If on 1st of month you lend some funds on long term and you borrow some in short term. In such scenario, by mid-month you may not have enough liquidity. ALM engine can identify and report such liquidity gaps ahead of time.
The ALM takes Asset type into account and allows you to segregate all the assets according to the time buckets. This helps in liquidity calculation.
Objectives of ALM
Manage liquidity risk
Foreign currency risk
Interest rate risk
Overview of features in ALM
Advances, Term loan, Working Capital, Overnight Deposits are all assets.
Investments of type Equities and Bonds are also assets.
Cash is also an asset
Market Repo is an asset
Repo is a repurchase agreement is when Anil gives Mike his Dell Server Machine for £1000, with a promise of purchasing it back for £1100 after 2 months. It’s Repo for Anil and reverse-repo for Mike.
Current account deposit, or term deposit money received by the bank are liabilities.
Certificate of Deposit [CDs]
CD’s help banks raise cash. Let us say bank sells CD’s to people which is valued at GBP 1000. But the bank will sell this for GBP 950/- i.e. at discount. At the end of term, bank will pay that person back £1000/-. This is exactly the same thing as Commercial Paper. This is liability as well, because it needs to be paid back.
Borrowings - Banks borrowing the money from one another. The borrowed money is again a liability.
Reverse Repo is a Liability
There are a lot of risks that banks are exposed to. The risk managed by ALM module is the market risk. OFSAA lets you calculate each of these risks via differing products.
Let’s say you do a transaction to buy assets or to buy bonds or commodities or anything with interest rates. If there is any loss in any of these, it is a position risk.
Exchange Rate Risk
The most obvious exchange rate risks are those that result from buying foreign currency denominated investments. The commonest of these are shares listed in another country or foreign currency bonds.
Interest Rate Risk
If you take a loan at 6% but market interest rate becomes 5%, then it becomes an interest rate risk.
Investment assets in equities carry a risk if the stock markets go down.
Risk that counterparty might not meet its obligation. There are three categories
Performing or normal assets
We still have to allocate some amount for things going bad
Here we calculate bigger amount
Here we provision for a lot of amount.
A counterparty may not be able to make a full payment when due is classed as a liquidity risk. If the counterparty defaults, then bank will not be able to meet funds obligation requirements. Another example is where a lot of people try to withdraw money from ATM, then the bank must be able to pay that money. For this reason, the central banks monitor the banks continuously to ensure that the retail customers do not suffer. When the counterparty is not making payment in full, then it becomes a liquidity risk. Also if the bank does not have sufficient funds to meet its obligation this is a liquidity risk.
A bank may have a lot of assets, but on one particular day the bank may have high liability and if the bank cannot liquidate assets to cover liability then it becomes a Market liquidity risk. For this reason, OFSAA bifurcates the assets into time buckets, so that ALM can monitor market liquidity risks.
This risk is because of the failure in system, for example the economic crises. If on a particular date you want money, but on that day your securities are not tradable. Inability of one party to fulfil their obligation will affect another causing domino effect.
If foreign currency fluctuations impact the profitability it becomes a translation risk. This can happen if a bank has various overseas branches.
When there is a lot of outflow in case of huge withdrawals, then it is called a funding risk. In such cases you need to replace it with higher cost of funds. Another funding risk is the time risk, if you can’t realise the commitment in time, and you need to compensate for non-receipt of the expected inflows of the funds. If a borrower needs to pay but cannot pay on that date, then it is a time risk.
Bank Guarantee Risk
For example, if you are a trader doing a deal with another trader. When you want to buy some goods, the other trader requires some bank guarantee before shipping the goods. The risk is on both the sides though, because if the buyer gives money but seller does not deliver goods. This is where the intermediary comes into the play whereby the bank gives a guarantee to the seller. Although the bank may have given a guarantee on behalf of the buyer, but yet bank does not make the payment. However for the bank a liability exists in case buyer does not make the payment to the seller on the due date. This is called off balance sheet liability. This liability is not shown in the balance sheet, but appears in the notes.
Measurement of Liquidity Risk
Current Asset divided by Current Liability, loans/assets, loans/core deposit ratio, risk assets/total assets. These are static ratios and can be calculated only when balance sheets are ready. Even the most aggressive banks do these calculations only on a monthly basis.
However, OFSAA also makes it possible to perform dynamic Liquidity analysis. In here, we make time buckets, how much my balance sheet will mature by a “as of date”. “As of date” how my assets and liabilities are placed. You plot the assets into maturity dates and likewise you also plot the liabilities. For simplicity, Outflows are your liabilities, and Assets are inflows. But this is not a thumb rule.
When you disburse a loan, you have to fix a limit for the customer. Even though customer may ask for 100K, but as per your analysis, you could give 200K. The limit you have given to the customer is 200K, which means remaining 100K can be a potential outflow.
If the mismatch between asset and liability becomes negative, then you need to enter a trade to ensure you get a level of cash coming in the relevant time bucket. You can generate new borrowings on those particular dates. The banks monitor liquidity on a daily basis, and can borrow to ensure they remain liquid.
Interest rate sensitivity statement in OFSAA
Here we are bifurcating the assets into rate sensitive and rate insensitive assets. OFSAA allows you to allocate assets and liabilities into interest rate sensitive buckets. Fixed assets like buildings are not rate sensitive. Cash is not rate sensitive either. However fixed deposits are interest rate sensitive.
You may buy a bond for £1000 with coupon of £100.
After two months, I can buy same bond again @990 but will still get coupon payments of £100. In that case the yield to maturity will increase. Hence bank identifies which asset and liabilities are sensitive to interest rate, and you plot those in OFSAA. And then you calculated gap of Asset-Liability. If this gap is negative then you have an issue, so you need to buy assets into those buckets. Basically, the bankers will try to keep bank insulated from interest rate fluctuations and hence they will try to keep the gap to zero, so that banks are not affected.
For 5 yr loan you may get 12% rate, but to raise cash for 1 year you may be paying only 4%. This how banks typically make money.
However, if you give a loan to business for let’s say five years, and raise funds for 1 yr, then after 1 yr you need to find money to pay to the business that has taken a five years loan from you.
Duration of Asset must be lower than duration of the Liability.
Therefore you cannot give loans over 2 yrs when you have funding [liability] available only for 8 months. OFSAA reports allow you to identify these funding gaps.
written by replica blancpain , July 11, 2012