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8/13/2019 ASSETS AND LIABILITIES MANAGEMENT RISKS
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ASSETS AND LIABILITIES
MANAGEMENTRISKS
Carl Abruquah
Consultant
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Agenda
Introduction
Risk in financial markets
Strategic risks
Interest rate risks
Foreign Exchange Risks
Liquidity risks
Credit portfolio risks
Summary/Conclusion
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Introduction
The key to bank management is managing the
Spread the difference between interest
income on assets and interest cost of liabilities.
This is supplemented by strategies to reduce the
burden on net interest incomereducing
operating costs and increasing non interest
income In managing the spread, the bank is faced with
the risk of volatility in its expected revenue
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ALM Risks
The risks that must be dealt with in ALM arethose factors that cause variation in the Banksnet interest income.
These include: Strategic risks
Interest rate risks
Liquidity risks Foreign exchange risks
Credit portfolio risks
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Strategic Risks
Strategic risk refers to the probability that achosen strategy will not have the desiredimpact on the achievement of objectives.
Strategic risk may arise from outcomes thatare a variance with the forecasts on which thestrategies were based.
A critical tool that may be used in ALM forevaluation of achievement of objectives isfinancial performance evaluation.
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Financial Report Analysis
Analysis of financial reports may be divided
under the following headings:
Capital
Assets Quality
Management
Earnings
Liquidity
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Capital Management
Capital management ratios measure the
banks ability to withstand a financial crisis
Capital indicators include the following:
Capital adequacy Ratio
Leverage
Profit retention
Dividend payout
Growth in fixed assets
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Capital Adequacy Ratio
CAR is defined as risk weighted assets divided
by adjusted capital base.
A high CAR of say 25% connotes inefficient
utilization of capital and loss of opportunities
to make profits
A very low CAR connotes a reckless
deployment of capital without regard to
eventualities resulting from impaired assets.
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Leverage (Multiplier) ratio
Financial leverage represents the Assets to Capitalturnover.
It shows how much assets have been generated withthe aid of external funds.
It indicates the level to which the bank is willing to takerisk.
Cost of equity is high compared to deposits, whichimplies that a higher leverage is cheaper to the bank
than a lower leverage. It is possible for a bank to have a high leverage but
good CAR if it deploys more of its assets in low riskweight assets.
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Erosion of Capital
Losses caused e.g. by lack of control of
overheads and mismanagement
Exogenous factors such as competition,
decline in the economy, natural disasters, staff
strike
Fraud by bank employees.
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Measures to Improve Capital
Increase profitability
Cost control
Efficient deployment of funds Strong internal controls to prevent fraud
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Assets Quality
In financial institutions, the main assets thatgenerate revenue are the monetary assets,primarily advances and investments.
The amount of revenue a bank earns hingessignificantly on the quality of the assets it hascreated.
Bad loans are written off as an expense in afinancial institutions income statementreducing the bottom-line
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Risk/Return Trade Off of Assets
Apart from the problem of collectability ofassets, there exists a risk return trade offthehigher the risk associated with a monetary
asset, the higher the earnings the asset pay. On the other hand, low risk assets like
government securities will normally havelower interest rates.
The bank should therefore select a portfolio inwhich the risk/return trade off is balanced.
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Asset Quality Ratios
Total Loan Provision (TPL) to Advances TPL =balance of loan provision account includingcurrent and previous provision
Risk Adjusted Margin = Net Interest Incomeless Impairment charge divided by AverageTotal Assets
Non performing Loans to Loans The risk adjusted margin shows the impact of
credit risk on profitability of a bank.
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Management Ratios
Management of a bank may be assessed by
observing the trend in certain parameters
including:
Growth in assets
Growth in number of branches
Market share of deposits
Market share of advances
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Assessment of Management with
Balanced Score Card
Customer related measures:
Number of customers per employee
Number of borrowers per employee
Market share by segment Customer satisfaction survey
Internal processes
Losses through fraud as a percentage of Net profit
after tax Investments in technology
Number of complaints
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Balanced Score Bard
Learning and Growth
Revenues from new products
Product development cycle
Employee survey
Revenue per employee
Employee turnover
Training hours per employee
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Earnings Ratios
Return on Equity = NPAT/Equity
Return on Assets = NPAT/Total Assets
Net Interest Margin = NII/ Average Total Assets
Net Operating Margin = Net OperatingIncome/Average Total Assets
Net Operating Income = Total Operating IncomeLess Total Non Interest Operating Expenses
(including depreciation) Less impairment charge) Total Operating Income = Net Interest Income
plus Non-Interest Operating Income
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Cost Management Ratios
Efficiency Ratio (Cost Income) = OperatingExpense divided by Total Operating Income
Overhead Burden Ratio = Non Interest Expenses
(Operating Expense) Less Other Income dividedby Net Interest Income
The overhead burden shows what percentage ofNet Interest Income is consumed by operating
expenses. The higher the burden the less efficient the
business is
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Interest Rate Risk
Assets Interest Yield = Interest Revenue / TotalAssets
Break Even Yield = Interest Expenses / TotalAssets
Cumulative gap = Rate Sensitive Assets/RateSensitive Liabilities
Change in NII = Gap X Expected change in interestrate.
A shrinking NIM is an indication of poor interestrate risk management.
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Liquidity Risk
Liquidity risk is the likelihood that a bank
would not be able to meet its commitments as
they fall due.
A bank must be able to strike the right balance
between avoiding the problem of excess cash
whilst ensuring that the bank does not run
into the problem of deficit cash.
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Liquidity Ratios
Liquid Assets Ratio = Total Cash Reserves/Total
Assets, where
Total cash reserves = cash + Government
Securities + placement with other banks
Advances Deposit Ratio = Total
Advances/Deposits
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ALM and Performance Evaluation
A key role of ALM is to evaluate the financial
performance of a bank in order to establish
whether a bank is achieving its strategic
objectives.
Financial report analysis and balanced score
card are key tools that are employed in playing
this role
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Interest Rate Risk
Interest rate risk is the probability that the
banks profits and capital would fall due to
variation in the level of interest rates.
Interest rate risks may arise due to the Assets
and Liabilities positions taken by the bank
Positions relate to the composition and
maturity structure of Assets and Liabilities,
including advances, investments and deposits
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Types of Interest Rate Risk
There are three main types of Interest rate
Risk:
Basis Risk
Repricing Risk
Yield Curve Risk
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Basis Risk
Basis risk arises when different basis are used inthe pricing of a banks assets and liabilities.
The upshot of this is that NII changes because of
differential changes in interest rates on assetsand liabilities.
For example, if deposits are priced relative toTreasury Bills whilst advances are priced relative
to the Bank of Ghana Prime rate, interest rate riskcould arise if Treasury Bills change at a differentrate than the prime rate.
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Repricing Risk
Repricing risk arises when assets and liabilitiesare repriced at different times leading to declinein interest income and NIM for that matter.
In the 1980s the Savings and Loans Companiesfaced repricing risk because they granted longterm facilities at a fixed rate which were fundedby short term wholesale deposits.
When deposit rates started going up it affectedmany of these institutions some of whichcollapsed.
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Yield Curve Risk
Yield curve risk arises due to unequal shifts in
the yield curve of assets and liabilities.
The yield curve is the maturity structure of
interest rates.
For example if the yield of government
securities change relative to the yield curve of
a banks fixed deposits, there would be
implications on NII
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Management of Interest Rate Risks
Banks have a number of tools that could be
used to manage interest rate risks. These
include:
Repricing schedules
Duration
Simulation
Hedging Futures
swaps
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Strategies for Controlling Interest Rate
Risks
Interest rate risk management should encompassstrategies that changes the banks interest ratesensitivity by altering various components of thebalance sheet
Theoretically, the actual ALM strategies shouldfocus on controlling the gap between interestsensitive assets and interest sensitive liabilities.
The rate sensitive gap could be varied in tune
with interest rate forecasts. If the bank is expecting interest rates to increase,
they widen the gap and vice versa.
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Strategies for Reducing Assets
Sensitivity
Extending investment portfolio maturity
Increase floating rate deposits
Increase fixed rate lending
Sell floating rate notes
Increase short term borrowing
Increase long term lending
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Strategies for Reducing Liabilities
Sensitivity
Reduce investment portfolio maturities
Increase floating rate lending
Increase long term deposits
Increase short term lending.
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Other Strategies
Matching of assets and liabilitiese.g.matching long term assets with long termliabilities
Match repriceable assets with repriceableliabilities
Use forward rate agreements, swaps optionsand financial futures to construct syntheticsecurities and thus hedge against anyexposure to interest rate risk.
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Other Strategies
The bank may set tolerance limits on interestsensitivity gapsthese should be smaller in theproximate time bands
The bank can do this by constantly reviewing therepricing structure of all new debt raised or newassets financed with a view to protecting interestrate margins.
Other tactics include investing short term whenrates are rapidly rising and long term when ratesare falling
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Forecasting
It is very critical that the bank develop suitable
in-house expertise for forecasting interest
rates to guide interest rate risk management
strategy at the Assets and LiabilitiesManagement Committee (ALCO)
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Control and Monitoring
An effective system of internal control for themanagement of interest rate risks include: A strong control environment
Adequate processes for identifying and evaluating
risks The establishment of control activities such as policies
and procedures and methodologies
Adequate MIS
Continual review of adherence to policy Continuous monitoring and evaluation of
performance.
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Sound Interest Rate Risk Management
Practices
Appropriate board supervision, management
and oversight
Appropriate risk management policies and
procedures
Appropriate risk measurement monitoring and
control function
Comprehensive interest rate controls and
independent audit.
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Foreign Exchange Risk
Foreign exchange risk is the risk that changes
in foreign exchange rate will cause some
variability in the banks earnings and capital.
Foreign exchange risk is a type of market risk
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Foreign Exchange Risk
There are three main types of foreign
exchange risks:
Transactions exposure
Translation exposure
Economic exposure
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Transactions Exposure
Transactions exposure measures the riskinvolved due to a change in foreign exchangerates between the time of a transaction is
executed and the time it is settled Examples:
Purchase and sale of goods and services in foreigncurrency
Loan repayment in foreign currency
Dividends paid or received in foreign currency
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Economic Exposure
Economic exposure, otherwise termed
operating exposure is the sensitivity of future
cash flows and profits of a bank to
unanticipated exchange rate changes.
Due to its nature, it is a less significant risk
considering the nature of banking activities.
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Management of Foreign Exchange
Risks
Open foreign exchange positions
Foreign exchange portfolio management
Hedging tools
Forwards
Options
Swaps
Currency futures
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Liquidity Risk Management
Liquidity is defined as the ability of a bank tomeet its day to day commitments as they fall due
Day to day commitments of a bank include fuel,
bills, payment of salaries, drawdown of loans andwithdrawal by depositors
A bank must have its own source of liquidityotherwise it must incur a cost to meet its liquidity
needs. Costs include interest expenses to be incurred
and the expense incurred in sourcing funds.
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Liquidity Risk
Liquidity risk is the probability that a bank will
not have sufficient funds to meet day to day
commitments as they fall due.
It has a negative impact on bank earnings due
to cost of borrowing to make up the liquidity
shortfall.
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f i idi i k
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Impact of Liquidity Risk
The bank would have to borrow the required
resources at a cost
The bank would not be able to secure the
required amount of liquidity needed.
There could be a run on the bank if a liquidity
crisis is not well managed.
The ultimate impact would be bank failure
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Component of Bank Liquidity
Branch cash
Reserve account
Near cash investments
Nostro account
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Causes of Liquidity Risk
Excessive expenditure
Executive abuse of power
Overambitious projects
Overtradingtoo much loans with very little
capital
Poor services leading to withdrawal ofdeposits and closing of accounts
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Liquidity Management
Liquidity risk management policy and liquidity
contingency planning
Liquidity forecasting
Investments in liquid assets
Setting of financial liquidity ratio targets
Reserve account management
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Liquidity Risk Management
Branch cash management
Nostro account management
Diversification of funding sources
Scenario planning
MIS
Centralized liquidity control
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Credit Portfolio Management
Whilst day to day management of credit is theresponsibility of the Risk management Division, ALM isconcerned with management of the advances portfolio as awhole.
Credit portfolio management is the process by which risks
that are inherent in the credit process are managed andcontrolled. Because review of the LPM process is soimportant, it is a primary supervisory activity.
It involves evaluating the steps bank management takes toidentify and control risk throughout the credit process. The
assessment focuses on what management does to identifyissues before they become problems.
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A h t C dit P tf li
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Approaches to Credit Portfolio
Management
Define the Portfolio to be managed
Identify the role and mandate of the Credit PortfolioManagement function
Standardize risk measures and models
Portfolio segmentation and Risk Diversificationmeasures
Deal with data issues and MIS
Understand economic value and accounting value Stress test portfolio
Rebalance portfolio to achieve strategic objectives
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Summary/Conclusion
ALM involves dealing with the foregoing risks on aholistic, enterprise wide basis.
Due to the correlations involved in ALM risks, it ispertinent to deal with them on a centralized basis
through a cross functional senior managementcommittee.
The Assets and Liabilities management Committee(ALCO) is normally charge with the responsibility ofspearheading the banks assets and liabilities
management policies procedures and practices. The ALM is the dashboard of a bank and neglecting it
would have inevitable dire consequences on a bank.
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THE END
THANK YOU