 The Risk and Return Tradeoff in ALM
 The Goal of ALM
 Types of Risk
 Which Risk Causes Banks to Fail?

Financial Organization Structure : Who Does ALM
 The ALM Process
The Characteristics of Successful Asset and Liability Manager

Banks offer multiple financial services through multiple departments and divisions
 All of the management decisions are intimately linked to each other
 In a well-managed bank all of these diverse management decisions must be coordinated
 Asset and liability portfolio must be looked as an integrated whole
 Asset-Liability Management Role
Dengan ALM/ALMA diharapkan :
1.
Adanya penetapan kebijakan bisnis yang jelas, terarah dan terukur
2.
Adanya arah dan tujuan yang jelas bagi manajemen dalam proses pelaksanaan tugas serta cara dalam menetapkan standar opearasional bank
3.
Diperolah data yang akurat yang akan menunjang keputusan ALMA
4.
Berkualitasnya analisis yang dilakukan dalam memberikan berbagai alternatif strategi ALMA sebelum manajemen mengambil keputusan
5.
Memudahkan dalam manajemen likuiditas sehingga dana dapat dikelola dengan baik pada tingkat suku bunga tertentu
8.
Mampu melakukan manajemen pricing secara tepat
Goal of ALM : to maximize the risk-adjusted return to shareholders over the long run
6.
Mampu meminimalkan gap
7.
Mampu mengambil keputusan yang tepat dalam mengelola valas
1.
Risk-adjusted Return
2.
Shareholders
3.
Long run
Types of Risk
 Credit Risk

Interest Rate Risk
 Foreign Exchange Risk
 Liquidity Risk

Operating Risk
 Capital Adequacy Ri
Credit Risk
The probability that the issuer of loan (debtor) or security will fail and default on any promised payment of interest or principal or both
Interest Rate Risk
The probability that rising or falling interest rates will adversely affect the margin of interest revenues over interest expenses or result in decreasing the value of net worth
 Foreign Exchange Risk
The risk of an investment's value changing due to changes in currency exchange rates.
 Liquidity Risk
The probability that an individual or institution will be unable to raise cash precisely when cash is needed at reasonable cost and in the volume required
 Operating Risk
Uncertainty surrounding a financial firm’s earning or rate of return due to failures in computer systems, management errors, employee misconduct s, floods, storm and similar events (natural disaster)

Capital Adequacy Risk
The probability that a financial institution or one of its borrowing customer will fail, exhausting its capital. Improperly allocated capital
Which Risks Cause Banks to Fail?
 There are 2 main factors for failures (large banking institution)
◦
The effects of significant credit losses
◦
Loss of liquidity
 Among smaller banking, a major factor in failure was fraud
Interest Rate Risk played substantial role in the number of failures during 1980
Financial organization structure: Who Does ALM ?
Departments involve in various aspects of asset liability management activies
 Controller
 Budgeting
 ALMController
Report historical financial performance

Budgeting / Financial Planning
Establishes the current year financial objectives of the bank. This is bottom-up process
 ALM
Forecasts the bank’s balance sheet, cash flow and income statement given changes or variances in the bank’s budget assumptions. This is top down process
The ALM Process
Steps involve in ALM
 Policies and guidelines
 Analysis
 Decisions
 Execution
 Evaluation
 Policies and Guidelines
Refer to setting up operating limits or boundaries for the risk and return trade-offs within which bank feels it can safely operate. The policies is prepared by ALCO (Asset and Liability Committee)
 Analysis
Refer to determining the bank’s current position in every risk dimension and where it is forecast to be for all future time periods.
Is Bank outside of its risk limit?
 Decisions
This responsibility of Bank’s ALM to decide where the bank risk position?
Two tipes of decision be made conceivably :
1.
To attempt to adjust the current or future risk position of the bank
to determine if the old risk limits are still appropriate for the bank
 Execution
Whenever ALCO decides to alter the risk profile of the bank, a set of incremental securities or off balance sheet positions must often be undertaken
 Evaluation
There should be a segregation of duty between execution unit and control performance unit
The Characteristics of a Successful ALM Manager
 It’s a collective duty among departments ; Controller,
Investment/funding, Scientist
 ALM requires a unique blend of skills and characteristics ; some of the most important attributes are as follows :
◦
Analysis
◦
Accountability
◦
Teaching
Chapter 2
The Nature of Risk, Return and Performance Measurement
What is Risk ?
 Risk refers to concepts of uncertainty
 Risk ; the volatility (standard deviation) of net cash flows of business unit
What is Return ?
 Common measurement : Net Income, Return on Asset (ROA), Return on
Equity (ROE)
 Problem; return should be measured in term of cash flow or market values rather than accounting terms
 There are 2 perspectives ; decision making and performance measurement
 We measure return confronted with a set of new business opportunities and risk involve
Net Income?
 Accounting measument of return or profitability
 Accepting all business opportunity without consider risk
 It violates the stated goal of ALM, which is to maximise risk-adjusted returns to shareholder
Return on Asset (ROA)
 Problem arises using this measurement
 Some activities do not have conventional balance sheet measure; trust, cash management, securities sales, SDB etc
(no Assets Involve)
 Shrink the Asset (one of portfolio of business) to improve
ROA
 Little incentive to seek out any new business
 New activity must generate ROA above average for the current portfolio

Return on Equity (ROE)
 Directly measure the investment return
 It is a step toward a risk-adjusted return concept
 However , as with using ROA, the easiest way to improve ROE is to shrink one of its portfolio
 New business will accepted if ROE higher than the current ROE
Shareholder Value Added (SVA)
 Shareholder Value Added (SVA) : Dollar earnings in excess of hurdle return on “ecomnomic” capital
 Hurdle Rate (expected return) = risk free rate + risk premium
 Eg: Average risk premium around 7%, current long bond yield 8%, thus hurdle rate for the bank is 15%
 For our next calculation we use 15% as hurdle rate
Return on Economic Capital (ROEC)
 This concept refers to the notion of economic capital allocations to business units
 Assuming capital allocation reflect some estimate of risk being undertaken by business unit
 ROEC = Earning of the Unit divided by capital allocated to it
 SVA concept is related to a dollar amount earning above the threshold, no shrinkage syndrome
 It promote finding good opportunities as well as ceasing inadequate activities
 It recognize the risk attribute
Summary
 The most rational measure is not the amount of earning
 Nor is it ROA, ROE
 The best measure is a hybrid concept : maximize dollar amount of earning in excess of the hurdle rate of return on capital
 SVA is a valid measure of the risk-adjusted return to shareholders. It will be consistent with our goal of ALM as long as it is applied as a long run concept
Chapter 3
Capital Regulation
Types of Capital
 Common Stock
 Preferred Stock
 Surplus
 Undivided Profits
 Equity Reserves
 Subordinated Debentures
 Minority Interest in Consolidated Subsidiaries
 Equity Commitment Notes
Reasons for Capital Regulation
 To Limit the Risk of Failures
 To Preserve Public Confidence
 To Limit Losses to the Federal Government Arising from Deposit
Insurance Claims
Federal Reserve Bank/ Central Bank provide emergency liquidity. Central Bank acts
As “Lender of last Resort”
National Banking Laws created a regulation to prevent “unsafe” or speculative growth by bank
 Regulation Q limited the interest rate could pay by bank
 Its prevented bank to grow in speculative manner
Insurance on deposit (FDIC, Blanket Guarantee, LPS)
In 1970 by Introducing MMMFs (Money Market Mutual Funds) set into motion end
Regulation Q
Higher Interest rate offer by other financial institutions (Insurance , mutual fund)
Capital Regulation Replaces Regulation Q
 New Risk-Constraining mechanism in Banking Industry  Capital
Regulation
 Central Bank/ Regulatory Agencies decided to focus on capital standard
Capital ratios as measurement, formulated of primary capital
Primary Capital: A Prescription for Higher Risk
 The major components of primary capital :
 Common Equity and Retained Earnings
 Preferred Stock
 Loan Loss Reserve
 Mandatory Convertible Notes (MCNs)
 The major trends that emerged as a result of primary capital :
 Decrease in liquid assets
 Sales of fixed assets
 Increase in off-balance sheet activities
 Decrease in liquid Assets
Pressure to improve capital ratios while improving earning assets led to decline in the holding of lower yielding liquid assets such as
 Sale of Fixed Assets
Banks sold its investment in real estate assets. This strategy contained double benefit ;
 converted hidden equity in the building
 Avoided the book tax provision on the gain and got the entire pretax gain into primary capital
 Increase in off-balance sheet activities
 Explosion of off-balance sheet risky assets as a source of revenue
 Off-balance sheet activities did not require capital
 However the riskiness of the industry increase as a direct result of the primary capital concept. This concept did not reflect actual financial risk
 Bank failures increased dramatically during 1980s (1037 banks compare with 81 in
1970)
The deisre level of International Playing Field
 A number of problems with primary capital and the use of regulatory capital :
 Decrease in liquid assets
 Increase in off balance sheet risk
 Sale of long term assets to recognize gains
 Bankers in US complain on unfairness regulations , Banks outside US were allowed to levered significantly more than US bank
Risk-Based Capital: Salvation or Panacea?
 Federal Reserve and Bank of England issued concept of “Risk Based
Capital” (RBC) in 1986
 It was issued to overcome the weaknesses of primary capital concept
 Reasons :
 To distinguish among the general riskiness of the major asset classes
 To reflect off-balance sheet risk in capital ratios
 To achieve consistency in capital standard among international bank
Risk-Based Capital : Illustrative Example
 Below is the illustrative example using a simple balance sheet
 For conventional, book equity to asset ratio = share holder equity divided by total assets
Total Asset = 400 Equity = 20
Equity to Asset Ratio = 20/400 = 5.00%
Basel Agreement Capital Requirements
 Ratio of Core Capital (Tier 1) to Risk Weighted Assets Must Be At Least
4 Percent
 Ratio of Total Capital (Tier 1 and Tier 2) to Risk Weighted Assets Must
Be At Least 8 Percent
 The Amount of Tier 2 Capital Limited to 100 Percent of Tier 1 Capital
Shortcoming of Risk-Based Capital
 There are some shortcoming of RBC:
1.
Credit is not only the risk, RBC ignored interest rate risk, liquidity, foreign exchange and operating risks
2.
Credit risk among loans is (almost) ignored
3.
Accounting capital definitions are used
Consequences of RBC Standards
 Cost of implementing and using RBC
 Modifying applications program
 Modifying accounting program
 Yet more emphasis on accounting measures of capital
 The loophole game
 Any capital standard that does not reflect all risk type cannot succeed
 Any use of accounting concepts to measure risk or capital cannot succeed
Administering the RBC Standard
 Regulatory capital should not be used to allocate capital or in measuring return
 What should banks do about the RBC standard :
“Always comply with the minimum regulatory capital standard”
Summary
 Regulation by capital was adopted to replace Regulation Q as growth and risk restraint on the banking industry
 All regulatory capital suffers from two serious weakness :
 They do not adequately reflect all of the risks
 They rely on accounting measures of capital ratio
 RBC was proposed to remove the disincentive to hold liquid asset, capture off balance sheet and to level playing field
 It is simplistic credit risk and its very labor and cost intensive to administer

Chapter 4
Using Market Signal in Loan Pricing and Capital Allocation
One Fundamental Problem with Bank
 Banks are not properly compensated for the credit risk they take
 Mispricing of credit is the main cause of the industry’s ill today, AAA rated company got the same interest rate with B rated company
 Prior 1970 banker had virtual monopoly on credit. Company did not have direct access to Money Market
 Loan pricing was adequate on average, but not within each rating category
 In 1980 were the first decade where the industry was left openly exposed to the consequences of its relatively indiscriminate pricing practice
 Problem for bank; not charged enough yield for lower-rated credit
 RBC suggested that all loans should loan be price identically, regardless credit rating
 Banker must adjust their pricing expectations to be more consistent with the clear signals offered by the money and capital market
 Classic reason ; market competition
Use of Market Signal in Capital Management
 Market Capital is the alternative method
 Market capital is market capitalization of the banking company, which is number of shares outstanding multiplied by its price per share
This concept satisfies the criteria established for a more effective alternative to regulatory capital
 Less expensive; market stock prices are readily available
 Encompasses all risk types
 No loopholes
 Utilizes market values rather than accounting concepts
Additional advantages of this approach are :
 It is fast : market capital maybe determined instatntly
 It is simple compared to the complexities of the risk-based capital calculation
 It is objective
Objections to and Disadvantages of using Market Capital Signals
 Many banks are not publicly traded; thousand of privately held banks have no market quotes
 “the market does not understand us” syndrome
 Market prices are too volatile
An Alternative approach for Market Capital
 For Non publicly listed bank , capital assessment should be based on the volatility of historical cash flows
 Bank’s Financial statement would be converted into economic cash flows (quarterly basis)
 Standard deviation of cash flow would be calculated for prior three or five year
 The value would be divided by the average cash flow level, its called
normalized standard deviation
The advantages of this procedures :
 Captures all sources all risk
 Broad applicability. It is universal and may be applied to any type of financial institution
 Simplicity: it is relatively simple compare with risk-based capital
 Robust ; the procedures does not have to modified for the emergence of new securities
Critical issue in this type of approach is the length of the historical time
 used to calculate standard deviation
Capital Allocations
Reasons to estimate capital allocations are:
 Unit or departmental profitability reports
 Product or service-line profitability analyses
 Loan pricing spread sheet
 Acquisition or divestiture decision
 Capital budgeting analyses
 We use cash flow and concept of annualized standard deviation of
cash flows
Advantages of this approach
 Easy to calculate
 Allows allocation across all product types
From table 4.1
 Target capital level of the bank is the amount of capital that the bank aspires to maintain over the long run
 Standard deviation for three products (add up value 18), standard deviation for total bank 12
Some observations on the Standard Deviation Method
Advantages using this method :
 Cash flows are relatively simple to measure
 Cash flow volatilities reflect all risks
 Cash flows are the basis for market valuations, so that this measure is consistent with a desire to use market signals or their closest substitute
Issues arise using this methods
 Diversification effects
 It seems to ignore the detailed effect of diversification
 Covariance analysis should be use
 Covariance reflect the diversification phenomenon in the way that the capital market do
 Author argues that using standard deviation automatically compensates for diversification effect
 Expected versus unexpected losses
 Allocating capital to start-up business unit
Access to New Capital
 One of the consequences of regulatory capital standard is to force large bank to raise new equity
 Raising capital can be a lose-lose situation if :
 Shareholder value is lost at least by the amount of underwriting fee
 The transactions may give management the luxury of not addressing more fundamental issues such as interest rate and credit risk . Regulator should look toward loan pricing and capital ratios based on market signals and economic risks
 Bank should not try to raise more equity unless they can convince the market that they will use the new capital to create shareholder value
(positive SVA)
 New equity is not to reduce risk
 Any Banks that have positive and sustainable SVA will have access to all the capital through the market place
Issues in Implementing Market Capital Measure
 If this method get approval to evaluate capital adequacy, the simple approach would be to utilize market capital ratios based upon 90 days moving average of market closing prices.
 If market capital ratios were to drop below the target level, making a plan to improve the ratio over 12 months to correct the situations
 If further deterioration result, the regulator should do some combination of the following
 Increase the FDIC insurance premium rate (rate penjaminan-LPS)
 Announce a reduction in the percentage coverage deposits
 Close the Bank
 In those cases where market signals do not exist, the standard deviation method may be applied
How not to Implement a Market Approach
 Certain regulatory agencies force bank to apply mark to market on its portfolio, but not on the rest of the balance sheet
 If marked to market adjustment is desired, it should be done on the entire on and off balance sheet
 Market signal provide current, complete adjustments for all sources of volatility from every known activity of organization
Summary
 Capital allocation is one of the most important of all financial activities
 It provides a critical mechanism in risk adjusting performance measure.
 Market signals provide the best set of benchmarks to utilize in gauging the propriety of either loan pricing or capital allocation
 The advantages of using market signal ; accessible, respond to quick change, fully encompass adjustments for all sources of risk volatility