Asset Liability Management

Vikram Singh Sankhala

 Topics
1. The definition and implications of Liquidity Risk
2. The role of the ALCO
3. The concept of funding gaps
4. The concept and implications of duration gaps
5. Some measures of liquidity risk
6. The concept of funds transfer pricing
 Reading Materials
1. ALCO (The Essentials of Risk Management, pp. 185-188)
2. Gap Analysis (The Essentials of Risk Management, pp. 188-195)
3. Earnings at Risk (The Essentials of Risk Management, pp. 195-199)
4. Duration Gap (The Essentials of Risk Management, pp. 199-203)
5. Liquidity Measures (The Essentials of Risk Management, pp. 203-205)
6. Funds Transfer Pricing (The Essentials of Risk Management, pp. 205-206)
 Case Studies
1. Continental Illinois: A Case Study
2. Daiwa Bank
 Example
• Consider a bank that borrows USD 100MM at
3.00% for a year and lends the same money at
3.20% to a highly-rated borrower for 5 years.
• For simplicity, assume interest rates are
annually compounded and all interest
accumulates to the maturity of the respective
obligations.
• The net transaction appears profitable—the bank is
earning a 20 basis point spread—but it entails
considerable risk.
• At the end of a year, the bank will have to find new
financing for the loan, which will have 4 more years
before it matures.
• If interest rates have risen, the bank may have to pay
a higher rate of interest on the new financing than
the fixed 3.20 it is earning on its loan.
• Suppose, at the end of a year, an applicable 4-
year interest rate is 6.00%.
• The bank is in serious trouble.
• It is going to be earning 3.20% on its loan and
paying 6.00% on its financing.
• The problem in this example was caused by a
mismatch between assets and liabilities.
• Prior to the 1970's, such mismatches tended
not to be a significant problem.
• Interest rates in developed countries
experienced only modest fluctuations,
• so losses due to asset-liability mismatches
were small or trivial.
• Many firms intentionally mismatched their
balance sheets.
• Because yield curves were generally upward
sloping, banks could earn a spread by
borrowing short and lending long.
• Things started to change in the 1970s, which
ushered in a period of volatile interest rates
that continued into the early 1980s.
Some Concepts
 Liquid Assets
• Liquid assets are assets that can be turned
quickly into cash
– Low transaction costs
– Little or no loss in principle value
– Traded in large market (trading does not move the
market)
 Liquid Assets

• Examples: T-bills, T-notes, T-bonds

 Liquidity Ratios
• Ratio of liquid assets to anticipated short-
term liability cash flows
• Multiple time horizons might be considered

Asset-Liability Management 13
 Duration
• Measures the sensitivity of the value of a
series of cash flows to changes in interest
rates
• Duration is approximately the average point
at which the projected cash flows occur
• For example, if a portfolio of assets has a
duration of 4, a 1% increase in interest rates
will cause a 4% decrease in its value

Asset-Liability Management 14
 Convexity
• Measures the sensitivity of the duration of a
series of cash flows to changes in interest
rates
• Convexity measures how rapidly duration
changes as interest rates change

Compare duration and convexity of

assets with those of liabilities

Asset-Liability Management 15
 Hedging
Create portfolios with offsetting cash flows
Uses
◦ Reduce systemic or non-diversifiable risk
Scope
◦ For a business segment
◦ Across business segments
Approaches
◦ Static or dynamic
◦ Rely on business cash flows or supplement with
derivatives

Asset-Liability Management 16
 Hedging Techniques
• Cash flow matching
– Structure portfolios to match asset and liability
cash flows
• Immunization
– Structure portfolios so that the impact of a change
in interest rates on the value of liabilities offsets
the corresponding impact on asset values

Asset-Liability Management 17
 Other Measurement Techniques
• Cash flow testing
– Project cash flows under various interest rate scenarios
– Examine the adequacy of asset cash flows to meet liability
cash flows under each scenario
• Value at risk (VaR)
– Probability-based boundary on losses
– Used by banks to measure risk in trading portfolio
• Economic capital
– Assets required, in excess of liabilities, to avoid ruin at a
given confidence level

Asset-Liability Management 18
LIQUIDITY RISK
 LIQUIDITY RISK

• What is liquidity risk?

– Liquidity risk refers to the risk that the institution might not be
able to generate sufficient cash flow to meet its financial
obligations
 WHAT ARE THE EFFECTS OF LIQUIDITY CRUNCH

• Risk to bank’s earnings

• Reputational risk
• Contagion effect
• Liquidity crisis can lead to runs on institutions
– Bank / FI failures affect economy
 LIQUIDITY RISK
• Factors affecting liquidity risk
– Over extension of credit
– High level of NPAs
– Poor asset quality
– Mismanagement
– Reliance on a few wholesale depositors
– Large undrawn loan commitments
– Lack of appropriate liquidity policy & contingent plan
 TYPES OF LIQUIDITY RISKS
Broadly of three types:

• Funding Risk: Due to withdrawal/non-renewal of

deposits

• Time Risk: Non-receipt of inflows on account of

assets(loan installments)

• Call Risk: contingent liabilities and new demand for

loans
 TACKLING LIQUIDITY RISK
• Tackling the liquidity problem
– A sound liquidity policy
– Funding strategies
– Contingency funding strategies
– Liquidity planning under alternate scenarios
– Measurement of mismatches through gap
statements
• Approaches
“Traditional” regulatory approach
• Broadly, regulators have developed 2 approaches to
liquidity regulation:
– The first is to monitor banks’ mismatch between

out-flows and inflows at short maturities (e.g. 1

day, week or month). Banks should measure the
potential outflows over the period & ensure that
they have sufficient liquidity to meet the funding
requirement.
– The second requires banks to hold, at all times, a

stock of highly liquid assets that can be used in

the event that they encounter problems raising
liquidity.
“Traditional” regulatory approach
• For authorities, ensuring that banks hold adequate
liquid assets makes banks individually, and the system as
a whole, more robust and better able to withstand
shocks without recourse to central bank support
• But there is an obvious public policy trade-off between
risk and efficiency in the size of the buffer banks hold.
“Traditional” regulatory approach
• This approach is fine as a starting point, but it has a
number of limitations:
– It is a broad-brush, “one size fits all” approach

which is not tailored to the circumstances of

particular banks;
– It places insufficient emphasis on qualitative

factors, particularly the adequacy of systems &

controls for managing liquidity risk; &
– It does not reflect the latest liquidity risk

management practices of major banks.

 LIQUIDITY RISK
• METHODOLOGIES FOR MEASUREMENT

– Liquidity index
– Peer group comparison
– Gap between sources and uses
– Maturity ladder construction
 1. Liquidity index
• Liquidity index:
Weighted sum of “fire sale price” P to fair market
price, P*, where the portfolio weights are the
percent of the portfolio value formed by the
individual assets.
I = Σ wi(Pi /Pi*)
 2. Peer group comparisons :
• Peer group comparisons: usual ratios include
borrowed funds/total assets, loan
commitments/assets etc.
 Other Measures:
• Peer group comparisons: usual ratios include:
– borrowed funds/total assets,
– loan commitments/assets
– Loan Losses / Net loans
– Total Deposits./ Total Assets
– Reserve for Loan losses / Net Loans
 3. Sources and Uses
• Net liquidity statement: shows sources and
uses of liquidity.
– Sources: incoming deposits, revenue from sale of
non deposit services, Customer Loan repayments,
Sale of bank Assets, Borrowing in money market
– Uses include: Deposit Withdraws, Volume of
Acceptable loan requests, repayments of bank
borrowing, other operating expenses, dividend
payments
 4. Maturity ladder Construction
• Maturity ladder/Scenario Analysis
– For each maturity, assess all cash inflows versus
outflows
– Daily and cumulative net funding requirements
can be determined in this manner
– Must also evaluate “what if” scenarios in this
framework
 For Liquidity Planning
• Important to know which types of depositors
are likely to withdraw first in a crisis.

– Allow for seasonal effects.

– Delineate managerial responsibilities clearly.
 Liquidity Management
• Liquidity can be managed from either the asset
side of the balance sheet or the liability side.
• Asset based management
– Main goal is storing liquidity in the form of liquid
assets.
– Less risky and often used by smaller institutions
– Costs
• Opportunity cost of foregone earnings if sold
• Opportunity cost of liquid assets
• Transaction Costs
• Weakened Balance Sheet
 Liquidity Management
• Raising funds via borrowing if needed
– Advantages
• Only borrow if funds are needed
• Volume and composition of asset portfolio is
unchanged
• Can always attract funds (by increasing rate)
– Disadvantages
• Dependent upon market rate
• Withdrawal risk (funding risk)
 Balanced Liquidity Management
• Combination of Asset and Liability
Management
• Borrow only for unanticipated (usually short
term needs)
• Plan for long term liquidity needs via asset
management.
• Interest Rate Risk
 Important Terms

Net Interest Income=

Interest Income-Interest Expenses.

Net Interest Margin=

Net Interest Income/Average Total Assets
 Net Interest Margin

Interest Income - Interest Expenses

NIM =
Total Earnings Assets
Net interest margin (NIM)
Example:
$100 million 5-year fixed-rate loans at 8% = $8 million interest
$90 million 30-day time deposits at 4% = $3.6 million interest
$10 million equity
Net interest income = $4.4 million
Net interest margin (NIM) = ($8 - $3.6)/$100 = 4.4%
If interest rates rise 2%, deposit costs will rise in next year but not
loan interest. Now, NIM = ($8 - $5.4)/$100 = 2.6%.
 Interest Rate Risk

• Interest rate risk refers to volatility in Net

Interest Income (NII) or variations in Net
Interest Margin(NIM).
• Therefore, an effective risk management
process that maintains interest rate risk
within prudent levels is essential to safety
and soundness of the bank.
 Sources of Interest Rate Risk
• Interest rate risk mainly arises from:
– Gap Risk
– Basis Risk
– Net Interest Position Risk
– Embedded Option Risk
– Price Risk
– Reinvestment Risk
 Interest rate risk is the volatility in net interest
income(NII) or in variations in net interest
margin(NIM).
 Gap:The gap is the difference between the
amount of assets and liabilities on which the
interest rates are reset during a given period.
 Basis risk:The risk that the interest rate of
different assets and liabilities may change in
different magnitudes is called basis risk.
 Embedded option:Prepayment of loans and
bonds and/or premature withdrawal of
deposits before their stated maturity dates.
• Price Risk
– When Interest Rates Rise, the Market Value
of the Bond or Asset Falls
• Reinvestment Risk
– When Interest Rates Fall, the Coupon
Payments on the Bond are Reinvested at
Lower Rates
 Interest Rate Risk: GAP & Earnings
Sensitivity
• When a bank’s assets and liabilities do not
reprice at the same time, the result is a
change in net interest income.
– The change in the value of assets and the change
in the value of liabilities will also differ, causing a
change in the value of stockholder’s equity
 How to mitigate the effect
• To mitigate interest rate risk, the structure of
the balance sheet has to be managed in such a
way
• that the effect on assets of any movement in
Interest rates
• remains highly correlated with its effect on
Liabilities,
• even in Volatile interest rate environments.
 Interest Rate Risk
• Banks typically focus on either:
– Net interest income or
– The market value of stockholders' equity
• GAP Analysis
– A static measure of risk that is commonly associated with
net interest income (margin) targeting
• Earnings Sensitivity Analysis
– Earnings sensitivity analysis extends GAP analysis by
focusing on changes in bank earnings due to changes in
interest rates and balance sheet composition
 How does it work?

FUNDAMENTALS OF ALM

Asset-Liability Management 50
 What is ALM
• ALM or Asset Liability Management is the
• structured decision making process
• for matching the mix of Assets and Liabilities
• on a firm’s Balance Sheet.
 Asset-Liability Management

The Purpose of Asset-Liability

Management is to Control a Bank’s
Sensitivity to Changes in Market Interest
Rates and Limit its Losses in its Net
Income or Equity
 Techniques used by ALM to control
Risk
• Gap Analysis
• Duration Gap Analysis
• Long Term Var
• ALM Strategy is the responsibility of the
treasurer of the company.
• But the control of Risk in the Balance Sheet is
typically the mandate of the risk management
function.
• ALM is especially critical in the case of
Financial Institutions such as commercial
banks and Insurance Companies.
• Financial Intermediation generates two types
of imbalances.
 First
• An imbalance between the amount of funds
collected and Lent.
 Second
• An imbalance between the maturities and
interest rate sensitivities of the sources of
funding and the loans extended to Clients.
• Deposits normally have lower maturities than
loans.
• The rate of interest normally increases with
the term of the loan.
 ALM is built on cash flows…
• Cash flows from both assets and liabilities
must be projected
• The timing and amount of some cash flows
are highly predictable, but many are not

Asset-Liability Management 59
 ALCO
• The asset liability management committee is the
traditional name in the banking industry for what is
often known today as the senior risk committee.
• ALCO is typically chaired by the CEO and composed
of senior executive team of the bank along with
Senior executives of Risk and Treasury.
• It is co-chaired by the Chief Risk Officer and the
treasurer.
 ALM must strike a balance…

Asset-Liability Management 61
 An historical perspective
• Before Oct. 1979, Fed monetary policy kept interest rates stable.
• Due to the above factors, banks concentrated on asset
management.
• As loan demand increased in the 1960s during bouts of inflation
associated with the Vietnam War, banks started to use liability
management.
• Under liability management, banks purchase funds from the
financial markets when needed. Unlike core deposits that are not
interest sensitive, purchased funds are highly interest elastic.
– Purchased funds have availability risk -- that is, these funds can dry up
quickly if the market perceives problems of bank safety and soundness.
 Liquidity Planning
• Important to know which types of depositors
are likely to withdraw first in a crisis.
• Composition of the depositor base will affect
the severity of funding shortfalls.
– Example: mutual funds/pension funds more likely
to withdraw than correspondent banks and small
businesses
• Allow for seasonal effects.
• Delineate managerial responsibilities clearly.
 Causes of Liquidity Risk

• Asset side
– May be forced to liquidate assets too rapidly
resulting n “fire sale prices”
– May result from loan commitments
• Traditional approach: reserve asset
management

• Alternative: liability management.

 Asset Side Liquidity Risk
• Risk from loan commitments and other credit
lines:
– met either by borrowing funds or
– by running down reserves
 Causes of Liquidity Risk
• Liability side
• Reliance on demand deposits
– Core deposits (provide long term source of funds)
– Need to be able to predict the distribution of net
deposit drains.
 Net Deposit Drains
• Deposit withdraws are in part offset by the
inflow of new funds and income generated by
from both on and off balance sheet activities.
• The amount by which the cash withdraws
exceed the new cash inflows is the Net
Deposit Drain.
• Positive NDD implies withdraws are greater
than inflows. Negative NDD implies that
inflows are greater than withdraws
 Using Cash
• The most obvious asset side management
technique is to use the cash reserves of the
firm.
 Gap Analysis
• Gap is defined as the difference between the
rate sensitive assets and rate sensitive
liabilities maturing within a specific time
period.
 Gap Analysis
• Gap Analysis- Simple maturity/re-pricing
Schedules can be used to generate simple
indicators of interest rate risk sensitivity of both
earnings and economic value to changing interest
rates.
- If a negative gap occurs (RSA<RSL) in given time
band, an increase in market interest rates could
cause a decline in NII.
- conversely, a positive gap (RSA>RSL) in a given
time band, an decrease in market interest rates
could cause a decline in NII.
Measuring Interest Rate Risk with GAP
• Traditional Static GAP Analysis
GAPt = RSAt -RSLt
– RSAt
• Rate Sensitive Assets
– Those assets that will mature or reprice in a given time
period (t)
– RSLt
• Rate Sensitive Liabilities
– Those liabilities that will mature or reprice in a given time
period (t)
 MATURITY GAP METHOD
(IRS)
• THREE OPTIONS:
• A) RSA>RSL= Positive Gap
• B) RSL>RSA= Negative Gap
• C) RSL=RSA= Zero Gap
 What Determines Rate Sensitivity?
• An asset or liability is considered rate sensitivity if
during the time interval:
– It matures
– It represents and interim, or partial, principal payment
– It can be repriced
• The interest rate applied to the outstanding principal changes
contractually during the interval
• The outstanding principal can be repriced when some base rate
of index changes and management expects the base rate / index
to change during the interval
 Interest-Sensitive Assets

• Short-Term Securities Issued by the

Government and Private Borrowers
• Short-Term Loans Made by the Bank to
Borrowing Customers
• Variable-Rate Loans Made by the Bank to
Borrowing Customers
 Interest-Sensitive Liabilities

• Borrowings from Money Markets

• Short-Term Savings Accounts
• Money-Market Deposits
• Variable-Rate Deposits
 Example
– A bank makes a $10,000 four-year car loan to a
customer at fixed rate of 8.5%. The bank initially funds
the car loan with a one-year $10,000 CD at a cost of
4.5%. The bank’s initial spread is 4%.

4 year Car Loan 8.50%

1 Year CD 4.50%
4.00%

– What is the bank’s one year gap?

 Example

• Traditional Static GAP Analysis

– What is the bank’s 1-year GAP with the auto loan?
• RSA1yr = $0
• RSL1yr = $10,000
• GAP1yr = $0 - $10,000 = -$10,000
– The bank’s one year funding GAP is -10,000
– If interest rates rise (fall) in 1 year, the bank’s margin will fall
(rise)
 Measuring Interest Rate Risk with
GAP
• Traditional Static GAP Analysis
– Funding GAP
• Focuses on managing net interest income in the short-
run
• Assumes a ‘parallel shift in the yield curve,’ or that all
rates change at the same time, in the same direction
and by the same amount.
 Asset-Sensitive Bank Has:

• Positive Dollar Interest-Sensitive Gap

• Positive Relative Interest-Sensitive Gap
• Interest Sensitivity Ratio Greater Than
One
 Liability Sensitive Bank Has:

• Negative Dollar Interest-Sensitive Gap

• Negative Relative Interest-Sensitive Gap
• Interest Sensitivity Ratio Less Than One
 Aim is to stabilise the short-term profits,long-
term earnings and long-term substance of the
bank.
 The parameters that are selected for the
purpose of stabilizing asset liability
management of banks are:
-Net Interest Income(NII)
-Net Interest Margin(NIM)
-Economic Equity Ratio
• Net Interest Income-
Interest Income-Interest Expenses.

• Net Interest Margin-

Net Interest Income/Average Total Assets

• Economic Equity Ratio-

The ratio of the shareholders funds to the total
assets measures the shifts in the ratio of owned
funds to total funds. The fact assesses the
sustenance capacity of the bank.
 Net Interest Margin

Interest Income - Interest Expenses

NIM =
Total Earnings Assets
 Factors Affecting Net Interest
Income
• Changes in the level of interest rates
• Changes in the composition of assets and
liabilities
• Changes in the volume of earning assets and
interest-bearing liabilities outstanding
• Changes in the relationship between the
yields on earning assets and rates paid on
interest-bearing liabilities
 Example
• Consider the following balance sheet:
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.0% $ 600 4.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NII = 78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
 Examine the impact of the following
changes
• A 1% increase in the level of all short-term rates?
• A 1% decrease in the spread between assets yields
and interest costs such that the rate on RSAs
increases to 8.5% and the rate on RSLs increase to
5.5%?
• Changes in the relationship between short-term
asset yields and liability costs
• A proportionate doubling in size of the bank?
1% increase in short-term rates
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 9.0% $ 600 5.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NII = 83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74% With a negative GAP, more
GAP = 500 - 600 = -100 liabilities than assets
reprice
higher; hence NII and NIM fall
 1% decrease in the spread
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.5% $ 600 5.5%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)

NII = 81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09% NII and NIM fall (rise) with a
GAP = 500 - 600 = -100 decrease (increase) in the
spread.
Why the larger change?
Proportionate doubling in size
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86% NII and GAP double, but NIM
GAP = 1000 - 1200 = -200 stays the same.
What has happened to risk?
 Changes in the Volume of Earning
Assets and Interest-Bearing Liabilities

• Net interest income varies directly with

changes in the volume of earning assets and
interest-bearing liabilities, regardless of the
level of interest rates
RSAs increase to $540 while fixed-rate assets decrease to
$310 and RSLs decrease to $560 while fixed-rate
liabilities increase to $260
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 540 8.0% $ 560 4.0%
Fixed rate $ 310 11.0% $ 260 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)

NII = 77.3 - 38 = 39.3 Although the bank’s GAP
NIM = 39.3 / 850 = 4.62% (and hence risk) is lower,
GAP = 540 - 560 = -20 NII is also lower.
Changes in Portfolio Composition and Risk

• To reduce risk, a bank with a negative GAP

would try to increase RSAs (variable rate loans
or shorter maturities on loans and
investments) and decrease RSLs (issue
relatively more longer-term CDs and fewer fed
funds purchased)
• Changes in portfolio composition also raise or
lower interest income and expense based on
the type of change
Measuring interest rate sensitivity and
the dollar gap
• Dollar gap:
– RSA($) - RSL($) (or dollars of rate-sensitive assets minus dollars of
rate-sensitive liabilities, which normally are less than one-year
maturity).
– To compare 2 or more banks, or make track a bank over time,
use the:
Relative gap ratio = Gap$/Total Assets
or
Interest rate sensitivity ratio = RSA$/$RSL$.
– Positive dollar gap occurs when RSA$>RSL$. If interest rates rise
(fall), bank NIMs or profit will rise (fall). The reverse happens in
the case of a negative dollar gap where RSA$<RSL$. A zero dollar
gap would protect bank profits from changes in interest rates.
 Measuring interest rate sensitivity and
the dollar gap
• Dollar Gap:
– Interest rate forecasts can be important in earning bank profit.
If interest rates are expected to increase in the near future, the bank
could use a positive dollar gap as an aggressive approach to gap
management.
If interest rates are expected to decrease in the near future, the bank
could use a negative dollar gap (so as rate declined, bank deposit
costs would fall more than bank revenues, causing profit to rise).
• Incremental and cumulative gaps
– Incremental gaps measure the gaps for different maturity buckets
(e.g., 0-30 days, 30-90 days, 90-180 days, and 180-365 days).
– Cumulative gaps add up the incremental gaps from maturity
bucket to bucket.
 Measuring interest rate sensitivity and
the dollar gap
• Gap, interest rates, and profitability:
– The change in the dollar amount of net interest income (∆NII) is:

∆NII = RSA$(∆ i) - RSL$(∆ i) = GAP$(∆ i)

Example: Assume that interest rates rise from 8% to 10%.

∆NII = $55 million (0.02) - $35 million (0.02) = $20 million (0.02)
= $400,000 expected change in NII
• Defensive versus aggressive asset/liability management:
– Defensively guard against changes in NII (e.g., near zero gap).
– Aggressively seek to increase NII in conjunction with interest rate
forecasts (e.g., positive or negative gaps).
– Many times some gaps are driven by market demands (e.g.,
borrowers want long-term loans and depositors want short-term
maturities).
 Measuring interest rate sensitivity and
the dollar gap
• Three problems with dollar gap management:
– Time horizon problems related to when assets and liabilities are
repriced. Dollar gap assumes they are all repriced on the same day,
which is not true.
For example, a bank could have a zero 30-day gap, but with daily liabilities and
30-day assets NII would react to changes in interest rates over time.
A solution is to divide the assets and liabilities into maturity buckets (i.e.,
incremental gap).
– Correlation with the market rates on assets and liabilities is 1.0. Of
course, it is possible that liabilities are less correlated with interest rate
movements than assets, or vice versa.
A solution is the Standardized gap.
For example, assume GAP$ = RSA$ - RSL$ = $200 (com’l paper) - $500 (CDs) = -
$300. Assume the CD rate is 105% as volatile as 90-day T-Bills, while the
com’l paper rate is 30% as volatile. Now we calculate the Standardized
Gap = 0.30($200) - 1.05($500) = $60 - $525 = -$460, which is much more
negative!
Measuring interest rate sensitivity and the
dollar gap
• Three problems with dollar gap management:
– Focus on net interest income rather than shareholder wealth.
Dollar gap may be set to increase NIM if interest rates increase, but equity
values may decrease if the value of assets fall more than liabilities fall
(i.e., the duration of assets is greater than the duration of liabilities).
– Financial derivatives could be used to hedge dollar gap effects on
equity values.
– While GAP$ can adjust NIM for changes in interest rates, it does not
consider effects of such changes on asset, liability, and equity values.
 Duration gap analysis
• How do changes in interest rates affect asset, liability, and
equity values?
– Duration gap analysis:
Ιn general, ∆V = -D x V x [∆i/(1 + i)]
For assets: ∆Α = -D x A x [∆i/(1 + i)]
For liabilities: ∆L = -D x L x [∆i/(1 + i)]
Change in equity value is: ∆E = ∆A - ∆L
DGAP (duration gap) = DA - W DL, where DA is the average duration of
assets, DL is the average duration of liabilities, and W is the ratio of
total liabilities to total assets.
DGAP can be positive, negative, or zero.
The change in net worth or equity value (or ∆E) here is different from
the market value of a bank’s stock (which is based on future
expectations of dividends). This new value is based on changes in the
market values of assets and liabilities on the bank’s balance sheet.
 Duration gap analysis
EXAMPLE: Balance Sheet Duration

Assets $ Duration (yrs) Liabilities $ Duration (yrs)

Cash 100 0 CD, 1 year 600 1.0
Business loans 400 1.25 CD, 5 year 300 5.0
Total liabilities $900 2.33
Mortgage loans 500 7.0 Equity 100
$1,000 4.0 $1,000

DGAP = 4.0 - (.9)(2.33) = 1.90 years

Suppose interest rates increase from 11% to 12%. Now,
% ∆E = (-1.90)(1/1.11) = -1.7%.
$ ∆E = -1.7% x total assets = 1.7% x $1,000 = -$17.
 Duration gap analysis
• Defensive and aggressive duration gap management:
– If you think interest rates will decrease in the future, a positive
duration gap is desirable -- as rates decline, asset values will
increase more than liability values increase (a positive equity
effect).
– If you predict an increase in interest rates, a negative duration
gap is desirable -- as rates rise, asset values will decline less than
the decline in liability values (a positive equity effect).
– Of course, zero gap protects equity from the valuation effects of
interest rate changes -- defensive management.
– Aggressive management adjusts duration gap in anticipation of
interest rate movements.
 Earnings at Risk
• On a periodic basis
• The potential impact of the firm’s various gap
positions
• On the income statement for the current
quarter and full year.
 Duration of equity
• Net worth = Market Value of Assets – Market
Value of Liabilities.
• Duration of Equity = (Market Value of Assets *
Duration of Assets– Market Value of
Liabilities*Duration of Liabilities) divided by
Net Worth
 Long Term Var
• Can be achieved only by the Monte Carlo
Method.
• Purpose is to generate statistical distributions
of Earnings at Risk and Net worth at different
time horizons
• In order to produce the worst case EAR and
NW at a given confidence level say 99%.
 Input Parameters
• Term structure of interest rates which will include a
random component.
• Implied Volatilities
• Interest rate sensitive prepayments
• Loan defaults etc.
• Simulation conducted at the pool level.
• Pricing models need to be developed at each stage
of the simulation to assess the value of assets and
liabilities at that point of time.
 Complex Relationship Model
• Since the EAR and NW is a function of the
range of input parameters, one needs a
complex pricing model to represent the
function as well as assumptions about the
dynamics of interest rates.
• Inconsistent assumptions both on the
relationships and the interest rate dynamics,
can distort the results.
 Liquidity Risk Measurement
• Liquidity can be quantified by using a
symmetrical scale.
• There is a rank score for the dollar amount of
the product.
• The process is done both for liquidity suppliers
and Liquidity users.
• The amount is multiplied by the rank score.
• The sum on both sides is netted out.
 Funds Transfer Pricing
• Here each business unit is taken separately.
• If one business unit obtains funds and the other
applies them, instead of taking the resultant profit
margin,
• We take an independent benchmark like the LIBOR
for each business unit and arrive at the profit margin
of each business unit independently.
• The independent margins of Business units result in
the overall margin of the Business.
Statements
Risk Management
Profile
Report Report Report
V@R Market
V@R Market Report
V@R Market

Behavior Income
Interest Rate
Liquidity
Liquidity

Behavior Income
Interest Rate
Liquidity
Report

Credit
Operational Credit
Private Fund
Report Report
Report Managem
Report
Bankingent

Operational
Report
Report
Corporate
Asset Wealth
WealthReport
Management
BankingManagement
Management
Report Report
Report Report Report
 STATEMENT OF STRUCTURAL
LIQUIDITY
• Placed all cash inflows and outflows in the maturity
ladder as per residual maturity
• Maturing Liability: cash outflow
• Maturing Assets : Cash Inflow
• Classified in to 8 time buckets
• Mismatches in the first two buckets not to exceed
20% of outflows
• Banks can fix higher tolerance level for other
maturity buckets.
Statement of Structural Liquidity
All Assets & Liabilities to be reported as per their maturity
profile into 8 maturity Buckets:

i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
 STATEMENT OF
STRUCTURAL LIQUIDITY
• Places all cash inflows and outflows in the
maturity ladder as per residual maturity
• Maturing Liability: cash outflow
• Maturing Assets : Cash Inflow
• Classified in to 8 time buckets
• Mismatches in the first two buckets not to
exceed 20% of outflows
• Shows the structure as of a particular date
• Banks can fix higher tolerance level for other
maturity buckets.
 An Example of Structural Liquidity
Statement
15-28 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5
1-14Days Days 3 Month 6 Mths 1Year Years 5 Years Years Total

Capital 200 200

Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total Outflow
-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
 STRATEGIES…
• To meet the mismatch in any maturity
bucket, the bank has to look into
taking deposit and invest it suitably
so as to mature in time bucket with
negative mismatch.
• Risk Management procedures vary vastly from
institution to institution as well as the available data
and environments

• This implies Integrated Risk Management will be

both expensive and time consuming

• Therefore, Integrated Risk Management MUST be

custom made according to the institution’s
requirements
Liquidity Risk in Banks
Cash versus liquid assets
• Banks own four types of cash assets:
1. vault cash,
2. demand deposit balances at Federal Reserve Banks,
3. demand deposit balances at private financial institutions,
and
4. cash items in the process of collection (CIPC).
• Cash assets do not earn any interest, so the entire
allocation of funds represents a substantial
opportunity cost for banks.
• Banks attempt to minimize the amount of cash
assets held and hold only those required by law or
for operational needs.
Why do banks hold cash assets?

1. Banks supply coin and currency to meet customers'

regular transactions needs.
2. Regulatory agencies mandate legal reserve
requirements that can only be met by holding
qualifying cash assets.
3. Banks serve as a clearinghouse for the nation's check
payment system.
4. Banks use cash balances to purchase services from
correspondent banks.
Cash assets are liquid assets

• …only to the extent that a bank holds more than the

minimum required.
• Liquid assets are generally considered to be:
1. cash and due from banks in excess of requirements,
2. federal funds sold and reverse repurchase agreements,
3. short-term Treasury and agency obligations,
4. high quality short-term corporate and municipal
securities, and
5. some government-guaranteed loans that can be readily
sold.
Liquidity versus profitability
• There is a short-run trade-off between liquidity and
profitability.
– The more liquid a bank is, the lower its return on equity
and return on assets, all other things being equal.
• Both asset and liability liquidity contribute to this
relationship.
– Asset liquidity is influenced by the composition and
maturity of funds.
– In terms of liability liquidity, banks with the best asset
quality and highest equity capital have greater access to
purchased funds. (They also pay lower interest rates and
generally report lower returns in the short run.)
Liquidity risk, credit risk, and interest rate risk

• Liquidity management is a day-to-day responsibility.

• Liquidity risk, for a poorly managed bank, closely
follows credit and interest rate risk.
– Banks that experience large deposit outflows can often
trace the source to either credit problems or earnings
declines from interest rate gambles that backfired.
• Few banks can replace lost deposits independently if
an outright run on the bank occurs.
Factors affecting certain liquidity needs:
• New Loan Demand
– Unused commercial credit lines outstanding
– Consumer credit available on bank-issued cards
– Business activity and growth in the bank’s trade area
– The aggressiveness of the bank’s loan officer call programs
• Potential deposit losses
– The composition of liabilities
– Insured versus uninsured deposits
– Deposit ownership between: money fund traders, trust fund traders, public
institutions, commercial banks by size, corporations by size, individuals,
foreign investors, and Treasury tax and loan accounts
– Large deposits held by any single entity
– Seasonal or cyclical patterns in deposits
– The sensitivity of deposits to changes in the level of interest rates
Asset liquidity measures

• Asset liquidity
…the ease of converting an asset to cash with a minimum loss.
• The most liquid assets mature near term and are highly
marketable.
• Liquidity measures are normally expressed in percentage terms
as a fraction of total assets.
• Highly liquid assets include:
• Cash and due from banks in excess of required holdings and due from banks-
interest bearing, typically with short maturities
• Federal funds sold and reverse RPs.
• U.S. Treasury securities maturing within one year
• U.S. agency obligations maturing within one year
• Corporate obligations maturing within one year and rated Baa and above
• Municipal securities maturing within one year and rated Baa and above
• Loans that can be readily sold and/or securitized
Pledging requirements

• Not all of a bank’s securities can be easily sold.

• Like their credit customers, banks are required to
pledge collateral against certain types of
borrowings.
• U.S. Treasuries or municipals normally constitute
the least-cost collateral and, if pledged against
debt, cannot be sold until the bank removes the
claim or substitutes other collateral.
What about loans?

• Many banks and bank analysts monitor loan-to-

deposit ratios as a general measure of liquidity.
• Loans are presumably the least liquid of assets,
while deposits are the primary sources of funds.
• A high ratio indicates illiquidity because a bank is
fully extended relative to its stable funding.
The Loan-to-Deposit Ratio, continued
• The loan-to-deposit ratio is not as meaningful a measure of
liquidity as it first appears.
• Two banks with identical deposits and loan-to-deposit ratios
may have substantially different liquidity if one bank has highly
marketable loans while the other has risky, long-term loans.
• An aggregate loan figure similarly ignores the timing of cash
flows from interest and principal payments.
• The same is true for a bank’s deposit base.
• Some deposits, such as long-term nonnegotiable time deposits,
are more stable than others, so there is less risk of withdrawal.
• In summary, the best measures of asset liquidity identifies the
dollar amounts of unpledged liquid assets as a fraction of total
assets.
Purchased Liquidity and Asset Quality
• A bank’s ability to borrow at reasonable rates of interest
is closely linked to the market’s perception of asset
quality. Banks with high quality assets and a large
capital base can issue more debt at relatively low rates.
• Banks with stable deposits generally have the same
widespread access to borrowed funds at relatively low
rates.
• Those that rely heavily on purchased funds, in contrast,
must pay higher rates and experience greater volatility in
the composition and average cost of liabilities.
• For this reason, most banks today compete aggressively
for retail core deposits.
 Funding Avenues

To satisfy funding needs, a bank must

perform one or a combination of the
following:
a. Dispose off liquid assets
b. Increase short term borrowings
c. Decrease holding of less liquid assets
d. Increase liability of a term nature
e. Increase Capital funds
Liquidity planning

• Banks actively engage in liquidity planning

at two levels.
– The first relates to managing the required
reserve position.
– The second stage involves forecasting net funds
needs derived, seasonal or cyclical phenomena
and overall bank growth.
Liquidity planning: Monthly intervals

• The second stage of liquidity planning involves

projecting funds needs over the coming year and
beyond, if necessary.
• Projections are separated into three categories:
1. base trend,
2. short-term seasonal, and
3. cyclical values.
• Management can supplement this analysis by
including projected changes in purchased funds and
in investments with specific loan and deposit flows.
Monthly liquidity needs

• The bank’s monthly liquidity needs are

estimated as the forecasted change in loans
plus required reserves minus the forecast
change in deposits:
Liquidity needs =
Forecasted ∆loans + ∆required reserves
- forecasted ∆deposits
Liquidity GAP measures
• Management can supplement this information with
projected changes in purchased funds and
investments with specific loan and deposit flows.
• The bank can calculate a liquidity GAP by
classifying potential uses and sources of funds into
separate time frames according to their cash flow
characteristics.
• The Liquidity GAP for each time interval equals
the dollar value of uses of funds minus the dollar
value of sources of funds.
Considerations in selecting liquidity sources

• The previous analysis focuses on estimating the

dollar magnitude of liquidity needs.
• Implicit in the discussion is the assumption that the
bank has adequate liquidity sources.
• Banks with options in meeting liquidity needs
evaluate the characteristics of various sources to
minimize costs.
Evaluating Asset sales:

• Brokerage fees
• Securities gains or losses
• Foregone interest income
• Any increase or decrease in taxes
• Any increase or decrease in interest receipts
Evaluating New borrowings:
• Brokerage fees
• Required reserves
• FDIC insurance premiums
• Servicing or promotion costs
• Interest expense.
• The costs should be evaluated in present value terms
because interest income and expense may arise over
time.
• The choice of one source over another often involves
an implicit interest rate forecast.
 LIQUIDITY RISK: Effects
EFFECTS OF LIQUIDITY CRUNCH
• Risk to bank’s earnings
• Reputational risk
• Contagion effect
• Liquidity crisis can lead to runs on institutions
– Bank and Financial Institutions failures affect economy

136
 LIQUIDITY RISK: Factors
• Factors affecting liquidity risk
– Over extension of credit
– High level of NPAs
– Poor asset quality
– Mismanagement
– Non recognition of embedded option risk
– Reliance on a few wholesale depositors
– Large undrawn loan commitments
– Lack of appropriate liquidity policy & contingent plan

137
 LIQUIDITY RISK: Solutions
• Tackling the liquidity problem
– A sound liquidity policy
– Funding strategies
– Contingency funding strategies
– Liquidity planning under alternate scenarios
– Measurement of mismatches through gap statements

138
 What is a Liquidity Contingency Plan?
• A documented process to ensure that your bank
has the ability and means to obtain the necessary
funds to manage through a liquidity crisis.
• Creates a process to follow to utilize management
talent to expedite access to the financial markets
and to inform shareholders, customers and the
regulatory authorities that you are taking the
appropriate actions to mitigate a liquidity crisis.

139
When could a liquidity crisis occur?
• Intraday – fraud, large wire out,
etc…
• End of Day – Market crisis, etc…
• Over several days.
• Over a month.
• Over several months.

Stems from Market, Credit and/or Operational Risk Events

Either Bank Specific or Systemic

140
 Liquidity Contingency Plan: Objectives
• Ensure that a viable capability exists to respond to an event.
• Accomplish the LCP in an efficient, documented and orderly
way.
• Minimize losses and reputational damage.
• Protect the Balance Sheet and financial position, even if the
Balance Sheet moves to a new structure.
• Minimize the risk of legal liabilities.
• Ensure compliance with all applicable laws and regulations.
• Maintain the confidence and good relations with the
shareholders, investment community, regulatory agencies,
customers, service providers and other involved parties.

141
How Do I know when the Liquidity Contingency
Plan should be activated?
• When a pre-determined set of parameters
are exceeded.
• When a pre-determined number of triggers
are activated.
– Note – Targets are difficult to assess without parameters
• Example – A target rate of 2% - When is it way off?

142
 LCP Activation – When do I do
• this?
Level 1 Event – Indicated by minor infringement on the liquidity
parameters and/or triggers. Handled in the normal course of business.

• Level 2 Event – Indicated by additional triggers and parameter violations.

Additional executives become involved in addressing the problem.
Access to unsecured lines, pledging additional collateral, brokered CD’s,
etc…

• Level 3 Event – At level 3, the LCP is formally activated. A pre-

determined set of parameters/triggers are exceeded.
– Not handled during the normal course of business.
– Scope and duration could have a strong adverse effect on the bank
– Need to utilize multiple internal and external resources.
– Could be as a result of a physical disaster (make sure this plan is
referenced in your Business Continuity Plan)

143
 When should liquidity actions be
taken?
• Below is an activation table that indicates when liquidity actions should be taken.
This table is a guidance table. To use this table, add the parameters and triggers
together. However, the plan may be activated with fewer or no parameters or
triggers exceeded, especially in the case of a sudden event.

Level # of Parameters Exceeded Number of Triggers Exceeded

Level I 2 2

Level II 4 4

Level III – Full Plan Activation 6 6

144
 Parameter Examples
Liquidity and Funding Ratios Low High
Gross Loans to Total Deposits 70% 140%
Duration and Maturity Adjusted Liquidity 75% 90%
Fixed Liability Ratio 25% 100%
Pledgable Mortgage Loans to Total Residential Mortgage Loans 70% 80%
Net Short Term Non-core Fund Dependence (Short term non core funding less 50% 80%
short term investments divided by long term assets)
Net Non-core Fund Dependence (Non core liabilities less short term investments 50% 85%
divided by long term assets)
Brokered Deposits to Deposits 0% 20%

145
 Triggers for different events
Triggers are used as the basis for scenarios for review by the Bank. The triggers are used in
order to ensure their relevance to the liquidity situation at the Bank.
Systemic financial risk is the risk that an event will trigger a loss of economic value or
confidence in, and attendant increases of uncertainty about, a substantial portion of
the financial system that is serious enough to quite probably have significant adverse
effects on the real economy.
Systemic risk events can be sudden and unexpected, or the likelihood of their occurrence
can build up over time in the absence of appropriate policy responses.
The adverse real economic effects from systemic problems are generally seen as arising
from disruptions to payment systems, to credit flows, and from the disruption of asset
values. This definition, from
The Group of Ten: Report on Consolidation in the Financial Sector, captures both the
timing and the scope of such an event.
Systemic risk is diversifiable and the events that trigger the LCP should match the Bank’s
exposures.

146
 Triggers - Examples
Description Change/Cap/Floor Probability/Severity
Strong shift from accommodative to restrictive monetary policy Qualitative Medium/Low

Unemployment rate changes to indicate a recession 50% Change Medium/Medium

Loss of confidence in a major capital markets participant by funds providers that Qualitative Low/Medium
may spill over to others

Indications of a potential asset bubble Qualitative Medium/High

Agency MBS spreads to the 5 year Swap – 5 day moving average 150 bp increase Low/High

3 month LIBOR to 3 Month T-Bills – 5 day rolling average 100 bp increase Low/Medium

Commercial Paper Issuance by Banks ($) year to year 50% decrease Low/Medium

147
 Parameters and Triggers
• Parameters are established for overall management.
• Triggers are identified for three types of situations
– Normal to Non-Normal – Systemic
– Normal to Non-Normal – Bank Specific
– Non-Normal with Further Deterioration – Systemic and
Bank Specific
• The most difficult triggers to identify
• Reports should be developed that contain this information
and should be reviewed on a pre-identified schedule. In a
crisis, critical reporting should be accelerated.

148
 Who Gets Involved?
Liquidity Event Management Team (LEMT)

LEMT Members Primary Responsibility

Activate LCP
Chief Executive Officer Ensure necessary decisions are made by appropriate executives
LEMT Leader LEMT Leader role can be delegated to another executive

Activate LCP (if necessary)

Chief Risk Officer Ensure necessary decisions are made by appropriate executives (if necessary)

Coordinate all financial efforts related to the event

Chief Financial Officer Coordinate communication with regulatory agencies

Chief Treasury Officer Coordinate activities in Investments, Deposits and Lending

Alternate LEMT Leader Coordinate actions to access and secure funds for the financial institution

Coordinate all actions related to enacting the LCP

Coordinate communication up to the LEMT and down to the identified interested parties, including
LCP Coordinator
the BCP if required

Provide data and run models to manage the event.

Treasury Operations/ALM Coordinate scenario planning.

Coordinates all communications, with the exception of the Regulatory Agencies

Corporate Communications Serve as the point of contact for the media and other outside parties (except regulatory agencies)
seeking information about the nature and status of the event and responses by the Bank

149
Key individuals who support
the LEMT
Other Executives Primary Responsibility

Chief Credit Officer Coordinate response for all lending area activities

SVP Retail Banking Assist in coordination of response for all regional community bank activities

Assistant Treasurer Coordinate all investment decisions

Senior Trust Officer Coordinate response for all trust area activities

Legal Counsel Identify legal issues as they arise and advise the LCP on liability issues
Expedite review of contracts for procurement of necessary funds
Coordinate insurance documentation and recordkeeping requirements for claims processing, if
necessary

Corporate Controller Balance sheet accounting and budget forecasting.

Human Resources Director Ensure officers and employees who are deemed to need to be exited are exited and access to
sensitive systems and information is discontinued.
Work with recruiters if key personnel are required with specific skill sets.

150
• FIVE STAGES OF LIQUIDITY CRISIS MANAGEMENT
 Stage 1
Declaration and Notification of Liquidity Crisis
• Declaration of Formal Liquidity Crisis, based on pre-defined triggers.
• Notification of interested and involved individuals through use of the
Contact List.
• Arranging the initial meeting to discuss actions to be taken to mitigate the
Liquidity Crisis
• The LEMT Leader assumes control of the response activities.

• Corporate Communications prepares

necessary employee notifications and news
releases for media, regulators and
counterparties.

152
 Stage 2
Initial Meeting of the Liquidity Event
Management Team
• Distribution of the LCP and the reasons for the declaration of the need
for contingent liquidity.
• Establish meeting schedule, information requirements and potential
actions.
• Arranging for full disclosure of issues to the LEMT.
• Ensuring actionable items come out of the initial meeting, enabling early
intervention.
• Developing communication to the appropriate regulatory authorities
regarding the reason for the activation and the intended actions.

153
 Stage 3
Subsequent Meetings and Actionable Items
• Provide updates regarding liquidity status and projected
needs.
• Review updated information.
• Determine how balance sheet, employees, customers,
shareholders and counterparties are responding to
draw downs of loan commitments, additional
collateralizations, securitizations, sales and other
actions.
• Determine next steps, responsibilities and next meeting.

154
 Stage 4
Movement to Stabilized State of Liquidity
• As liquidity stabilizes, determine methods to
pay down loans, unwind positions and other
steps to resume a stable liquidity state.
• Reforecast upcoming months to develop
strategy.
• Identify communications requirements

155
 Stage 5
Forensic Review of Crisis
• Conduct table top walk through of crisis.
• Amend plan as appropriate.
• Communicate forensic activities to
appropriate personnel.

156
 LCP: The Goal
• It is important to remember that the goal is to bridge the
liquidity deficiency and not attempt to restructure the balance
sheet for long term profitability. In fact, because of the liquidity
issues, the profitability of the Bank should expect to suffer. The
goal is to focus on short term solutions to enable the Bank to
continue operating until longer term stability can be achieved.

157
 Actions to be taken during a Liquidity Crisis –
In order of consideration

• A liquidity crisis, whether a Level I, II, III, requires a concerted effort by the Bank to manage
through. Because each liquidity crisis is somewhat unique, the actions outlined below are
not specified as being required but are rather presented in menu form.
1. In general, a financial institution should consider tapping funds that are readily available,
unsecured and can be termed longer than originally projected. These types of funds will be
made unavailable or priced out of range more quickly than funds that require collateral to
access.
2. Of secondary importance is the cost of these funds, as they are being used to deal with a crisis
and should be expected to have a higher cost associated with them.
3. At the same time, some diversification is considered prudent because of the message that is
being sent to the market.
4. It is important to keep in mind that the funds being accessed are to address the crisis until the
Bank returns to a new level of stability, even if the new level is of a significantly riskier
institution. In other words, the goal is to survive.
• The LCP Coordinator should keep a list of available sources of funds and understand any
covenants associated with their use. This list should be updated at least monthly or more
frequently in case of a crisis.

158
Action
Examples of Actions Impact
Determine severity and duration of crisis through current Creates platform from which to build recovery strategy.
observations and estimates of the short-term outlook.

Have all Business Units that could have large outflows of Provides ability to negotiate on deposits or alerts Treasury on wire activity.
cash contact Treasury prior to Outflow Reduces cash outflow.
Move maturing less liquid securities into more liquid Typically reduces yield but provides pledgable collateral. Preferable to total
instruments. liquidation because investments remain after liquidity crisis subsides.

Acquire fed funds to cover liquidity shortfall. Very short term strategy to cover intraday or interday liquidity needs.
Reduce correspondent balances and move to paying fees Short term strategy to cover immediate cash needs.
for services instead of compensating balances.

Access unsecured lines. Counterparties noted in Appendix Accessing unsecured lines should be an early stage activity and addresses
I. short term needs. These funds will typically not be available as the
crisis unfolds. Early use saves collateral for use at a later stage.
However, a blended approach should be used (unsecured and secured).

Access unsecured term loans. Counterparties noted in Accessing unsecured term loans should be an early stage activity and
Appendix I. addresses the need to lengthen maturities. These funds will typically
not be available as the crisis unfolds. Early use saves collateral for use
at a later stage.

Move customer repurchase agreements away from pledged Pledged securities (repos) used for customer deposits may need to be
securities. redirected to access market funds. While there might be some flight
from the bank because of this, alternatives can be offered to customers
to retain deposits for a short period of time.
159
 LIQUIDITY RISK
• RBI GUIDELINES
– Structural liquidity statement
– Dynamic liquidity statement
– Board / ALCO
• ALM Information System
• ALM organisation
• ALM process (Risk Mgt process)
– Mismatch limits in the gap statement
– Assumptions / Behavioural study
ALM - Funds Transfer Pricing

Loan
LIBOR Curve
Credit Spread

Maturity Mismatch
Rate

Funding Margin

Deposit

Maturity
 Questions for Revision
• What are liquid assets ? What is a liquidity
crisis ? What is its impact on an organization ?
Illustrate with examples ?
• What is meant by liquidity Risk ? Why is it so
important ?
 Define the following
• Net Interest Income
• Net Interest Margin
• Static Gap Analysis in ALM.
 Questions for Revision
• What is Interest Rate Risk ? How does it affect
a bank’s earnings ?
• What is meant by Asset Liability
Management ? What is ALCO ? What is the
composition of ALCO ?
 Questions for Revision
• What are the traditional regulatory
approaches towards Managing Liquidity Risk?
• Discuss the methods that an organization can
use to tackle liquidity risk ? What are the
committees, contingency plans, triggers and
actions that an organization put in place to
tackle liquidity Risk ?
The End