Liquidity Risk ALM Policy - ALCO

Liquidity risk, Bank ALM policy and the Treasury Operating Model Extracted from “The Principles of Banking” John Wiley & Sons Limited May 2012

Professor Moorad Choudhry Department of Mathematical Sciences Brunel University

Agenda  ALCO policy  Treasury operating model  ALCO best practice

Please read and note the DISCLAIMER stated at the end of the presentation.

© 2008, 2010, 2012 Moorad Choudhry

Liquidity Risk Management Feb 2013 2

ALCO policy  The Asset-Liability Committee (ALCO) is responsible for setting, and

implementing, the ALM policy. Its composition varies in different banks but usually includes heads of business lines as well as director-level staff such as the Finance Director. The ALCO also sets hedging policy.  The ALM process may be undertaken by the Treasury desk, ALM desk or other

dedicated function within the bank. In traditional commercial banks it will be responsible for management reporting to the asset-liability management committee (ALCO). The ALCO will consider the report in detail at regular meetings, usually weekly.  Main points of interest in the ALCO report include funding structure, variations in

interest income, the areas that experienced fluctuations in income and what the latest short-term income projections are. The ALM report will link these strands across the group entity and also to each individual business line. That is, it will consider macro-level factors driving variations in interest income as well as specific desk-level factors. The former includes changes in the s hape and level of the yield curve, while the latter will include new business, customer behaviour etc  Of necessity the ALM report is a detailed, large document.



ALCO policy…main mission: strategic overview Mission

Components

ALCO management and reporting

Formulating ALM strategy Management reporting ALCO agenda and minutes Assessing liquidity, gap and interest-rate risk reports Scenario planning and analysis Interest income projection

Asset management

Managing bank liquidity book (CDs, Bills) Managing FRN book Investing bank capital

ALM strategy

Yield curve analysis Money market trading

Funding and liquidity management

Liquidity policy Managing funding and liquidity risk Ensuring funding diversification Managing lending of funds

Risk management

Formulating hedging policy Interest-rate risk exposure management Implementing hedging policy using cash and derivative instruments

Internal Treasury function

Formulating transfer pricing system and level Funding group entities Calculating the cost of capital



Liquidity Management  The continuous process of raising new funds or investing surplus funds

is known as liquidity management. 

It has several objectives; possibly the most important is to ensure that deficits can be funded under all foreseen circumstances.

 In addition there are regulatory requirements that force a bank to

operate certain limits and state that short term assets be excess of short run liabilities.  Managing the banking book’s liquidity is a dynamic process, as loans

and deposits are known at any given point, but new business will be taking place continuously and the profile of the book must be rebalanced.  There are several factors that influence this dynamic process -



Liquidity Management cont… 



Demand deposits have no stated maturity There are a number of ways that a bank can choose to deal with these balances : 







To group all outstanding balances into one maturity bucket at a future date that is the preferred time horizon of the bank, or a date beyond this. To rely on an assumed rate of amortisation for the balances, say 5% or 10% each year. To divide deposits into stable and unstable balances, of which t he core deposits are set as a permanent balance (behaviouralisation that can be demonstrated to the regulator). Market practice ranges from 2-3 years tenor to 7-8 years tenor. To make projections based on observable variables that are correlated with the outstanding balances of deposits.



Treasury organistion structure  There is no one “right” Treasury operating model  The first decision to consider is whether Treasury is a front-office

function or a middle-office function  See next slides for scope of the function…  …and the ones after that for alternative approaches!



Capital and balance sheet

Liquidity

Net Interest Income / NIM

STRATEGIC MANAGEMENT

Capital management Risk limits (RWA) Cost of capital Budget forecasting ICAAP Setting capital policy Setting return metrics Defining capital structure and ratios Capital allocation

Liquidity risk management Liquidity limits Liquidity stress tests Liquidity policy ILAA Contingency funding plan LAB policy Liquidity cost calculation Funding strategy Internal funds pricing policy (FTP)

Banking book interest rate risk Interest rate risk management Interest rate risk modelling Forecasting NII/NIM

MARKET FACING FUNCTIONS

Term Liabilities Issuance Senior unsecured debt Subordinated debt Equity instruments Securitisation Secured

Money Markets Desk Cash management Money markets -- depos -- CD/CP -- FX Repo

Swaps and Derivatives desks Banking book Trading book Market risk hedging

-- ABS/MBS -- Covered bonds

Collateral management Counterparty risk management Investor Relations Rating Agencies Investors

GOVERNANCE


Finance and Risk Management Financial control and reporting Regulatory reporting Liquidity Risk Management Feb 2013

8

Front-office Treasury op model

Capi tal management

L iqui di ty ri sk management

Banki ng book i nterest rate ri sk

Term L iabi l i ti es I ssuance

Money Markets D esk

Swaps and D eri vati ves desks

Col l ateral management Coun terparty r i sk management I nvestor Rel ati ons F i nance and Ri sk Management



Middle office Treasury op model

Capi tal management




Money Markets D esk



Regulatory reporting



Treasury op model with market facing function Capi tal management




Money Markets D esk






Treasury op model with market facing and governance functions Capi tal management




Money Markets D esk






Treasury Infrastructure & Scope Treasurer’s (or Group Treasurer’s) Dual Mandate 1.

2.

Mandated by the Chairman and CEO, and ALCO 

Manage and control market & liquidity risk



Manage the activity & scope of local Treasuries



Draft and own liquidity and funding policies (Governance and Policy function)



Funds Transfer Pricing policy (clearing centre is Money Markets desk)

(Front office Treasury) Mandated by the Chairman and CEO to generate earnings 

Money market trading



FX trading revenue



Portfolio management



NII & gains from capital markets trading & holdings



Funds Transfer Pricing – Treasury is the cash market place

13 © 2008, 2010, 2012 Moorad Choudhry


Infrastructure & Scope… Structure of Treasury Function 



Global Treasury Management 

Risk mitigation, allocation and control



Local and Group-level risk control



Reporting, control, analysis, risk allocation, general support & advisory

Bank Group Operating Treasuries 

Risk consumption – Money markets, FX trading, Capital markets



The centrally controlled Treasury teams - Arab Bank plc branches and majority-owned subsidiaries



Similar operating models



Country Treasurers directed by Global Treasurer in partnership with local ALCOs



Vertical, functional reporting lines



Mandated to meet local business and regulatory requirements



and also to collaborate in order to meet Group needs

Segregation of Duties – multiple levels of control 

Front office, managed by Group Treasurer



Middle office, managed by CFO



Back office, managed by COO



CRO, responsible for determining risk appetite



Internal Audit, reporting to CEO/Chairman 14



Infrastructure & Scope…Group Treasury Level of Control & Influence over Country Treasuries

Branches

Subsidiaries

Organised into geographical regions

For 100%-owned subsidiaries

Each region has a Regional

Dotted reporting lines from

Treasurers

Treasurer Solid reporting lines from Treasurers

Global Treasurer has  Non-executive role?

Global Treasurer has

 Influence, advisory, advocacy

 Direct executive control over

only?  No P&L ownership

activities  Full P&L ownership

15 © 2008, 2010, 2012 Moorad Choudhry


Country Treasury Org Model Global Treasurer

• Regional Treasurers have a direct reporting line to the Global Treasurer • Country Treasurers for controlled subsidiaries have a dotted reporting line to the Global Treasurer

Regional Treasurer

• Regional Treasurer and Country Treasurer position is a dual role in certain regions

Roles combined in certain countries

• Capital Markets trading is subject to appropriate limits and dealing mandates, controlled by Global Treasury Management • Where staff levels do not support specialisation, Treasury staff my have responsibility for any combination of Treasury Sales, Capital Markets, Money Markets and FX roles


Country Treasurer

Money Markets

Foreign Exchange

Treasury Sales

Capital Markets


Tactical & Strategic Initiatives at GT level  Consolidate liquidity gains, and optimise deployment of liquidity  Model and prepare for threats to liquidity  Connect better with external customers with more cross-selling  Earn income by extending risk profile – Esp. FX  Invest in building Bank’s new system and process architecture, to

facilitate FSA-style new regulatory reporting  Mobility of liquidity and other assets



Tactical & Strategic Initiatives at GT level…  Re-set local & Group-wide liquidity limits  Re-draft and execute Treasury Policy Manual  Improve information sharing between Treasury customer-facing SBUs  Model and prepare for regulatory changes which might affect the Group’s

business model  Model and prepare for market changes which might affect Group’s liquidity  Build income-generating capacity by advocating greater risk consumption in FX

trading  Increase income with better use of cash  Complete design template for Bank-wide cash, market risk and Treasury

processes



Tactical & Strategic Initiatives at GT level Themes 

Continue and dual-mandated function – Risk Control and Risk Consumption



Design and implement group-wide funding strategy



Mobility of Liquidity and Assets



Globally standardised processes with globally standardised systems



Boost operational effectiveness with smart use of technology



Realising operational synergies 

Reduce duplication in support functions



Improved understanding of FX and IR risk characteristics of the business



Full-service connection with Corporate Banking, Investment Banking, Project Finance/Trade Finance, Private Banking and Retail customers



ALCO best practice

ALCO best-practice  UK FSA guidelines for the structure, ToR and process of ALCO  Proactively controls the business in line with firms objectives; focuses on

entire balance sheet  Ensures risks remain within risk appetite  Considers impact on earnings volatility of changing economic and market

conditions  Ensures an appropriate funds transfer pricing mechanism that aligns to the

firms strategic objectives and risk appetite, and regularly reviews this mechanism  Acts as the arbitrator in the debate and challenge process between

business lines  Attended by CEO, chaired by CFO, includes Head of Treasury, all business

group heads, chief economist and Head of Internal Audit



ALCO best-practice guidelines…  Focuses on effects of future plans / strategy at bank and business line level  Takes decisions to manage ALM risks or escalates issues to ExCo, rather

than simply ‘observing’ the risks  Ensures issues are fully articulated and debated  Considers recommendations from a tactical sub-committee that excludes

the CEO and other ExCo members  AND  Engages in active dialogue amongst various members  Displays strong degree of challenge  Minutes give insight into the discussions and extent of challenge, and do not

only list action points



The ALCO pack: guidelines  Make it succinct and as accessible as possible  Relegate detailed MI to an Appendix and just have key indicators and

summaries at front  Compare packs and agendas. Get chummy with Treasury counterparts

and look at their banks’ packs (and show them yours)…  Include market data in summary fashion…see examples overleaf



Market Update • Eurozone Sovereign CDS spreads remain stressed ahead of expected Greek default. Market reaction has now pushed G reek CDS in excess of 6,000 bps. • Other southern Eurozone Sovereigns expected to trade higher next month. • Moody’s downgraded Italy downgraded 3 levels from Aa2 to A2. This follows S&P’s downgrade in September. Italy remains on negative watch. • Significant spike in 3-mo TED spread reflects increased USD funding pressures, the spread at end August was 32 bps and the highest observed since September. • USD funding levels have not abated. TED since risen to 39 bps as at 6 October. • OIS spreads to 3-month spreads have blown out to 12-month highs, markedly so for USD, indicating renewed USD funding pressure in the interbank market, to match already widened EUR EONIA-Euribor spreads which have widened significantly.

USD, EUR and GBP OIS-Libor spread 90

GBP

80

EUR

70

USD

60 50 40 30 20 10 0 Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct10 10 10 10 11 11 11 11 11 11 11 11 11 11



Market Update (continued) • The market-implied cost-of-funds shows an equalised true TLP for the specified peer group. • Applying the bank’s Svensson (94) non-parametric construction methodology to our peer group enables us to make a direct comparison • Bank funding level is significantly in excess of the named peers, a reflection of the bank’s market position • For ASW levels, EUR and USD secondary market funding levels peer group comparison show Bank significantly above peers.

Asset Swap over 6 months Euribor of large Investment Banks

Funding Update • Market conditions remain stressed with shortening tenors on wholesale funding and associated pressure on liquidity metrics. • Unsecured funding mitigating actions have resulted in £13bn reduction in unsecured funding usage being achieved through better asset utilisation and asset sales. • Work underway to identify potential to further reduce unsecured funding usage.


Asset Swap over 3 months USD of large Investment Banks


Liquidity Position • Money Markets desk weighted-average maturity (WAM) has shortened during the quarter, from 71 days in Q2 to 49 days in Q3 • Due to shortening tenors, the ILAA stressed outflows have increased to £38.3mln since June, approaching the internal limit of £40 mln • Improved asset utilisation has led to a higher level of secured funding and a resulting increase in repo stressed outflow limits (it may be necessary to revise these limits). • The FSA 3 month metric showed Green status (< £10mln excess) during September.

Capital Position • Widening CDS spreads and increasing FX and IR volatility will drive increased Capital requirements over forthcoming months through modelled counterparty and market risk changes. • Given current undershoot versus capital targets, no immediate business actions proposed as impact is expected to be within capacity.



Discussion point  Do we agree with foregoing?  The ALCO pack exam question:  Does it provide senior and exec management with information necessary to

run the bank?  Does it help ExCo to do its job?



DISCLAIMER The material in this presentation is based on information that we consider reliable, but we do not warrant that it is accurate or complete, and it should not be relied on as such. Opinions expressed are current opinions only. We are not soliciting any action based upon this material. Neither the author, his employers, any operating arm of his employers nor any affiliated body can be held liable or responsible for any outcomes resulting from actions arising as a result of delivering this presentation. This presentation does not constitute investment advice nor should it be considered as such. The views expressed in this presentation represent those of Moorad Choudhry in his individual private capacity and should not be taken to be the views of his employer or any affiliated body, including Brunel University or YieldCurve.com, or of Moorad Choudhry as an employee of any employer or affiliated body. Either he or his employers may or may not hold, or have recently held, a position in any security identified in this document. This presentation is © Moorad Choudhry 2008, 2012. No part of this presentation may be copied, reproduced, distributed or stored in any form including electronically without express written permission in advance from the author.



Liquidity Risk ALM Policy - ALCO

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