BWBB3193

SEMINAR IN BANKING

ASSET-LIABILITY
MANAGEMENT

1
 KEY TOPICS
1. ASSET, LIABILITY, AND FUNDS
MANAGEMENT
2. MANAGING WITH INTEREST RATE
EXPECTATIONS
3. GAP MANAGEMENT

2
 • Interest Net interest
revenues margin
Managing the
bank’s or • Interest Bank’s or
other financial costs other
institution’s financial
response to • Market institution’s
changing value of investment
market assets Net worth value,
interest rates (equity) profitability
• Market and risk
value of
liabilities

ASSET-LIABILITY MANAGEMENT IN
BANKING & FINANCIAL SERVICES
3
 ASSET-LIABILITY MANAGEMENT
(ALM)
 One of the most useful analytical tools developed in
modern banking and financial-services management.
 A series of management tools to help reduce risk
exposure (particularly to the probability of loss from
changing market interest rates) in the banking system.
 Provides banking system with defensive weapons to
handle business cycles and seasonal pressures and also
helps to shape portfolios of assets and liabilities to
promote bank’s goal.
 ALM STRATEGIES

1. Asset management strategy

2. Liability management strategy
3. Funds management strategy
 Asset Management Strategy
 This strategy views that the amount and kinds of
deposits a bank held and the volume of other
borrowed funds it was able to attract were largely
determined by its customers.
 Under this view, the public determined the relative
amounts of checkable deposits, savings accounts, and
other sources of funds available to depository
institutions.
 The banker could exercise control only over the
allocation of incoming funds by deciding who was to
receive the quantity of loans available.
 Liability Management Strategy
 The bankers can control over the price and interest rate
on their deposits and borrowings to achieve volume,
mix, and cost desired.
 Example: A bank faced with heavy loan demand that
exceeded its available funds could simply raise the offer
rate on its deposits in order to get funds flow in.
 Funds Management Strategy
This strategy stresses several objectives:
1. Management should exercise as much control as
possible over the volume, mix, and return or cost of
both assets and liabilities in order to achieve their
goals.
2. Management’s control over assets must be
coordinated with its control over liabilities so that
asset management and liability management are
internally consistent and do not pull against each
other.
3. Revenues and costs arise from both sides of balance
sheet (from both assets and liabilities).
 Interest rate risk: One of the greatest
ALM challenges
 When interest rates change in the financial
marketplace, interest income and interest expenses
must also change.
 Moreover, changing market interest rates also change
the market value of assets and liabilities, thereby
changing the financial institution’s net worth (the
value of the owner’s investment in the firm).
 Thus, changing market interest rates impact both the
balance sheet and the statement of income and
expense of banks and other financial institutions.
Forces determining interest rates
 Can bank managers control the level of market rates of
interest? NO
 The rate of interest is ultimately determined by the
financial marketplace.
 Suppliers of loanable funds interact with demanders of
loanable funds.
 Interest rate determined when the quantities of demand =
quantities of supply

https://www.bnm.gov.my/monetary-stability/opr-decisions

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 The measurement of interest rates

 Interest rates = the price of credit

 One of the most popular rate measures is the yield to
maturity (YTM).
 YTM – the discount rate that equalizes the current
market value of a loan or security with the expected
stream of future income payments that the loan or
security will generate.

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 The component of interest rates
Nominal Risk premium to
(published) compensate
market Risk-free real lenders to cover
interest rate = interest rate + their default risk
on a risky (credit), inflation
loan or security risk, maturity risk,
liquidity risk, call risk..

Base rate

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 Managing with Interest Rate
Expectations
 Why do interest rates differ from one another?
This is a question that concerns everyone
involved in debt markets.
 Duration or maturity is a major factor that cause
interest rate to differ from one another.
 Other factors include differences in market
liquidity, default risk, taxability and call risk (the
risk that duration may turn out to be shorter than
stated).

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 Managing with Interest Rate
Expectations
 Information on the relationship between rates
and maturity helps bankers to manage the rate
sensitivity of their balance sheets.
 The term structure of interest rates explains the
behavior of the yield to maturity as the term to
maturity increases.
 There are several theories of the term structure
developed by financial economists and each
theory has a different explanation of why
maturity causes interest rates to differ.

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 Managing with Interest Rate
Expectations
 The graphical depiction of the term structure is
called the yield curve and it represents the term
structure of interest rates on a specific date.
 The yield curve is one of the most important
indicators of the level and changes in interest
rates in the economy.
 Any change in rates across the maturity
spectrum can be observed by comparing the
position and slope of yield curves for different
periods.

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 Managing with Interest Rate
Expectations
 The shape of the yield curve gives investment
managers, including asset and liability
managers, valuable information.
 A steeply positive (upward) slope gives a large
yield spread between short and long maturities
and many banks invest in assets with maturities
that are longer than their liabilities.
 It might appear to bankers that this (upward
sloping) yield curve provides an attractive
earnings spread simply for mismatching asset
maturities with shorter liability maturities.

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 Managing with Interest Rate
Expectations
 Shape of the Yield Curve
 Upward – Long-Term Rates Higher than
Short-Term Rates
 Downward – Short-Term Rates Higher than
Long-Term Rates
 Horizontal – Short-Term and Long-Term
Rates the Same

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 Managing with Interest Rate
Expectations
 There are multiple approaches to estimating the yield
curve:
 Empirical: polynomial splines (McCullogh 1971), exponential
splines, B-splines (Vasicek and Fong 1982), Nelson-Siegel
function (Nelson and Siegel 1987), Fama-Bliss function (Fama
and Bliss 1997) – requires market information of bond prices,
across a spectrum of maturities.
 Theoretical: general equilibrium models (Vasicek 1977; Cox,
Ingersoll and Ross 1985); Longstaff and Schwartz 1992) or no-
arbitrage models (Ho and Lee 1986; Heath, Jarrow and Morton
1990; Hull and White 1990) – requires market information on the
level and the volatility of the short-term interest rate and forward
rates.

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 INTEREST SENSITIVE GAP MANAGEMENT

 The purpose of ALM is to control a bank’s sensitivity

to changes in interest rate risk and limit its losses in its
net income or equity.
 Therefore, the most popular interest rate hedging
strategy in use today is called interest-sensitive gap
management.
 Gap management techniques require management to
perform an analysis of the maturities and repricing
opportunities associated with interest-bearing assets
and deposits and other borrowings.
 If management feels its institution is excessively exposed to
interest rate risk, it will try to match as closely as possible the
volume of assets that can be repriced as interest rate change with
the volume of deposits and other liabilities whose rates can also
be adjusted with market conditions during the same period.

Dollar amount of repriceable = Dollar amount of repriceable

(interest-sensitive assets) (interest-sensitive liabilities)

 The revenue from earning assets will change in the same

direction and same proportion as the interest cost of liabilities.
 Repriceable asset:
 short-term loans, short-term securities issued by govt and

private borrowers, and variable-rate loans and securities.

 Repriceable liabilities:
 certificate of deposits, borrowings from the money

market, short-term savings account, money market

deposit.
 Nonrepriceable assets:
 cash in the vault and deposits at the Central Bank, long-

term loans made at a fixed interest rate, long-term

securities carrying fixed rates, and buildings &
equipment.
Cont…
 Non-repriceable liabilities:
 Demand deposits (pay no rate), long-term savings
& retirement accounts, equity capital.

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Interest-sensitive gap = interest-sensitive assets
– interest sensitive
liabilities

1. Asset-sensitive (positive) gap =

Interest-sensitive assets – interest-sensitive liabilities >
0

2. Liability-sensitive (negative) gap =

Interest-sensitive assets – interest-sensitive liabilities <
0
 Asset-sensitive (positive)Gap

Example: A commercial bank has interest-sensitive assets

of RM500 million and interest-sensitive liabilities of
RM400 million. So it has a positive gap of RM100 million.
 If interest rate rises, the bank’s net interest margin (NIM)
will increase because the interest revenue generated by
assets will increase more than the cost of borrowed funds
 Interest rate rises – interest on loan will generate more

income than interest on deposits

Cont…
 If interest rate falls, the bank’s NIM will
decline as interest revenues from assets drop
by more than interest expenses associated with
liabilities.
 The bank with a positive gap will lose net
interest income if interest rates fall.

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 Liability-sensitive (negative) gap

Example: A commercial bank has interest-sensitive assets of

RM150 million and interest-sensitive liabilities of RM200
with a negative gap of RM50 million.
 If interest rate rises, the bank’s net interest margin (NIM)
will decrease because the rising cost associated with interest-
sensitive liabilities will exceed the increase in interest
revenue.
 Interest rate increase- increase in deposits – NIM

decrease as bank has to pay more interest on deposits

Cont…
 In interest rate falls, the bank’s NIM and
earnings will increase because borrowing costs
will decline by more than interest revenues.

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 INTEREST SENSITIVE GAP
MANAGEMENT
  Bank can hedge against interest rate risk by
making:

Interest-sensitive assets = interest sensitive liabilities

Factors affecting Net Interest Margin:

i. Changes in the level of interest rate.

ii. Changes in the slope of the yield curve or
the relationship between assets yields and liability
cost of funds.
iii. Changes in the volume of assets and liabilities.
iv. Changes in the composition of assets and
liabilities.
 INTEREST SENSITIVE GAP
MANAGEMENT
To measure interest sensitive gap (IS GAP):

1)  Dollar gap

  GAP (RM) = ISA (RM) - ISL (RM)
 ISA = Interest Sensitive Assets
 ISL = Interest Sensitive Liabilities
 If dollar gap is positive, bank is asset sensitive, and
vice versa.
2)  Relative IS Gap = Gap (RM)
bank size = total assets

 If relative IS Gap is greater than zero, bank is asset

sensitive.

3)  Interest sensitivity ratio (ISR)

= ISA (RM)
ISL (RM)
 If ISR is greater than 1, bank is asset sensitive.
 Only if interest-sensitive assets and liabilities are equal is a
bank relatively insulated from interest rate risk.
 In reality, a zero gap does not eliminate all interest rate risk
because the interest rates attached to assets and liabilities
are not perfectly correlated.
 Example, loan interest rates tend to lag behind interest rates
on money market borrowings.
 So, interest revenues often tend to grow more slowly than
expenses during economic expansions, while interest
expenses tend to fall more rapidly than revenues during
economic downturns.
 INTEREST SENSITIVE GAP
MANAGEMENT

An asset sensitive bank A liability sensitive bank

has: has:

Positive Dollar IS GAP Negative Dollar IS GAP

Positive Relative IS GAP Negative relative IS GAP

Interest Sensitivity ratio Interest Sensitivity ratio less

greater than 1 than 1
 INTEREST SENSITIVE GAP
MANAGEMENT
Gap Change in Change in net
interest rate interest margin
Positive ISA > ISL Increase Increase

Decrease Decrease

Negative ISA < ISL Increase Decrease

Decrease Increase

Zero ISA = ISL Increase No change

Decrease No change
 INTEREST SENSITIVE GAP
MANAGEMENT

With positive gap The risk Possible

management
responses
Asset sensitive Losses if interest rate fall Do nothing (maybe
because bank net interest interest rate will rise or
ISA > ISL margin will be reduced stable)
Extend asset maturities
or shorten liability
maturities
Increase ISL or
decrease ISA
With negative gap The risk Possible
management
responses
Liability sensitive Losses if interest rate Do nothing (maybe
ISA < ISL rise because the interest rate will fall
bank’s net interest or stable)
margin will be Shorten asset
reduced maturities or lengthen
liability maturities
Decrease ISL or
increase ISA
 How to Measure Interest Rate Risk
Exposure

1. Cumulative gap
2. Aggressive gap management
3. Weighted interest-sensitive gap
 Cumulative gap
 The total difference in dollars between those assets
and liabilities that can be repriced over a designated
period of time.
 Example: The bank has RM100 million in earning
assets and RM200 million in liabilities subject to an
interest rate change each month over the next 6
months.
 The cumulative gap:
(RM100 million per month x 6) – (RM200 million per
month x 6) = - RM600 million.
 The cumulative gap is useful because, given any
specific change in market interest rates, we can
calculate approximately how net interest income
will be affected by an interest rate change.

Change in net interest income = Overall change in interest

rate (in percentage points) x size of the cumulative gap (in
dollars).
Example: Suppose market interest rate rises by 1
percentage point. The loss of net interest income will be:
0.01 x –RM600 million = -RM6 million
 Aggressive Gap Management
 Some banks shade their interest-sensitive gaps toward
either asset sensitivity or liability sensitivity, depending on
their degree of confidence in their own interest rate
forecast.
 Example: If management believes interest rates are going
to fall over the current situation, it will probably allow
interest-sensitive liabilities to climb above interest-
sensitive assets.
 If interest rates do fall as predicted, liability costs will drop
by more than revenues and the NIM will increase.
 Weighted Interest-Sensitive Gap
 This approach takes into account the tendency of
interest rates to vary in speed and magnitude relative
to each other and with the up and down cycle of
business activity.
 The interest rates on assets often change by different
amounts and by different speeds than interest rates on
liabilities.
 Under this approach, all interest-sensitive assets and
liabilities are given weight based on their speed
(sensitivity) relative to some market interest rate.
 For example, federal funds loans generally carry interest
rates set in the open market, so these loans have an interest
rate sensitivity weight of 1.0.
 On the other way, loans and leases are the most rate-
volatile so its weight is estimated to be 1.5.
 On the liability side, the bank can assume deposits have a
rate-sensitive weight of 0.86 because deposits rate may
change more slowly than market interest rates.
 To determine the interest-sensitive gap, the dollar amount
of each type of assets or liability would be multiplied by
its weight and added to the rest of the interest-sensitive
assets or liabilities.
 More rate-volatile assets and liabilities will weigh
more heavily in the refigured balance sheet.
 This weighted interest-sensitive gap should be more
accurate than the unweighted interest-sensitive gap.
 The interest-sensitive gap may change from negative
to positive or vice versa and may change significantly
the interest rate strategy pursued by the bank.
 INTEREST SENSITIVE GAP
MANAGEMENT
Optimal value for a bank’s gap?
 There is NO general optimal value for a bank’s gap in
all environment.
 Gap is a measure of interest rate risk.
 The best gap for a bank can be determined only by
evaluating a bank’s overall risk and return profile and
objectives.
 The farther the bank’s gap from zero, the greater the
bank’s risk.
 Bank managers try to adjust the interest rate exposure in
anticipation of changes in interest rates.
 Speculating on the gap:
* Difficult to vary the gap and win (requires
accurate interest rate forecast on a consistent basis).
* Usually only look short term.
* Limited flexibility in adjusting the gap,
customers and depositors.
* No adjustment for timing of cash flows or
dynamics of the changing gap position.
Problems with IS gap management:
i. Interest paid on liabilities tend to move
faster than interest rates earned on assets.
ii. Interest rate attached to bank assets and
liabilities do not move at the same speed as
market interest rates.
iii. Point at which some assets and liabilities are
repriced is not easy to identify.
iv. Interest sensitive gap does not consider the
impact of changing interest rates in equity
position.
 DURATION GAP MANAGEMENT
 Duration is a value and time-weighted measure of
maturity that considers the timing of all cash
inflows from earning assets and all cash outflows
associated with liabilities.
 It measures the average maturity of a promised
stream of future cash payments.
 In effect, duration measures the average time
needed to recover the funds committed to an
investment.
 CONCEPT OF DURATION:
1. How to Calculate Duration.
2. How to Calculate Change in Net Worth if Interest
Rate Rises.
3. How to Calculate Dollar-Weighted Asset Portfolio
Duration.
4. How to Calculate Dollar-Weighted Liability
Portfolio Duration.
5. How to Calculate Duration Gap.
 How to Calculate Duration

Example: Suppose a commercial bank grants a loan

to one of its customers for a term of 5 years. The
customer promises the bank an annual interest
payment of 10%. The par value of the loan is
RM1,000, which is also its current market value
(price) because the loan’s current yield to maturity
is 10%. What is this loan’s duration?
How to Calculate Duration

n
t * CFt
t 1 (1  YTM)
t
D n
CFt
t 1 (1  YTM)
t

50
 5

 RM 100  t /(1  .10) t

 RM 1,000  5 /(1  0 .10) 5

D t 1
RM 1,000

RM4,169.87

RM1,000

 4.17 years

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 How to Calculate Change in Net
Worth if Interest Rate Rises
Example: Suppose a commercial bank has an
average duration in its assets of 3 years, an average
liability duration of 2 years, total liabilities of
RM100 million, and total assets of RM120 million.
Interest rate was originally 10%, but suddenly they
rise to 12%. Find the change in the value of net
worth.
 How to Calculate Change in
Net Worth if Interest Rate
Rises

 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 

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  0.02   0.02 
NW  - 3 * *120 - - 2 * *100
 (1  0.10)   (1  0.10) 

  RM 2.91 million

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 How to Calculate Ringgit-Weighted Asset
Portfolio Duration

Example:
Assets Held Market Value (RM) Asset durations
Treasury bonds 90 million 7.49 years
Commercial loans 100 million 0.60 years
Consumer loans 50 million 1.20 years
Real estate loans 40 million 2.25 years
Municipal bonds 20 million 1.50 years
How to Calculate Ringgit-Weighted
Asset Portfolio Duration

n
D A   w i * D Ai
i 1

Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio
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 n

 Duration of each asset  Market value of each asset

DA  t 1

Total market value of all assets

(7.49  90)  (0.60  100)  (1.20  50)  (2.25  40)  (1.5  20)

90  100  50  40  20

914.10

300

 3.05 years

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 How to Calculate Ringgit-Weighted Liability
Portfolio Duration

Example:
Liabilities Held Market Value (RM) Durations
Deposit 78 million 2.5 years
Other non-deposit 60 million 3.0 years
borrowings
How to Calculate Ringgit-Weighted
Liability Portfolio Duration

n
D L   w i * D Li
i 1

Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio
59
 (2.5  78)  (3.0  60)
DL 
78  60

375

138

 2.72 years

60
 How to Calculate Leverage-Adjusted
Duration Gap

Formula:
Dollar-Weighted Asset Duration minus

Dollar-Weighted Liability Duration x Total

liabilities
Total
assets
How to Calculate Leverage-Adjusted
Duration Gap

TL
D  DA - DL *
TA

62
Cont…

 138 
D  3.05 - 2.72  
 300 

 1.80 years

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 Limitations of Duration Gap
Management
 Finding Assets and Liabilities of the Same Duration
Can be Difficult
 Some Assets and Liabilities May Have Patterns of
Cash Flows that are Not Well Defined
 Customer Prepayments May Distort the Expected Cash
Flows in Duration
 Customer Defaults May Distort the Expected Cash
Flows in Duration
 Convexity Can Cause Problems

64
 ALM JOB
Risk Modeling Analyst (Retail)
RHB Banking Group
Job Description:
Primary Objective
Support development and the monitoring of the industry
leading regulatory compliant credit risk models, also
internal models for early warning as well as behavioral
models for Asset Liability Management (ALM) for
effective risk management and decision making in the
Bank on the designated subject area.

65
 ALM JOB
Key Responsibilities
Risk Modeling
Support Head, Retail Risk Modeling in relation to the respective
area’s risk modeling activities.
Assist to develop and maintain industry leading credit risk
models in accordance to Basel and MFRS requirements.
Assist to develop Asset Liability Management (ALM) behavioral
model to identify the behavior of deposits and loans for
application in Interest Rate Risk in the Banking Book
(IRRBB)/Rate of Return Risk in the Banking Book (RORBB) and
Net Stable Funding Ratio (NSFR).
Assist to develop early warning model which predicts the
likelihood of a customer moving from performing to arrears,
collaborate with business in developing a customer strategy for
‘at-risk’ customers.
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 ALM JOB
Key Responsibilities
Assist in preparing clear and thorough model development
documentation for regulatory submission and approval.
Prepare test script, test cases and perform User Acceptance
Test to ensure model is implemented as per expected.
Prepare model performance monitoring report for timely
reporting to the management committee, the monitoring report
served to provide insights to ensure correct use of model and
enable critical decision making related to model recalibration
or refinement.
Socialize with business expert to gather business insights in
respective area of data analytics.

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 ALM JOB
Requirements
Candidate must possess at least a Bachelor's Degree,
Post Graduate Diploma, Professional Degree, Master's
Degree, Computer Science/Information Technology,
Finance/Accountancy/Banking, Mathematics or
equivalent.
At least 2 year(s) of working experience in the related
field is required for this position.
Preferably Senior Executives specializing in
Banking/Financial Services or equivalent.

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 ALM JOB
Requirements
Good understanding on the respective area’s
business products and operations.
Good analytical skills.

Good statistical modeling knowledge.

Good understanding of relational databases and data

models.
Good programming skills in data handling and
statistical modeling.
https://www.jobstreet.com.my/en/job-search/asset-
liability-management-jobs/
https://www.uob.com.my/stakeholders/risk/risk.page?
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 ALM Software
https://www.infopro.com.my/core-banking/

https://www.sas.com/en_my/software/asset-liability-
management.html

https://www.oracle.com/industries/financial-services/
analytics/asset-liability-management/

https://themalaysianreserve.com/2017/11/20/bank-islam-
picks-kamakura-solutions/

https://www.kamakuraco.com/
70