ASSET – LIABILITY MANAGEMENT
Dr Sotiris K. Staikouras
DESCRIPTION & EDUCATIONAL OBJECTIVES
The discipline of asset-liability management (ALM) has gone through enormous
changes since the term was first coined in the late 1960s and early 1970s. From its
origins as a cash flow matching technique, ALM has now instituted the use of
advanced analytical techniques, quantitative finance tools as well as sophisticated
pricing formulas and hedging strategies. The course brings the risk management of
both sides of the balance sheet together in a unified framework. The module focuses
on the management of financial intermediaries, and aims to analyse financial risks,
choose appropriate hedging strategies and monitor their implementation. The prime
objective of these lectures is to provide a) a thorough grounding in the way banks
and insurance firms operate, b) the necessary theoretical knowledge and statistical
tools to measure different kinds of risks, and c) a comprehensive examination of the
techniques and instruments for managing those risks in the banking and insurance
industry. The lectures are highly participative and there will be practical case-studies
in measuring and managing interest rate risk, FOREX exposure, market risk, as well
as credit allocation and capital adequacy.
LEARNING OUTCOMES
Upon completing the course, the participants will:
! Have a clear understanding of the ALM theory, which imposes distinctive
managerial challenges in today’s fast changing financial markets
! Have a deep awareness of the vocational aspects of financial risk management
along with the ALM strategies applied in banks and insurance firms
! Be able to address and tackle key issues such as:
• Measuring and managing various risks in modern financial institutions
• Applying hedging strategies to enhance the intermediary’s risk-return
profile
• Identifying complex ALM issue within financial conglomerates and
universal banks
! Be able to contribute to the shaping and implementation of an institution’s ALM
policy
TEACHING FORMAT
The course consists of 10 lectures of 3 hours contact time each. In addition, the
participants will be expected to devote, roughly, an equivalent amount of learning
time in private and group study of the course material. The preparation of the group
project will involve additional time in private study and independent empirical
research.
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Asset-Liability Management
LECTURES
The module’s aims and the intended learning outcomes will be addresses in a series
of lectures. The lectures will embody activities such as formal lectures, participative
discussions, problem solving, and analysis of case studies or research papers with
relevance to the course.
x Lecture 1
Overview of ALM & the risks of FI
x Lecture 2
GAP analysis & IR risk exposure
x Lecture 3
IRR, balance sheet immunisation & hedging strategies
x Lecture 4
FOREX risk measurement & hedging
x Lecture 5
Liquidity risk analysis
x Lecture 6
Credit risk analysis & measurement
x Lecture 7
Loan portfolio management & concentration risk
x Lecture 8
Market risk capital & IMA
x Lecture 9
Credit risk capital & Basel
x Lecture 10
Synopsis of the course, review questions and problem solving
SYLLABUS
A brief description of the aforementioned lectures is given below. A more detailed
outline of the issues examined will be given at the beginning of each lecture.
x Overview of asset-liability management
The theory of ALM, The risk-return trade-off in ALM, The goal of ALM, The
process of ALM, Developments in ALM, The spread of FI and the ALM, The main
theories in ALM, The financial sector, Sources and uses of funds of FI,
Introduction to the risks of FI (Interest rate risk, Trading risk, Credit risk, Offbalance sheet risk, Technology/operational risk, FOREX risk, Country/sovereign
risk, Liquidity risk), Interaction among risks, Other risks in the financial system,
ALM: An introduction to IR risk, GAP analysis and management.
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Asset-Liability Management
x GAP analysis & IR risk exposure
Cases in monitoring the balance sheet (sensitivity analysis), Multi-period GAP and
profitability analysis, Preparing and interpreting the GAP report, Active GAP
management, Asset and liability restructuring, Managing a positive GAP,
Empirical issues in GAP management, Factors affecting the GAP strategy,
Managing a negative GAP, GAP analysis, IR changes and the NIM, Review of GAP
analysis, The maturity model, Portfolio of A/L, The timing of cash flows, The
duration model, Duration and IR elasticity, Duration and the value of equity, The
adjusted for convexity model, The repricing model, RSA – RSL, A cumulative
alternative, GTA ratio, Problems with the model, New empirical suggestions.
x IRR & Balance sheet immunisation
Overview of derivatives instruments, Forward vs Futures, Hedging IR risk using
forward contracts, Hedging IR risk using futures, Macro-hedging, Micro-hedging,
Selective hedging, Routine hedging, Adjustments for basis risk, Options and the
balance sheet exposure, Hedging the duration GAP with options, Hedging
instruments for borrowers, The use of caps, Hedging IR risk for lending FI, The
use of floors, Hedging IR risk with synthetics, The use of collars, A numerical
application of hedging strategies.
x FOREX risk measurement & Hedging
Fundamentals of FOREX risk, FX trading activities, FX trading and sources of FX
risk, FX quotations, FOREX exposure, A/L approach of FX risk, FOREX GAP
analysis, Multi-currency ALM, Measuring FOREX volatility, Implementing the
DEAR approach, The BIS proposal, Mismatched currency composition, Onbalance-sheet hedging of FX risk, Off-balance-sheet hedging of FX risk, Currency
futures, Spot-Futures perfect correlation, Basis risk, Currency options, Hedging
FX sensitive assets, Hedging FX sensitive liabilities.
x Liquidity risk analysis
Causes of liquidity risk, Liquidity risk at depository institutions, Asset conversion
and liquidity, Liability-side liquidity risk, Asset-side liquidity risk, Measuring a DI's
liquidity exposure, Liquidity planning, Funding risk versus cost, Crises and
liquidity, Volatility and liquidity, Unexpected deposit drains, Bank runs, The
discount window, Deposit insurance, Continental Illinois 1984, Basel and liquidity,
Liquidity in life insurance, Liquidity in general insurance, Liquidity in investment
funds, Lender of last resort, The complicated nature of liquidity.
x Credit risk analysis & Loan portfolio management
Different kinds of loans, The fundamentals of credit risk analysis, Default risk
models, Qualitative models, Idiosyncratic factors, Market factors, Credit scoring
models, Linear probability model, Logit/Probit modelling, Linear discriminant
models, Term structure derivation of credit risk, Mortality rate derivation of credit
risk, RAROC models, An option theory approach to the value of bank debt and
equity, Option models of default risk, Merton’s model, KMV model, Loan portfolio
risk, Simple approaches, MPT approach, Loan volume approach, Loan loss ratio,
KMV portfolio manager model, Hedging credit risk, CQS, Credit forwards, Stock
index futures, Put index options, Put option collateral, Credit spread call option,
Digital default option, CAT insurance futures, CAT call spread, Credit
securitisation, Double credit securitisation: The SBC case.
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Asset-Liability Management
x Market risk capital & IMA
Overview of market risk management, Fundamentals of VAR models, VAR and
CAR in ALM, VAR Vs CAR, Loss distributions and VAR, Issues in measuring VAR,
Intuition of CAR models, JPM’s RiskMetrics Model, Fixed income investment,
FOREX trading, Equity investment, Portfolio effects, Regulatory models, The
1993-95 BIS proposal, Internal models approach (IMA) for large banks, Case
study: Barings and VAR, Summary of VAR and CAR framework.
x Credit risk capital & Basel
The role of capital, The cost of equity capital, Capital and insolvency risk, Market
values and insolvency risk, Credit and IR risk, Book values and insolvency risk,
Credit and IR risk, The discrepancies between market and book values,
Arguments against market value accounting, Issues in capital adequacy, Capital
to asset ratio, RBC ratios, Calculating RBC ratios, Distinction of capital classes,
Risk adjusted assets, Risk adjusted on balance sheet assets, Risk adjusted off
balance sheet assets, Risk adjusted value of derivative instruments with netting,
Criticism of RBC ratios, Capital requirements for other FI, Securities firms, Life
insurance, P/C insurance.
ASSESSMENT
Assessment will be based on the successful completion of a coursework and a 2¼hour examination. The written examination and the coursework count for 70% and
30% respectively. The module is highly vocational and the participants will have to
apply their theoretical, computational, and/or quantitative skills where necessary.
The coursework should demonstrate a sufficient understanding of modern financial
markets.
Note: Past exam papers are published for illustrative purposes only. They
can be used as a study aid, but do not provide a definitive guide to either the format
of the next exam, the topics that will be examined or the style of questions that will
be set. Students should not expect their own exam to be directly comparable with
previous papers. Remember that a degree requires an amount of self-study, reading
around topics, and lateral thinking. The lecturer will provide specific guidance
regarding your exam structure.
Coursework
The coursework should be done in groups of minimum two (2) and maximum four
(4) people. A typed report, of approximately 3,000 words, should be uploaded to
Moodle by the end of week six (6).
!
Extensions will only be given in exceptional circumstances, and under the joint
approval of your personal tutor and the course director. Projects, which will not
meet all the aforementioned requirements, will not be accepted.
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Asset-Liability Management
Coursework topic
Students are required to analyse and review the liquidity risk exposure of the
banking sector. Discussion and analysis of banks that have gone through liquidity
crises is central to the current survey. Students are strongly advised to compare
and contrast the pertinent empirical and/or theoretical studies found in the academic
literature.
READING LIST
Given the broad nature of this course, no single textbook will suffice. A detailed
reading list will be given in each individual lecture. Nevertheless, the following
material along with the financial papers will provide a guideline to the topics covered
in the course. Books followed by a tick (ü) are useful for your lectures and
assignment(s). Books followed by a + are helpful for beginners to clarify basic
concepts; while books followed by a O are helpful for general knowledge, regardless
of the course you study.
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Arnott R.D. – F.J.Fabozzi “Active asset allocation” Rev. Ed. Irwin.
Bessis J. “Risk management in banking” Wiley.
Campbell T.S. - W.A.Kracaw “Financial risk management” Harper Collins.
Casu, B. – Girardone, C. – Molyneux, P. “Introduction to banking” FT – Prentice
Hall.
Dowd, K. “Beyond VAR: The new science of risk management” Wiley.
Fabozzi F.J. “Pension fund investment management” FJF.
Fabozzi F.J. “Managing institutional assets” Harper & Row.
Fabozzi F.J. – A.Konishi “The handbook of asset-liability management” Rev. Ed.
Irwin.
Gup B.E. – J.W. Kolari “Commercial Banking: The management of risk” Wiley.
Gardner M.J. – D.L.Mills “Managing financial institutions: An asset-liability
approach” Dryden – Only 3rd Edition.
+
Glantz M. “Managing bank risk” Academic Press.
Gup B.E. – R.Brooks “Interest rate risk management” Probus.
Heffernan S. “Modern banking” Wiley.
Jorion, P. “Value at Risk: The new benchmark for managing financial risk”
McGraw-Hill.
Jorion P. – S.J.Khoury “Financial risk management” Blackwell.
Kamakura Corp. “Asset and liability management: A synthesis of new
methodologies” Risk.
Leibowitz M.L. – L.N.Bader - S.Kogelman “Return targets and shortfall risks”
Irwin.
Malkiel B.G. “A random walk down Wall Street” Norton.
O
Marrison, C. “The fundamentals of risk measurement” McGraw-Hill.
Saunders A. “Credit risk measurement” Wiley.
Saunders, A. – M.M.Cornett “Financial institutions management: A risk
management approach.” McGraw-Hill. ü
• Schroeck, G. “Risk management and value creation in financial institution.” Wiley.
• Uyemura D.G. – D.R.Van Deventer “Financial risk management in banking”
Probus.
• Vaitilingam R. “The FT guide to using the financial pages” FT – Prentice Hall.
O
• Van Deventer D.R. – K.Imai – M.Mesler “Advanced financial risk management”
Wiley.
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Asset-Liability Management
Ø Baker, J.V. Jr. (1978a) To Meet Accelerating Change: Why you Need a Formal
Asset-Liability Management Policy. Banking Journal 70, June, 33-43.
Ø Baker, J.V. Jr. (1978b) Asset/Liability Management (II): Three Ways to Get There
– and How to Read ‘Road Signs’ Along the Way. Banking Journal 70, July, 78114.
Ø Baker, J.V. Jr. (1978c) Asset/Liability Management (III): The Liability
Management Method Demonstrates Six Principles. Banking Journal 70, August,
74-78.
Ø Baker, J.V. Jr. (1978d) Asset/Liability Management (IV): System Method of
Asset/Liability Management: What is it, How it Works. Banking Journal 70,
September, 114-162.
Ø Baker, J.V. Jr. (1978e) Asset/Liability Management (V): A Model Asset-Liability
Management Policy. Banking Journal 70, October, 82-88.
Ø Baker, J.V. Jr. (1980) Riding the Rates or Asset-Liability Management Revisited.
Banking Journal 72, August, 57-62.
Ø Baker, J.V. Jr. (1986) Everything you Ever Wanted to Know about A/L
Management…..and weren’t Afraid to Ask. Banking Journal 78, October, 66-70.
Ø Lamm-Tennant J. (1989) Asset-liability management for the life insurer:
Situation analysis and strategy formulation. Journal of Risk and Insurance, 501517.
Ø Smink M. – R.A.H.Van der Meer (1997) Life insurance asset-liability
management: An international survey. The Geneva Papers on Risk and Insurance
22:128-142.
Ø Staikouras, S.K. (2003) The interest rate risk exposure of financial
intermediaries: A review of the theory and empirical evidence. Financial Markets,
Institutions and Instruments 12:257-289.
Ø Staikouras, S.K. (2004) A chronicle of the banking and currency crises. Applied
Economics Letters 11:873-878.
Ø Staikouras, S.K. (2006) Financial intermediaries and interest rate risk: II.
Financial Markets, Institutions and Instruments 15:225-272.
Ø Van der Meer R. – M.Smink (1993) Strategies and techniques for asset-liability
management: An overview. The Geneva Papers on Risk and Insurance 18:144157.
Ø Vij M. (2001) Asset liability management in banks and financial institutions.
Journal of Management Research 1:111-120.
In addition to the above, journal articles, research papers and case studies will be
distributed, where necessary, to update your knowledge given the fast-changing
environment where financial institutions operate.
Contact
Open door policy during office hours – no appointments needed. Please note that
emails sent by students from non-university accounts and outside business hours,
during weekends and bank holidays will be filtered out. Student who cannot come
during office hours, they’ll need to book an appointment.
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Asset-Liability Management
My Personal View about Studying and Learning
My objective is to teach you some aspects of asset-liability management. From my
own perspective there is a big difference between lecturing and teaching. The
latter is usual much harder and time consuming. Thus, I shall try to do my best to
offer you my own knowledge and experience within the current framework. It is
important to note, however, that this learning process needs your own effort
and contribution much more than mine.
Although the current set of notes is quite detailed, I shall avoid providing exhaustive
guidance since it encourages participants to fall into a passive and even lethargic
mode at the expense of lateral thinking. Falling into such mode could be proved
detrimental during any assessment and later in the professional arena. Thus, it
becomes your responsibility to organise the main ideas of the course in a way that
makes them meaningful to you.
To successfully achieve a marketable learning curve, students should participate in
all learning activities. The latter requires that students a) attend all lectures and
tutorials, b) actively participate in all additional workshops provided and c) prepare
their own set of notes rather than solely relying on the distributed material. Such
notes should include material from the class discussions, from prescribed textbooks
as well as from any other readings that the students believe to be relevant.
Finally, may I say this to you, “Take time to work hard and discover things,
for this is the seed of wisdom and the price of success”.
Short Bio
Sotiris K. Staikouras currently serves as associate professor of banking & finance at
Bayes Business School, City, University of London. His major research interests are
bank risk analysis and management, financial intermediation, asset pricing
and financial modelling. Dr Staikouras has worked as a research advisor at
London Clearing House and has delivered training courses for other institutions. He
served as the Director of various Undergraduate and Postgraduate programmes. He
holds a Ph.D. degree in finance from City University Business School (CUBS). His
research has been covered by the media and has been published in various US and
European journals.
Email: sks@city.ac.uk
More information at:
https://www.bayes.city.ac.uk/faculties-and-research/experts/sotiris-k-staikouras
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