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 interest-
rate 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 rate-
sensitive 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 on-
balance 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 Balance-
Sheet 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 income-
expense 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 Interest-
Rate Risk on Loans

 Effects on the Loan Portfolio

 Interest Rates (Up)
Old Loans Worth Less
 Adverse Price Effect New Loans Worth More
 Favorable Reinvestment Effect

 Interest Rates (Down)

 Favorable Price Effect Old Loans Worth More
New Loans Worth Less
 Adverse Reinvestment Effect
Chapter 8 15
 Effects of Interest-
Rate 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] = Δ NII
Pos + Neg = Neg
Pos + Pos = Pos
Neg + Pos = Neg
Neg + Neg = Pos

Chapter 8 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 Interest-
Rate 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 Cash-
Market 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
fixed-receive 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. 242-243)
 1. Convert a fixed-rate loan to floating
 2. Convert a floating-rate loan to fixed
 3. Convert a fixed-rate deposit to floating
 4. Convert a 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