Assets and Liability Management

Liquidity risk is measured by conducting an analysis of net funding requirements, which is determined by analysing future cash flows based on the assumptions about changes in rates an the expected behaviour of assets and liabilities, as well as off-balance sheet items.

In its essence, the “engine room” of the Treasury Platform is the modelling of these future cash flows. By running (an unlimited number of) different rate view / strategy / behavioural combination models, the ALM Section evaluates the results under different scenarios, namely going concern / business as usual and stress situation. Each scenario will consider significant positive and negative liquidity
movements that could occur.

The ALM Section not only measures and reports on mismatches between assets and liabilities on a contractual basis (to meet Regulatory reporting requirements).
In practice, current accounts and savings deposits are not withdrawn the next day and overdrafts are not repaid on demand. The ALM Section caters for this “real life” situation by also calculating these mismatches on a ‘business as usual’ basis. The “business as usual” mismatch calculation predicts future cash flow patterns based on past behavioural patterns as specified by the user.

In addition to mismatch calculations, the ALM Section allows the user to calculate “net liquid assets”, which the difference between liquid assets and volatile liabilities within the portfolio. This is referred to as the liquidity gap. The ALM Section offers facilities for stress testing, in order to assess the extent of the bank’s exposure to liquidity risk. To determine net liquidity under stressed conditions, liquidity outflow is quantified for each scenario, and cash inflows to mitigate liquidity shortfalls are identified.

This also assists the Liquidity Risk manager in assessing adequacy of liquidity cushion and contingency funding. Sound liquidity risk management requires that sources of available funds must be diversified in order for the organisation to capitalise on changes in market conditions and to be more resilient in tight market conditions. The ALM Section allows for the modelling of any combination of funding sources, to see the effect of different funding mixes.

The ALM Section ensures that modelling of future cash flows meet all existing (or perceived future) regulatory requirements in terms of minimum liquid asset holdings. The ALM Section enables continuous monitoring of liabilities (e.g. deposits from the public) to assess the bank’s ability to raise funds. Future cash flow projections calculate and highlight the funding shortfall or surplus (for each month in the modelling horizon) that will result from each modelling scenario.

The ALM Section offers the following standard Liquidity reports:

• Liquidity need report
• Liquid asset composition report
• Capital adequacy report.

Furthermore, by virtue of the fact that all modelling results are stored on a database in the Treasury Platform, it allows the Liquidity Risk manager to create an unlimited number of user-defined reports using its powerful report writer.

Examples of reports that can be generated using this facility:

• actual cash flows against budget
• performance against limits
• liquid assets held per prudential requirements
• additional liquid assets held
• ratio of liquid assets to demand deposits
• ratio of non-performing assets to total assets
• ratio of short-term demand deposits to total deposits
• ratio of contingent liabilities for loans to total loans
• ratio of pledged securities to total loans

By defining reports in the ALM Section the Liquidity Risk manager can create a report suite that will serve as early warning monitor for liquidity concerns such as:

• Concentrations in a particular portfolio of assets or liabilities
• Deterioration in asset quality
• A decline in earnings performance or projections
• Funding cost increases
• Heavy cash withdrawals
• Transaction size reductions
• A large off-balance sheet exposure

By virtue of the fact that an unlimited number of future scenarios can be modelled in the ALM Section, stress testing can be conducted to assess the ability of the bank to withstand stressed liquidity conditions and to determine how it will cope in such a situation. This allows for the identification of expected losses and assessing the impact of unlikely but still plausible events. Stress testing in the ALM Section allows for any (user-specified) upward and downward basis point rate shock. Stress
tests can also be performed to measure the effect of any (user-specified) reduction in deposit base.

The ALM Section’s “what-if” scenario modelling facilities can also model the effects of different potential sources of funding available, e.g.

• Deposit growth
• Lengthening of maturities of liabilities
• Cash injections

Interest rate risk is the risk that the company will experience deterioration in its financial position as interest rates move over time. The ALM Section enables the IRR manager to identify, measure and monitor the following sources of interest rate risk:

• Repricing Risk, which reflects the fact that assets and liabilities are of different maturities and are priced off different interest rates.
• Basis Risk, which arises when there is an imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates change, these differences may give rise to unexpected changes in the cash flow and earnings spread between assets, liabilities and off-balance sheet instruments of similar maturities or repricing frequencies.
• Optionality Risk, arising from the options embedded in the assets and liabilities and off-balance sheet portfolios. An option may be embedded within a portfolio, e.g. loans that give borrowers the right to prepay balances and deposits that give the depositor the right to withdraw funds prior to final maturity without penalties.

The following standard IRR reports are available in the ALM Section:

• Gap report
• Cumulative gap report
• Interest sensitivity report
• Balance sheet sensitivity report
• Income statement sensitivity report
• Rate spread report

A myriad of stress testing facilities exists on the platform to provide information on the kinds of conditions under which the bank’s strategies would be most vulnerable. Examples include:

• abrupt changes in the general level of interest rates,
• changes in the relationships among key market rates (i.e. basis risk),
• changes in the volatility of market rates.

By modeling different strategies, the ALM Section will enable the IRR manager to minimize risk while maximizing earnings and net worth. This is done by means of measuring the projected earnings for different product mixes, with strategies such as:

• Buying and selling assets
• Changing the liability structure and mix
• Introducing new products (assets and/or liabilities)
• Hedging

The ALM Section will identify the appropriate strategy, which will depend on the current level of risk, the time frame, and the current interest rate environment, as a strategy for an expected increasing interest rate cycle will not be appropriate for a decreasing interest rate cycle.

Foreign exchange (“FX”) risk management may be defined as managing exposure to adverse exchange rate fluctuations within an acceptable range at an acceptable cost. The ALM Section allows the FXR manager to model an unlimited number of foreign exchange rate views. These can be defined for all of the currencies that the bank are currently trading in, as well as currencies which are considered for future trading. As is the case with Interest Rate Risk modeling, the ALM Section calculation engine will produce results for strategies based on any number of FX rate views to measure the effect of changes in exchange rates on future projected cash flows.

The ALM Section allows the modeller to define each product in terms of a selected currency and thus reporting is done taking cognizance of current and future FX rates. This allows for reporting based on (current and projected future) cash flows as converted to the base currency. The user can specify currency conversions as direct (e.g. 1 ZAR = 0.1 EURO) or indirect (e.g. 1 USD = 6 ZAR). In a multi-currency model, all reports (standard ALM Section reports as well as user-defined reports) can be produced for one or more selected currencies only. This enables the FX Risk manager to analyze that portion of their portfolio (or the whole book) that pertains to one currency only, so as see the effect of perceived changes in FX rates on the cash flows (and future profitability of the bank).

The ALM Section also caters for the following FX derivatives to measure their effectiveness in terms of hedging FX risk:

• FX swaps
• Forward Exchange contracts (FECs)

These deals can be specified as off-balance sheet items so as not to affect the future balance sheet projection reports. The ALM Section calculates (and reports on) swap costs and accumulated interest swap costs (for FX swaps) and premium costs (for FECs) are calculated. To further assist the FX Risk manager in evaluating possible hedges, the ALM Section offers the facility to view each hedging contract in terms of: For FX swaps:

• Capital swap cost
• Total cost
• Yield cost (as percentage of base currency)

For FEC’s

• Transaction valued at spot rate
• Transaction valued at forecasted FX rate
• Profit/Loss

The effect of changes in future exchange rates (FX risk) is reflected in each of the standard risk reports in the ALM Section. In addition, the ALM Section has a standard Hedge Effectiveness report, which shows:

• The repricing gap before and after derivatives
• The aggregate impact of derivatives
• The cumulative impact on Net Interest Income for rate shocks (up and down)
• Including derivatives
• Excluding derivatives

The ALM Section is effectively a management decision support system that will provide the Finance Department with the capability to do inter alia the following:

• Budgets
• Support Management Decisions
• Do What-if scenarios
• Produce User-Defined Reports
• Create Management Information
• Do Fair value calculations

The ALM Section allows its user to simulate an indefinite number of Balance Sheets, Income Statements, Cash flow statements and User-Defined Reports into the future.

• The time frame used may vary from situation to situation, depending on the purpose of the simulation. For example, a five-year time frame might be used if the simulation is done to calculate the future need for capital, whereas a six to twelve-month time frame could be used to measure the impact of interest rate changes in the current financial year or eighteen months to be able to produce a budget for the next financial year.
• The ALM Section is an effective budgeting tool giving the user unlimited access to define various scenarios.
• Scenarios, comprising a strategy, interest and exchange rate view can be set as a budget, called the original budget in the system. An additional revised budget can be created, which can be reset from any future month for a defined planning horizon.
• Variance analysis – The ALM Section has the capability to do variance analysis based on interest bearing products comparing actual to an original budget, revised budget and any of the myriad scenarios the user has defined. To be able to do variance analysis the ALM Section accepts historical data for average balances, interest earned or paid per product defined.The ALM Section provides variances in terms of volume and price (rate). Consolidations, business unit and portfolios – The ALM Section has a unique feature to merge simulations from different models, allowing consolidated models to use projections generated by source models. Consolidations can be very useful when budgets are created for various business units (branches) and portfolios. Due to the unique funding and investment algorithm of the ALM
  Section, models can also be created to determine short or long (open) positions per currency. Money can be transferred between models to fund shortfalls or the investment of surpluses. All financial and risk reports are available per consolidated and sub-models. Consolidated models contain the same level of details as their source (sub) models.
• Fixed Assets – All projected Capital Expenditure can be captured in the ALM Section. The ALM Section has the capability to define fixed asset classes, calculate depreciation and measure the impact of acquisitions and disposal as well as the timing thereof on the need for cash.
• Non-interest items – The ALM Section caters for setting up rules for the calculation of fee and other income items as well as operational expenditure items. Rules can be set up to calculate provisions and reserves.
• Year-to-date figures – Income statement items can be presented on a monthly and year-to-date basis, incorporating the actual figures for the current financial year.

The YTD figures can be used for the following:

• to proportion operational expenses,
• to provide the base for growth in other income lines and
• to do YTD reporting

• Funding of cash shortfall
• Investment of surplus cash
• Limit risk exposure
• Strategies/budgets into the future

The major advantage of using the ALM Section is the quantification of management decisions, for example, the volume of time (fixed) deposits by tenure required on a monthly basis or the new business (production) to be written on mortgages on a monthly basis.

The ALM Section allows management to analyze the impact of any defined (internal) or external (interest and currency rates) factors on funding requirements, debt management, and cash flow.

• Every “what-if” can be defined as a scenario and be compared with a base case or another scenario.

The ALM Section is an integrated system complying with general acceptable accounting principles. This allows the user to refer to any of the financial report lines and specific variables.

The ALM Section has a vast number of standard reports besides the risk and financial reports covered above providing the following type of management information:

• Rate spreads – This report provides interest rate returns and cost on a NACM basis, allowing the user to compare rates on a similar basis per currency. An example of how it can be applied is to divide Loans and Advances into Performing versus Non-performing in order to obtain a net return position for Loans and Advances, highlighting the impact of defaulting.
• Executive summary – This report calculates the break-even yield on assets in order to have a zero net interest margin. This report also provides the profit differential between interest bearing assets and liabilities.
• Ratio Analysis – Thanks to the facility to define user defined reports, there are no limitations to the number of ratios that can be expressed in the ALM Section. Common ratios include:
  • Earning Assets/Total Assets
  • Total Advances/Total Deposits
  • Total Expenses/Total Income
  • Return on Assets
  • Return on Equity
  • Transfer Pricing

The ALM Section can do funds transfer pricing (FTP). FTP refers to:

• The technique of analysing the interest rate margin broken down into asset margin, liability margin and mismatch margin.
• The process and methodology of establishing the cost of allocating funds within anorganisation at rates internal to the organisation.

Future cash flows of all instruments are “present valued” at a rate determined by a yield curve. For a product with an indeterminate maturity date (such as “standard products”), the future flows are not considered. Instead, the product’s capital (face value) is taken as the fair value.  Fair value calculations in the ALM Section are very much influenced by the type of interest calculation that is set by the user. The setting of fair value calculations in the ALM Section is based on the selection of the mark-to-market calculation.

Within the ALM Section the following instrument types are specifically influenced by this of type calculation, namely:

• YTM product type (Typical Bond calculation)
• Discount product type
• NCD type instrument where interest is payable at the end of the term

In essence, the budgeting process is the primary strategy for achieving the organisation’s objectives – be it growth, maximising profit, achieving sales targets, or any combination thereof. Underpinning the budgeting process is the production requirements for meeting the budget. It is essential that those who are responsible for managing production (sales) and controlling expenses, understand what the capital requirements are in order to “make the budget”. A budget is said to be “out of date” as soon the first set of actual results become available. As such, it requires performance measuring on a regular basis and access to information such as:

• Are we on target to make the budgeted figures?
• What is the variance between the actual results and the budget?
• What do we have to do the meet the budget target?
• What are the cash flow and liquidity constraints?
• What will be the effect of changes in external factors (e.g. changes in interest rates, foreign exchange, etc.) on the budget?
• What will be the effect of credit impairments (or other forms of deterioration in asset quality on the targets?

Adjusting the budget is a reality. It is no use to ignore variances (between the actual results and budget/targeted), or to be unrealistic in believing that those variances will somehow disappear. Early warning signals should be recognised and strategies put in place to address the variances. Most
importantly, senior management must be forewarned as soon as it becomes clear that targets may not be achieved. Modern budgeting techniques make extensive use of modelling for the forward projection of the organisation’s Balance sheet, Income statement and Cash flow statement to see what the financial effects will be if the budget targets are reached. Best-practice models will allow the comparison of different strategies for reaching the targets and measuring the effectiveness of each planned strategy.

In order to refrain from repeating most of the items listed above which could very well be used in the
corporate and institutional department it might be worth highlighting some aspects such as:

• The ALM Section has a product type called pre-structured product flows which allows the user to construct a financial transaction using a spreadsheet to calculate loan repayments unique to a single deal incorporating capital outflows, interest accruals and paybacks.
• The ALM Section can be used to define production targets (new business) and the impact of different repayment schedules.
• Specific deals could be inserted to see impact on profitability and cash flow, allowing an indefinite number of “What-if” scenarios.
• The corporate and institutional department can be modeled as a separate entity selling surplus funds to and borrowing funds from a central unit (treasury)