CHAPTER 8
RISK MANAGEMENT:
ASSET-LIABILITY
MANAGEMENT (ALM) AND
INTEREST-RATE RISK

Chapter 8
1
LEARNING OBJECTIVES
TO UNDERSTAND…
 Risk management as driven by the R in
TRICK – risk exposure
 Asset-liability management (ALM) as the
coordinated management of a bank’s on- and
off-balance sheet activities driven by interestrate risk and its two components: price risk
and reinvestment risk
 Accounting and economic measures of ALM
performance
Chapter 8
2
LEARNING OBJECTIVES
(continued)
TO UNDERSTAND…


The duration or maturity imbalance (“gap”)
in banks’ balance sheets in terms of ratesensitive assets (RSAs) and rate-sensitive
liabilities (RSLs)
ALM risk profiles as pictures of banks’
exposure to interest-rate risk and how to
hedge that risk using on- and off-balance
sheet methods
Chapter 8
3
CHAPTER THEME



The business of banking involves the
measuring, managing, and accepting of risk
This chapter focuses on asset-liability
management (ALM) and interest-rate risk
ALM is the coordinated management of a
bank’s balance sheet to take account of
alternative interest-rate, liquidity, and
prepayment scenarios
Chapter 8
4
Asset-Liability Management
(ALM)
Three techniques of ALM:



On-balance sheet matching of the
repricing of assets and liabilities
Off-balance sheet hedging of onbalance sheet risks, and
Securitization, which removes risk from
the balance sheet
Chapter 8
5
R in Trick – Risk Exposure


Risk Exposure calls for Risk
Management
Basic Exposures Banks Face Arise
From:



Credit Risk
Interest-rate Risk
Liquidity Risk
Chapter 8
6
ALM As Coordinated BalanceSheet Financial Management
Three Stage Approach:



Stage I – Reflects a global or general approach that
focuses on the coordinated management of a bank’s
assets, liabilities, capital, and off-balance sheet
activities
Stage II – Identifies specific components of a bank’s
balance sheet used in coordinating its overall
portfolio management
Stage III – Shows that, given interest rate and
prices, a bank’s balance sheet generates its incomeexpense statement and free cash flow
Chapter 8
7
Balance Sheet Generates the
Income-Expense Statement

Policies to achieve objectives:







1. Spread management
2. Loan quality
3. Generating fee income and service charges
4. Control of noninterest operating expenses
5. Tax management
6. Capital adequacy
7. Hedging practices
Chapter 8
8
Rate Sensitivity



An important distinction should be made
between assets and liabilities that are rate
sensitive and those that are not (RSA, RSL)
Sensitivity can be described in terms of the
effective time to repricing or duration
Reserves and other liquid assets reprice
quickly while long-term, fixed-rate securities
and loans do not; since most deposits are
short term, they reprice quickly
Chapter 8
9
Liability-Management (LM)
Aspect of ALM
Two Functions:

Reserve-Position LM

Generalized or Loan-Position LM
Chapter 8
10
Target Net Interest Income
(NII)

Minimization of the variability of NII

Most critical determinant of a bank’s
profitability is credit risk. Viewed in
terms of a bank’s risk index (RI):
RI = [E(ROA) + CAP]/sROA
Chapter 8
11
Net Interest Margin (NIM)

NIM can be viewed as the “spread” on
earning assets, hence the term “spread
management” and “spread model”
NIM = Net Interest Income/Average Total Assets
Where NII = Interest Income – Interest Expense
Chapter 8
12
Why Does NIM Vary Inversely
With Bank Size?

Competitiveness of the loan-and-deposit
markets are a major factor

Differences in the volumes, mixes, and
pricing (interest rates) of the balance sheet

Banks with more variable-rate loans will
experience greater fluctuations in interest
revenue
Chapter 8
13
Variability of NIM Versus ROA




Time period: 1985-2000
NIM
ROA
Mean 3.64%
0.88%
S.D.
0.18%
0.38%
CV
0.05
0.43
Chapter 8
14
Effects of InterestRate Risk on Loans

Effects on the Loan Portfolio

Interest Rates (Up)

Old Loans Worth Less
New Loans Worth More

Adverse Price Effect

Favorable Reinvestment Effect
Interest Rates (Down)

Favorable Price Effect

Adverse Reinvestment Effect
Chapter 8
Old Loans Worth More
New Loans Worth Less
15
Effects of InterestRate Risk on Deposits

Effects on Deposits

Interest Rates (Up)



Early Withdrawal (Depositors Seek Higher Rates)
Banks Must Attract New Depositors at Higher Rate
or Face Liquidity Problems
Interest Rates (Down)


Loan Prepayments Due to Refinancing
Banks Must Issue New Loans at Lower Rates or
Face Shrinking Balance Sheet
Chapter 8
16
Risk Profiles and Embedded
Options



Loan contracts: When interest rates
decline, borrowers tend to refinance –
prepayment risk
Deposit contracts: When interest rates
rise, lenders might be willing to take
penalties for early withdrawal – liquidity
risk
See Figure 8-1, p. 225
Chapter 8
17
Two Faces of ALM: Accounting
and Economic Perspectives


The accounting model focuses on NII
and NIM vis-à-vis measures of maturity
gap
The focal variable of the economic
model is a bank’s market value of equity
(MVE)
Chapter 8
18
Relationship Between Change in
Interest Rate and Change in NII
Δ



NII = Δr[GAP]= Δr[RSA-RSL]
GAP is the difference between rate-sensitive
assets (RSA) and rate-sensitive liabilities
(RSL).
When RSA – RSL > 0, bank has positive
maturity gap
When RSA – RSL < 0, bank has negative
maturity gap
Chapter 8
19
General Illustration of the
Accounting Model
Δr
+
GAP=[RSA-RSL]
=
Pos +
Neg
=
Neg
Pos +
Pos
=
Pos
Neg +
Pos
=
Neg
Neg +
Neg
=
Pos
Chapter 8
Δ
NII
20
The Economic Model and a
Bank’s MVE





Table 8-4, p. 229
MVE reduced to 1.8 = 10 – 8.2
The duration approach approximates
this change at –8.5, that is,
[89.4(-4.17) – 87.6(-1)]0.03 = -8.5
The next slide explains duration
Chapter 8
21
Duration (Box 8-2, p. 230)


Duration can be viewed as the
“effective time to repricing”.
Take the difference between the
market value of assets and the market
value of liabilities with each component
weighted by its respective duration
multiplied by change in interest rate:
ΔV
≈ [PV(A)x(-DA) ΔrA-[PV(L)x(-DL)] ΔrL
Chapter 8
22
Variable-Rate Pricing as an
ALM Tool



If the loan reprices annually, then the
bank has a built-in hedge against rates
rising
The hedge, however, is not perfect as
MVE is not immunized
To achieve this a solvent bank must be
slightly asset sensitive
Chapter 8
23
Determinants of the Change in
MVE (see eqn 8.4b, p. 232)




Duration gap adjusted for leverage –
the first term below
Scale (size) of a bank’s operations – the
second term
Magnitude of the change in interest
rates – the third term
ΔV ~ -[DA - λDL][A][Δr/(1+r)]
Chapter 8
24
The Tactical Versus the Strategic
Bank and Yield Curves



See Box 8-3 (p. 233), Figures 8-2 (p. 234)
and 8-3 (p. 235), and Table 8-5 (p. 236)
Exploit a positively shaped yield curve by
borrowing short and lending longer, but not
too long – avoid the old S&L problem
Tactical Bank (LRBA) + Strategic Bank (ARBL)
= Overall Bank (ARBL)
Chapter 8
25
Interest-Rate Derivatives (IRDs)



Off-Balance sheet activities (OBSAs)
that ALM managers use for hedging or
trading.
Includes forwards, futures, options, and
swaps.
Four or five of the largest banks/BHCs
dominate the IRD market.
Chapter 8
26
Examples of InterestRate Derivatives

Interest-rate swap (“plain vanilla”)

Interest-rate futures

Interest-rate cap

Interest-rate floor

Interest-rate collar

See Glossary in Box 8-4, p. 238
Chapter 8
27
Citigroup’s IRDs
(30 September 2000)









Type
Notional value ($ mils)
Swaps
3,655,151
Forwards
926,933
OTC Options
538,634
Futures
285,765
Exchange options
37,754
Total
5,444,237
Net Fair Value:
306
Ratio of Notional to Fair Value: 17,792 to 1
Chapter 8
28
Relationships between IRDs and CashMarket Instruments and Among IRDs





Figure 8-4 (p. 239)
Credit risk and performance period
Forward: pure credit instrument with
performance at maturity
Futures: Guaranteed contract with daily
performance (mark-to-market)
Swaps: Interval performance
Chapter 8
29
Swap Building Blocks


A swap can be viewed as a portfolio of
forward contracts
A swap can be viewed as a portfolio of
cash-market contracts, e.g., a pay fixedreceive floating swap is the same as
borrowing at a fixed rate and lending at
a floating rate
Chapter 8
30
RISK PROFILES AND
HEDGING



A LRBA bank has a negatively sloped
risk profile
An ARBL bank has a positively sloped
risk profile
Hedging profiles depend on the type of
contract. Futures, forwards, and swaps
are “linear” while options (caps, floors,
collars) are “nonlinear”
Chapter 8
31
Micro and Macro Hedges



Macro => hedge the balance sheet’s
MVE
Micro => hedge a particular transaction
Examples of micro hedges (pp. 242243)




1.
2.
3.
4.
Convert
Convert
Convert
Convert
a
a
a
a
fixed-rate loan to floating
floating-rate loan to fixed
fixed-rate deposit to floating
floating-rate deposit to fixed
Chapter 8
32
Swaps: Comparative Advantage
and Arbitrage Potential


Analyze the following situations:

1.
AAA
BBB
10% fixed
12% fixed
LIBOR + 0.1% LIBOR + 1%

2.
LIC
Bank
Asset
T-bill+1% (6mos.) 8% (fixed,5yrs)
Liability 7% (GIC,5yrs) T-bill+0.25% (6 mos. CD)
Construct swaps for both situations (pp.
244-245) and assume A, L = $50 million
Chapter 8
33
Caps, Floors, and Collars




See Figures 8-7, 8-8, 8-9 (pp. 246-248)
Buy cap + sell floor = collar (Fig. 8-7)
Buy floor + sell cap = collar (Fig. 8-9)
The use of collars by LRBA and ARBL
banks
Chapter 8
34
Asset Securitization


Technique for managing interest-rate
risk by removing risky assets from the
balance sheet.
Pass-through finance – banks either

(1) originates and sells loans or

(2) originates, sells, and services loans
Chapter 8
35
Building Blocks of ALM
Four key building blocks of ALM:
 Measurement of dollar gaps based on maturity
buckets (0-90 days, 91-180 days, etc.) to determine
the amount of assets and liabilities being repriced;
 Estimating the interest rate at which these funds will
be repriced;
 Projecting future interest income and interest
expense (rate x volume);

Exploring alternative interest-rate scenarios to
estimate the bank’s downside vulnerability.
Chapter 8
36
Risk Management
Quotes
The fact is that bankers are in the business
of managing risk. Pure and simple that is the
business of banking, Walter Wriston, former
Chairman of Citicorp
Risk management is perhaps the central
topic of the 1990s among managers of
financial institutions and their regulators, The
Economist
Chapter 8
37
Modern Risk Management


Key actions of bank risk management can be
highlighted by five action verbs: identify,
measure, price, monitor, and control.
Two important concepts:


Value-at risk (VAR) – A comprehensive measure
of risk.
Capital-at-risk (KAR) – KAR tolerance level
captures the default probability of the bank in
terms of its insolvency risk or risk of ruin.
Chapter 8
38
Criticism of ALM



ALM is balance-sheet oriented and therefore
not easily adapted to OBSAs.
ALM measures, which are interest-rate based
(gaps and duration) are not necessarily easy
to translate across other asset classes.
ALM provides little mechanism for arriving at
an overall risk level for a firm and is not
easily adapted to a risk-adjusted-return
framework.
Chapter 8
39
CHAPTER SUMMARY


Risk management is the heart of bank
financial management and ALM is one of the
most important risk-management functions in
a bank
ALM techniques include



1. Maturity or duration matching of on-balance
sheet items
2. Off-balance sheet hedging using IRDs
3. Securitization
Chapter 8
40