

Define the following

Net Interest Income
Net Interest Margin
Static Gap Analysis in ALM.

Questions for Revision

What is Interest Rate Risk ? How
does it affect a banks earnings ?
What is meant by Asset Liability
Management ? What is ALCO ? What
is the composition of ALCO ?

Questions for Revision

What are the traditional regulatory
approaches towards Managing
Liquidity Risk?
Discuss the methods that an
organization can use to tackle liquidity
risk ? What are the committees,
contingency plans, triggers and
actions that an organization put in
place to tackle liquidity Risk ?

The End