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Boardwalk :: Forum List Banking
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Assets & Liabilities Management
Date: 2006/05/17 09:02 By: mvadmin Status: Admin  
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I will try to describe what is Assets and Liabilities Management in a bank. An AL Manager must manage with the whole balance and off-balance sheet to ensure the financial permanence of the bank and to protect its results. For that purpose, he must respect both external and internal rules (ratios, limits), calculate internal rates of return, evaluate the deformation of assets and liabilities, ensure the funding of the activity… He faces three main risks : the interest rate risk, the risk of liquidity, the risk of failure (or bankruptcy or credit risk). He tackles with that problem with derivatives products or techniques such as Assets Backed Securitisation or credit derivatives.

Let’s see the example of my bank, Casden Banque Populaire. The main activity consists in collecting and lending money, through saving plans and different kinds of loans such as property or consumer loans.

First of all, we can notice that the amount of savings which are liabilities for the bank is never equal to the amount of loans which are assets for the bank. Now, Casden holds 5,2 billions euro of loans and gets only 3,6 billions euro of deposits from its customers. As a result, Casden must borrow 1,6 billion euro on financial markets. Here rises the first problem an AL manager must handle with : funding.
On which maturity must he decide to borrow ? He must also choose between a fixed rate and a floater rate for his bond or loan issue. Most of the time, banks prefer to index their funding on a short term interest rate such as Euribor 3 months, because most of the time a short term interest rate is lower than a long term one. So to simplify, the bank will earn the difference between the rate paid by the customer which is closed to a ten years interest rate for a property loan and E3M. this spread is now around 2%.
In this case, Casden will borrow for example 100 millions euro for ten years at E3M plus a spread of liquidity increasing with the maturity, plus a spread of signature all the more high because of the risk of failure of Casden. Those two spreads are decided at the beginning of the operation and don’t change during the life of the loan. However, as E3M is a rate for a three months loan and Casden borrows for ten years, E3M will be fixed every three months, and Casden will pay the interest over the relevant quarter. So if E3M increases, Casden cost of funding will increase and its margin will reduce. This is the interest rate risk.
It would be more simple to borrow and lend money at two fixed rates on the same maturity and earn the difference. But competition between banks makes them reduce their rates to their customers. Thus they have to borrow at lower rates. It makes them being exposed to interest rate variations.
Secondly, the depreciation of assets and liabilities are not the same, because particular loans are mainly with constant payments, though interbanker loans are with capital amortising in fine. So ALM must also take into account the amortising profile of all assets and liabilities. For that purpose, it has to assume some rules and tries to settle a model based upon statistical datas. He must appreciate the risk of prepayment of loans which is an embedded option. For example, Mr. Taylor borrowed 100 000 euro in 2000 at 6% for ten years. Now he has 70 000 euro left to pay back to Casden within six years. Rates are now lower than four years ago, so he borrows 70 000 euro from BNP at 3% over six years in order to reimburse totally Casden now. For Mr. Taylor prepayment is financially better, but not for Casden which will have to reinvest that money at a lower rate. ALM must evaluate the correlation between prepayment and interest rates which explains arbitrage prepayments, and also statistical prepayments which occur even when it’s financially worse for the borrower (in case of divorce selling the house, death…).
Managing the balance sheet means also ensuring some regulatory ratios between assets and liabilities, depending on their maturity. The idea is to prevent the bank from lending more money for a long term period than it can, in order to be able to get back their savings to the customers whenever they want. This is the risk of liquidity. When Mr. Smith lets money on a current account for example, the bank doesn’t pay him any interest on it and uses its money buying shares or lending it to other people, but it must be able to give it him back at any moment. A statistical study upon currents accounts behaviour is thus required to appreciate how that money can be used.
He must also ensure and allow the capital required by the European Ratio of Solvability, called ratio Cook, which will soon be replaced by Mc Donough ratio. The idea is to put capital regarding to assets in a proportion increasing with the risk of failure of the other party of the assets.
The ALM can use many tools to protect the bank result from all that risks. With derivatives such as interest rate swaps or caps and collars, he can fix his funding cost or put a maximum on it.
He uses also ABS and credit derivatives techniques to manage the ratio Cook. When regulatory capital is not enough, the bank prefers to sell some assets rather than increase its regulatory capital because of its expensive cost. The point is that a loan is not sellable as a bond. The idea of ABS is to sell a portfolio of loans to a special purpose vehicle which then issues bonds fitted to the different wills of investors. The total assets of the bank is reduced and capital requirement also.
A credit default swap can hedge the credit risk over a loans portfolio without changing the total of the assets. It works as an insurance contract with excess. The bank buys a protection, paying premiums periodically. The seller of the protection holds all the losses of the portfolio over a first loss which remains for the buyer of the protection. Premiums and first loss depend on the rating by Moody’s or Standard & Poor’s. As they study statistical datas to estimate probability of default and recovery rate over the portfolio, though ratio Cook applies a same coefficient, a CDS can liberate regulatory capital. Those techniques must handle with big portfolio because of the important fees for structuring the deal.
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