ASSET LIABILITY MANAGEMENT FINACIAL INSTITUTIONS & SERVICES Sequence of Steps in ALM (Asset / Liability Management) ALM refers to simultaneous management of assets and liabilities of any financial institution to achieve its target RONW ( ROE) . HOW IS IT DONE? • 1. Managing the size of NIM • 2. managing the risk of NIM Step1. Managing the size of NIM • Set a RONW target for next year ( because co’s owners are most important, and the return on their investment is NI / OE) • Given the regulation about Capital Adequacy and Tax rate, set NIM target for The next year to achieve the target RONW. • Given the NIM target , set the targets for r (effective annual yield on assets) & c (effective annual yield on liabilities) • Given the targets r on assets, decide the amounts and yields (‘r’s) of different types of assets you want to have in your balance sheet . Similarly given the target ‘c’ on liabilities, decide the amounts and yield (‘c’s) of different types of liabilities you want to have in your balance sheet . Step 2. Managing the risk of NIM 1. By Restructuring the Balance Sheet • a) Rate sensitive GAP management • b) Duration GAP Mgmt. • Please note the restructuring needed to manage rate sensitive GAP may not be suitable to manage Duration GAP. So there is possibility that the management strategy for rate sensitive gap ( also called funding GAP, Maturities mismatching GAP) may go counter to the strategy for Duration GAP management; and manager may face a dilemma as to which GAP to manage and which GAP to leave un managed. 2. Without restructuring the Balance Sheet: by using financial derivative such as : • i-rate Futures contracts • i-rate Options contracts • i- rate Swap contracts • i-rate swap options • i-rate Caps, floors • you can achieve the same desired future CFs (cash flows) pattern by taking position in the above stated derivative contracts as you would achieve by restructuring the balance sheet. Exercise: • A financial Institution has target for RONW=30%. It earns 15% yield (r )on its assets, its tax rate is 60% . Govt.’s capital adequacy requirement is minimum 10% , its NIE / TA ratio is 2% and its TL / TA ratio = 90%. Required: • What should be its cost of funds to achieve target RONW? (i.e. c) • What should be is NIM to achieve target RONW? • If Govt. changes the Capital Adequacy rules and brings it at par with the int’l standards (4%), then what RONW it can expect to earn, keeping the target NIM same as in no. 2 above. Solution 1).NIM= {RONW * NW/TA * 1/(1-t)} + NIE/TA = r - (c * TL/TA) {0.3*0.10*1/(1-0.6)} + 0.02 = 0.15 - (c* 0.9) 0.095=0.15-0.90c 0.095 - 0.15= -0.90c -0.055= -0.90c 0.0611=c (i.e. 6.11%) 2. NIM= { RONW * NW/TA* 1/(1-t)} + NIE/TA = {0.3 * 0.1 * 1 / (1-0.6)} + 0.02 = 0.095 i.e. 9.5% 3. NIM= { RONW * NW/TA * 1/(1-t)} + NIE/TA 0.095= { RONW * 0.04 * 1/(1-0.6)} + 0.02 0.095 = (RONW* 0.1) + 0.02 0.095 - 0.02 = ( RONW * 0.01) 0.075/0.01= RONW 0.75 =RONW i.e 75% RESULT: When Capital Adequacy from 10% to 4%: • RONW from30% to 75% • Financial Leverage (TA / NW) is from 1/10% =10 time to 1/ 4%= 25 time • When FI Financial leverage its RONW • In good economic times , when revenue , high Fin leverage RONW • In bad economies when revenue , high Financial Leverage causes in RONW How to Financial Leverage ? • (TA/NW) i.e NW Multiplier ratio • (TL/ TA) i.e Debt Ratio • (TL / NW) i.e Debt Equity Ratio • to TA /NW , you can NW by : issuing shares to raise fresh equity, or increasing NI and therefore RE, or by only decreasing dividends and thus increasing RE without increasing NI. A FIs’ financial leverage should be adjusted according to the economic conditions in the country, and should be such that it does not violate minimum capital adequacy requirements. • In Recession: it is sensible to have Leverage and in Boom Leverage; but ability to correctly predict recession or boom for the next year is self questionable; please note that not many economist were correct in 2007 in predicting the ensuing recession of 2008-2009. • However, apart from economic conditions other variables have to be considered as well. • A bank can TL by decreasing the deposits by i-rates on deposits and thus discouraging depositors, or by minimum balance requirement of depositors , again to discourage depositors. EXERCISE A FI institution has c of 7% and r of 11%. It is operating at minimum capital adequacy of 4%. Tax rate is 50%. Its NIE / TA ratio is 3%. REQUIRED: 1. TL/TA ratio 2. NIM it can earn 3. RONW it can earn 4. If this bank has a target of 25% for its RONW then what NIM should it earn? 5. To achieve 5% NIM, what yield on assets this bank should earn? 6. What was the required %age change in NIM to achieve target RONW of 25% 7. Increasing NIM 16.82% caused what %age change in RONW 8. To achieve 16.82% increase in NIM, you needed to make what %age change in yield on assets ( r )? Solution 1) NW /TA is given 4%. TA = TL + NW. TA / TA = TL / TA + NW /TA 1 = TL /TA + 0 .04. TL /TA = 0.96 2) NIM = r - c * TL/TA. = 11% - 7%*0.96. =11% - 6.72%. = 4.28% 3) NIM = [ RONW * NW / TA * 1 / ( 1 – T)] + NIE /TA 4.28% = [RONW * 4% * 1 / (1 -0.5)] + 3%. 4.28% = [RONW * 4% * 2] + 3% 4.28% = [RONW *8%] + 3% 4.28% - 3% = RONW * 8% 1.28% / 8% = RONW 0.16 = RONW = 16% Solution 4) NIM = [RONW * NW / TA * 1 / (1 – T)] + NIE / TA = [0.25 * 0.04 * 1 / (1 –0.5)] + 0.03 = [ 0.02] + 0.03 = 0.05 = 5% 5) NIM = r – c* TL / TA 0.05 = r - 0.07 * 0.96 0.05 = r - 0.0672 0.05 + 0.0672 = r = r = 11.72% 6) (0.05 – 0.0428) / 0.0428 = 16.82% 7) ( 25% - 16%) / 16% = 56.25% 8)(11.72% - 11%) / 11% = 6.54% NOTE: A 6.54% increase in r caused 16.82% increase in NIM, and 16.82% increase in NIM caused 56.25% increase in RONW. This is a prove that FIs are highly leveraged businesses, and minor improvements on revenue earning side have magnified impact on return for owners; the same is true for cost cutting, a slight decrease in cost of funds would have magnified impact on RONW.