Chapter 5: Balance Sheet Management: Liquidity Risk (PDF)

Chapter 5 BALANCE SHEET MANAGEMENT: LIQUIDITY RISK AND INTEREST RATE RISK Background  The structure of bank's B/S and income statements has changed a lot over time.  Because  Banks now deal in av wide range of instruments.  Significant growth in off-balance sheet busin...

Chapter 5 BALANCE SHEET MANAGEMENT: LIQUIDITY RISK AND INTEREST RATE RISK Background  The structure of bank's B/S and income statements has changed a lot over time.  Because  Banks now deal in av wide range of instruments.  Significant growth in off-balance sheet business.  Increased diversity- to spread risks and increase profitability, but also brings new risks.  Banks adopting an increasingly systematic approach to b/s management.  Therefore, Banks must devote resources to the coordinated management of both sides of b/s: Known as Asset Liability Management (ALM). Asset and liability management (ALM) is a practice used by financial institutions to mitigate financial risks resulting from a mismatch of assets and liabilities. Because banks have become far more complex on both sides of b/s - in terms of  types of instruments they use to hedge,  types of assets they invest in and  the loans they lend.  Liability side is also just as complex today – Because banks fund themselves in diff ways. E.g. Short term funding - less than one year funding- certificates of deposits. Other types of ST loans. Long term funding- banks using securitization as a type of LT funding. This makes it more difficult for banks to manage all their activities. There's been a huge rise in off b/s activities - e.g. SIV (Structured Investment Vehicle (SIV) A structured investment vehicle (SIV) is a type of special- purpose fund that borrows for the short-term by issuing commercial paper, in order to invest in long-term assets with credit ratings between AAA and BBB) set up by banks to make money. It had a risk - banks thought there was no risk at the time, but had large liquidity risk  So increasingly trying to be more sophisticated in how they manage what's on their b/s. What's off b/s not enough pressure from regulators to manage, but they should manage it, or they're only fooling themselves! Any bank that isn't monitoring e.g. a SIV = very stupid! From a regulatory perspective Liability side has grown in importance over last few decades, and interbank markets have also expanded - where banks can easily buy and sell excess liquidity. Due to these changes, modern banks have become more likely to undertake a coordinated management of both sides of the b/s, rather than focusing on just asset side  Main obj of any Bank= max profit and S/H wealth. To do this, financial management must make investment decisions (allocate finance), undertake financing decisions (how to acquire finance) and control resources (how to conserve finance). Therefore, investment and financing decisions are essential in planning process to achieve the obj of bank. Banks - goal is manage assets/liab in a way that max profits/shareholder wealth, whilst also being 'safe and sound’. Banks must be prudent, due to the special role that they play in the economy, and the 'domino' effects which would occur when a bank fails.  Capital management - must keep adequate level of capital to comply with regulatory requirements, to maintain appropriate level of solvency. These are funds that can be used as a cushion against losses - if loans aren't repaid, it is the capital that bares the loss, so the more capital a bank has, the bigger the cushion to absorb losses, so the safer it is. Moreover, Coordinating financing and investment decisions is the essence of asset and liability management (ALM): ALM is typically associated with managing the int rate risk and bank liquidity – AML goal = controlling a bank's value and profits, subject to taking a certain level of risk, and maintaining an appropriate level of safety. Asset management Maximize return on loans and securities focuses on trying to charge the max amount that they can for the loans that they provide. Bank manages assets well, when it maximizes returns on loans and securities, e.g. by increasing loan screening, and monitoring activities, and by choosing low-credit risk/high-return customers. Aims to diversify portfolio of assets, to avoid over-investing in a single sector. Asset management - bank must ensure that its portfolio of assets (mainly loans) includes low-risk assets, and is well diversified. Adequate liquidity asset management team require adequate liquidity- e.g. agreement to lend money will be made today, but they won't lend you the money for several weeks. So entered into a contract to deliver in two/three weeks - if they don't deliver that to you, can take insolvency proceedings against bank= bank in trouble! Must be able to pay the loans that bank has committed to, but not delivered yet.  Decisions about amount of liquid assets and reserves to keep on hand, considering the trade-off between profitability and liquidity liquid assets= yield low returns, so bank that holds high proportion of liquid assets on b/s = lower income and profits). Hence Banks should calc opportunity cost of amount kept as liquid assets, as these assets are typically non-earning or low-yielding. Banks' reserves= insurance against costs associated with deposit outflows. To obtain liquidity, a bank can either borrow from other banks, sell some of its securities, sell some of its loans or borrow from the central bank. If bank has liquidity problems - must act quickly and discreetly to meet any shortfalls. If other institutions/depositors find out - bank run - insolvency. Therefore, selling off/calling in loans= problematic, and borrowing from central bank is a last resort!  Liquidity management - bank must predict with lowest possible margin of error, the daily withdrawals and other payments by customers, so that they make sure to keep enough cash and other liquid assets readily available. Must ensure that it has enough cash/liquid assets to meet obligations to depositors and satisfy customer loan demand. Bank must always be able to meet both normal and abnormal shortfalls in anticipated cash flows. Liability management: Banks are diff from ordinary firms - they make money on both sides of their B/S. even on their liability side! Maximize return in the interbank market. Minimize cost of deposits - try to pay the smallest possible amount they can, to attract deposits. Banks aims to acquire funds (raise deposits) at low cost when operating in money markets (borrowing from other banks, or by offering negotiable CDs), whilst also minimizing the interest paid on deposits. Asset and Liability Management: Focuses on liquidity and interest rate risk, at b/s level. It is a subset of bank's overall risk management process, which also addresses other forms of risk, e.g. credit risk and market risk, as well as aspects of risk measurement and control. ALM techniques - most applicable to commercial banks involved in deposit collection and lending businesses. Int rate risk - the worry that what you earn from lending, isn't greater than what you have to pay to borrow the money. Net interest margin (NIM) assumed target of ALM policies. Defined as Net interest income= interest revenues - interest expenses, as proportion of bank's total assets. NIM - often used to measure performance of banks -ALM is constantly worried about it, because we want NIM to be as high as poss. It is the interest revenues - the interest expenses. The debt interest income as prop of bank's assets. Banks aim to minimize variability of NIM for a given target level, or max NIM for a given level of risk. Requires continual monitoring of a bank's position.  American banks had rep for being extremely risk loving. People who have worked for a German bank find it difficult to work in an American bank! Level of setting the risk depends on the bank and the country of origin - some countries v risk averse! Bank sets NIM targets and want to achieve them! Management must monitor their positions all day long, to ensure bank is on target to achieve its goals. Continual monitoring of bank's position: Undertaking transactions (including hedging), to move towards desired position. Can hedge that risk away if bank is taking on too much. Objective= enhance profitability, while controlling and limiting risk, and complying with the constraints of banking supervision. Assess risks and benefits of all assets/liability in the light of the contribution they make to the earnings, and risk of overall portfolio.  Problems arise, as bank portfolios are constantly changing, as maturities, interest rates and exchange rates change, and as new transactions are undertaken. Therefore, banks continually adjust assets and liab, by varying the terms for bus with clients, and by regular trading. Problems - banks have large trading books= as bank buys/sells things - changes overall position of bank, so if these portfolio are always changing, every day some loans are gonna reach maturity= get repaid to the bank. So bank has to find a new place to invest it. Interest rates change daily. Exchange rates constantly go up and down. Bank isn't static - both sides of the b/s aren't changing. Some ST money market instruments will reach maturity= bank has to repay them.  When deciding an ALM strategy, bank management must consider many factors, with the important inclusion of the bank's attitude towards risk. If bank is 'risk averse' = managers prefer to match where poss. If bank is risk averse, have to do matching - match maturity and sizes on b/s. The more risk averse you are, the more matching you do, and vice versa. If managers prepared to take increased risk= greater mismatching, and more complex hedging arrangements will be undertaken, in hope of earning extra margin. Mismatching= borrowing ST, lending LT. Size of loans are huge, deposits are smaller will do hedging, to hit extra margins - earn an extra profit. Five major problems with ALM: 1. Seasonal loan and deposit flows: ensure that b/s structure is flexible enough to meet unanticipated demands for funds (borrowers), or withdrawals of funds (depositors). Sufficient funds must be available, but at the same time, bank must be as fully prudent as poss, in order to earn the best return. 2. Changes in the economic env: Strong econ with strong loan demand = encourages banks to depend more on market liquidity, to protect their positions, as liquid asset portfolios are run down, in order to support loan demand. Weak loan demand = causes banks to rely less on instruments such as negotiables CDs and money market instruments and may even cause banks that had been primarily concerned with such liab management, to revert back to asset management. 3. Monetary Policy and Supervisory Regulation: Central bank can implement policies that have direct impact on reserve availability, and level of int rates. Can have huge effect on ALM. Monetary policy instrument – RRR(required rate of return), reserve ratio requirement - there's a view that it doesn't work - bank can cheat and get around it. A percentage of bank's deposits that must be held at the central bank. Purpose of this is to restrict bank's ability to make new credit/lend new money. The higher it is, the more restricted. 4. Financial Markets: Banks must be in position to forecast performance of financial markets (esp money markets, as they determine term structure of int rates}. Banks need to be able to forecast future movements. If bank management thinks int rates will increase, they should lend with as short a maturity as poss. Lending out at fixed rate of int, when variable rates in the market weren't steady.  5. Customer Relationships: Banks have commitments (unused overdrafts and credit lines}, and guarantees (standby letter of credit, or commercial letter of credit}, which can be drawn on during periods of tight money or unusual circumstances. Asset and liab managers must be aware of the lines of credit and guarantees that have been extended by loan officers, and what usage is expected in the future. Liquidity gap analysis: Liquidity risk= generated in b/s by mismatch between sizes and maturities of assets and liab. Approach for how banks can measure liquidity on the b/s Bank faces liquidity risk when, due to lack of confidence or unexpected need for cash, withdrawals are higher than normal, and bank is unable to meet its liabilities. If bank has temporary liq problem, and is unable/unwilling to borrow on interbank market, then can borrow funds from central bank, in form of loans and advances - costly, in terms of int rates charged, as well as bank's reputation!  Liquidity pressure can arise from both sides of b/s. Liab side - unexpectedly high cash withdrawals can cause solvent banks to have liquidity problems. Asset side - liq problems can be caused by unexpectedly high loan defaults, and by customers unexpectedly drawing down lines of credit. Therefore, Liq risk management is an integral part of the ALM function. It's aim - protect bank against liquidity risk and avoid a situation of negative net assets. Liquidity gap Liquidity gap= net liquid assets - volatile liab. If bank's assets exceed liab, gap should be funded in the market. If reverse is true, then excess resources must be invested. Banks can either store liquidity in their assets, OR purchase it in money/deposit markets. As liquid assets have lower returns, stored liquidity has opp cost that results in trade-off between liquidity and profitability.  o To avoid liquidity problems, bank can hold liquid assets. Liquidity can be stored on the b/s, or banks can purchase liquidity from the money markets. Trade-off between liquidity and profitability - storing liquidity is expensive, the more you store, the more your profits are going to be negatively/adversely affected. The more liquid the asset, the lower the rate of return. Instead of holding liquid funds, a bank could make more profitable loans.  However, despite the costs, holding liquidity is necessary, as it: Reassures creditors that the bank is safe and able to meet its liab. Signals to the market that the bank is prudent and well managed. Ensures that all lending commitments can be met. Avoids forced sale of the bank's assets. Avoids having to pay excessive borrowing costs in the interbank markets. Avoids central bank borrowing.  Therefore, Aim of ALM = increase earning capacity of bank, while ensuring adequate liquidity cushion. Aim of ALM team = to increase earnings - to maintain sufficient liquidity. Need for liquidity To replace net outflow of funds: Need liquidity to replace an outflow of funds that occurs - e.g. loan to a comp, or a depositor withdraws its depositors. To compensate non-receipt of expected inflows: Need to have liquidity in the event that e.g. large loan to Microsoft - don't pay back loan = non-receipt of expected inflows To find new funds when contingent liab become due (e.g. exercise of lines of credit): letigations To undertake new transactions when desirable. Cautionary demand for holding liquidity- bank can move v quickly when faced with investment opp. Sources of liquidity: Expect a mismatched b/s: ST liab > ST assets ST liab will always be greater than ST assets, as banks borrow short, and lend long - this is their mismatch. The size of their borrowings is diff - size mismatching too Medium and LT liab < medium and LT assets. Medium and LT liab will be far less than the medium to LT assets that the bank holds. Must manage this mismatching to avoid liquidity problems - risk= possibility of holding inadequate resources, to balance the assets. Liquidity Gap Analysis Most widely used technique for managing bank's liquidity position Liquidity gap - the shortfall of liquidity that a bank might face. The difference between net liquid assets, and unpredictable/volatile liab. LGAP = NLA - VL NLA = net liquid assets. VL = volatile liab. Interest Rate gap analysis Best-known int rate risk management technique. Aim - evaluate the impact of a change in int rates, on the bank net int income, and net int margin. The gap should be managed to expand when int rates are rising, and contract when they're declining, but it's difficult for bank managers to know what phase of the int rate cycle they're facing.  Need to identify rate-sensitive assets and liab, i.e. those that will be repriced within a given interval, due to maturity or automatically (variable rate). The gap for a given period = interest sensitive assets - interest sensitive liab over a specific time horizon. If int rate-sensitive liab > int rate-sensitive assets, then inc in int rates= decrease in bank's profit, and vice versa. The focus is on the maturity of the rate-sensitive assets and liab. GAP= RSA (rate-sensitive assets) - RSL (rate-sensitive liab) An asset/liab is rate-sensitive, if cash flow from it changes in the same direction as changes in int rates.  The interest rate gap can be positive or negative. Most banks have positive gap (RSA> RSL}, because they borrow short, and lend long, and therefore have assets that will mature later than liab. Two ALM techniques used to manage int rate risk: Income gap analysis Duration gap analysis Income gap analysis Duration gap Analysis Other formula Ended