ALM Materials Eng

Funds Management for Financial Institutions
February 8-10, 2006
Welcome
1. 2. 3. 4. 5. 6. 7. 8.
Introduction Overview of Risk and Risk Management ALM Overview Funds (Liquidity risk) Management IRR Management FX Risk Management Credit Risk Management Summary and Review
1. Workshop Introduction
Sarah W. Hargrove
Native of North Carolina Wharton MBA, CFA Thirty years of experience in investment and commercial banking in NY, NC and PA Top bank regulator in Commonwealth of PA with supervision of banks, savings institutions, licensed lenders, pawnbrokers..aggregate assets of USD 90 billion Consulting for past 10 years in emerging markets (Russia and other CIS, Thailand, Turkey, China, Jordan) ranging from bank appraisals, bank supervision and bank technical assistance Special expertise in bank supervision, bank valuation, risk management and corporate governance
4
Objectives of Workshop
To understand the role of ALM and its relationship to strategic and annual profit planning To be able to define and measure different risks involved in financial intermediation To understand how ALM decisions affect changes in net interest margin, ROA and ROE To be able to design ALM strategies in different interest rate environments To understand the role of capital in ALM decisions
5
There are some administrative matters to review

Hours 9:00 am 5:00 pm Breaks: 10:30 am 10:45 am 12:00 pm 1:00 pm 3:00 pm 3:15 pm Summary and feedback at end of each session No cell phones!
We will first review some basic principles of risk and risk management
Definition of risk and risk/reward trade-off Purpose of capital and role of risk management The road to Basel 2 Major risks faced by financial institutions
Credit risk Market risk Operational risk
RAROC/RORAC principles
We will then look at an overview of Asset Liability Management

Management of non-credit financial risks Objectives of ALM Framework for ALM decision-making Determining risk appetite Business strategies in different interest rate environments
We will review funds management
Tools of funds management Application of tools Asset liquidity vs liability liquidity Determination of minimum liquidity needs
We will then examine how gap analysis is used to measure and manage IRR
Periodic and cumulative gaps Static and dynamic gaps Data needed for a gap report Steps in preparation of a gap report
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We will look at another aspect of ALM: FX risk management

Definition of FX risk Identification of FX risk: Long vs short positions Measurement of FX risk Management of FX risk
11
We will look at risk valuation methods
Value at risk and earnings at risk Inverse relationship Capital Asset Pricing Model Systematic vs diversifiable risk
Standard deviation Correlation and covariance
12
We will look at credit risk valuation methods

Individual vs Portfolio risk Default factors Marginal risk Expected loss
Probability of default Loss given default Exposure at default
Unexpected loss
13
We will then apply the risk management principles to business planning

Sensitivity analysis Flexible budget allocation Volatility of earnings and EVE Application of Models
Dangers of Models Limitations of Models
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The last day will be devoted to review
Putting it all together with case study Final review
15
2. Overview of Risk and Risk Management
16
Financial institutions intermediate capital flows between savers and borrowers
Sources of Funds
(Surplus accounts or Savings)
Users of Funds
(Deficit accounts or Borrowings)
17
Financial institutions assume risks in the intermediation process

Economic Sectors Intermediaries
Assets
Liabilities
Insurance Companies Households Pension Funds Banks, Savings Assoc., Investment Banks, Leasing Cos. Stock Exchange Other markets
Governments Businesses
Liabilities
Assets
18
Certain principles rule financial intermediation in free markets

Supply and demand
Interest rate as the clearing price Opportunity cost of consumption/investment
Rational investors
Risk averse Maximize return/Minimize risk
Efficient markets
Allocation of resources Information impounded in prices Competition Economies of scale
19
Accumulation/protection of capital is the goal of risk taking and risk management

Capital represents net assets or shareholder ownership Capital serves to absorb losses
Operating or financial losses Protects other creditors Permits growth Equity is the most costly source of capital
20
What is risk?
The concept of financial risk underlies modern portfolio theory with roots in capital market and investment theory
Risk aversion Risk premiums Historical and expected returns Probability distributions Variance and standard deviation Systematic vs diversifiable risk
21
Perceived risk is based on historical or expected volatility

160 140 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10
Series1
Series2
22
What is return?
Cash flows Net income Dividends Capital appreciation/gains Time value of money
PV =
n=o-t
C (1+r)n C (1+r) n
FV =
n=o-t
23
The higher the risk, the higher the required rate of return
Required rate of return determines the price
Current income stream Capital appreciation
Based on perceived risk

The greater the historical volatility the greater the risk The greater the uncertainty the greater the risk The longer the horizon the greater the risk
24
Risk is priced by the discount rate: absolute and relative

MV=PV = Rate of Return C + TV t=0-n (1+r)t (1+r)t CCC B Risk Premium BBB A AA AAA BB Common Stock Conv. Preferred Preferred Stock Income Bonds Subordinated Debentures 2nd Mortgage Bonds
First Mortgage Bonds Treasury Bonds
Risk Free Rate Level of Risk
25
There is risk-reward trade-off inherent in financial intermediation

Risk is the uncertainty or the standard deviation of probable returns
Short-term vs longer-term Liquidity Floating vs fixed rates Credit Leverage
26
How much capital does a bank need?
Enoughbut not too much.
27
What is enough capital?

Capital protects depositors and other creditors
Safety and soundness Supports growth Is a buffer against losses Can be in the form of non-equity
Equity capital represents owners interests

Last creditors to be paid in liquidation Requires a return in cash income and appreciation Retained earnings are a good source of capital
28
What is too much capital?

Capital is a non-interest bearing source of funds
Equity capital is the most expensive source of funds Must earn a required rate of return (ROE) Is a scarce resource
Managements goal is to maximize risk-adjusted returns

Rational investor theory Competes with risk-free rate and alternative investments Affects pricing and competitive position if too much
29
Bank management must satisfy different stakeholders with different objectives

Return Pricing
Owners
Safety and Soundness
Customers
Compensation
Regulators/Rating Agencies
Employees
30
Capital adequacy is in the eyes of the beholder

Accounting capital
Focus is historical cost of Focus is historical cost of assets and recognition of assets and recognition of impairment (fair value) impairment (fair value) Focus is income, the Focus is income, the markets expectations markets expectations and required return and required return Focus is market value Focus is market value (PV of cash flows) of (PV of cash flows) of assets/liabilities assets/liabilities Focus is balance sheet Focus is balance sheet and income risk and and income risk and capital components capital components
Market capital
Economic capital
Regulatory capital
BIS II attempts a more precise calibration of economic and regulatory capital
31
In a perfect market the different capital definitions would theoretically be equal

Book values represent present values of future cash flows discounted at current required rates of return Market values of capital stock reflect net present values Economic capital is the same as net book value Regulatory capital would be a realizable value of assets in excess of liabilities
32
But financial markets are neither perfect nor efficient

Different expectations Abnormal profits Asymmetrical and imperfect information Information not instantaneously impounded in prices Transactions costs Etc.
33
Banking regulation has historically protected the industry from undue risks
Restricted licenses Geographical limitations Interest rate ceilings Product line uniqueness Limited competition
Lets look at how regulation has evolved as these protections eroded and market structures changed
34
World-wide trends have changed the nature of banking

Deregulation and liberalization of markets Globalization and interdependence of markets Technological advances Product innovation and increased complexity Increased size and speed of financial transactions Increased competition
Increased volatility and risk
35
In ma teres rke t t d rate ere a gu nd lat ion Pri ma reg ry ca ula pit t io a l n
Bank regulatory trends have followed but with a lag
Economist, October 5, 2002
New rules follow every financial crash, almost always with unintended consequences.
36
Ris k-b Ca ase d pit al Re gu lat ory /a st co anda ccou nv erg rds nting en ce Ris km ris anag ka vo emen ida nc t vs. e
The introduction of primary capital led to unintended consequences

Reduction in liquid assets Gains trading to create capital Explosion of off-balance sheet items Overcapitalized banks and disintermediation Undercapitalized banks in emerging markets
Int ere st ma rate de reg rket and u la ti o n
Pri m cap ary reg ita ula l t io n
Unfair competition
37
Different capital requirements allowed some banks to gain market share

Japanese Bank Loan Net interest margin Income Capital USD 100 million .6% USD 600,000 2% USD 2 million ROE 30% US Bank USD 100 million 1.25% USD 1,250,000 6% USD 6 million 20.8%
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The 1988 BIS Capital Accord created an international level playing field
Harmonized capital standards with risk-based capital Addressed off-balance sheet assets Distinguished among riskiness of different asset classes Applied to large, internationally active banks
Int e an rest de d ma rate reg r ula ket tio n Pr i m cap ary reg ita ula l tio n Ris kCa base d pit al
39
Regulation of capital has become the primary tool to limit bank risk-taking
Tier I: Shareholders equity (Paid-in capital and R/E) Tier II: Supplementary capital Tier III: Add on capital to support market risk only
In ma tere rke st r t d ate ere a gu nd lat ion ita l Ris k-b ase d Ca p
Pr i
ma reg ry ca ula pit tio al n
40
Since 1988, other banking standards have converged with capital standards
Core Principles of Effective Supervision (1995) Amendments .to Incorporate Market Risk (1996,1998) Principles for the Management of Interest Rate Risk (1997) Framework for Internal Control Systems (1998) Guidelines for Corporate Governance (2000) Principles for Internal Audit (2001)
Int ere st ma rate de reg rket and ula tio n
Ris kCa base d pit al
Re g acc ulato r sta ounti y / co nda ng nv erg rds en ce
Pr i m cap ary reg ita ula l tio n
BIS II
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BIS II permits banks to customize capital adequacy assessment

New guidelines intend to align regulatory capital requirements more closely with underlying risk Emphasis is on banks risk management and economic capital allocations There is flexibility in assessing capital adequacy: standardized vs. IRB approaches
Int ere st ra de mark te an reg et d ula tio n Re g acc ulato sta ounti ry / co nda ng nv erg rds en ce Ris kCa base d pit al ma Risk na vs. gem avo Ris ent ida k nc e Pr i m cap ary reg ita ula l tio n
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Capital adequacy should be a function of a banks mission, strategy and risk tolerance
Mission
Bank Strategy
Capital Allocation Pricing
Business Plans for Priority Business Segments

Target Customers, Products/Services Objectives and Business / Financial Plans
Support Infrastructure
Performance Management Funding and Liquidity
43
Capital should be set to meet a banks target credit rating

S & P RATING
AAA AA A BBB BB B CCC CC C
MOODYS EQUIVALENT
Aaa Aa3/A1 As/A3 Baa2 Ba1/Ba2 Ba3/B1 B2/B3 B3/Caa Caa/Ca
DEFAULT PROBABILITY (SUBSEQUENT YEAR)

0.01% 0.03% 0.10% 0.30% 0.81% 2.21% 6.00% 11.68% 16.29%
The higher the rating the more unexpected losses that need to be covered by capital
44
Capital must be allocated to cover major risks to the appropriate confidence level
Credit Risk Standardized Approach IRB Approach
Foundation Advanced
Market Risk Standardized Approach Internal Models Approach
Minimum 8% of Capital to Risk-Weighted Assets
Operational Risk Basic Indicator Approach Standardized Approach Internal Measurement Approach
45
Capital adequacy is a function of three pillars

Pillar 1: Minimum Capital Internal capital assessment process and control environment Capital f (how sound the process is)
Pillar 2: Supervisory Review Review assessment process Evaluate IRR in banking book Pillar 3: Market Discipline
Formal disclosure policy Describe risk profile, capital levels, risk management process and capital adequacy
Mutually reinforcing factors that determine capital adequacy
46
Ultimately the financial market is the harshest regulator

Quantitative Requirement Qualitative Requirement
Minimum Capital Requirement
Supervisory Review Process

Many players Many players Self interested, Self interested, rational rational Independent Independent Real time Real time
Market Discipline
Public Disclosure
47
The level of capital required is a function of the quality of information
The less the history, the less reliable the data The less certain or transparent, the greater the risk The more the risk, the more capital needed All the above implies higher capital levels for some banks in less mature markets
48
BIS II guidelines are guidelines only but have become best practice
The quality of bank management, particularly the risk management process, is the key concern in ensuring the safety and stability of both individual banks and the system as a whole.
49
The purpose of capital is to absorb unexpected losses and support growth
Capital is not a substitute for inadequate control or for risk management processes.
- Bank for International Settlements
50
Assumption of risk is the raison detre of banking
Banks make money by assuming risk Banks lose money by not managing risk or by not getting paid for the risk assumed Banks manage what they measure
51
A formalized risk management framework is best practice

Risk Management is the deliberate acceptance of risk for profit making informed decisions on the trade-offs between risk and reward and using various financial and other tools to maximize risk-adjusted returns within pre-established limits.
52
A Risk Management framework facilitates informed decision-making
Identify Measure Manage Monitor
53
Risk Management is now basic to financial management
The nature of Risk Management in banks is changing fundamentally. Until recently, it has been an exercise in damage limitation. Now it is becoming an important weapon in the competitive struggle between financial institutions. Those who can manage and control their risks best will be the most profitable, lowest priced producers. Those who misjudge or mis-price will be out on their ear.
The Risk Game The Economist, Survey of International Banking (1996)
54
Risk management permits the optimization of the risk-reward trade-offs
The primary objective is to minimize the volatility of earnings and capital (hence the risk as perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.
55
Different risks affect different parts of the income stream and capital levels
Interest rate risk
Net Interest Income Average Assets ALM Focus (+) Non Interest Income Average Assets (-) Return on Operating risk Average Total Assets Return on Average Equity (x) Leverage Credit risk Multiplier Overhead Average Assets (-) Provisions Average Assets (-) Income Taxes Average Assets
Market risk
ALM Concern
56
Rational shareholders require a return commensurate with risk

Balance Sheet Assets Liabilities Equity Income Statement
Net Interest Income Average Assets
+
Non Interest Income Average Assets
Return on Average Total Assets Return on Average Equity x Leverage Multiplier Overhead Average Assets
Provisions Average Assets
Equity
Income Taxes Average Assets
57
RAROC rigorously calculates returns recognizing the capital cost of risk

RAROC: Risk-adjusted return on capital
Revenue less funding and other costs Predictable losses are expensed
Profit RAROC =
Provisions
Economic Capital
The cushion needed to support Unexpected Losses
58
RAROC allows bank management to make proper risk-reward trade-offs

Loan/Product/Branch
Interest and fee income Interest and fee income Less cost-of-funds Less cost-of-funds Net interest income Net interest income Less expected loss Less expected loss Less non interest expenses Less non interest expenses Pretax income Pretax income Less tax Less tax Divided by Economic Divided by Economic Capital Capital RAROC RAROC xxx xxx (xxx) (xxx) xxx xxx (xxx) (xxx) (xxx) (xxx) xxx xxx (xxx) (xxx) xxx xxx xxx xxx X% X%
Pricing guidelines FTP
Credit analysis
Direct and allocated indirect costs
Allocated capital
Applied to hurdle rate
59
RAROC drives BIS Pillar 1: Depends on a banks own capital charge given risks
Return
RAROC
Efficient Frontier
Business Units, Sub-Portfolios, Transactions
Risk Free Rate
Risk
60
One of the most difficult aspects of RAROC is the assignment of EC

RAROC uses a banks own allocation RORAC uses BIS assigned weights The more the capital the more the perceived risk of the asset.but more conservative and less risky the bank The more the capital the higher the required return from the asset
61
Which bank is the better bank?

A ROE ROA Net Int. Income Other Income Spread NIM 20% 2% 2% 6% 6% 4% B 20% 1% 6% 1% 6% 7%
How do we explain the differences in measures of profitability?
62
3. Asset Liability Management Overview
63
ALM is one component of a broader risk management framework
Internal Audit Credit Risk Management
ALM
Treasury Management
64
ALMs focus is non-credit financial risks
Liquidity risk Interest rate risk Foreign currency risk Capital risk
65
Market risk is due to movements in market prices or interest rates
Liquidity risk Interest rate risk Foreign currency risk Equity price risk Commodity price risk Banking Book Trading Book
66
ALM is the process of managing the interest spread while insuring liquidity
The ultimate viability of a bank depends on managements ability to manage both assets and liabilities to provide adequate liquidity and adequate protection of both earnings and capital against significant market interest rate fluctuations
67
It is a balancing act to achieve the banks objectives within risk limits
Net Interest Income
Market Value of Equity
68
ALM is a process of making risk/reward trade-offs.

C
Expected Return
B A
Risk/Standard Deviation
69
ALM manages the structural balance sheet to satisfy the different stakeholders
Market Value Return on Equity Return on Assets Net interest margin Capital Adequacy Liquidity
70
ALM is an integrated function of strategic, profit and capital planning

Business strategy & credit policy
Set Policies and Objectives (including FTP rules)
Interest Rates FX rates Economy Reg .trends Competition
Gather External Information
Develop and Assess Scenarios
Collect and Analyze Internal data
Set Liquidity Policy
Set Interest rate position
Set FX Exposure position
Set investment and earnings management guidelines
Execute Drives strategy and credit risk management 71
ALM manages the banking book usually through an ALCO
Targets
ALCO Balance sheet composition Funding requirements Interest rate risk management Capital planning Profit planning Loan pipeline Business Units Treasury Execution arm for ALCO Customer transactions Issue bonds FX trading Cash management Derivatives/hedging Funds transfer pricing
Reports Monitor
RAROC
FIS
FTP
72
ALCO monitors economic environment, actual vs plan and adjusts accordingly

Treasury
Executes ALCOs Transactions
Funding/FTP Cash Management Investment Portfolio Hedging/Derivatives
ALCO
Targets
As set Pip e l i ne
Reports
Manages Trading Risk

Securities Derivatives Foreign Currency
FAD
Planning/Budgeting Yield and spread analysis Capital allocations
Business Units
FIS
73
Customer Relationships Loan originations Deposit gathering
ALM risks arise due to a mismatch between assets and liabilities capital
Contractual differences between assets and liabilities Yield curve Exchange rates Customer preferences
The objectives are a predictable level of earnings and growth

Financial Objectives
Short-term: Net income Long-term: Market Value of Equity
Balance Sheet Objectives

Balance Sheet growth targets Capital Growth and Dividends Markets served and markets ignored Product offerings and Pricing Desired image of bank
75
ALM seeks to maximize ROE within given risk limits

Net Interest Income Average Assets (+) Non Interest Income Average Assets (-) Return on Average Total Assets Return on Average Equity (x) Leverage Multiplier Overhead Average Assets (-) Provisions Average Assets (-) Income Taxes Average Assets
76
Net interest income is usually the most predicable source of earnings

Interest Yield on Earning Assets Net Interest Spread (-)
Cost of Interest-paying Liabilities Net Interest Margin on Earning Assets (+/-)
NIM
(x) Gain (Loss)
Earning Assets Interest Bearing Liabilities (x) Cost of Interest-paying Liabilities
Earning Assets Total Assets
77
Interest margin objective worksheet

Determined Required Return on Assets Desired Return on Equity times Required Equity to Assets Ratio equals % Return on Assets ROE x 1 2 Capital Ratio = 3 ROA
Determined Required Net Income Decimal Required Return on Assets Times Total Assets equals net income ROA x 3a 4 Assets = 5 Net Income
Determining Interest Margin Required Net Income plus operating expenses plus loan and security losses plus taxes Net Income 5 Less fees equals desired margin Fees 9 = 10 Interest Margin + 6 Operating Expenses + 7 Loan and Security Loss + 8 Taxes
78
Target ROE can be achieved if each asset produces its return on allocated equity
Required ROE of 20% with Capital Ratio of 10% Assets Cash Investments Loans Total 10 20 70 100 Net Income Capital Return 0 0.6 1.4 2.0 0 3 7 10 0% 20% 20% 20%
79
Capital is a scarce resource and its effective utilization is a focus of ALM
Bank Profits
Business Unit Profits
Product Profitability
Client Profitability
Staff Productivity
80
The goal of ALM is to maximize returns to shareholders over the long run
Strategic and financial planning
Business & balance sheet mix
Earnings and capital guidelines
Other key ratios and targets
81
A banks strategy is the backdrop for any ALM policy
Mission Performance-driven Bank Strategy

Capital Allocation Pricing
Business Plans for Priority Business Segments

Target Customers, Products/Services Objectives and Business / Financial Plans
Support Infrastructure
Performance Management Funding and Liquidity
82
Consider whether all a banks assets should be allocated to interbank loans?

Commercial Loan Amount NIM Income Capital ROE 100 million 1.25% 1,250,000 8 million 15.6% Interbank 100 million .5% 500,000 1.6 million 31.25%
83
4. Funds Management
84
Funds management is concerned with funding assets and managing liquidity risk
Cost of funds Diversified sources of funds Diversified tenors Asset Sales Roll over risk Capital planning
85
What is Liquidity Risk?
The volatility in income or economic capital of the bank due to an inability to meet cash needs for payments/withdrawals or to support credit demands and growth in a timely and cost-effective manner.
86
What Does Liquidity Mean?

Liquidity is a banks ability to meet all cash demands (withdrawing deposits, borrowing money, operational demands, etc.) anytime and entirely at a reasonable cost It is not
Cash or other types of assets A ratio Earnings of a bank
87
Liquidity Risk: Deposit withdrawals and roll-over risk

Composition of liabilities and sensitivity to changes in interest rates and credit rating Funding from money traders, public institutions, foreign investors, and large corporations Large funding held by any single group or individual Seasonal or cyclical patterns
BUT The higher the asset quality and the greater the The higher the asset quality and the greater the liquidity ... the better a banks perceived liquidity ... the better a banks perceived creditworthiness and access to refinancing creditworthiness and access to refinancing sources at reasonable prices sources at reasonable prices
88
Liquidity Risk: Asset Growth

Unused credit lines outstanding Business activity in banks trade area Demographic changes in market Aggressiveness of marketing efforts-strategies to expand market share and pricing decisions Funding under letters of credit and bank guarantees
89
There is a trade-off between liquidity vs. profitability
Cash holdings provide no interest income Short-term securities normally carry lower yields Short-term loans normally carry lower rates Less liquid assets provide more income
90
But
The better the quality assets and the greater the liquidity the better a banks perceived creditworthiness and access to refinancing sources at reasonable prices A banks liquidity risk closely follows its credit, capital and interest rate risk Banks large deposit outflow often traced to credit problems or interest rate gambles that failed
91
Liquidity risk is identified by maturity gaps Liquidity risk is identified by maturity gaps
Assets Cash Interbank loans Investments Loans REPOs Other assets Total Liabilities Deposits Notes Interbank Loans Debentures Other Capital Total GAP (A-L) Cumulative GAP GAP Ratio(A/L) O/N 35 97 62 4 20 218 327 20 214 43 85 689 -471 -471 0.32 2-30 days 70 118 158 126 194 666 31-90 91-180 181-360 Over 43 219 102 131 495 Total 35 210 802 885 312 375 2619 327 241 714 772 147 102 2303 257 275 77 30 639 100 105 205 396 108 288
75 89 391 46 601 65 -406 0.69
101 183 187
31 153
14 71 151
4 16 102 122 373 1.14
471 168 -238 0.86 Board Limits > .7 >1 >=1
184 21 -217 0.89
236 160 -57 0.97 Actual 1.28 2.21 0.86
Limits 30 day Assets/overnight liabilities 90 day Assets/overnight liabilities 90 day Assets/90 day liabilities
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The key to liquidity risk management is planning

To guarantee permanent liquidity, the Liquidity Plan has to accurately project all cash flows However, the longer the planning horizon, the more inaccurate the cash flow prediction Need for good data bases and communication systems to estimate future cash flows based on historical behavior Plan should include worst case scenario
93
Examples of Asset Liquidity
Cash and due from banks in excess of required reserves or compensating balances Federal funds sold and repurchase agreements Government securities that mature within one year Loans that can be readily sold or securitized Collateral for borrowings
94
Concerns with Asset Liquidity
Some assets cannot be sold because they are already pledged as collateral Market risk Target loan to deposit ratio
Loans are among the least liquid assets Deposits represent the primary source of fund High (low) ratio indicates illiquidity (strong liquidity)
95
There are measures of liquidity that indicate borrowing capacity

Equity to asset ratio ( well capitalized ) Risk assets to total assets Loan losses to net loans Reserve for loan losses to non-performing loans Core deposits to total assets Volatile (purchased) liabilities to liquid assets Composition of deposits (diversified customer base) Market access
96
Liquidity risk management is a daily responsibility

Monitor balance sheet trends Forecast funding needs Identify alternative sources of funds Asset liquidity vs liability liquidity Stress testing Peer analysis
97
Liquidity Risk Monitoring: Minimum MIS/Reports

Liquidity gap limits Sources of funds Maturity distribution Volatile funds dependency Stress testing using assumptions of funding attrition Contingency plan
98
Liquidity risk management is a continuous process
Quantity of Risk.
Quality of Liquidity Risk Management Determine: How diversified are our sources of funds assets and liabilities?
Strategies for Managing Risk
Monitor Risks
Identify: What kind of risks? Where do they exist in our bank? How much risk?
Assure: That plans are sufficient to avert funding crises and to gain a fair return for liquid assets
Continue: Regular, ongoing evaluation of quantity and quality of liquidity and management practices
99
Liquidity Risk Identification

Assets
O/N Cash Interbank Securities Investments Loans Other Total 62 24 341 35 220 70 118 60 158 330 726 357 36 275 107 880 396 288 102 131 495 108 43 219 2-30 31-180 181-360 Over Total 35 333 802 96 885 687 2838
100

Liabilities
O/N Deposits Interbank Term Deposits Notes Other Borrow. Other Total 327 33 4 20 257 85 726 109 75 480 46 710 233 132 523 107 888 378 142 14 222 4 118 136 14 2-30 31-180 181-360 Over Total 327 33 502 241 1486 249 2838
101

Net Liquidity Gap
O/N 2-30 31-180 181-360 Over Total
Assets
341
726
880
396
495
2838
Liabilities
726
710
888
378
136
2838
Gap(A-L) Cumulative
-385 -385
16 -369
-8 -377
18 -359
359
102
Short-Term Liquidity Plan

Liquidity Plan from .... to .... TDM 0. 1. Initial Liquid Assets Inflows 1.1 Certain cash inflows 1.2 Uncertain cash inflows Outflows 2.1 Certain outflows 2.2 Uncertain outflows Assets - Level 1 (= 0. + 1. - 2.) Minimum required reserves 4.1 Required reserves at Central Bank 4.2 Required internal reserves Excess or Gap (=3. - 4.) Used sources Funds - Level 11 (=5. + 6.) Funding sources Used sources Potential funding sources (= 8. - 6.) Required internal reserves Excess Potential Funding Sources (9. +4.2.) 103 Expected Amount Worst Case
2.
3. 4.
5. 6. 7. 8. 6. 9. 4.2 10.
5. Interest Rate Risk Management
104
Assume gap in previous exercise reflects repricing schedules

Net Liquidity Gap O/N Assets Liabilities Gap(A-L) -385 Cumulative 341 726 16 -385 2-30 726 710 -8 -369 31-180 880 401 18 -377 181-360 Over 396 378 359 -359 495 136 Total 2838 2838
What happens if interest rates increase/decrease?
Interest rate risk occurs because interest rates change, and there is a yield curve
105
The Yield Curve Positively Sloped-Normal
8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 3 2.5 2 3 6 12 24 36 60 120 360 Maturity (in months)
Interest Rates
Generally implies: Growing economy Moderate Central Bank policy Expectation of some future rate increases
The Yield Curve Positively Sloped-Steep
8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 3 2.5 2 3 6 12 24 36 60 120

Maturity (in months)
Interest Rates
Generally implies: Economy rebounding from recession Easy Central Bank policy Expectation of significant future rate increases
360
The Yield Curve A Flat Yield Curve

Generally implies: High growth economy CB tightening to reduce growth and inflation Expectation of falling future rates
Interest Rates
The Yield Curve Inverted Yield Curve

12.5 12 11.5 11 10.5 10 9.5 9 8.5 8 7.5 7 6.5 6
12 36 3 12 0
Generally implies: Unsustainably high growth economy Aggressive Central Bank tightening Expectation of significantly lower future rates
Interest Rates
Maturity (in months)
Relative interest rates reflect a risk-reward tradeoff

Compounding
Benefit of compounding available in shorter maturities must be incorporated in the rate for longer maturities
Liquidity Price Risk

Investors will accept a lower yield over time to have access to their money more often
Credit Risk
Longer the maturity of a loan, the higher the uncertainty as to the borrowers ability to repay the debt Investors believe that the risk of a company defaulting on its debt grows over time
The Yield Curve - Credit Differences

Interest Rates
US Treasury A Rated
What is interest rate risk?
The volatility in earnings or economic capital of the bank due to a change in the level of interest rates, interest rate spreads or shifts in the yield curve.
112
Volatility in earnings or economic capital are inversely related

Changes in market rates cause a change in interest income and expense of the portfolio Changes in market rates cause a change in the opposite direction in market value of assets and liabilities Increase in asset values mean reinvestment of funds at lower rates
Interest income is lower Maturing values must be reinvested Asset sales look good, but future income could be lower
113
Examples of interest rate risk on earnings

Earnings are affected if assets and liabilities have different interest rate sensitivity. Example: 10 million loan @ 8% fixed for one year 10 million 3-month deposit at variable rate currently 4% Interest margin of 4% or 400,000 decreases if the variable rate increases during the year.
114
Examples of interest rate risk on EVE
Capital or EVE is affected if fixed rate assets are marked-to-market and interest rates change. Example: 10 million 6% due 2006 currently selling at par (ie., market yield is 6%) If interest rates increase 1% (100 basis points), the market value of the bond decreases to 9.59 million for a loss of 410,000.
115
Interest Rate Risk is identified by gaps

GAP = Rate Sensitive Assets - Rate Sensitive Liabilities
Rate Sensitive Assets

Assets which reprice in a given time period if interest rates change maturing assets principal payments on assets variable rate assets
Rate Sensitive Liabilities

Liabilities which reprice in a given time period if interest rates change maturing liabilities principal payments on liabilities variable rate liabilities
116
Positive Gap exists when sensitive assets exceed sensitive liabilities

Example (RSA) Assets (RSL) Liabilities Repricing Gap = = = 400,000 350,000 50,000
If interest rates rise, more assets will reprice than liabilities. Therefore, expect interest income to increase in the short run more quickly than interest expense. If rates fall, the reverse will occur. Therefore, when rates rise, expect profits to rise; and when rates fall, expect profits to fall.
117
Negative Gap exists when sensitive assets are less than sensitive liabilities
Example (RSA) Assets (RSL) Liabilities Funding Gap = = = 350,000 400,000 -50,000
If interest rates rise, more liabilities will reprice than f assets. Therefore, expect interest expense to increase in the short run more quickly than interest income. If rates fall, the reverse will occur. Therefore, when rates rise, expect profits to fall; and when rates fall, expect profits to rise.
118
Interest Mismatch Ladder

PERIOD TO MATURITY OR ROLLOVER DATE LIABILITIES ASSETS MISMATCH
Non-interest bearing Up to 1 month 1-3 months 3-6 months
(1,500) (17,000) (9,600) (18,000)
18,000 9,000 22,000
(1,500) 1,000 (600) 4,000
An analysis of the mismatches (gaps) between assets and liabilities at each value date will show the banks exposure to both liquidity risk (i.e., the risk of being unable to raise funds to meet payment obligations at a future date) and interest risk.
119
Interest Rate Risk Measurement: Exercise

Measuring the impact of different % of Rate Sensitive Assets on Interest Revenue With an Increase in the General Level of Interest Rates
General Level of Interest Rates
Beginning (%) After increase (%) Change (%)
Earning Assets (000)
% of Assets Repriced
Rate Sensitive (%)
Interest Revenue
Beginning After increase % Change
10 10 10
12 12 12
20 20 20
15,509 15,509 15,509
100 50 25
129,241 129,241 129,241
155,091 142,166 135,704
20% 10% 5%
Measuring the impact of different % of Rate Sensitive Liabilities on Interest Expense With an Increase in the General Level of Interest Rates
General Level of Interest Rates
Beginning (%) After increase (%) Change (%)
Liabilities (000)
% of Liabilities Repriced
Rate Sensitive (%) Beginning
Interest Expense
After increase
% Change
10 10 10
12 12 12
20 20 20
14,011 14,011 14,011 120
100 50 25
116,758 116,758 116,758
140,110 128,434 122,596
20% 10% 5%
Interest Rate Risk Measurement: Exercise

Beginning Level of Rates (Base Case) Interest Income Interest Expense Net Interest Income Interest Rates Increase 20% Interest Income Interest Expense Net Interest Income Change from Base Interest Rates Decrease 20% RSA RSL Interest Income Interest Expense Net Interest Income Change from Base RSA RSL 129,241 116,758 12,483 50% 100% 142,166 140,110 2,056 (85)% 50% 100% ________ ________ ________ ____% RSA RSL RSA RSL 100% 50% 155,091 128,434 26,657 114% 100% 50% _______ _______ _______ ____%
121
Losing Money with Gap Strategies

Consider the following maturity/rate structure
Interest Rates Assets: Loans 1-year maturity 2-year maturity 3-year maturity 8.5% 9.5% 10.5% Liabilities: Deposits 5.5% 6.5% 7.5%
Interest rates are expected to increase in the future Appropriate Gap strategy for a rising rate environment Hold positive Gap Invest in short-term assets Fund with long-term liabilities
122
Losing Money with Gap Strategies

Suppose rates do increase
One-year rates one year from now have increased 1.5% One-year rates two years from now have increased another 1%, or 2.5% higher than current rates Assume that the yield curves for assets and liabilities increase by equal amounts
Calculate the three-year income performance for this bank for a strategy of a positive Gap.
123
What is the performance with a zero Gap or negative Gap?

Interest Income Interest Expense Net Interest Income
Strategy Zero Gap: (1-yr assets & 1-yr liabilities) Negative Gap: (3-yr assets & 1-yr liabilities)
____.__
____.__
____.__
____.__
____.__
____.__
124
Duration is a common measure of interest rate risk from a capital perspective

Change in Price from Initial Price at 10% Interest Rate (Percent)
+3.90
+3.63 0 -3.46 -3.72

10%, 2 year Zero Coupon, 2 year
8.0
10.0
12.0
Required Yield (Percent)

Price of 10% Bonds $1,036.30 1,000.00 965.36 Price of Zero Coupon $854.80 822.70 792.09
Market Rate 8.0% 10.0% 12.0%
125
Simulation is used to test IRR limits

Rate Shock Exposure Change in Rates (b.p.) + 400 + 200 Base -200 -400 Net Estimated Value 6,155 5,969 5,679 5,401 4,978 Interest Change From Base 476 290 0 (278) (701) Income % Change from Base 8.4 5.1 0.0 (4.9) (12.3) Current Estimated Value 10,812 12,741 13,686 14,565 16,426 Market Change From Base (2,875) (946) 0 879 2,740 Value % Change from Base (21.0) (6.9) 0.0 6.4 20.0
Rate Cycle Exposure Net Estimated Value 7,111 Interest Change From Base 1,414 Income % Change from Base 24.8 Current Estimated Value 9,409 Market Change From Base (4,277) Value % Change from Base (31.3)
Y/Curve Type Fully Inverted Semi Inverted Flattening Base Steepening
6,641 5,762 5,697 5,148
944 65 0 (549)
16.6 1.1 0.0 (9.6)
11,052 13,237 13,686 14,790
(2,634) (449) 0 1,103
(19.2) (3.3) 0.0 8.1
Rate Forecast Exposure Net Estimated Value 5,829 5,691 5,700 5,536 Interest Change From Base 129 (9) 0 (164) Income % Change from Base 2.3 (0.2) 0.0 (2.9) Current Estimated Value 17,102 18,461 18,145 19,412 Market Change From Base (1,043) 316 0 1,267 Value % Change from Base (5.7) 1.7 0.0 7.0
Change in Rates (b.p.) Rising Most Likely Base Declining
126
Interest rate risk management has evolved

STATIC GAP ANALYSIS
Stage 1 Develop Gap analysis - basic approach
DATA BASE SUPPORT
DYNAMIC GAP ANALYSIS
HISTORY OF RATE VOLATILITY
Stage 2 Create history of rates and data base
SIMULATION MODELING
VALUE AT RISK ANALYSIS
Stage 3 Create models and begin VaR analysis
DETERMINE RISK TOLERANCE
State 4 Utilize all of the tools to manage limits and balance sheet
DETERMINE BALANCE SHEET TARGETS
SET TRADING LIMITS
127
Interest Risk Management: Difficulties

Forecast the direction and magnitude of interest rate changes GAP measures do not accurately indicate interest rate and do not recognize the timing differences in cash flows for assets and liabilities within the same maturity groupings Duration is a good measure only for small changes in interest rates What is ideal for the customers is not ideal for the bank
128
Interest Rate Risk Management: Monitoring of MIS/Reports

Asset yields, liability costs NIM, variances from prior period and budget Longer term interest margin trends Rate sensitivity position Static and dynamic gap Exceptions to policy guidelines
ABC DEF GHI JKL MNO 19 14 33 22 1 30 18 42 26 24 49 32 75 48 25 19 14 33 22 1 11 4ABC 9 DEF 4 GHI JKL MNO 23 335 22 1 5 4 19 4 144 42 26 24 133 86 30 196 18 126 79 19 14
ABC DEF GHI JKL MNO 19 14 33 22 1 30 18 42 26 24 49 32 75 48 25 19 14 33 22 1 11 4 9 4 23 5 4 4 4 5 133 86 196 126 79 19 14 33 22 1
49 33 19 11 5 133 19
32 75 22 14 331 4 9 4 4 86 196
48 22 4 4 126
25 1 23 5 79 1
ABC DEF GHI JKL MNO 19 14 33 22 1 22 24 30 14 18 33 42 26 49 32 75 48 25 19 14 33 22 1 11 4 9 4 23 5 4 4 4 5 133 86 196 126 79 19 14 33 22 1
ABC DEF GHI JKL MNO 19 14 33 22 1 30 18 42 26 24 49 32 75 48 25 19 14 33 22 1 11 4 9 4 ABC 23 DEF 5 4 4 4 19 514 133 86 196 126 30 7918 19 14 33
49 19 22 11 5 133 19 32 14 14 4 86 14
GHI JKL MNO 33 22 1 42 26 24 75 48 25 33 22 1 9 4 23 4 4 5 196 126 79 33 22 1
129
6. Foreign Exchange Risk Management
130
What is foreign currency risk?
The volatility in income or economic value of The volatility in income or economic value of equity due to movements in foreign currency equity due to movements in foreign currency exchange rates exchange rates
131
Foreign currency risk arises from movements in exchange rates

Spot rate Cash Market Forward rate Derivative Market
Transaction Economic
Translation
132
FX risk comes in two forms

Translation risk: Balance sheet assets and liabilities translated at FX rate prevailing on date of the balance sheet. Income statements translated at an average FX rate prevailing over the measurement period Measures impact of a change in exchange rates on a companys financial statements
Transaction risk: Potential gains or losses on future settlements of outstanding obligations denominated in a foreign currency, ie., booked sales may be paid in different actual amounts Measures impact of a change in exchange rates on actual collections (the difference between receivables and payables)
Like interest rates, risk arises from a mismatch of assets and liabilities
ASSETS
LIABILITIES
Foreign currency appreciates Foreign currency depreciates
gain
loss
loss
gain
What is an institutions FX Position

The Balance Sheet position in a particular currency is a function of total assets and total liabilities in that currency When assets in a currency exceed liabilities in that currency, there is a long (or overbought) position in the currency When liabilities in a currency exceed assets in that currency, there is a short (or oversold) position in the currency
FX position can be determined by analyzing the balance sheet
The total of : (A) FX Assets + contingent FX bought Less (B) FX Liabilities + contingent FX sold Equals the Foreign Exchange Position
FX exposure is identified in the banking and the trading book by open positions
Foreign Currency Risk
RMB 808688 754088 54600 $US 3863 3692 171 -4568 54600 -4397 8.17 -35923 29934 0.067 2006 0 11.753 JPY 30000 66 29934 GBP 200 200 0 Euro 28 45000 -44972 230000 185028 7.242
Banking Assets Banking Liabilites On-balance sheet position Off-balance sheet position Net exposure Exchange Rate RMB Equivalent (millions)
0 1339973
137
The FX position includes the Forward Position

Forward contracts represent the obligations to purchase or sell a specific amount of a currency at a specific future date When a bank dealer executes a forward FX deal, the bank's actual assets and liabilities in the deal currencies do not change until the deal is settled on the specified date (typically in 1, 2, 3, 6, 9 or 12 months)
What is the exposure effect?
A Chinese company sells hospital diagnostic equipment. Most of its revenues are in China, but about half its expenses are in EUR, because the company buys many components abroad. Its primary competition is from Chinese companies with no international business at all. How will a strengthening of the EUR affect this company?
Another example: Japanese TVs
A Japanese firm sells television sets to an American importer for JPY 1 billion payable in 90 days. What is the importers risk? How should the importer protect against it?
FX risk is measured like interest rate risk
Foreign exchange gap analysis Foreign exchange duration analysis Foreign exchange rate simulation Rate volatility analysis
FX risk is managed with effective policies

Objectives and principles of FX risk management Measurement of risk Risk exposure limits Net open position limits Currency position limits Other position limits Stop-loss provisions Concentration limits Revaluation procedures
142
FX risk management tools are available in some markets

Contractual hedges
Forwards Money Futures Options
Natural hedges
Payment leads and lags Matching
Forward exchange rates are derived from relative interest rates

The spot USD/CHF rate is 1.40. Six month interest rates are 6% on the dollar and 4% on the Swiss Franc. (The six month interest period is 184 days.) An organization with USD 1 million and a requirement for Swiss Francs in six months should be indifferent, financially speaking, as to whether it:
Invests the USD 1 million for six months and converts the dollars (plus interest) into CHF at the end of this time Sells the USD 1 million spot for CHF, and invests the CHF for six months until they are needed
Derivation of Forward Exchange Rates

OPTION 1 Invest USD 1 million at 6% for 6 months (184 days) OPTION 2 Sell USD 1 million spot at 1.40 Buy CHF 1.4 million Invest CHF for 6 months at 4% Interest earned CHF 28,622.22 (1.4 million x 4% x 184/360)
Interest earned USD 30,666.67
Value after 6 months USD 1,030,666.67
Value after 6 months CHF 1,428,622.22
Exchange Rate: 1.3861
Value at risk (VaR) is a common market risk measure

Captures Captures Position size Value sensitivity to price movements Probability distribution of price movements
Tail Probability = 2.5% Value at Risk
Daily Changes in Position Value
146
Rate of Return (%) 0.05 0.15 -0.05 0.1 0 0.2 -0.1 Aug-87 Jan-88 Jul-88 Dec-88 Jun-89 Nov-89 May-90 Oct-90 Apr-91 Sep-91 Mar-92 Aug-92 Feb-93 Jul-93 Jan-94 Jun-94 Dec-94 May-95 Nov-95 May-96 Oct-96 Apr-97
The historical volatility of exchange rates determines the risk

/$ RETURNS
The returns can then be plotted in a histogram
Frequency 35 30
Fr eq ue nc y
DM/$ RETURNS HISTOGRAM
/$ RETURNS
25 20 15 10
Price Change (%)
5 0 -5.43% -3.46% -1.48% 0.49% 2.47% 4.45% 6.42% 8.40% More
Price Change (%)
The greater the number of observations, the more normal the distribution
2.5% of Distribution
Standard Deviation
-4 -3 -2 -1 0 1 2 3 4
Change in Portfolio Value
The standard deviation is a measure of dispersion
Assume an asset returns the following over three periods:

10% 15% 20%
What is the standard deviation/volatility? (10% - 15%)2 + (15% - 15%)2 + (20% - 15%) 2 = 5% 2
The number of standard deviations varies depending on how sure you want to be
How much we can expect to lose over a given period of time at a certain confidence level?
VaR = Position in Portfolio (i.e., $100) * Volatility (i.e., standard deviation) * No. of Standard Deviations specified (i.e., 95% = 2) Note: The 95% confidence is for a +/- 2 standard deviations. For a one-tailed test (- 2 standard deviations), we are 97.5% (or rounding 98%) confident.
An example of VAR
Assume:
Monthly Volatility of $/Sterling is 3.3% Current Spot Rate = $1.6/Sterling Current Position = GBP 10 Million
The most we can lose over the next month with 98% confidence is 10*1.6*3.3*2 is $1,056,000
Exercise
Assume
Monthly volatility of $/EUR is 2% Current spot rate = .9 EUR/$ Current position = EUR 20 million
What is the most we can lose in $s over the next month with 98% confidence? What is the most we can lose in $s over the next month with 99% confidence?
VaR can be calculated for individual asset or portfolio of assets

JPMorganChases RiskMetrics
Non-simulation variance/covariance approach Uses daily volatility and correlation estimates System implementation from 3rd parties
Historical simulation Portfolio aggregation Monte Carlo simulation
The best VaR models use a combination of methods

Parametric VAR Parametric VAR
Normal distribution Normal distribution assumption assumption Easy to calculate Easy to calculate No event risk No event risk capabilities capabilities No compensation for No compensation for fat tails fat tails No ability to fully No ability to fully calculate non-linear calculate non-linear instruments instruments
Monte Carlo Monte Carlo Simulation Simulation

Can simulate many Can simulate many price paths price paths Limits model risk Limits model risk Accounts for nonAccounts for nonlinearity and nonlinearity and nonnormality normality Computationally Computationally expensive expensive
Historical Historical Simulation Simulation

Can test current Can test current portfolio over past portfolio over past periods (even crash periods (even crash conditions) conditions) Relies on the Relies on the existence of existence of historical price series historical price series Incorporates nonIncorporates nonlinearities and nonlinearities and nonnormal distributions normal distributions Doesnt necessarily Doesnt necessarily reflect future reflect future conditions conditions
155
Jan-Peter Onstwedder, The Royal Bank of Scotland

Judgment still must be applied to the VaR process of setting limits and watching or forecasting changing economic conditions. Changes in fundamental economic conditions (even less dramatic than the 1991 events in Eastern Europe) can cause losses that exceed the levels of risk tolerancesuch as the unwinding of the Asian economies and its impact on the securities of developing economies. VaR is a valuable tool because it attempts to quantify a process that would otherwise be purely judgmental. It should be used along with interest sensitivity dynamic Gap analysis.
156
7. Credit Risk Management
157
What is credit risk?
The volatility in income or economic value of The volatility in income or economic value of equity due to non-performance by a debtor equity due to movements in foreign currency or counter-party exchange rates
158
That means a number of things

The risk that a borrower will not pay what was lent in full and on time
The potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms
Principles for the Management of Credit Risk - BIS 1999
Must also include all threats to value, in a probability / net present value sense; e.g. deterioration in quality throughout the life of the loan is a credit risk in itself
159
Credit risk is typically the greatest threat to capital health in the banking business
Int. Income Net Int. Income Int. Expense plus Other income
Credit risk
less ROE Op. Expense less Provisions less Tax

160
Successful credit risk is a competitive advantage
Identify Measure Monitor Control

And price appropriately!
161
There are two major factors to consider with as much confidence as possible
What is the likelihood a borrower will default? Probability [%]
If the borrower defaults, how much are we likely to lose? Amount [$ / / $ or %]
162
Credit analysis, ratings, pricing and controls focus on these two factors
What is the likelihood a borrower will default? Probability [%]

Likelihood that cash flow will sustain through life of credit: Financial strength Management quality Market and economy Other factors
If the borrower defaults, how much are we likely to lose? Amount [$ / / $ or %] of distressed credit: Value
Exposure at default Compromised financial strength Guarantees or security Other factors
163
Credit risk affects both capital and earnings

Foregone Interest and provisions And mark-to-market losses
The primary objective is to minimize the volatility of earnings and capital (hence the risk as perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.
Losses in economic capital
164
Financial success in any enterprise means at the least breaking even

Profit
Breakeven
n Other costs
Manufacturer
Operating Costs
How is a Financial Institution different from a manufacturer?
Cost of Goods Sold
165
For a financial institution, this means effectively managing credit risks . . .

Profit
Reserves for Unexpected Losses
Losses resulting from volatility true risk
Financial Institution
Margin for Expected Credit Losses
Predictable losses that can be built into pricing
Why we need capital
Operating Costs
Cost of Funds
166
Credit risk measurement takes different forms Expert systems Credit scoring models Rating systems
CAMELS Pass, OLEM, Substandard, Doubtful, Loss Public bond ratings
167
Credit analysis drives the credit risk assessment of all methods
Both the ability and the willingness to pay are key
168
There are several indicators of future ability and willingness to pay

Past record of meeting debt payments, particularly in stress situation like a recession Proven record of careful financial management Adequate financial reserves or other liquid assets Fiscal flexibility .or the ability to
Raise funds or sell assets Access bank lines on short notice Draw on cash reserves Cut discretionary spending Alter the business plan or delay capital expenditures
169
Credit risk analysis is an evolving field using basic quantitative methods

Basic algebra
Equations define relationship among variables Solving 2 unknowns with 2 equations Expected value
Present value vs future value

Opportunity cost of $ today Inverse relationship between rates and prices
Statistics
Variables describing a sample Measures of central tendency (Median, mean and mode) Measures of dispersion (Range and std deviation) Regression analysis and correlation
170
There are two basic aspects of credit risk

Standalone risks
Default probability Loss given default Migration risk
Portfolio risks
Default correlations Exposure
Credit risk management means diversifying and transferring risk
171
Industry sector
Competitive position
Standalone creditworthiness depends on many factors
172
Mgmt. / organization
Financial strength
Cash flow/ debt serv.
Data drives the credit analysis

Category
Data Required Industry profile -- 3 years Size, growth Concentrations Cyclicality/seasonality Explanation of trends Industry outlook Profiles of key competitors (top two) Regulatory profile -- current, recent changes, expected changes Borrowers strategy Key alliances: With government With private sector With other influential players Company financials -- 3 years Profit & loss statements, balance sheets Supplementary statements -reconciliation of net worth, fixed assets\ Audited where possible Creditor facilities Banks amounts and condition Suppliers of facilities
Data Sources Internal Files Research department Other managers familiar with industry Third parties Ministries Multilateral agencies -- World Bank, IADB, etc. Other government organizations Trade associations Other banks Other companies in industries External -- customer calls Business press Internal Files Other managers familiar with borrower Issuer In person calls Site visits
Industry
Financial Condition
s example
SAMPLE DATA COLLECTION
173
Financial ratio analysis provides the basis for ability to pay

RATIOS RATIOS
Liquidity (Cash/Current Liabilities) Cashflow-Measures (Repayment) (e.g. CF/interest, CF/liabilities) Profitability (e.g. pre-tax profit/assets) Activity (e.g. Revenues/Assets) Leverage (e.g. equity/liabilities) Size (e.g. Sales) Growth (e.g. Revenue growth) Need to test numerous ratios given sufficient data
SELECTION SELECTION
Financial statements relevant (even) in emerging economies Depending on maturity of economy and reporting systems different factors are dominant Liquidity and Cashflow measures likely to dominate a rating Precise definition of factor will depend on consistent availability of data
174
Both quantitative and qualitative analyses are required
Financial factors Financial factors
Non-financial Non-financial factors factors
Warning signals // Warning signals Behavioral factors Behavioral factors
Financial rating Financial rating
Non-financial rating Non-financial rating
Warning signal rating Warning signal rating
Issurer rating Issurer rating
175
Their relative importance typically varies according to the issuer segment

FACTOR WEIGHTS
Financial Non-Financial - ILLUSTRATIVE -
Behavioural
Large Corporate
Profitability Insider transactions
SIZE SEGMENT
Leverage
Mgt quality Growth Industry outlook Small Business Liquidity Evergreen loans
176
Credit ratings are an assessment of managementa leading indicator

Management (not external conditions) drives performance How cope in periods of rapid change Attitudes toward risk, a focus on fundamentals Corporate culture: how motivated and promoted Collegial versus dictatorial decision making Quality of management information systems Realism of long-term strategies and goals
177
Ratios are tools in the rating process
Absolute and relative trend Peer group comparisons Not the final step or whole answer Ratios put you in the right neighborhood, but you need the right address Non-quantifiable (subjective) side of the analysis just as important as the numbers
178
A credit analysis is essentially a bottomup pyramid analysis
AAA? Qualitative Analysis -Management -Financial Flexibility Quantitative Analysis -Financial Statements -Past/Future Performance Market Position Competitive Trends (domestic/global) Regulatory Environment Industry Analysis Sovereign Macroeconomic Analysis
179
BIS II has led to a new generation of statistical rating models

Capital required to support risk-weighted assets Three measures for credit risk
Standardized using external ratings for risk weights IRB: Foundation and Advanced
IRB uses banks own rating systems with required features Provisions should equal expected losses Capital must be held for UL
180
Traditional credit risk measurement has not been discriminate

Not compensating for risk Evolved to KMV Credit Monitor Model Loans as options using Black-Scholes JP Morgans CreditMetrics and other models Risk neutral valuation approach Differ in terms of definition of risk (MTM or DM); risk drivers; volatility and correlation of credit events; recovery rates; simulation or analytic
181
BIS IIs objective is to have same level of capital in the system as a whole
Source: Bank of England Spring Quarterly Report, 2001
182
Probability of Default (PD) is based on historical experience

X Corporate Loans Y Credit Cards
-4
-3
-2
-1
Standard Deviation
X = 2% Y = 4%
X = 4% Y = 5%
183
Which loan type is more risky.X or Y?

X Corporate Loans Y Credit Cards
-4
-3
-2
-1
Standard Deviation
X = 2% Y = 4%
X = 4% Y = 5%
184
Databases of historical defaults are maintained by international CRAs

S&P Moodys Fitch Dun & Bradstreet Others
185
Default histories drive PD
S & P RATING
AAA AA A BBB BB B CCC CC C
MOODYS EQUIVALENT
Aaa Aa3/A1 As/A3 Baa2 Ba1/Ba2 Ba3/B1 B2/B3 B3/Caa Caa/Ca
DEFAULT PROBABILITY (SUBSEQUENT YEAR)

0.01% 0.03% 0.10% 0.30% 0.81% 2.21% 6.00% 11.68% 16.29%
186
Quantitative modeling provides the basis of the analysis
Input
Calculation
Output
Raw data Raw data
Economic Economic Interpretation Interpretation
Individual Individual Scores Scores
Aggregation to Aggregation to overall Score overall Score
Calibrated Calibrated Rating (PD) Rating (PD) Calibration fixed
Financials Assessment of qualitative Factors
Ratios
Scale comparable for all factors
Weights fixed (e.g. linear algorithm)
May be different by segment (size, state -owned /private, industry, available information)
187
The oldest and simplest model is Altmans Z Score

Overall profitability (ROA) Sales to Total Assets Leverage (Market Value of Equity to Debt) Working Capital to Total Assets Cumulative profitability (Retained earnings/Total Assets)
188
A Z score below 2.99 could be an early warning sign of default

RATIO FORMULA Earnings Before Interest and Taxes ---------------------------------------Total Assets Net Sales ---------------------------------------Total Assets Market Value of Equity ---------------------------------------Total Liabilities Working Capital ---------------------------------------Total Assets Retained Earnings ---------------------------------------Total Assets WEIGHT FACTOR WEIGHTED RATIO
Return on Total Assets
x. 3.3
-4 to +8.0
Sales to Total Assets
x 0.999
-4 to +8.0
Equity to Debt
x 0.6
-4 to +8.0
Working Capital to Total Assets
x 1.2
-4 to +8.0
Retained Earnings to Total Assets
x1.4
-4 to +8.0
189
Hindsight is perfect.but how do we predict default
190
If we have the data, we can begin to generalize about a similar population

Example: Life insurance company
How we can we classify individuals into broad risk bands to manage our actuarial risk?
191
What would be a logical process for discerning the predictive risk variables?
Example: Life insurance company
Set hypothesis Examine experience Select variables Test predictability Test and Calibrate Age Male / female Smoker / non-smoker Obesity Family history
192
What would be a logical process for discerning the predictive risk variables?
Risk factor: Obesity Set hypothesis Examine experience Select variables Test predictability Test and Calibrate
100 80 60 40 20 0 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k
90 80 70 60 50 40 30 20 10 0 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k
90 80 70 60 50 40 30 20 10 0 40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k
193
The larger the data population, and the more reliable the data, the more confident
194
and
the easier to test the predictability of our data points

60.00 50.00 40.00 30.00 20.00 10.00 0.00 1 2 3 4 5 6 7 8 9 10
195
The most reliable credit risk models are from consumer credit scoring models
: Example s ard Credit C
100 80 100 60 40 20 0
80 100 60 40 20 1 0
80 100 60 40 2 20 1 0
80 100 60 80 3 4 100 6 7 8 9 10 5 40 60 80 100 2 3 4 5 6 7 8 9 10 20 40 60 80 1 2 3 4 5 6 7 8 9 0 20 40 60 1 2 3 4 5 6 7 8 0 20 40
10
10
1 0
2 20
10
1 0
10
10
Examples of predictive factors for credit cards
196
Not surprisingly, for such credits, the models drive the whole credit process
100 80 100 60 40 20 0
80 100 60 40 20 1 0
80 100 60 40 2 20 1 0
80 100 60 80 3 4 100 6 7 8 9 10 5 40 60 80 100 2 3 4 5 6 7 8 9 10 20 40 60 80 1 2 3 4 5 6 7 8 9 0 20 40 60 1 2 3 4 5 6 7 8 0 20 40
10
10
1 0
2 20
10
1 0
10
10
Planning Marketing Approval Pricing Monitoring Collections Provisioning
197
Design, integrity, maintenance, and validity of the model is the core
100 80 100 60 40 20 0
80 100 60 40 20 1 0
80 100 60 40 2 20 1 0
80 100 60 80 3 4 100 6 7 8 9 10 5 40 60 80 100 2 3 4 5 6 7 8 9 10 20 40 60 80 1 2 3 4 5 6 7 8 9 0 20 40 60 1 2 3 4 5 6 7 8 0 20 40
10
10
1 0
2 20
10
1 0
10
10
198
Risk managers always try to evolve towards a model approach if practical

Judgment Template Scoring Model
199
But by their nature, different risks lend themselves to different levels of prototyping
Judgment Template Scoring Model
Large unique risks, small populations, variable characteristics
Medium-sized risks, average populations, predictable characteristics
Small individual risk, large populations, homogenous characteristics
Large corporates, sovereigns, banks, project finance
Small business, high-end consumer, homogenous commercial
Credit cards, home mortgages, car and student loans
200
If we can predict our potential losses we can price them in our rates
Expected loss
How much we expect to lose (probability) on a credit or group of credits May be expressed as a per cent or an absolute number Often abbreviated as EL also known as ROL (risk of loss)
201
Lets calculate a simple example
Expected loss
Probability of default
Rating 1 2 3 4 5 6 7 8 9 10 PD % 0.01 0.03 0.05 0.25 0.70 1.50 6.00 20.0 50.0 100.0 202
Loss given default

LGD % 0 10 25 50 75 100
Exposure at default
EaD % 100
In per cent
Expected .03 or 3% loss
Probability .06 of default
Loss given .50 default

LGD % 0 10 25 50 75 100
Exposure 1.00 at default

EaD % 100
Rating PD So if the credit is $ 7,000, % 0.01 EL for that credit 1 $ 210 is 2 0.03 (3% x $ 7,000) 3 4 5 6 7 8 9 10 0.05 0.25 0.70 1.50 6.00 20.0 50.0 100.0 203
or in numbers
3% $ 210
.06
.50
$ 1.00 7,000
Rating 1 2 3 4 5 6 7 8 9 10
PD % 0.01 0.03 0.05 0.25 0.70 1.50 6.00 20.0 50.0 100.0 204
LGD % 0 10 25 50 75 100
EaD % 100
Expected loss is a function of three variables
Expected loss
Probability of default
Loss given default
Exposure at default
205
The standalone ELs can be aggregated for for the whole portfolio
100 90 80
100 90 80 70 60 50 40
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
30 20 10 0 1 2 3 4 5 6
10
90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9
Probability
Losses
206
Active portfolio management has become best practice

Modern portfolio theory used to reduce risk Based on Capital Asset Pricing Model (CAPM)
Specific risks of different assets can be diversified in a portfolio Market or systematic risk cannot be diversified Required return = Rf + (Market return Rf)
207
Portfolios are managed to maximize returns at a given level of risk

The variance-covariance of different assets reduce the portfolio variance Relatively riskier assets, depending on correlation with portfolio, can be added to portfolio and reduce the aggregate variance
Marginal risk may be additive But may be less than standalone risk Returns on the portfolio can be enhanced
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
208
Over time actual can be compared to expected losses

100 90 80
100 90 80 70 60 50 40
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6
70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5
30 20 10 0 1 2 3 90
80 70 60 50 7 40 30 20 10 0 1 2 3
8 9 10
100 90 80 70 60 6 50 40 30 20 10 0 1
100 80
10
?
8 9
10
10
60 40 20 0 1 2 3 4 5 6 7 8 9
Models must be recalibrated, back-tested and stresstested
209
Models must be recalibrated, back-tested and stress-tested

100 90 80
100 90 80 70 60 50 40
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6
70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10
100 90 80 70 60 50 40 30 20 10
30 20 10 0 1 2 3 90
80 70 60 50 7 40 30 20 10 0 1 2 3
8 9 10
100 90 80 70
1 2 3 4 5
10
60 6 50 40 30 20 10 0
10
1
100 80
10
9
60 40 20 0 1 2 3 4 5 6 7 8 9
How did we do? What should we change? How sensitive is the output to different assumptions? How does our risk change with worst case scenarios?
210
EL are predictable UL losses (i.e. volatility) represent true risk

Expected Loss (EL) Expected Loss (EL)
Anticipated average loss Anticipated average loss rate rate Foreseeable cost Foreseeable cost Charged through Charged through income statement income statement
Unexpected Loss (UL) Unexpected Loss (UL)
Anticipated volatility of Anticipated volatility of loss rate loss rate True risk True risk Captured through Captured through assignment of capital assignment of capital
211
The greater the variance, the more capital required

Unexpected Loss Requires capital support - as a cushion
Probability of Loss
Mean expected Loss
Unexpected Loss (Standard Deviation)
Amount of Loss
212
The amount of capital depends on target debt rating
Mean expected Loss
Unexpected Loss ( 1 Standard Deviation) Required Capital Solvency Standard

BBB A .03 .01 AA AAA .003 .001
Total Economic Capital = Reserves + Equity
Uncovered Risk
213
In summary, credit analysis drives the PD but is only one component of risk
Based on analysis & identified comparative standards
Feedback loop
Credit Analysis and Structuring
Feedback process: annual review & experience
Risk Rating: Borrower and Facility
Loss Given Default

A function of analysis and structuring
Probability of Default
Based on historical risk rating data
Exposure at Default
Expected Loss
EL=PD x LGD x EAD
214
Credit risk analysis is an evolving field
Quantitative modeling includes structural and reduced form models Credit risk management means diversifying and transferring risk Research continues to integrate new asset classes and correlations
215
Over-reliance on models can be risky

Loan uniformity is a problem Correlation analysis for loans is in its infancy and correlations change over time The industry knows less than it thinks about actual loss probabilities and little of migration Volatility measures are unstable and differ across time horizons Operational risk increases
216
Daniel Mudge, Bankers Trust (from Risk

Magazine, 1994)
I would prefer a C-rated model with weaknesses and have people with experience and intuition than an Arated model with a C-rate team of people who are unable to question the numbers that the system generates.
217
8. Summary and Review
218
Before we discuss the final case lets summarize some concepts

Overview of Risk and Risk Management ALM Overview Funds (Liquidity risk) Management IRR Management FX Risk Management Credit Risk Management
219
Banks assume credit, liquidity, interest rate, FX and capital risks

Economic Sectors
Assets
Liabilities
Demand Deposits Households Time Deposits Governments Other Borrowings Businesses
Borrowings
Assets
Loans, leases and Investments
220
Bank management must satisfy many stakeholders

Return
Loans/services
Shareholders
Safety/Soundness
Customers
Employment
Regulators/Rating Agencies
Employees
221
Risk management is the key to success along with good governance practices
Quantity of Risk.
Quality of Risk Management Risk control processes Risk appetite and limits
Strategies for Managing Risk What are the policies? Last reviewed? Risk mitigation strategies?
Monitor Risks How are exposures monitored? What is role of the internal auditor?
What kind of risks does the bank have? Where do they exist? How is risk measured?
222
We looked at risk and risk management

What is risk? Managing the risk/reward tradeoff is the business of banking, particularly ALM Risk management system Identification Measurement Management Monitoring Financial statements, annual plans and ALM strategies
223
Rational investors require a return commensurate with risk

Non-linear CCC Rate of Return Risk Premium BBB A AA AAA B BB Common Stock Conv. Preferred Preferred Stock Income Bonds Subordinated Debentures 2nd Mortgage Bonds
First Mortgage Bonds Treasury Bonds
Risk Free Rate Level of Risk

224
ALM manages the non-credit financial risks

Liquidity risk
Low-cost, predictable funding sources Asset vs Liability liquidity Financial flexibility and optimal distribution/pricing of securities
Interest rate risk

Gap and duration analysis CaR
FX risk
Long and short positions VaR
Capital risk
Portfolio management
225
Credit worthiness plays an important role
Both the ability and the willingness to pay debt obligations in full and on time
226
Both quantitative and qualitative analyses are inputs in the credit rating process
Financial factors Financial factors
Non-financial Non-financial factors factors
Warning signals // Warning signals Behavioral factors Behavioral factors
Financial input Financial input
Non-financial input Non-financial input
CreditWatches or CreditWatches or outlook changes outlook changes
Issuer rating Issuer rating
227
Risk measurement determines how much capital is at risk

Capital represents net assets or shareholder ownership Capital serves to absorb losses
Operating or financial losses Protects other creditors Permits growth Equity is the most costly source of capital
RAROC is used to allocate capital based on risk/reward trade-off
228
PD, LGD estimation and verification help determine capital at risk

BIS definition of default and loss given default Explanatory inputs
Company, sector/country or economic specific Relevant and logic
Data collection for model fitting Modeling (Private, public)

Altman Z-score Merton model Most commercial PD models are variants of these
229
BIS II has led to a new generation of statistical rating models

Saying dont take too much risk is like saying dont swim too far from shore
230
Successful risk management is an integrated process

Systems
Data extraction Data transfer links Data mapping MIS support
Policies & Processes

Approval Limits / Control Reports Disclosure
Methodologies Risk Management

Grading / Scoring Calculators Capital attribution
Organization
Independence Audit Education Performance Evaluation
231
Lets put all this in context with International Azeri Bank case
Break into groups Read case facts and make assumptions as necessary You are a new member of ALCO and have been asked to provide an assessment of IZB Analyze IZBs performance and plans Provide critical observations Formulate recommendations to improve positioning of the bank Make any additional assumptions as necessary
232
Balance Sheet Analysis

International Azeri Bank
BALANCE SHEET Assets Cash Deposits at Banks Net Loans to Customers Interest in Joint Venture Trading Investments Premises Other Assets Total Assets Liabilities Demand deposits Savings deposits Core Time Volatile time Total deposits Other liabilities Interbank borrowed Repos LTD Total Liabilities Stockholders' Equity Total Liabilities & NW 2005 % 27552 684205 3.0% 0.0% 75.4% 0.0% 0.0% 16.7% 0.0% 1.0% 3.8% 100.0% Index 100 118 27494 578974 2004 % 3.4% 0.0% 72.5% 0.0% 0.0% 19.1% 0.0% 1.2% 3.7% 100.0% Base 100 100 100 100 100 100 100 100 100 100
151729 9470 34063 907019
99 0 0 114
152641 0 9673 29873 798655
185862 165502 192100 109194 652658 34998 148823 30624 5000 872103 34916 907019
20.5% 18.2% 21.2% 12.0% 72.0% 3.9% 16.4% 3.4% 0.6% 96.2% 3.8% 100.0%
101 99 110 132 107 109 155 150 100 114 96 114
184844 167247 173892 82600 608583 32055 96155 20400 5000 762193 36462 798655
23.1% 20.9% 21.8% 10.3% 76.2% 4.0% 12.0% 2.6% 0.6% 95.4% 4.6% 100.0%
100 100 100 100 100 100 100 100 100 100 100 100
233
Profitability Analysis
Profit and Loss Statement Interest Income Interest Expense Net Interest Income Provision for credit losses Net Interest after provision Fee and commission income Fee and commission expense Net Fees and commissions Trading Profits Operating Leases Other income Total Non-interest Income Overhead Pre-Tax Profit Taxation Net Profit Average Assets* Average Equity* Avg. Earning Assets* Avg Interest Bearing Liabilities* ROA ROE Leverage Spread Net interest margin Other operating margin Efficiency Ratio Overhead/Avg assets Provisions/Avg Assets Yield on EA Cost of Funds EA Ratio Capital Ratio Loans/Deposits Income Statements 2005 % Index 90684 267% 10.6% 57640 170% 6.8% 33044 97% 3.9% 8056 24% 0.9% 24988 73% 2.9% 960 3% 0.1% 0% 0.0% 960 3% 0.1% 0% 0.0% 0% 0.0% 0% 0.0% 960 3% 0.1% 25592 75% 3.0% 356 1% 0.0% 0% 0.0% 356 1% 0.0% 852837 35689 793346 351728 0.04% 1.0% 23.90 -0.79% 4.2% 0.11% 98.6% 3.0% 0.9% 15.6% 16.4% 93.0% 3.8% 104.8% 71732 43644 28088 6460 21628 5788 5788 0 2004 % 212% 129% 83% 19% 64% 17% 0% 17% 0% 0% 0% 17% 76% 5% 2% 3% Base 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100
5788 25844 1572 628 944 1562074 109735 1336493 1215379 0.10% 1.4% 14.23 3.88% 2.1% 0.37% 94.3% 1.7% 0.4% 7.5% 3.6% 85.6% 4.6% 95.1%
234
Thank you for your attention!
235
Funds Management for Financial Institutions Additional Examples

February 8-10, 2006
236
Net interest income is usually the most predicable source of earnings

Interest Yield on Earning Assets Net Interest Spread (-)
Cost of Interest-paying Liabilities Net Interest Margin on Earning Assets (+/-)
NIM
(x) Gain (Loss)
Earning Assets Interest Bearing Liabilities (x) Cost of Interest-paying Liabilities
Earning Assets Total Assets
237
Examples of Calculation of Gains/Losses

I Earning Assets Interest-bearing Liabilities Spread 100 90 10 I Earning Assets Interest-bearing Liabilities Spread 100 120 -20 I Earning Assets Interest-bearing Liabilities Spread 200 100 100 I Earning Assets Interest-bearing Liabilities Spread 350 400 -50 Income Expense 10% 10 4.5 5% 5% 0.5 Income Expense 10% 10 6 5% 5% -1 Income Expense 10% 20 5 5% 5% 2.5 Income Expense 10% 35 20 5% 5% -0.714 NII 5.5 NIM 5.5% 5.5% NII 4.0 NIM 4.0% 4.0% NII 15.0 NIM 7.5% 7.5% NII 15.0 NIM 4.3% 4.286%
It is the relative proportion of earning assets and interestbearing liabilities

238
Liquidity Planning: Gap Analysis

0-30 Days Potential Uses of Funds Add: Maturing time deposits Small time deposits $ 5.5 Certificates of deposit over $100,000 40.0 Eurodollar deposits 10.0 Plus: Forecast new loans Commercial loans 60.0 Consumer loans 22.0 Real estate and other loans 31.0 Minus: Forecast net change in transactional accountsa Demand deposits -6.5 NOW accounts 0.3 Super NOW accounts 0.1 Money market deposit accounts 1.6 Total uses $173.0 Potential Sources of Funds Add: Maturing investments Money market instruments US Treasury and agency securities Municipal securities Plus: Principal payments on loans Total sources Periodic Liquidity Gapb Cumulative Liquidity Gap 31-90 Days 91-365 Days
$ 8.0 70.0 10.0 112.0 46.0 23.0 105.5 4.5 1.0 3.0 $155.0
$ 34.0 100.0 30.0 686.0 210.0 223.0 10.0 5.0 2.0 6.0 $1,260.0
$ 8.0 7.5 2.5 80.0 $98.0 $75.0 75.0
$ 16.5 10.5 1.0 262.0 $290.0 -$135.0 -60.0
$ 36.5 40.0 12.5 903.0 $ 992.0 $ 268.0 208.0
239
Liquidity Planning: Potential Funding Sources

Time Frame
0-30 Days Purchased Funds Capacity Federal funds purchased (overnight and term) Repurchase agreements Negotiable certificates of deposit Local National Eurodollar certificates of deposit Total Additional Funding Sources Reductions in federal funds sold Loan participants Sale of money market securities Sale of unpledged securities Total Potential Funding Sourcesa Potential Extraordinary Funding Needs 50% of outstanding letters of credit 20% of unfunded loan commitments Total Excess Potential Funding Sources
a
31-90 Days
91-365 Days
$20 10 50 20 20 $120
$20 10 50 20 20 $120
$30 10 60 25 20 $145
$5 20 5 10 $50
$5 20 5 10 $50
$5 20 5 10 $50
$170
$170
$195
5 25 $30 $140
10 30 $40 $130
15 35 $50 $145
Purchased funds capacity plus additional funding sources.
240
Liquidity Guidelines for Major Regional Bank Consolidated

Ratio of Available Sources/Potential Funding Needs over 6 month period Liquid Assets/Market Sources < 6 months (min) Market Sources/Total Assets Maturing in 1 month (max)
Guideline
200% 10% 15%
Holding Company
Market sources/Backup facilities (max) Liquid Assets/Market Sources < 1 months (min) Backup Facilities (min) Higher of
Total commercial paper o/s or Assets > 9 months funded by sources < 9 months
241
Guideline
40% 25% 50% 75%
ALM Report at xxx, 20xx
Liquidity Management ($millions)
xxxx, 20xx Poicy Guideline
$ Limit
Actual
Liability Coverage Ratio 1 Consolidated over 6 month period Maturity Structure of Net Market Sources 2 Consolidated within 1 month 3 HC within 1 month Liquid Assets as % of Market Sources 4 Consolidated market sources < 6 months 5 HC market sources < 1 month Commercial Paper Backup Facilities 6 Greater of CP outstandings Assets > 9 months supported by funding < 9 months
200% 15% 40% 10% 25%
5,342 6,824 280 420 54
10,862 2,491 -713 3073 854
50% 700 75%
338
-396
242
Other Risk Guidelines
Tier 1 Leverage Total Risk-adjusted Capital Tier 1 Risk-adjusted Capital Double Leverage
Poicy Guideline Midpoint Range 7% 6.3- 7.7% 12% 11.412.6%
Regulatory Well-capitalized 5% 10% 6%
120-
125%
243
Moodys has traditionally focused on twelve ratios in four categories
Earnings Asset Quality Capital Liquidity
244
Earnings are the first line of defense against losses
PPP-Pfd. Dividends-CNCO/BIS RWA + SA Return on BIS RW + SA Efficiency ratio (Operating expense/Operating income) Net interest margin
245
Asset quality needs to be adjusted for seasoning of loans and reserves
Non-performing assets/PPP Non-performing assets/TCE + SA Provisions/PPP
246
Capital is important but less so than ability to earn capital

Capital
TCE/BIS RWA + SA
Liquidity
Net-cash capital position at bank level/bank assets Core deposits/Loans Net Short-term position at BHC/NI Double Leverage (Investments/TCE)
247
The primary ratios looked at reflect these factors

Median
Aa2 7,677
Aa3 4,474
A1 931
A2 551
A3 268
Baa1 105
Size (PPP in millions) Liquidity Core deposits/Loans Liquid assets/ST Loans Capital TCE/RWA+SS Double Leverage ROA ROE NPA/TCE + Reserves
384
76.6 72.2
69.2 66.0
55.2 33.1
70 62.6
79 62
75.7 36.3
91.1 99.1
7 112.5 1.63 21.5 7.7
5.8 116.8 1.58 26.8 11.7
4.5 125.7 1.52 23.5 9.8
5.8 120.1 0.9 15.8 7.4
8.75 115.1 2.1 22.1 3.2
8.47 107.1 1.63 18.7 24.3
8.2 104 1.93 23.2 4.6
Source: Moodys (Ratings as of 12/21/2000 and Balance Sheet and income data YTD 6/00.)
248
Financial Overview: Major Regional Bank

Assets : $47.6 billion 72% Customer Loans 7% Interbank 8% Securities (1% Trading) 7% Cash and Short-term Equivalents 1% Fixed Assets Total Liabilities: $44.5 billion 19% Non-interest bearing deposits 3% Interbank 49% Customer deposits 9% Short-term borrowings 8% Long-term debt Off-balance sheet commitments and financial instruments: $49 billion (110% of total liabilities) Shareholders Equity: $3.1 billion 6.5% of assets Tier I Capital: 9.45% Total Capital: 13.23%
Per Share: $3.82 earnings per share $1.88 dividend per share (49% payout) $18.90 book value per share (estimated) $80 acquisition value (4x book)
Operating Performance ROA 1.8% ROE 23.2% Net interest margin 5.32% Interest spread 4.62% Loans/Deposits 106% Efficiency ratio 53.6% Annual growth rate (1992-1996): Less than 1% in assets due to pooling accounting; equity at 3% Branches: 550 Employees: 19, 340 (at 2/28/97 including 3,505 FTE)
249
Financial Overview: Russian Bank
Assets: $1.09 billion Per Share: N/A 49% Customer Loans 9.6% Interbank Operating Performance 23.4% Securities (19% Trading) ROA 3.3% 8.7% Cash and Short-term Equivalents ROE 18.9% 4.6% Fixed Assets Net interest margin 2.7% Interest spread 2.8% Total Liabilities: $.926 billion Loans/Deposits 115% 30.8% Interbank Efficiency ratio 62.3% 42.7% Customer deposits Annual growth rate (1995-1996): 44% 0% Short-term borrowings Branches: 19 0% Long-term debt Employees: 1,012 Off-balance sheet commitments and financial instruments: $629 million (68% of total liabilities) Shareholders Equity: $164.1 million 15.1% of assets Tier I Capital: 12% Total Capital: 28.5%
250
Financial Overview: Major Money Center Bank

Assets at 9/30/97: $118.3 billion 53% Customer Loans 20% Interbank 15% Securities (1% Trading) 2% Cash and Short-term Equivalent 1.5% Fixed Assets Total Liabilities: $113.4 billion 8.3% Interbank 65.5% Customer deposits 6.9% Short-term borrowings 3.8% Long-term debt and MI Off-balance sheet commitments and financial instruments: $32 billion (28% of total liabilities) Shareholders Equity: $4.9 billion 4.2% of Assets Tier I Capital: 6.8% Total Capital: 11.6% Per Share: $.90 earnings per share $.35 dividend per share (39% payout) $4.37 book value per share $11.25 acquisition value (2.6x book) Operating Performance ROA .8% ROE 22.6% Net interest margin 2.5% Interest Spread 2.0% Loans/deposits 81% (excluding interbank) Efficiency ratio 52.5% Annual growth rate (1992-1996): 18% in assets; equity at 14% Branches: 1,026 Employees: 30,900
251
Year DTB
A 1 2 3 4 5 B 1 2 3 4 5 6 7 8 9 10 11 C 1 2 3 4 D 1 2 3 E 1 2 3 4 5 Size Total Assets Risk -Weighted Assets (RWA) Total Em ployees M arket Capitalization M arket Value / Book Value Profitability Return on Equity Return on Assets Net Interest Incom e on Assets Net Interest M argin Yield on Earning Assets Funding Cost Spread Efficiency Ratio Operating Cost Ratio Provisions / Average Assets Earning Assets / Average Assets Capital Adequacy BIS Tier 1 / Total RWA BIS Total / Total RWA Leverage RWA / Total Assets Liquidity Net Loans to Total Deposits Net Loans to Capital (tim es) Liquid Asset Ratio Asset Quality NPL / Total Loans ALLL / NPLs ALLL / Total Loans Net Charge-offs / Average Loans Open Loan Exposure
ABN 529,264 242,232 112,206 25,340 2.5
HSB 698,312 391,478 171,049 109,000 2.3
2001 CIT 452,343 344,950 117,103 -
JPM 693,575 455,123 95,812 76,254 1.9
BAR 517,676 230,604 78,600 -
WAC 330,452 269,726 84,046 42,701 1.5
813,545 288,532 94,782 43,237 1.2
0.4 0.0 0.9 1.0 6.1 5.7 0.4 90.4 2.9 0.1 85.8
20.5 0.6 1.8 1.9 6.7 6.6 0.1 71.5 2.3 0.3 91.8
10.2 0.7 2.2 2.5 6.1 (4.0) 2.1 56.4 1.7 0.3 84.6
16.3 1.3 3.3 3.7 7.3 4.1 3.3 59.4 3.7 0.6 87.8
3.9 0.2 1.5 2.0 5.9 4.2 1.7 67.0 3.2 0.4 73.3
19.0 0.6 1.8 1.7 5.6 4.2 1.4 57.9 1.9 0.3 94.7
8.0 0.6 2.9 3.6 7.3 4.2 3.2 63.6 3.4 0.4 -
8.1 12.1 4.4 35.5
7.0 10.9 7.3 45.8
9.0 13.0 6.8 56.1
9.2 13.6 7.0 76.3
8.3 11.9 5.2 65.6
7.8 12.5 3.4 44.5
7.0 11.1 6.2 81.6
69.5 6.5 38.7
91.0 6.8 13.4
82.1 6.7 3.7
91.0 7.4 10.8
72.5 5.3 11.5
98.8 15.7 3.1
85.8 5.7 22.6
4.2 34.5 1.4 0.7 17.6
2.2 76.1 1.7 252 0.3 11.9
3.4 77.4 2.6 4.9
3.6 53.4 1.9 1.0 12.6
1.3 119.2 2.1 1.1 (1.8)
2.9 51.5 1.2 0.4 17.6
1.1 175.0 1.8 0.7 (3.7)
Target Spread on a Loan
Required RAROC (Hurdle Rate) Required RAROC (Hurdle Rate) Allocated Capital Allocated Capital Net income Net income Pretax income Pretax income Plus non interest expenses Plus non interest expenses Plus EL Plus EL Required NIM Required NIM Cost of Funds Cost of Funds Interest rate required Interest rate required
20% 20% 88 22 44 10 10 11 15 15 10 10 25% 25%
253
Example
Operating Expenses Commercial Loan Department Retail Branches Administration Total
Allocated
Load
300 600 200 1100
33% 67% 100%
66 134 200
0.22
Commercial Loan Interest FTP NII EL Direct Costs Allocated Costs Pre-tax After-tax Allocated capital RAROC
100,000 25,000 10,000 15,000 1,000 8,200 1,800 4,000 2,000 8,000 25%
254
Transfer Pricing
Example of a Funds Transfer Pricing Yield Curve

Rate in %
9 8 7 6 5 4 3 2 1
Lending Unit
Credit spread
Treasury/ALM
Rate risk spread
Term in Years
255
Formulas
Formulas for the Variance
or or
Formulas for the Standard Deviation Formulas for the Covariance

or or
256
References and further information

Credit Risk Measurement by A. Saunders, Wiley, 1999 Plain English Guide to ALM for Community Banks, Profitstar, Inc. (www.profitstar.com) www.rmahq.org www.riskmetrics.com www.defaultrisk.com Search other risk sites. Analyze other bank financial statements Web pages of Moodys, S&P and Fitch
257

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Funds Management for Financial Institutions

February 8-10, 2006

There are some administrative matters to review

We will then look at an overview of Asset Liability Management

We will review funds management

We will look at another aspect of ALM: FX risk management

We will look at risk valuation methods

We will look at credit risk valuation methods

We will then apply the risk management principles to business planning

The last day will be devoted to review

Putting it all together with case study Final review

2. Overview of Risk and Risk Management

Financial institutions intermediate capital flows between savers and borrowers

Financial institutions assume risks in the intermediation process

Certain principles rule financial intermediation in free markets

Accumulation/protection of capital is the goal of risk taking and risk management

Perceived risk is based on historical or expected volatility

Based on perceived risk

Risk is priced by the discount rate: absolute and relative

First Mortgage Bonds Treasury Bonds

Risk Free Rate Level of Risk

There is risk-reward trade-off inherent in financial intermediation

Short-term vs longer-term Liquidity Floating vs fixed rates Credit Leverage

How much capital does a bank need?

Enoughbut not too much.

What is enough capital?

Equity capital represents owners interests

What is too much capital?

Managements goal is to maximize risk-adjusted returns

Bank management must satisfy different stakeholders with different objectives

Safety and Soundness

Capital adequacy is in the eyes of the beholder

BIS II attempts a more precise calibration of economic and regulatory capital

In a perfect market the different capital definitions would theoretically be equal

But financial markets are neither perfect nor efficient

World-wide trends have changed the nature of banking

Bank regulatory trends have followed but with a lag

Economist, October 5, 2002

The introduction of primary capital led to unintended consequences

Pri m cap ary reg ita ula l t io n

Different capital requirements allowed some banks to gain market share

ma reg ry ca ula pit tio al n

Ris kCa base d pit al

Re g acc ulato r sta ounti y / co nda ng nv erg rds en ce

Pr i m cap ary reg ita ula l tio n

BIS II permits banks to customize capital adequacy assessment

Business Plans for Priority Business Segments

Capital should be set to meet a banks target credit rating

DEFAULT PROBABILITY (SUBSEQUENT YEAR)

Market Risk Standardized Approach Internal Models Approach

Minimum 8% of Capital to Risk-Weighted Assets

Capital adequacy is a function of three pillars

Mutually reinforcing factors that determine capital adequacy

Ultimately the financial market is the harshest regulator

Minimum Capital Requirement

Supervisory Review Process

The level of capital required is a function of the quality of information

The purpose of capital is to absorb unexpected losses and support growth

Assumption of risk is the raison detre of banking

A formalized risk management framework is best practice

A Risk Management framework facilitates informed decision-making

Identify Measure Manage Monitor

Risk Management is now basic to financial management

Risk management permits the optimization of the risk-reward trade-offs