Balance Sheet Management Reviewer PDF
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This document provides an overview of balance sheet management in finance. It discusses various aspects, including asset classes like interest rates, currencies, commodities, and credit, and how banks earn through different methods. It also refers to core principles of asset liability management (ALM).
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MONEY MARKET ( lenders/investors)tonetfundsdeficitunits (borrowers/issuers)...
MONEY MARKET ( lenders/investors)tonetfundsdeficitunits (borrowers/issuers) Participate in the financial markets → FX, commodities, credits and equity securities BALANCE SHEET MANAGEMENT Structured for hedging and active risk-taking A. FINANCIAL INTERMEDIATION ○ Hedging (take out risks) → you have an existing disposition (overshort/overlong) ○ Speculative (take risks) → long/short position in assetclasses / alsodotheoppositeifyouwantto speculate a long/short position Balance Sheet: Sources and Uses of Funds USES SOURCES ssets A L iabilities Reserves with CB Demand deposits Consumer loans Term deposits Basel Standards → set of standards that central 4 Corporate loans Interbank deposits banks follow Interbank loans I. Balance Sheet Management Government bonds tockholders’ equity S II. Bank Policies Fixed assets Equity capital III. Dodd-Frank Act IV. Regulatory & Tax Framework Balance Sheet Management High-levelmanagementofabank’sassetsand Asset classes→ ICCCE liabilities I - Interest rate Strategy level → ALCO, business line level C - Currency FX tactical operations → Treasury group C - Commodities Manage interest rate risk and liquidityrisk; C - Credit (default/premium) setoverallpolicyforcounterpartycreditrisk E - Equities (index/individual) management Core principles apply to both commercial & How do banks earn? investment banking and ALM and trading 1. Net interest income books 2. Trading profits 3. Fee-based income Core Principles of ALCO → ALM strategic concerns: Broker’s commission I. Understand all your assets and liabilities Credit card before managing them Account maintenance fees II. Treat banking business as portfolio of risks; Processing fees banking is not about avoidance of risk III. ALM = Risk management → both involve Role of Commercial Banks constant and evolving trade-off between risk and return and capital allocation IV. FMS → not static, collective nouns Main points: representing human emotions (hope,fearand Intermediary between sectors → mobilize greed) → basic tenet of EW analysis capital from net funds surplus units V. Anticipate worst-case scenario (Black Swan events → low probability, high impact) 1 R eserve ratio = 5.00% Effective rate = 0.08/(1-0.05) =0.0842 or 8.42% What is t he impact of earnings on reserves, e.g., 20bps on effective interest rate? ○ 0.08 + 0.0020 / (1-0.05) = 0.0844 or 8.44%(will also increase by 20bps) Open Market Operations Bank Treasury Group Management of asset andliabilitystructure →increaseROEC1 numerator(NRRFandNFR) within the overall risk preference and risk capital adequacy of the bank Reserve Requirements→ two primary reserves by BSP C reation of value → higher ROEC/RAROC 1. Deposit liability →percentageofbankdeposits allocation/diversification and pricing of A&L & deposit substitute liabilities that banks → transfer pool pricing must keep in deposit with BSP Liquidity and reserves management 2. Liquidityfloorreserves→maintain50%liquidity Reduction of funding costsandmaximization floor of assets yields Transferable government securities Centralized management of market risks → direct obligation to the government Compliance with internal and external policies Free portion of demand deposit account(DDA)balancewithBSP(after Role of the Fed/BSP satisfying reserve requirement) Special deposit accountswith BSP ain Points: M Control money supply(increase/decrease)inthe Basel Rules economy 1. Bankingbookpositions→traditionalportfolio lending, assets typically HTM and subject to Legalreserverequirements→cash&other accrual accounting liquid assets 2. Capital requirement = longer holding period Discount rate/Fed fundsrate/policyrate→ 3. Trading book positions → more market risk rate at which banks can borrow from Fed flavor, marked-to-market, must be either sold Open market operations → buying/selling or readily hedged securities 4. Capital charges at commercial banks →arise Effect of Reserve Requirements from the banking book 5. Liquidity coverage ratio (LCR) → short-term resiliency of liquidity risk profile of banks through high-quality liquid assets (HQLA)to survivestressscenarioslast30calendardays (Basel III) 6. Netstablefundingratio(NSFR)→resiliencyfora **same color = same relationship longertimehorizon(1Y)bycreatingadditional incentivesforbankswithmorestablefunding Worked Example: (Basel III) Nominal rate = 8.00% 1 Risk on economic capital; internal capital attribution 2 O ff-balance sheet; minimal capital B. BANK TREASURY MANAGEMENT requirement Capital → market risk Banking and trading books THINGS TO REMEMBER: Strategies: FX trading → Basis points → money market overbought/sold bps → FX arketrisk→riskoflossesfromadversemovements M ank Treasury Group: Intermediary Within an B in market prices Intermediary → Transfer Pool Pricing Interest rate risk → unexpected rate Net interest income is generated by: fluctuations (affecting ALM and trading books) ○ Borrowing low Currency exchange risks → unexpected rate ○ Selling high fluctuations affecting currency Commodity risk → unanticipated losses due to change in prices of commodities Credit risk premium → change in credit spread due to rating up/downgrade Equity risk → unfavorable move in stock prices Illustration: Liquidity risk → inability to make timely 1. CitigrantsaUSD10MMloanforsixmonths@ payment**any currency 2.50% p.a. to a multinational company. The ○ Funding liquidity risk → mismatch of loan is funded bya3-monthdeposit@1.75% A&L, exchange contracts and p.a. contingent commitment maturities ○ 2.50% - 1.75% = 75 basis points (net ○ Trading liquidity risk → inability to interest income) unwind positions from markets, ○ Income earned by borrowing low (at exchanges and counterparties due to 1.75) , lending high (at 2.50%) temp/perm factors ○ Risk: counterparty credit risk 2. Citi buys USD 5MM vs JPY @ 118.90 in the Profit-center Treasury morning which it leaves open and sells the Creation of financial innovations, structured same @119.10in the afternoon products: futures, forwards, swaps and ○ 119.10 - 118.90 = 20 bps (net interest options income) Introduction of risk-taking activities, ○ Income earned by buying low (at centralization of bank-wide market risk and 118.90) and selling high (at 119.10) counterpartyrisk:moneymarketgappingand foreign exchange positioning ○ Risk: Counterparty credit risk Market Factors Bank Revenue Drivers 1. Net Revenue from Funds (NRRF) or Net Interest Income Interest earned on assets - interest paid on liabilities (use of funds) Booking of assets in balance sheet Capital → credit risk Banking (ALM) books Strategies: gapping → positive/negative 2. Non-Funds Revenue (NFR) or Fee-based Income Tradingincomeandservice-basedfees (spread); not require use of funds 3 Yield Curve (Term Structure of Interest rates) Negative gap Positive gap Money Market Gapping Scenario Lower IR Higher IR Strategy L end long, borrow B orrow l ong, short (refund lend short lower) (reinvest higher) Impact utflows ahead of I nflows ahead O inflows of outflows Risks Price and liquidity Price only **Negative gapping (view is IR will go down) Lend long (assets) ALM gaps are taken based on: Borrow short (liabilities) FED/BSP actions Economic conditions Yield curve analysis Market sentiments Human emotions C. Market Risk Management ccounting A Revenues Risks isk R treatment Measure and control **Positive gapping (view is IR will go up) Borrow long (liabilities) anking B Accrual et N unding, F V M Lend short (assets) book interest liquidity, Commodity income interest outflow, EAR rate limits rading T ark to M rading T rading, T osition P book Market profits, liquidity, limits, VAR fees interest limits rate Intermediation risks 1. Credit → what if the borrower does not repay? 4 2. M arket (rate, liquidity) → what if rates move IR rise IR fall higher? What if the bank cannot borrow? 3. Operations → what if a loan is booked as PHP? Short bond Profit Loss **sell-buy * sell now - low IR, high * sell now - high IR, low Worked Example: Measuring Risk price *buy in the future - high price *buy in the future - low IR, Role: balance sheet manager IR, low price high price Goal: measure bank’s exposure to interest Long bond Loss Profit rates given ALM gaps in balance sheet **buy-sell * buy now - low IR, high * buy now - high IR, low price price Q: How much can you potentially lose, if the *sell in the future - high *sell in the future - low IR, IR, low price high price market will move against you? Value at Risk Estimate of max expected l oss of a risk position based on adverse overnight move (assuming a certain CL) onfidence levels: C 95% = 1.645 97.72% = 2 99% = 2.326 Worked Example: Measuring Risk Role: bond trader Goal: measure bank’s exposure to interest rates given long bond position Q: How much can you potentially lose if the market will move against you overnight? P=USD10MM,MD=6.85,SD=0.0075,CL:99%, DP: 1-day (O/N) Effective Annual Rate Used by ALCO to quantify measureofprofitto interest rate change Used control interest rate risk by imposing limits or maximum loss amount Change in rate Assumes SD (Confidence level) Trading Risk Positions Law of Fixed Income: there is an inverse relationship between bond prices and yields Youlongabondwhenyouexpectinterestrates to fall ○ Long → buy-sell ○ Youbuyabondnow(higherrate,lower price) so you can sell @ higher price, lower rate (when you expect interest rates to fall) 5 D. Return on Economic Capital Return on Economic Capital Measures performance on a risk-adjusted basis Performance metric that helps determine if a company has optimal balance bet. capital, returns and risks Economic capital → amount of capital a company should put aside basedontherisks it runs * *higher capital requirements and costs duetoBasel III changes will motivate banks to look for lines of businesswithlowerriskcapitalattribution,toachieve higherROEC or RAROC 6
