Unit 4 alm
- 2. WHAT IS ALM? • Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. • ALM is a systematic approach that attempts to provide a degree of protection to the risk arising out of asset/liability mismatch. • Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting assets. Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (fixed or floating) and lend long term (fixed or floating). • A comprehensive ALM policy framework focuses on bank profitability and long- term viability by targeting the net interest margin (NIM) ratio and Net Economic • Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital.
- 3. FOUNDATION CONCEPTS • Liquidity • The ease with which the assets can be converted to cash • Two dimensions: Maturity liquidity, Marketability • Liquid assets: Fed funds, overnight repos • Illiquid assets: Multi-year commercial loans • Term structure • The relationship between debt instruments yields and instruments’maturities • Represented via yield curve • Interest rate sensitivity • Instruments’ price Vs Instruments’ yield • Interest rate sensitivity Vs Variable or floating rate assets and liabilities • Maturity composition • Maturity of assets Vs Maturity of Liabilities - Spread Lock • Default risk • Debtor will be unable to pay the principal and/or interest
- 4. MEASURING RISK • The function of ALM is not just protection from risk. • The safety achieved through ALM also opens up opportunities for enhancing net worth. Interest rate risk (IRR) largely poses a problem to a bank’s net interest income and hence profitability. • Changes in interest rates can significantly alter a bank’s net interest income (NII), depending on the extent of mismatch between the asset and liability interest rate reset times. Changes in interest rates also affect the market value of a bank’s equity. • Methods of managing IRR first require a bank to specify goals for either the book value or the market value of NII. In the former case, the focus will be on the current value of NII and in the latter, the focus will be on the market value of equity. • In either case, though, the bank has to measure the risk exposure and formulate strategies to minimise or mitigate risk. The immediate focus of ALM is interest-rate risk and return as measured by a bank’s net interest margin.
- 5. MARGIN MANAGEMENT • Gap : • The difference between a financial institution’s floating rate assets and floating rate liabilities • The difference between an institution’s fixed rate liabilities and fixed rate assets • Spread lock strategy • Increase the gap when interest rates are expected to rise and to decrease the gap when the interest rates are expected to fall.
- 6. INVESTMENT BANKER IN ALM • Total return optimization • Total returns consist of interests, reinvestment income, change in market values of the assets • Portfolio attributes – liquidity requirements, durations, industry sector specifications, obligations to hold minimum quantities of specific entities’ debt • Risk-controlled arbitrage • Effort to mazimize the interest spread by purchasing high-yield assets and at the lowest cost
- 7. ASSETS LIABILITIES MORTGAGE MARKETS FINANCIAL INSTITUTION REPO MARKET SWAP DEALER RISK CONTROLLED ARBITRAGE
- 8. NET INTEREST MARGIN • NIM = (Interest income – Interest expense) / Earning assets • A bank’s NIM, in turn, is a function of the interest-rate sensitivity, volume, and mix of its earning assets and liabilities. That is, NIM = f (Rate, Volume, Mix)
- 9. Sources of interest rate risk: • repricing risk, • yield curve risk, • basis risk • optionality. Effects of interest rate risk: Changes in interest rates can have adverse effects both on a bank’s earnings and its economic value. • The earnings perspective: From the earnings perspective, the focus of analyses is the impact of changes in interest rates on accrual or reported earnings. Variation in earnings (NII) is an important focal point for IRR analysis because reduced interest earnings will threaten the financial performance of an institution. • Economic value perspective: Variation in market interest rates can also affect the economic value of a bank’s assets, liabilities, and Off Balance Sheet (OBS) positions. Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective.
- 10. • A zero GAP will be the best choice either if the bank is unable to speculate interest rates accurately or if its capacity to absorb risk is close to zero. With a zero GAP, the bank is fully protected against both increases and decreases in interest rates as its NII will not change in both cases. • As a tool for managing IRR, GAP management suffers from three limitations: • Financial institutions in the normal course are incapable of out-predicting the markets, hence maintain the zero GAP. • It assumes that banks can flexibly adjust assets and liabilities to attain the desired GAP. • It focuses only on the current interest sensitivity of the assets and liabilities, and ignores the effect of interest rate movements on the value of bank assets and liabilities.