Forum Asset Liability Management

Bank Liquidity Risk Management: Reporting and MetricsAsset Liability Management Forum MWB, Canary Wharf 17 November 2009 Professor Moorad Choudhry Europe Arab Bank... Introduction • Liqu

Gautam Mitra

Forum on Asset Liability Management

• Background and overview of Asset and Liability Management

• Asset and Liability Management applied to Banks

• Asset and Liability Management applied to Insurance

Companies

• Asset and Liability Management applied to Pension Funds

• Asset and Liability Management: Other application areas

• Industry insights, technology, products and services

• Directory of Asset Liability Management Solution and Service

Providers

• Bibliography

Forum on Asset Liability Management

Con Keating

Forum on Asset Liability Management

It is impossible to achieve demonstrably true knowledge about

our universe or ourselves

Nor is logic decisive No kind of reasoning can ever give rise

to a new idea.

Hume

Liability Driven Investment

The PPF

• The PPF reported investment returns for 2008/9 of 13.4% including swaps versus a target of 6.2%

• Ex swaps the return was -3.4%

• Long dated gilts moved just 3 basis points in this year

• But swaps versus gilts (25 year) compressed by 61 basis points

• This is a return equivalent of 14.5%

• This is the principal source of the swap performance.

• Swaps were trading 45 basis points through gilts

• Having been 100 basis points through earlier in the crisis

• It is a staggering basis risk for the ALM position.

• Why does the PPF own swaps which yield less than gilts?

• A UK corporate borrowed £100 million as a 12 year floating rate

note paying 5/8% over interbank offered two years ago.

• They swapped this for fixed paying 5.5%

• They entered a credit support agreement for the swap, under which cash collateral could be called.

• Swap rates declined to 4.00%

• They were called for collateral of £12.2 million

• This was cash they did not have and were forced to borrow from their bank on adverse terms

• The cost of the financing has risen dramatically

• The effective term of the financing has shortened

• The basis risk is enormous

The individual

• Only 20% of personal wealth takes the form of financial assets and property.

• 80% is human capital to be consumed and converted to other

wealth over the future life time.

• Many other institutions share this property of future income

• Pension schemes are one example

• The status quo is simply an accrued endowment - the present

value of future contributions can dominate this entirely.

A pension scheme

• Once future contributions are considered

• The optimisation problem is no longer maximisation of current asset values at either short or long horizons

• The new contributions can be thought of as consuming investments

• And for those we want the price of investments to remain low

• The ALM problem is dramatically different

• Think about a coupon bond when prices decline and yields rise

• The realised total return increases due to the higher reinvestment rates

• We no longer want high market (beta) returns since these hurt our new money contributions

• But we do want returns which are independent of the market

• And that is the case for Alpha

BrightonRock Policy

• Institutionalises this insight contractually

• It stabilises the current value of the portfolio

• By removing short term concerns

• Allowing long term investment

• And lowering scheme financing costs

Michael Dempster

Forum on Asset Liability Management

Elena Medova

Forum on Asset Liability Management

Moorad Choudhry

Forum on Asset Liability Management

Bank Liquidity Risk Management: Reporting and Metrics

Asset Liability Management Forum

MWB, Canary Wharf

17 November 2009

Professor Moorad Choudhry

Europe Arab Bank

Introduction

• Liquidity management has emerged as the dominant

element of bank asset-liability management in the post

2007-08 crisis era

• Measuring and managing liquidity risk is an art rather

than a science and should be undertaken with prudence

and a close eye to the particular bank’s own risk-reward

profile and operating model

A common approach…

• Management often direct Treasury and money market desk

behaviour by assigning simple targets (e.g the Loan-to-Deposit

ratio, or target deposit levels)

• Market best practice is for more than the single liquidity metric

(LTD), to a broader set of measurements and reports (to

complement the LTD)

• For instance, the LTD is the best metric to measure the

contribution of customer funding The LTD, however, is not

predictive, and is blind to duration, concentration and volatility, three

critical aspects of liquidity Finally, it is not always “aggregatable”.

• Liquidity forecasts should be upgraded to incorporate better

estimates of deposits/withdrawals on the deposit side, drawings

of unused direct commitments on the loan side, and assessment

of the quality/liquidity of our near-cash assets

• Post-Lehmans, a bank ALM crisis may arise from a negative gap

situation, a withdrawal of customer deposits or loss of interbank

liquidity, among other scenarios

What to Look For from Liquidity Data

Self-sufficiency and supportiveness of a business unit

terms

Overall level of exposure to roll risk

Early warning of funding stress points

Specific daily funding needs

Metrics: Five Liquidity Reports

• Loan-to-Deposit Ratio

• 1 Week & 1 Month Liquidity Ratios

• Cumulative Liquidity Model

• Inter-company Lending Report

• Liquidity Risk Factor These reports measure and illustrate different elements of liquidity risk:

High ALCO

Loan to Deposit Ratio 1 Week & 1 Month

Liquidity Ratios

Cumulative Liquidity Model

Intercompany Lending Report

Liquidity Risk Factor

Characteristics

• The relationship between lending and customer

deposits

• Measure of the self-sustainability of the bank (or

each branch / subsidiary)

• A very common metric, usually reported monthly

Points to note

• Differentiate between stand-alone and aggregate-able LTD

(depends on transferability and currency)

• Branch / sub targets: to improve the LTD when it’s over a

certain threshold (e.g 70%), and to maintain their LTD

when it’s under that threshold

• Exceptions can be granted to certain countries in local

currency (LCY) when they are below the threshold and

when the use of their excess liquidity is constrained

Loan-to-Deposit Ratio

1-Week & 1-Month Liquidity Ratios

Characteristics

• Shows net cash flows, including the cash effect of liquidating

“liquid” securities, as a percentage of liabilities

• An effective measure of structural liquidity, with early warning of likely stress points

• Produced weekly, one week in arrears

• Follows a Regulatory Authority limit structure for 1 Week and 1 Month ratios

• It is important to review assumptions including “stickiness”

assumptions regularly

• Review Limits regularly

Country 1-week Gap 1-week Liquidity 1-month Liquidity

• Forward looking model of inflows, outflows and available liquidity

• Recognises and predicts liquidity stress points on a cash basis

• Prepared daily, at legal entity level, and Group level

• Prepared for material original currencies and at consolidated

currency level Note

• Revised assumptions on deposit stickiness, liquidity of “liquid”

securities, and committed facilities will be included here

position of each branch / sub

• Measure of the

self-sustainability of each

branch / sub

• Clearly displays cash

contributors and cash users

• Major KPI for Treasurers

– Average asset duration 5.00 years

– Average liability tenor 3 months = 0.25 years

– 5.00/0.25 = Liquidity Risk Factor of 20

• The higher the LRF, the larger the liquidity gap, and the

greater the liquidity risk

• Tenor of liabilities will incorporate revised stickiness

assumptions

• Report weekly and monthly

• Observe the trend over time and change to long-run averages

Liquidity Risk Factor

Sharing of Information: effective MI

Presentation of Information

• All outputs presented with a common look

• Reports designed for simplicity, with unnecessary detail

removed

• Trends and limits incorporated

• Information will be shared at operating unit level,

headquarters level, and at Group level

• Reports will be published initially on a shared online

directory, ensuring the latest versions are available in

the same place.

Risk reports 1: the weekly Qualitative

• As important: the weekly qualitative report for

Group Treasury (who summarises all for High

ALCO)

• Content:

• Explain significant changes in your 1 week and 1 month liquidity

ratios

• Explain any changes to your cash and liquidity gap in your

Cumulative Liquidity model

• Explain significant changes to the Liquidity Risk Factor

• Explain growth or shrinkage of asset books

• Detail any changes to intergroup borrowing/lending position;

detail the counterparties for any large-size deals

• Any increase/decrease in corporate deposits, detail large dated

transactions with an estimated confidence level of roll over

• Any increase/decrease in retail deposits

• Average daily opening cash position

Risk reports 2: Monthly Liquidity Snapshot

• Simply a MI summary for Group-wide dissemination

– Liquidity ratio current to previous month

– LTD current to previous month

– Net intergroup lending current to previous month

Purpose: To measure the net funding requirement (or surplus) per maturity

bucket This is the main regulatory requirement for liquidity measurement.

Measure: Measures the net cash flow for each maturity bucket.

Analysis: In the short-term, when commitments (cash outflows) exceed

liquid assets (cash inflows) the Money Markets desk need to raise

additional funding In the longer-term, structural imbalances, ALCO will

determine the appropriate funding strategy.

Maturity Mismatch Ladder

Sight 8 Day 1 month 3 mo 6 mo 1 year 3 years 5 years 5 years+ TOTAL

Measure: Funding minus lending, per currency.

Analysis: By measuring FX mismatch, the bank gains an understanding of its exposure to the risk that FX swap markets become illiquid which could force a large open FX position or make it difficult to meet commitments in a particular currency.

Purpose: To measure the asset liquidity and likely stickiness of liabilities

Measure: Each asset/liability type (per COA) is rated based on size of

holding, contractual maturity, behavioural stickiness, yield, cost to

liquidate.

Analysis: A detailed understanding of the attributes and behaviour of the

bank’s balance sheet allows ALCO to make better informed strategic

choices.

Purpose: To measure the relative concentration of each funding source.

Measure: % concentration of each funding source per maturity bucket.

Analysis: Analysing funding concentration risk allows the bank to develop

effective diversification strategies.

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bank deposits Group deposits

Inter-Group deposits Group deposits

bank deposits

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Inter-Custome

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Funding Lending

Sight – 8 days 1 month 1 year

ILL UST RAT IVE

ILL UST RAT IVE

ILL UST

RAT IVE

• Consolidated basis - FSA Form LR

is the key daily report this is based around the maturity mismatch framework.

• Daily Liquidity Report

Management Reporting Leading and lagging risk indicators to

provide a 360° view of the bank’s liquidity.

Prepared by: Finance Regulatory

• No source > 25% (except customer deposits)

• Customer deposits > 33% of funding

FX mismatch limit

• No mismatch > 25% of currency volume (G7)

• No mismatch > €10mn for non-G7 currencies

Minimum cash buffer

• Cash buffer > 2% of liabilities at all times

Prepared by: Finance

Management Information Team

• DLR = Daily to management

• Form LR = Monthly to FSA

• Consolidated basis - FSA Form LR

is the key daily report this is based around the maturity mismatch framework.

• Daily Liquidity Report

• Copy of monthly reports send to each host regulator (tbc)

• Daily to Finance + Treasury

Bibliography

• Choudhry, M., et al, Capital Market Instruments: Analysis and Valuation, 3rd

edition, Basingstoke: Palgrave MacMillan

• Choudhry, M., Bank Asset and Liability Management, Singapore: John

Wiley & Sons 2007

• Choudhry, M., The Money Markets Handbook, Singapore: John Wiley &

Sons 2004

DISCLAIMER

The material in this presentation is based on information that we consider reliable, but we do not warrant that

it is accurate or complete, and it should not be relied on as such Opinions expressed are current opinions

only We are not soliciting any action based upon this material Neither the author, his employers, any

operating arm of his employers nor any affiliated body can be held liable or responsible for any outcomes

resulting from actions arising as a result of delivering this presentation This presentation does not constitute

investment advice nor should it be considered as such

The views expressed in this presentation represent those of Moorad Choudhry in his individual private

capacity and should not be taken to be the views of Europe Arab Bank or Arab Bank Group, any affiliated

body, including London Metropolitan University and YieldCurve.com, or of Moorad Choudhry as an employee

of Europe Arab Bank or representative of affiliated body Either he or his employers may or may not hold, or

have recently held, a position in any security identified in this document.

This presentation is © Moorad Choudhry 2009 No part of this presentation may be copied, reproduced,

distributed or stored in any form including electronically without express written permission in advance from

the author.

Stuart Jarvis

Forum on Asset Liability Management

Asset Liability Management

34

Private and confidential Not for public distribution Professional investors only.

Summary

• Funding challenges for UK pension plans

• Constructing asset liability solutions for pension plans

• Asset liability management in practice

35

Private and confidential Not for public distribution Professional investors only.

36

Funding challenge

Source: Pension Protection Fund

• Since a peak in mid 2007, funding positions have worsened considerably

• UK plans have historically taken

a lot of risk

• Now widely accepted that strategies

need to be more liability-led and

dynamic

Private and confidential Not for public distribution Professional investors only.

Evolution of investment strategy

37

Equity β and constrained α

Typical current investment policy

Bonds

Diversified β and α

Possible intermediate solution ‘Ideal’ future investment policy

 Hedge unrewarded risks

 Diversify risk budget

 Constrained ability to grasp opportunities

Static perspective: spend risk budget as efficiently as possible

Private and confidential Not for public distribution Professional investors only.

Eyes on the prize

New target path

Initial target path

Private and confidential Not for public distribution Professional investors only.

Dynamic portfolio allocation process

As the return target changes, so must the portfolio allocation

Private and confidential Not for public distribution Professional investors only.

Cumulative impact of dynamic asset allocation policy

40

Distribution of outcomes no longer so wide; significant downside benefit