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Treasury and Asset-Liability Management (ALM)
Essay Contents:
- Essay on the Meaning of Asset-Liability Management (ALM)
- Essay on the Liquidity Risk and Interest Rate Risk
- Essay on the Role of Treasury in ALM
- Essay on the Significance of Asset Liability Management
- Essay on the Purpose and Objectives of Asset Liability Management
- Essay on the Use of Derivatives in ALM
- Essay on Credit Risk and Credit Derivatives
- Essay on Transfer Pricing
- Essay on Policy Environment
- Essay on ALM as Co-Ordinated Balance Sheet Management
1. Essay on the Meaning of Asset-Liability Management (ALM):
Modern banking may be defined as maturity intermediation or risk intermediation. Bank collects deposits from customers with various maturities ranging from 7 days to 5 years (though there is no bar on longer-term deposits, major banks discourage deposits for longer-terms in order to avoid interest rate risk).
The funds so collected along with capital funds and call borrowings are lent to borrowers with varying maturities, ranging from an overdraft for a few days to mortgage loans of, say 15 years. Thus the bank modifies and extends maturities which the retail depositors themselves could not afford to.
Similarly while the depositors have assured safety of funds together with interest, the bank does not have the same comfort while lending or investing funds in various avenues fraught with market risk and credit risk – thus the bank also absorbs risk which individual depositors could not on their own do.
While credit risk of a bank is obvious and is managed conventionally through effective credit supervision, what is not so obvious is the market risk, which is manifest as liquidity risk and interest rate risk in banking operations.
The risk is spread all over the balance sheet of a bank. To illustrate, assume that the bank has accepted a deposit of 3 years at 8% p.a. and has been using funds to provide a 90-day bill discounting facility to a borrower company. Over the first year interest rates start declining and by second year let us say the bank is no longer able to charge over 7% on the working capital loan.
Clearly there is a negative earnings for the bank as the deposit has a fixed rate of interest, while the bill discounting facility is to be repriced every 90 days (effectively, floating rate of interest). In another context, assume that the average deposits of the bank are of one year maturity, while they have extended quite a few mortgage loans with average maturity exceeding over 5 years at a fixed rate.
Firstly the bank will face a liquidity problem when large deposits are to be paid out and secondly, the bank would have to accept fresh deposits or borrow from inter-bank market at current rates to meet such obligations. If current interest rates are higher than the contracted rates on mortgage advances, the mismatch in interest rates leads to negative spread, or reduction in net interest income (Nil).
The risks arise out of mismatch of assets and liabilities of the bank and asset-liability management is managing such balance sheet risks. The risks, if not controlled, may result in negative spreads or in erosion of net worth. ALM is therefore defined as protection of net worth of the bank.
Because the business of banking involves the identifying, measuring, accepting and managing the risk, the heart of bank financial management is risk management. One of the most important risk-management functions in banking is Asset Liability Management (ALM).
Traditionally, administered interest rates were used to price the assets and liabilities of banks. However, in the deregulated environment, competition has narrowed the spreads of banks. This not only has led to the introduction of discriminate pricing policies, but has also highlighted the need to match the maturities of the assets and liabilities.
The changes in the profile of the sources and uses of funds are reflected in the borrowers’ profile, the industry profile and the exposure limits for the same, interest rate structure for deposits and advances, etc. The developments that have taken place since liberalisation have led to a remarkable transition in the risk profile of the bank.
Asset Liability Management is concerned with strategic balance sheet management involving risks caused by changes in interest rates, exchange rate, credit risk and the liquidity position of bank. With profit becoming a key-factor, it has now become imperative for a bank to move away from partial asset management (Credit and Non-Performing Asset) and partial liability management, towards an integrated balance sheet management where all the components of balance sheet and its different maturity mix will be looked at profit angle of the bank.
Asset Liability Management (ALM) is the act of planning, acquiring, and directing the flow of funds through an organisation. The ultimate objective of this process is to generate adequate/stable earnings and to steadily build an organisation’s equity over time, while taking reasonable and measured business risks.
ALM is therefore, the management of the Net Interest Margin (NIM) to ensure that its level and riskiness are compatible with risk/return objectives of the bank. So ALM is more than just managing individual assets and liabilities categories well. It is an integrated approach to Bank Financial Management requiring simultaneous decision about the types and amount of financial assets and liabilities it holds or its mix and volume. In addition ALM requires an understanding of the market area in which the bank operates.
The strategy of actively managing the composition and mix of assets and liabilities portfolios is called balance sheet restructuring. In this approach, bank managers make efforts to adjust and readjust their portfolios in response to corporate objectives, economic conditions and future interest rate scenario to prevent undesirable imbalance between asset and liability maturities.
Asset Liability Management can hence be broadly defined as co-ordinated management of a bank’s balance sheet to allow for alternative interest rate, liquidity and prepayment summaries. It is a flexible methodology that allows the bank to test inter-relationships between a wide variety of risk factors including market risks, liquidity risk, management decisions, uncertain product cycles, etc.
2. Essay on the Liquidity Risk and Interest Rate Risk:
i. Liquidity:
Liquidity and interest rate are two sides of the same coin, as the liquidity risk translates into interest rate risk, when the bank has to recycle the deposit funds or rollover a credit on market determined terms. However banks are extra sensitive to liquidity risks, as they cannot afford to default or delay meeting their obligations to depositors and other lenders.
Even suspicion of pressure over a bank’s liquidity may prompt a run on the bank, or indeed, threaten the very survival of the bank. Hence special attention is paid to liquidity, in particular short-term liquidity (intra-day to one month) to ensure funds are promptly made available when they are needed.
In ALM, assets yield income, hence are shown as cash inflows, while liabilities need to be repaid, hence are shown as cash outflows. Asset-liability mismatch is therefore, a cash flow mismatch, with excess inflow or outflow of funds. If part of inflow or outflow is denominated in foreign currency, there is also currency mismatch which needs to be managed by the Treasury.
Liquidity implies a positive cash flow. It is not only cash surpluses retained by the bank, but also other sources where cash can be readily drawn, such as committed credit lines from other banks, liquefiable securities and nostro balances. The available cash resources are compared with immediate liabilities of the bank in the given time range and the net liquidity is worked out.
In different time bands, the loans falling due for repayment constitute main source of funds, while the deposits and other obligations maturing during the same time band constitute uses of funds. (In both cases interest flows are also considered as and when they arise.) The difference between sources and uses of funds in specific time bands is known as liquidity gap which may be positive or negative. The liquidity gap arises out of mismatch of assets and liabilities of the bank.
RBI has prescribed time bands (1 to 14 days, 14 to 29 days, 1 month to 3 months etc.) for measuring and monitoring liquidity gaps. ALM process involves plotting of assets and liabilities maturity wise in time buckets and measuring the gap between assets and liabilities maturing in a specific time period. Liquidity risk is reflected as maturity mismatch – which is the gap in cash inflow and outflow. The risk is not being able to find enough cash, or cash at acceptable rate of interest, to fund the gap.
Liquidity risk will also arise if the liquidity in market dries up and the bank is not able to dispose of its liquid securities without suffering a loss, or if the liquefiable securities suddenly become ‘illiquid’. The Bank should hence take in to account, the marketability of securities, while classifying them as liquid instruments in the nearest time buckets.
RBI from time to time issues detailed guidelines for managing ALM risks. RBI is more particular about short-term liquidity, ranging from intra-day to one month. Current guidelines stipulate that the net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5%, 10%, 15% and 20% of the cumulative cash outflows in the respective time buckets.
Banks are required to provide in their Liquidity Management Policy, contingency measures to meet any shortfall in liquidity. The contingency measures may include stand-by credit lines from other banks, liquid investments and maintenance of adequate securities (in excess of minimum requirement) to facilitate borrowing under Liquidity Adjustment Facility of RBI/ or under CBLO.
ii. Interest Rate:
Interest rate risk arises when interest earnings are not adequate to set off interest payments due in a given period, even if the book value of the asset equals that of the liability, owing to a change in market rates of interest.
Net interest income (NII) of the bank is the difference between interest earnings and interest payments in a given accounting period. Hence interest rate risk may be defined as the risk of erosion of Nil, on account of interest rate movements in the market.
In a hypothetical situation, let us assume that the Bank has mobilized deposits of Rs. 100 cr., with average maturity of 6 months, at 5% interest. Let us also assume that the bank invested the amount in a fixed interest loan payable after 5 years at 7% p a. the NII is a clear2% or Rs. 2 cr. per year.
The deposits mature after 6 months and need to be replaced or recycled at current market rate, say, at 6% as interest rates have risen by that time. The interest on loan continues to be 7%, hence NII for second half of the year is reduced by 1%. If we assume that the deposits become even costlier after next 6 months, demanding renewal at market rate of say, 8%, the NII actually becomes negative by 1%. However, if deposit rates fall by 2%, the NII correspondingly rises for the specific period.
In a reverse situation, a deposit for 5 years may have a fixed interest, while the deposit funds are deployed, say, in discounting 3-month usance bills, to start with, with a positive spread. If the interest rates fall, subsequent discounting of bills may earn lower rate of interest, in line with market rates, while cost of deposit remains fixed, thereby adversely impacting the NII.
The risk of erosion of NII is on account of deposit rates being floating (repriced every 6 months), while the loan interest is fixed (repriced only after 5 years when the funds are available for fresh lending, on repayment of the loan), or vice versa. The interest rate mismatch is therefore also known as repricing risk.
Repricing risk exists where, in a given time bucket, say 6 months to 1 year, the assets and liabilities which are due for repricing are not equal. A tier-2 bond maturing after 7 years with fixed interest rate of 7%, is not due for repricing during 6m – 1yr time bucket, hence is not sensitive to changes in market price. However a loan getting repaid during this period is due for repricing, as fresh lending can take place only at market rates. The bond amount appears in the 5-7 year time bucket, while the loan amount appears in the 6M – 1yr time bucket, revealing a interest rate mismatch in both cases.
For the purpose of ALM, all assets and liabilities are placed in time buckets, based on their repricing dates (i.e., when the interest rate is due for a change). The mismatch in each time bucket is measured as a gap between rate sensitive assets and rate sensitive liabilities. The mismatch may be measured either in absolute amounts, or as sensitivity ratio, or as a % of rate sensitive assets to rate sensitive liabilities. The mismatch presents a risk to the NII, hence is to be monitored regularly, with pre-set limits.
It is possible to reduce the mismatch by swapping floating rate to fixed rate or fixed rate to floating rate, that is, by using derivative instruments.
RBI stipulates capital adequacy requirement for market risk, which includes interest rate mismatches. Capital is also to be provided for any derivatives (forwards, options and swaps) used to bridge such mismatches. RBI is recommending simplified approach under Basel 2, for determining the capital requirement for derivative instruments.
The gap management is only one way of monitoring ALM. There are other methods for measuring asset-liability mismatches, using VaR, Present Value, duration and simulations which would make ALM more effective.
3. Essay on the Role of Treasury in ALM:
The core function of Treasury is fund management. It automatically engulfs liquidity and interest rate risks, as the treasury maintains the pool of bank’s funds.
We may briefly explain the relationship between Treasury and ALM as under:
i. The balance sheet of a bank carries enormous market risk (in addition to credit risk), but the banking operation itself is confined to accepting deposits, and extending credit to needy borrowers, besides miscellaneous payment services. It is Treasury which operates in financial markets directly, establishing a link between core banking functions and market operations. Hence the market risk is identified and monitored through Treasury.
ii. The asset-liability mismatches cannot be ironed out as the assets or liabilities cannot be physically moved across the time bands. It may also be noted that bank earns profits out of mismatches and it is not really advisable to remove the mismatches completely from the balance sheet. Treasury uses derivatives and other means, including new product structures to bridge the liquidity and rate sensitivity gaps.
iii. Treasury, while taking trading positions in forex and securities markets, is also exposed to market risk on its own creation. Sometimes the risks are compensatory in nature and help bridge the mismatches on banking side. The Treasury may therefore hedge only residual risk.
iv. As the markets develop, many credit products are being substituted by treasury products, For instance, bank may subscribe to commercial purpose, instead of extending working capital to an entity. Treasury products are marketable and hence liquidity can be infused in times of need. Treasury also monitors exchange rate and interest rate movements in the markets, and hence it is much easier to administer such risks through treasury operations.
It is for the above reasons that operations relating to market risk management have become an integral part of treasury. In many banks, either ALM desk is part of dealing room, or, ALCO support group is part of treasury team. The Treasury head is always an important member of ALCO, contributing not only to risk management but also to product pricing and other policy issues.
4. Essay on the Significance of Asset Liability Management:
Why do we need asset liability management? In simple terms – a financial institution may have enough assets to pay off its liabilities. But what if 50% of the liabilities are maturing within 1 year but only 10% of the assets are maturing within the same period. Though the financial institution has enough assets, it may become temporarily insolvent due to a severe liquidity crisis.
Thus, ALM is required to match the assets and liabilities and minimise liquidity as well as market risk. Asset-liability management can be performed on a per-liability basis by matching a specific asset to support each liability. Here you ensure that for every liability, there is an equivalent tenure and amount matching asset.
Again even if the assets and liabilities maturity is matched to a large extent, the interest rates can change during the period thereby affecting the interest income from assets and interest expenses on liabilities. Depending upon the movement of interest rates the net interest margin may increase or decrease result in corresponding increase or decrease in profit during a certain period.
Asset liability management views the financial institutions as a set of interrelationships that must be identified, coordinated and managed as an integral system. The primary management goal is the control of interest income and expenses and the resulting net interest margins on an ongoing basis.
Some of the reasons for growing significance of Asset Liability Management are:
i. Volatility:
Deregulation of financial system changed the dynamics of financial markets. The vagaries of such free economic environment are reflected in interest rate structures, money supply and the overall credit position of the market, the exchange rates and price levels. For a business, which involves trading in money, rate fluctuations invariably affect the market value, yields/costs of assets and liabilities, which further affect the market value of the bank and its Net Interest Income (NII).
ii. Product Innovation:
The second reason for growing importance of ALM is the rapid innovations taking place in the financial products of the bank. While there were some innovations that came as passing fads, others have received tremendous response. In several cases, the same product has been repeated with certain differences and offered by various banks. Whatever may be features of the products, most of them have an impact on the risk profile of the bank thereby enhancing the need for ALM. For example, Flexi- deposits facility.
iii. Regulatory Environment:
At the international level, Bank for International Settlements (BIS) provides a framework for banks to tackle the market risks that may arise due to rate fluctuations and excessive credit risk. Central Bank in various countries (including Reserve Bank of India) has issued frameworks and guidelines for banks to develop Asset Liability Management policies.
iv. Management Recognition:
All the above-mentioned aspects forced bank managements to give a serious thought to effective management of assets and liabilities. The management have realised that it is just not sufficient to have a very good franchise for credit disbursement, nor is it enough to have just a very good retail deposit base. In addition to these, a bank should be in a position to relate and link the asset side with liability side. And this calls for efficient asset-liability management.
There is increasing awareness in the top management that banking is now a different game altogether since all risks of the game have since changed.
5. Essay on the Purpose and Objectives of Asset Liability Management:
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 ratio. Thus, purpose of Asset Liability Management is to enhance the asset quality; quantify risks associated with the assets and liabilities and further manage them.
Such a process will involve the following steps:
i. Review the interest rate structure and compare the same to the interest/product pricing of both assets and liabilities.
ii. Examine the loan and investment portfolios in the light of the foreign exchange risk and liquidity risk that might arise.
iii. Examine the credit risk and contingency risk that may originate either due to rate fluctuations or otherwise and assess the quality of assets.
iv. Review the actual performance against the projections made and analyse the reasons for any effect on the spreads.
The Asset Liability Management technique so designed to manage various risks primarily aim to stabilise the short-term profits, long-term earnings and long-term substance of the bank.
The parameters that are selected for the purpose of stabilising Asset Liability Management of banks are:
i. Net Interest Income (NII)
ii. Net Interest Margin (NIM)
iii. Economic Equity Ratio.
A brief description of these parameters is given below:
i. Net Interest Income (NII):
The impact of volatility on the short-term profit is measured by Net Interest Income.
Net Interest Income = Interest Income – Interest Expenses.
In order to stabilise short-term profits; banks have to minimise fluctuation in the NII.
ii. Net Interest Margin (NIM):
Net Interest Margin is defined as net interest income divided by average total assets.
Net Interest Margin (NIM) = Net Interest Income/Average total Assets.
Net Interest Margin can be viewed as the ‘Spread’ on earning assets.
The net income of banks comes mostly from the spreads maintained between total interest income and total interest expense. The higher the spread the more will be the NIM. There exists a direct correlation between risks and return. As a result, greater spreads only imply enhanced risk exposure. But since any business is conducted with the objective of making profits and achieving higher profitability is the target, it is the management of risks that holds key to success and not risk elimination.
iii. Economic Equity Ratio:
The ratio of the share-holders funds to the total assets measures the shifts in the ratio of owned funds to total funds. This fact assesses the sustenance capacity of the bank.
Objectives of ALM:
At macro-level, Asset Liability Management leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies. And at micro-level the objectives of Asset Liability Management are two folds. It aims at profitability through price matching while ensuring liquidity by means of maturity matching.
a. Price Matching:
Price Matching basically aims to maintain spreads by ensuring that deployment of liabilities will be at a rate higher than the costs. This exercise would indicate whether the institution is in a position to benefit from rising interest rates by having a positive gap (assets > liabilities) or whether it is in a position to benefit from declining interest rates by a negative gap (liabilities > assets).
b. Liquidity:
Liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. The gap is then assessed to identify future financing requirements. However, there are often maturity mismatches, which may to a certain extent affect the expected results.
6. Essay on the Use of Derivatives in ALM:
Derivative instruments are useful in managing the liquidity and interest rate risks, as also in structuring new products which help overcome market risk to a large extent. Derivatives replicate market movements, and hence can be used to counter the risks inherent in regular transactions.
For instance, if we are buying a stock which is highly sensitive to market movements, we can sell index futures as an insurance against fall in stock prices. The advantage in derivatives is that the requirement of capital is very small, and largely there is no deployment of funds (except in case of exchange a traded instrument, where there is a margin requirement – but it is only a fraction of notional amount).
Derivatives can be used to hedge high value individual transactions, or aggregate risks as reflected in the asset-liability mismatches. In the latter case a dynamic management of hedge is necessary as the composition of assets and liabilities is always changing. The following illustrations show how derivatives can be used to manage ALM risks.
Assume that the bank is funding a medium-term loan of 3 years with deposits having average maturity of 3 months. A short-term deposit or borrowing in inter-bank market is much cheaper than a 3-year deposit; hence many banks have resorted to funding their regular loans from short-term resources in order to increase their spreads. There is however, liquidity risk as the bank needs to payback the short- term deposits much earlier to repayment of the 3-year loan. There is also interest rate risk as the deposits will be repriced 12 times during the life of the loan.
The interest rate on the deposit is akin to a floating rate, as the bank has to pay the market rate of interest whenever the deposit is recycled (repriced). Market rates can be benchmarked to risk-free interest rates, say, 91-day T-bill rate in the above case. The bank may therefore swap the 3-month interest rate into a fixed rate for 3 years, so that its interest cost is also fixed and the spread over the loan is protected.
Note that the derivative transaction is independent of the banking transaction. Under the swap the bank is receiving floating rate linked to T-bill, which meets the (basic) cost of the deposit. The bank is paying fixed rate under the swap which now is effectively the cost of the deposit. The 3-month deposit is now as good as a 3-year deposit. Fixed interest income from the loan less the swap cost of deposit, is gross margin (spread, or net interest income) which is now protected from market risk.
As an alternative, the bank may swap fixed interest rate on the loan into floating rate linked to T-bill rate. Assume that Alco prices the three month deposit at 91 day T-bill + 1% and the swap rate of the loan yields T+ 3 %. There is a clear spread of 2% in bank’s favour protected throughout the life of the loan.
Treasury often arbitrages in foreign currencies. The bank may borrow, say for 6 months, in USD and lend equivalent Rupee funds in domestic market. USD funds cost around 3% while the Rupee loan yields, say, 6.5% for the same period. The spread is a clear 3.5% for the bank. The Treasury takes care of exchange risk by paying a forward premium of 1.5%. The bank then earns a spread of 2% (= 3.5 – 1.5) without any exchange risk. The forward premium is the cost of hedge against the currency risk. Treasury can thus supplement domestic liquidity and also ensure a positive spread for the bank.
Treasury may also hedge currency mismatches resulting from foreign currency operations of the bank. For instance, Treasury may buy call options to meet repayment of FC loans, or buy put options to protect value of foreign currency receivables in domestic terms.
Treasury enables the bank in structuring new products which help reduce the mismatches in the balance sheet. Floating rate deposits and floating rate loans, where the interest rates are linked to a benchmark rate have become fairly popular. In securities market, we have govt. securities where interest rate is linked to rate of inflation.
Protection against rate rise is inbuilt in the index-linked bonds. Corporate debt paper is also issued with call and put options, to suit the risk appetite of individual investors. The embedded options are also useful to improve the liquidity of the investment. For instance, a 7-year bond issue with a put option at the end of 3rd year is as good as a 3-year investment.
Use of derivatives however is subject to certain limitations. It is assumed that the bank’s products are priced rationally. If the interest rates on deposits and loans are not based on benchmark rates, interest rate swaps may not be really helpful. Even when the interest rates are fairly aligned, the product prices may not exactly move in line with market rates, hence the Treasury may not be able to provide a perfect hedge.
ALM uses broad time bands, hence even after using appropriate hedges, the market risk may not be completely mitigated – the residual risk is called basis risk. There are embedded options in certain bank products – for instance, a fixed deposit or a term loan can be prepaid, and such prepayment escapes ALM analysis and cannot be fully hedged. Finally, the preconditions for efficient use of derivatives are that the derivative market should be well developed; and the dealers in treasury should have adequate skills in using and pricing derivatives.
7. Essay on Credit Risk and Credit Derivatives:
Treasury and Credit Risk:
Treasury is mostly concerned with market risk. Credit risk in treasury business is only with respect to counterparty dealings, contained by exposure limits and risk management norms. In normal course, treasury operations are untouched by the credit risk present in bank’s lending business.
However, there are two ways in which Treasury may get intertwined with banking operations in the credit area. Firstly there are several treasury products, or more correctly debt-market products, such as commercial paper and bonds, which are credit substitutes. Highly rated companies prefer issue of debt paper to bank credit, as cost of credit (interest rate) is relatively lower in the debt market – where in addition to banks, there are other investors (insurance companies, mutual funds etc.) who may invest in debt instruments.
Instead of lending to a company, the bank may also prefer to invest in corporate bonds through the Treasury. While credit risk in a loan and bond is similar, unlike a loan, bond is tradable and hence is a more liquid asset. The bank has an easy exit in that the bond can be sold at a discount if the credit status of the issuer deteriorates.
While a loan is normally with a fixed rate of interest or interest linked to PLR of the bank, the bond is priced in the market on the basis of credit quality and interest rate movements – hence, the bond can be marked-to-market as frequently as required, for assessing potential gain / or loss. The non-SLR investment portfolio of treasury, which supplements bank’s credit portfolio, is therefore more flexible and ideal from ALM point of view.
Secondly, there are new products which convert conventional credit into tradable treasury assets. The process is called securitisation, whereby credit receivables of the bank can be converted into units or bonds (often called pass-through certificates – PTCs) that can be traded in the market. For instance, the mortgage loans of a bank can be securitised and issued in the form of PTCs through a special purpose vehicle (SPV) – which amounts to sale of bank’s loan assets.
Securitisation infuses liquidity into the issuing bank, and frees capital blocked in such assets for fresh lending. Several banks have used the securitisation route to encash their future receivables, not only in respect of long-term loan assets, but also of medium-term retail assets such as consumer loans. Banks with surplus funds can also invest in such PTCs, through their Treasury, as a means to expand their credit portfolio indirectly.
Credit Derivatives:
Credit derivatives have come into vogue only in the last 10 years. Credit derivatives segregate credit risk from loan/investment assets. The instruments, known as credit default swap or credit linked certificate transfer the credit risk from owner of the asset to another person who is in a position to absorb the credit risk, for a fee.
There is a protection buyer, say a bank, a protection seller who may be another bank or an investor, and a reference asset – which may be a large corporate loan or a bond or any other debt obligation. The protection seller guarantees payment of principal or interest or both, of the reference asset owned by the protection buyer, in case of credit default (or, a credit event defined in the contract). In consideration of the protection, the protection buyer pays a premium (akin to a guarantee fee) to the protection seller.
Credit derivatives (CD) help the issuer diversify the credit risk and use the capital more efficiently. The CD is a transferable instrument, though the market for CDs is not very liquid. The CD products are still emerging and various covenants related to the transaction are incorporated in the ISDA Master Agreement for Credit Derivatives.
The global financial crisis (2008-2009) brought out some negative aspects of credit derivatives, which in fact, aggravated the crisis.
Following two aspects have been of prime concern to the regulators as well as market payers:
i. Banks and investment institutions (in particular, in US, U K and Europe) have rather been negligent in assessing the credit quality of the assets, as they could securitise the assets as soon as they are acquired, or transfer the credit risk to a third party who would sell them credit default protection (by issuing credit default notes or credit linked notes) for a small fee. The protection however is not perfect, as there is a counter party risk (the credit status of protection provider), which replaces the underlying credit risk of the loan.
The lending bank (or the institution originating the loan) also needs to provide credit enhancement, by retaining part of the underlying risk. During the crisis period, credit quality of the assets (mainly home loan mortgages) as well as credit status of the protection providers deteriorated very fast, threatening the survival of some large commercial and investment banks. Finally the governments / central banks had to come to rescue by lending against weak assets (troubled assets) to infuse liquidity and support shrinking capital of the banks.
ii. Credit Derivatives are highly leveraged as the protection fee or the credit default spread is a tiny portion of notional value of the underlying credit. As there is no initial investment, credit derivatives are highly profitable so long as credit default does not take place. Trading in credit derivatives became very active, particularly as some of the investment institutions and fund managers created credit default swaps based on synthetic assets (virtually, without underlying credit).
Once the mortgage crisis hit the underlying credit market, the protection value offered by these institutions almost disappeared, further spreading the crisis to protection sellers like investment banks and insurance companies. This necessitated huge bail-outs from governments, as the entire financial system was at risk if some of these large institutions were to go into bankruptcy.
For the above reasons, Reserve Bank of India has been very cautious in introducing credit derivatives in India. Recently RBI has circulated draft guidelines for credit derivatives, and would take a decision in due course based on responses from banks and other market players.
8. Essay on Transfer Pricing:
Transfer pricing is an integral function of asset-liability management and is in the domain of bank’s treasury. Transfer pricing refers to fixing the cost of resources and return on assets of the bank in a rational manner. The treasury notionally buys and sells the deposits and loans of the bank, and the price at which the treasury buys and sells forms the basis for assessing profitability of banking activity.
The treasury determines the buy/sell prices on the basis of market rates of interest, the cost of hedging market risk and the cost of maintaining reserve assets of the bank. For instance, the banking department may procure a deposit at 7% but the treasury buys the deposit only at its market cost, after adjusting to hedging and liquidity, say at 6% – the difference being the cost exclusively borne by the banking department.
Similarly the bank may lend at 10% and sell the loan to Treasury at transfer cost, say, 7% – the balance being risk premium earned by the banking section. The prices vary according to the tenor/maturity of the loan/deposit. There are of course different ways of arriving at transfer pricing and the bank has to formulate a conscious policy in this regard.
Once transfer pricing is implemented, treasury takes care of the liquidity and interest rate risks of the entire bank, and profits of credit department reflect only the credit risk, net of all mismatches of sources and uses of funds. In a multi-branch environment, transfer pricing is particularly useful to assess the branch profitability.
9. Essay on Policy Environment:
The asset-liability management will be effective, only if there is a strong policy foundation. Though in general we describe it as ALM Policy, the policy should aim at aggregate risk of the bank and should achieve coordination between different departments of the bank and treasury.
An Integrated Risk Management Policy, bearing upon Market Risk of the Bank, should ideally have the following components:
i. ALM Policy prescribes the composition of Asset Liability Management Committee (ALCO) and operational aspects of ALM, including risk measures, monitoring of risks, risk neutralization, product pricing, management information systems etc.
ii. Liquidity Policy prescribes minimum liquidity to be maintained, funding of reserve assets, limits on exposure to money market, contingent funding, inter-bank committed credit lines etc.
iii. Derivatives Policy prescribes norms for use of derivatives, capital allocation, restrictions on derivative trading, valuation norms, exposure limits etc.
iv. Investment Policy prescribes the permissible investments, norms re- credit rating and listing, SLR and Non-SLR investments, private placement, trading in securities and repos, classification and valuation of investments, accounting policy etc.
v. Composite Risk Policy for Foreign Exchange and Treasury prescribes norms for merchant and trading positions, securities trading, exposure limits, limits on intra-day and overnight positions, stop-loss limits, periodical valuation of trading positions etc.
vi. Transfer Pricing Policy prescribes the methodology, spreads to be retained by treasury, segregation of administrative costs and hedging costs, allocation of costs to branches/other departments of the bank etc.
As per RBI requirements, the above policies are also to be supplemented with Prevention of Money Laundering Policy and Hedging Policy for customer risks, both of which will have impact on bank’s treasury activity.
The Policies quoted above exclude Risk Management Policies for Credit Risk and Operational Risk, which are not in the purview of ALCO.
Essential requirements of all the above policies are:
(a) The policies are to be approved at the highest level, either by the Board or by a Board committee,
(b) The policies should comply with the extant regulations of RBI and other regulatory bodies such as SEBI, and
(c) The policies should also comply with the current market practices and code of conduct as evolved by SROs like FIMMDA and FEDAI.
There should also be a monitoring committee, comprising of senior executives of the bank, to ensure compliance with the Policy provisions. All the policies should be subject to annual review, and in most cases, there is a requirement to file a copy of the policy with RBI.
10. Essay on ALM as Co-Ordinated Balance Sheet Management:
The asset liability management function can be viewed in terms of two-stage approach to balance sheet financial management as follows:
i. Stage 1:
Specific Balance Sheet Management Functions:
Asset side Management will include:
i. Reserve position management
ii. Liquidity management
iii. Investment/Security Management
iv. Loan Management
v. Fixed-Assets Management.
Liability side Management will include:
i. Liability Management
ii. Reserve Position Management
iii. Long-Term Management (Notes and Debentures)
iv. Capital Management.
ii. Stage 2:
Income-Expense Functions:
Profit = Interest Income – Interest expense – provision for loan loss + non-interest revenue – non-interest expense – taxes
Banks are required to formulate policies to achieve following objectives of Asset Liability Management:
i. Spread Management
ii. Loan Quality
iii. Generating fee income and service charges
iv. Control of non-interest operating expenses
v. Tax Management
vi. Capital Adequacy.