1

Funds Management

for

Financial Institutions

February 8-10, 2006

2

Welcome

1. Introduction

2. Overview of Risk and Risk Management

3. ALM Overview

4. Funds (Liquidity risk) Management

5. IRR Management

6. FX Risk Management

7. Credit Risk Management

8. Summary and Review

3

1. Workshop Introduction

4

Sarah W. Hargrove

Native of North Carolina

Wharton MBA, CFA

Thirty years of experience in investment and commercial banking in NY, NC and PA

Top bank regulator in Commonwealth of PA with supervision of banks, savings institutions, licensed lenders, pawnbrokers…..aggregate assets of USD 90 billion

Consulting for past 10 years in emerging markets (Russia and other CIS, Thailand, Turkey, China, Jordan) ranging from bank appraisals, bank supervision and bank technical assistance

Special expertise in bank supervision, bank valuation, risk management and corporate governance

5

Objectives of Workshop

To understand the role of ALM and its relationship to strategic and annual profit planning

To be able to define and measure different risks involved in financial intermediation

To understand how ALM decisions affect changes in net interest margin, ROA and ROE

To be able to design ALM strategies in different interest rate environments

To understand the role of capital in ALM decisions

6

There are some administrative matters to review

Hours 9:00 am – 5:00 pm

Breaks: 10:30 am –10:45 am

12:00 pm – 1:00 pm

3:00 pm – 3:15 pm

Summary and feedback at end of each session

No cell phones!

7

We will first review some basic principles of risk and risk management

Definition of risk and risk/reward trade-off

Purpose of capital and role of risk management

The road to Basel 2

Major risks faced by financial institutionsCredit riskMarket riskOperational risk

RAROC/RORAC principles

8

We will then look at an overview of Asset Liability Management

Management of non-credit financial risks

Objectives of ALM

Framework for ALM decision-making

Determining risk appetite

Business strategies in different interest rate environments

9

We will review funds management

Tools of funds management

Application of tools

Asset liquidity vs liability liquidity

Determination of minimum liquidity needs

10

We will then examine how gap analysis is used to measure and manage IRR

Periodic and cumulative gaps

Static and dynamic gaps

Data needed for a gap report

Steps in preparation of a gap report

11

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

Definition of FX risk

Identification of FX risk: Long vs short positions

Measurement of FX risk

Management of FX risk

12

We will look at risk valuation methods

Value at risk and earnings at risk

Inverse relationship

Capital Asset Pricing Model

Systematic vs diversifiable riskStandard deviation

Correlation and covariance

13

We will look at credit risk valuation methods

Individual vs Portfolio risk

Default factors

Marginal risk

Expected lossProbability of default

Loss given default

Exposure at default

Unexpected loss

14

We will then apply the risk management principles to business planning

Sensitivity analysis

Flexible budget allocation

Volatility of earnings and EVE

Application of ModelsDangers of Models

Limitations of Models

15

The last day will be devoted to review

Putting it all together with case study

Final review

16

2. Overview of Risk and Risk Management

17

Financial institutions intermediate capital flows between savers and borrowers

Sources of Funds(Surplus accounts or Savings)

Users of Funds(Deficit accounts or Borrowings)

18

Financial institutions assume risks in the intermediation process

Economic Sectors Intermediaries

Assets Liabilities

Insurance Companies

Pension Funds

Businesses

Governments

Households

Banks, Savings Assoc., Investment Banks, Leasing Cos.

Stock Exchange

Other markets

Liabilities Assets

19

Certain principles rule financial intermediation in free markets

Supply and demandInterest rate as the “clearing price”Opportunity cost of consumption/investment

Rational investorsRisk averseMaximize return/Minimize risk

Efficient marketsAllocation of resourcesInformation impounded in pricesCompetitionEconomies of scale

20

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

Capital represents net assets or shareholder ownership

Capital serves to absorb lossesOperating or financial losses

Protects other creditors

Permits growth

Equity is the most costly source of capital

21

What is risk?

The concept of financial risk underlies modern portfolio theory with roots in capital market and investment theory

Risk aversionRisk premiumsHistorical and expected returnsProbability distributionsVariance and standard deviationSystematic vs diversifiable risk

22

Perceived risk is based on historical or expected volatility

0

20

40

60

80

100

120

140

160

1 2 3 4 5 6 7 8 9 10

Series1Series2

23

What is return?

Cash flows

Net income

Dividends

Capital appreciation/gainsTime value of money

PV = Σ Cn=o-t (1+r)n

FV = Σ C (1+r) nn=o-t

24

The higher the risk, the higher the required rate of return

Required rate of return determines the priceCurrent income streamCapital appreciation

Based on perceived riskThe greater the historical volatility the greater the riskThe greater the uncertainty the greater the risk The longer the horizon the greater the risk

25

Risk is priced by the discount rate: absolute and relative

Rate of Return

RiskPremium

Risk FreeRate

MV=PV = Σ C + TVt=0-n (1+r)t (1+r)t

Treasury Bonds

First Mortgage Bonds

2nd Mortgage BondsSubordinated Debentures

Income BondsPreferred Stock

Conv. PreferredCommon Stock

AAAAA

ABBB

BB

B

CCC

Level of Risk

26

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

Short-term vs longer-termLiquidityFloating vs fixed ratesCreditLeverage

Risk is the uncertainty or the standard deviation of probable returns

27

How much capital does a bank need?

“Enough…but not too much.”

28

What is enough capital?

Capital protects depositors and other creditorsSafety and soundnessSupports growthIs a buffer against lossesCan be in the form of non-equity

Equity capital represents owners’ interests Last creditors to be paid in liquidationRequires a return in cash income and appreciationRetained earnings are a good source of capital

29

What is too much capital?

Capital is a non-interest bearing source of fundsEquity capital is the most expensive source of fundsMust earn a required rate of return (ROE)Is a scarce resource

Management’s goal is to maximize risk-adjusted returns

Rational investor theoryCompetes with risk-free rate and alternative investmentsAffects pricing and competitive position if too much

30

Bank management must satisfy different stakeholders with different objectives

Owners

Regulators/Rating Agencies Employees

Return

Pricing

Safety and Soundness

Compensation

Customers

31

Capital adequacy is in the eyes of the beholder

Focus is historical cost of assets and recognition of impairment (fair value)

Focus is historical cost of assets and recognition of impairment (fair value)

Accounting capital

Market capital

Economic capital

Regulatory capital

Focus is income, the market’s expectations and required return

Focus is income, the market’s expectations and required return

Focus is market value (PV of cash flows) of assets/liabilities

Focus is market value (PV of cash flows) of assets/liabilities

Focus is balance sheet and income risk and capital components

Focus is balance sheet and income risk and capital components

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

32

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

Book values represent present values of future cash flows discounted at current required rates of return

Market values of capital stock reflect net present values

Economic capital is the same as net book value

Regulatory capital would be a realizable value of assets in excess of liabilities

33

But financial markets are neither perfect nor efficient

Different expectations

Abnormal profits

Asymmetrical and imperfect information

Information not instantaneously impounded in prices

Transactions costs

Etc.

34

Banking regulation has historically protected the industry from undue risks

Restricted licenses

Geographical limitations

Interest rate ceilings

Product line uniqueness

Limited competition

Let’s look at how regulation has evolved as these protections eroded and market structures changed

35

World-wide trends have changed the nature of banking

Deregulation and liberalization of markets

Globalization and interdependence of markets

Technological advances

Product innovation and increased complexity

Increased size and speed of financial transactions

Increased competition

Increased volatility and risk

36

Bank regulatory trends have followed – but with a lag

Prim

ary

capi

tal

regu

latio

n

Risk

-bas

ed

Capi

tal

Regu

lato

ry /

acco

untin

g

stan

dard

s co

nver

genc

eRi

sk m

anag

emen

t vs.

risk

avoi

danc

e

Inte

rest

rate

and

mar

ket d

ereg

ulat

ion

New rules follow every financial crash, almost always with unintended consequences.Economist, October 5, 2002

37

The introduction of “primary capital” led to unintended consequences

Reduction in liquid assets

“Gains trading” to create capital

Explosion of off-balance sheet items

Overcapitalized banks and disintermediation

Undercapitalized banks in emerging markets

Unfair competition

Inte

rest

rate

and

m

arke

t de

regu

latio

n

Prim

ary

capi

tal

regu

latio

n

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Different capital requirements allowed some banks to gain market share

Japanese Bank US Bank

Loan USD 100 million USD 100 million

Net interest margin .6% 1.25%

Income USD 600,000 USD 1,250,000

Capital 2% 6%

USD 2 million USD 6 million

ROE 30% 20.8%

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The 1988 BIS Capital Accord created an international level playing field

Harmonized capital standards with risk-based capital

Addressed off-balance sheet assets

Distinguished among riskiness of different asset classes

Applied to large, internationally active banks

Risk

-bas

ed

Capi

tal

Inte

rest

rate

an

d m

arke

t de

regu

latio

n

Prim

ary

capi

tal

regu

latio

n

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Regulation of capital has become the primary tool to limit bank risk-taking

Tier I: Shareholders’ equity (Paid-in capital and R/E)

Tier II: Supplementary capital

Tier III: Add on capital to support market risk only

Risk

-bas

ed C

apita

l

Inte

rest

rate

and

mar

ket d

ereg

ulat

ion

Prim

ary

capi

tal

regu

latio

n

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Since 1988, other banking standards have converged with capital standards

Core Principles of Effective Supervision (1995)

Amendments ….to Incorporate Market Risk (1996,1998)

Principles for the Management of Interest Rate Risk (1997)

Framework for Internal Control Systems (1998)

Guidelines for Corporate Governance (2000)

Principles for Internal Audit (2001)

BIS II

Prim

ary

capi

tal

regu

latio

n

Risk

-bas

ed

Capi

tal

Inte

rest

rate

and

m

arke

t de

regu

latio

n

Regu

lato

ry /

acco

untin

g st

anda

rds

conv

erge

nce

42

BIS II permits banks to customize capital adequacy assessment

New guidelines intend to align regulatory capital requirements more closely with underlying risk

Emphasis is on banks’ risk management and economic capital allocations

There is flexibility in assessing capital adequacy: standardized vs. IRB approaches

Prim

ary

capi

tal

regu

latio

n

Risk

-bas

ed

Capi

tal

Risk

m

anag

emen

t vs

. Ri

sk

avoi

danc

e

Inte

rest

rate

and

m

arke

t de

regu

latio

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Regu

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ry /

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g st

anda

rds

conv

erge

nce

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Capital adequacy should be a function of a bank’s mission, strategy and risk tolerance

Mission

Bank Strategy

♦ Capital Allocation♦Pricing

Business Plans for PriorityBusiness Segments

♦ Target Customers, Products/Services♦ Objectives and Business / Financial Plans

Support Infrastructure

♦ Performance Management♦Funding and Liquidity

44

Capital should be set to meet a bank’s target credit rating

S & P RATING MOODY’S EQUIVALENT

DEFAULT PROBABILITY (SUBSEQUENT YEAR)

AAA Aaa 0.01%

AA Aa3/A1 0.03% A As/A3 0.10%

BBB Baa2 0.30% BB Ba1/Ba2 0.81% B Ba3/B1 2.21%

CCC B2/B3 6.00% CC B3/Caa 11.68% C Caa/Ca 16.29%

The higher the rating the more unexpected losses that need to be covered by capital

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Capital must be allocated to cover major risks to the appropriate confidence level

Credit Risk• Standardized Approach• IRB Approach

• Foundation • Advanced

Market Risk• Standardized Approach• Internal Models Approach

Operational Risk • Basic Indicator Approach• Standardized Approach• Internal Measurement Approach

Minimum 8% of Capital to Risk-Weighted

Assets

46

Capital adequacy is a function of three pillars

Mutually reinforcing factors that

determine capital adequacy

Pillar 3: Market Discipline • Formal disclosure policy• Describe risk profile, capital levels, risk

management process and capital adequacy

Pillar 1: Minimum Capital• Internal capital assessment process

and control environment• Capital f (how sound the process is)

Pillar 2: Supervisory Review • Review assessment process• Evaluate IRR in banking book

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Ultimately the financial market is the harshest regulator

Market Discipline

Quantitative Requirement Qualitative Requirement

Public Disclosure

Minimum Capital Requirement

Supervisory Review Process

• Many players• Self interested,

rational• Independent• Real time

• Many players• Self interested,

rational• Independent• Real time

48

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

The less the history, the less reliable the dataThe less certain or transparent, the greater the riskThe more the risk, the more capital neededAll the above implies higher capital levels for some banks in less mature markets

49

BIS II guidelines are guidelines only …but have become best practice

The quality of bank management, particularly the risk management

process, is the key concern in ensuring the safety and stability of

both individual banks and the system as a whole.

50

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

““Capital is not a substitute for inadequate Capital is not a substitute for inadequate control or for risk management control or for risk management processes.processes.””

- Bank for International Settlements

51

Assumption of risk is the raison d’etreof banking

Banks make money by assuming risk

Banks lose money by not managing risk or by not getting paid for the risk assumed

Banks manage what they measure

52

A formalized risk management framework is best practice

Risk Management is the deliberate acceptance of risk for profit – making informed decisions on the trade-offs between risk and reward and using various financial and other tools to maximize risk-adjusted returns within pre-established limits.

53

A Risk Management framework facilitates informed decision-making

Identify

Measure

Manage

Monitor

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Risk Management is now basic to financial management

“The nature of Risk Management in banks is changing fundamentally. Until recently, it has been an exercise in damage limitation. Now it is becoming an important weapon in the competitive struggle between financial institutions.

Those who can manage and control their risks best will be the most profitable, lowest priced producers. Those who misjudge or mis-price will be out on their ear.”

The Risk GameThe Economist, Survey of International Banking (1996)

55

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

The primary objective is to minimize the volatility of earnings and capital (hence the risk as perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.

56

Different risks affect different parts of the income stream and capital levels

Net Interest IncomeAverage Assets

Non Interest IncomeAverage Assets

OverheadAverage Assets

Income TaxesAverage Assets

Return onAverage TotalAssets

LeverageMultiplier

Return onAverageEquity

(x)

(+)

(-)

(-)

ProvisionsAverage Assets

(-)

Credit risk

Operating risk

Market risk

Interest rate risk

ALM Focus

ALM Concern

57

Rational shareholders require a return commensurate with risk

Balance Sheet

EquityAssets Liabilities

Equity

Net Interest IncomeAverage Assets

Non Interest IncomeAverage Assets

OverheadAverage Assets

Income TaxesAverage Assets

Return onAverage TotalAssets

LeverageMultiplier

Return onAverageEquity

x

+

-

-

ProvisionsAverage Assets

-

Income Statement

58

RAROC rigorously calculates returns –recognizing the capital cost of risk

RAROC: Risk-adjusted return on capital

RAROC =Profit

Economic Capital

Provisions _

Revenue less funding and other costs

Predictable losses are expensed

The cushion needed to support Unexpected Losses

59

RAROC allows bank management to make proper risk-reward trade-offs

Interest and fee income xxxLess cost-of-funds (xxx)Net interest income xxx Less “expected loss” (xxx)Less non interest expenses (xxx)Pretax income xxxLess tax (xxx)

xxx

Divided by Economic xxxCapital

RAROC X%

Interest and fee income xxxLess cost-of-funds (xxx)Net interest income xxx Less “expected loss” (xxx)Less non interest expenses (xxx)Pretax income xxxLess tax (xxx)

xxx

Divided by Economic xxxCapital

RAROC X%

Pricing guidelines

FTP

Credit analysis

Allocated capital

Direct and allocatedindirect costs

Applied to hurdle rate

Loan/Product/Branch

60

RAROC drives BIS Pillar 1: Depends on a bank’s own capital charge given risks

Risk

RiskFreeRate

Return

Business Units, Sub-Portfolios, Transactions•

•

•

Efficient Frontier

RAROC

•

61

One of the most difficult aspects of RAROC is the assignment of EC

RAROC uses a bank’s own allocation

RORAC uses BIS assigned weights

The more the capital the more the perceived risk of the asset….but more conservative and less risky the bank

The more the capital the higher the required return from the asset

62

Which bank is the “better bank”?

A B

ROE 20% 20%

ROA 2% 1%

Net Int. Income 2% 6%

Other Income 6% 1%

Spread 6% 6%

NIM 4% 7%

How do we explain the differences in measures of profitability?

63

3. Asset Liability Management Overview

64

ALM is one component of a broader risk management framework

Credit Risk Management

Internal Audit

Treasury Management

ALM

65

ALM’s focus is non-credit financial risks

Interest rate risk

Capital risk

Liquidity risk

Foreign currency risk

66

Market risk is due to movements in market prices or interest rates

Liquidity risk

Interest rate risk

Foreign currency risk

Equity price risk

Commodity price risk

Banking Book

Trading Book

67

ALM is the process of managing the interest spread while insuring liquidity

The ultimate viability of a bank depends on management’s ability to manage both assets and liabilities to provide adequate liquidity and adequate protection of both earnings and capital against significant marketinterest rate fluctuations

68

It is a balancing act to achieve the bank’s objectives within risk limits

Net Interest Income

Market Value of Equity

69

ALM is a process of making risk/reward trade-offs.

Expe

cted

Ret

urn

Risk/Standard Deviation

A

C

B

70

ALM manages the structural balance sheet to satisfy the different stakeholders

Market Value

Return on Equity

Return on Assets

Net interest margin

Capital Adequacy

Liquidity

71

ALM is an integrated function of strategic, profit and capital planning

Set Policies and Objectives (including FTP rules)

Gather External

Information

Develop and Assess

Scenarios

Collect and Analyze Internal

data

Set Liquidity

Policy

Set Interest

rate position

SetFX

Exposure position

Set investment

and earnings management

guidelines

Execute

Interest RatesFX ratesEconomyReg .trendsCompetition

Business strategy &

credit policy

Drives strategy and credit risk management

72

ALM manages the banking book usually through an ALCO

Targets

ALCO

Balance sheet composition

Funding requirements

Interest rate risk management

Capital planning

Profit planning

Loan pipeline

TreasuryExecution arm for ALCO Customer transactionsIssue bondsFX tradingCash managementDerivatives/hedgingFunds transfer pricing

Business Units

FISReportsMonitor

FTPRAROC

73

ALCO monitors economic environment, actual vs plan and adjusts accordingly

• Planning/Budgeting• Yield and spread analysis• Capital allocations

Executes ALCO’s Transactions• Funding/FTP• Cash Management• Investment Portfolio• Hedging/DerivativesManages Trading Risk• Securities• Derivatives• Foreign Currency

Treasury

FAD

Reports

ALCO Targets

FIS

Asset Pipeline

• Customer Relationships• Loan originations• Deposit gathering

Business Units

ALM risks arise due to a mismatch between assets and liabilities capital

Contractual differences between assets and liabilities

Yield curve

Exchange rates

Customer preferences

75

The objectives are a predictable level of earnings and growth

Financial ObjectivesShort-term: Net income

Long-term: Market Value of Equity

Balance Sheet ObjectivesBalance Sheet growth targets

Capital Growth and Dividends

Markets served and markets ignored

Product offerings and Pricing

Desired image of bank

76

ALM seeks to maximize ROE within given risk limits

Net Interest IncomeAverage Assets

Non Interest IncomeAverage Assets

OverheadAverage Assets

Income TaxesAverage Assets

Return onAverage TotalAssets

LeverageMultiplier

Return onAverageEquity

(x)

(+)

(-)

(-)

ProvisionsAverage Assets

(-)

77

Net interest income is usually the most predicable source of earnings

Cost ofInterest-paying

Liabilities

Net Interest Spread

Gain (Loss)

Net InterestMargin on EarningAssets

Earning AssetsTotal Assets

(x)Earning Assets -Interest BearingLiabilities

Cost ofInterest-payingLiabilities

Interest Yield onEarning Assets

(-)

(+/-)

(x)

NIM

78

Interest margin objective worksheet

Determining Interest MarginRequired Net Income plus operating expenses plus loan and security losses plus taxes

Net Income OperatingExpenses

Loan and Security Loss

Taxes

5 + 6 + 7 + 8

Determined Required Return on AssetsDesired Return on Equity times Required Equity to Assets Ratio equals % Return on Assets

ROE Capital Ratio ROA

1x

2=

3

Determined Required Net IncomeDecimal Required Return on Assets Times Total Assets equals net income

ROA Assets Net Income

3ax

4=

5

Less fees equals desired margin

Fees Interest Margin-

9=

10

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Target ROE can be achieved if each asset produces its return on allocated equity

Required ROE of 20% with Capital Ratio of 10%

NetAssets Income Capital Return

Cash 10 0 0 0%

Investments 20 0.6 3 20%

Loans 70 1.4 7 20%

Total 100 2.0 10 20%

80

Capital is a scarce resource and its effective utilization is a focus of ALM

Bank Profits

Business Unit Profits

Product Profitability

Client Profitability

Staff Productivity

81

The goal of ALM is to maximize returns to shareholders over the long run

Strategic and financial planning

Earnings and capital

guidelines

Business & balance sheet mix Other key ratios

and targets

82

A bank’s strategy is the backdrop for any ALM policy

Performance-driven

Mission

Bank Strategy

♦ Capital Allocation♦Pricing

Business Plans for PriorityBusiness Segments

♦ Target Customers, Products/Services♦ Objectives and Business / Financial Plans

Support Infrastructure

♦ Performance Management♦Funding and Liquidity

83

Consider whether all a bank’s assets should be allocated to interbank loans?

Commercial Interbank

Loan Amount 100 million 100 million

NIM 1.25% .5%

Income 1,250,000 500,000

Capital 8 million 1.6 millionROE 15.6% 31.25%

84

4. Funds Management

85

Funds management is concerned with funding assets and managing liquidity risk

Cost of funds

Diversified sources of funds

Diversified tenors

Asset Sales

Roll over risk

Capital planning

86

What is Liquidity Risk?

The volatility in income or economic capital of the bank due to an inability to meet cash

needs for payments/withdrawals or to support credit demands and growth in a

timely and cost-effective manner.

87

What Does Liquidity Mean?

Liquidity is a bank’s ability to meet all cash demands (withdrawing deposits, borrowing money, operational demands, etc.) anytime and entirely at a reasonable cost

It is notCash or other types of assets

A ratio

Earnings of a bank

88

Liquidity Risk: Deposit withdrawals and roll-over risk

Composition of liabilities and sensitivity to changes in interest rates and credit rating

Funding from money traders, public institutions, foreign investors, and large corporations

Large funding held by any single group or individual

Seasonal or cyclical patternsThe higher the asset quality and the greater the liquidity ... the better a bank’s perceived creditworthiness… and access to refinancing sources at reasonable prices

The higher the asset quality and the greater the liquidity ... the better a bank’s perceived creditworthiness… and access to refinancing sources at reasonable prices

BUT

89

Liquidity Risk: Asset Growth

Unused credit lines outstanding

Business activity in bank’s trade area

Demographic changes in market

Aggressiveness of marketing efforts--strategies to expand market share and pricing decisions

Funding under letters of credit and bank guarantees

90

There is a trade-off between liquidity vs. profitability

Cash holdings provide no interest incomeShort-term securities normally carry lower yieldsShort-term loans normally carry lower ratesLess liquid assets provide more income

91

But…

The better the quality assets and the greater the liquidity the better a bank’s perceived creditworthiness and access to refinancing sources at reasonable prices

A bank’s liquidity risk closely follows its credit, capital and interest rate risk

Bank’s large deposit outflow often traced to credit problems or interest rate gambles that failed

92

Liquidity risk is identified by maturity gapsAssets O/N 2-30 days 31-90 91-180 181-360 Over Total

Cash 35 35Interbank loans 97 70 43 210Investments 118 257 100 108 219 802Loans 62 158 275 288 102 885REPOs 4 126 77 105 312Other assets 20 194 30 131 375

Total 218 666 639 205 396 495 2619Liabilities

Deposits 327 327Notes 20 75 101 31 14 241Interbank Loans 214 89 183 153 71 4 714Debentures 43 391 187 151 772

Other 85 46 16 147Capital 102 102Total 689 601 471 184 236 122 2303

GAP (A-L) -471 65 168 21 160 373Cumulative GAP -471 -406 -238 -217 -57GAP Ratio(A/L) 0.32 0.69 0.86 0.89 0.97 1.14

Limits Board Limits Actual30 day Assets/overnight liabilities > .7 1.2890 day Assets/overnight liabilities >1 2.2190 day Assets/90 day liabilities >=1 0.86

Liquidity risk is identified by maturity gaps

93

The key to liquidity risk management is planning

To guarantee permanent liquidity, the Liquidity Plan has to accurately project all cash flows

However, the longer the planning horizon, the more inaccurate the cash flow prediction

Need for good data bases and communication systems to estimate future cash flows based on historical behaviorPlan should include worst case scenario

94

Examples of Asset Liquidity

Cash and due from banks in excess of required reserves or compensating balances

Federal funds sold and repurchase agreements

Government securities that mature within one year

Loans that can be readily sold or “securitized”

Collateral for borrowings

95

Concerns with Asset Liquidity

Some assets cannot be sold because they are already pledged as collateral

Market risk

Target loan to deposit ratio

Loans are among the least liquid assets

Deposits represent the primary source of fund

High (low) ratio indicates illiquidity (strong liquidity)

96

There are measures of liquidity that indicate borrowing capacity

Equity to asset ratio ( “well capitalized” )

Risk assets to total assets

Loan losses to net loans

Reserve for loan losses to non-performing loans

Core deposits to total assetsVolatile (purchased) liabilities to liquid assets

Composition of deposits (diversified customer base)

Market access

97

Liquidity risk management is a daily responsibility

Monitor balance sheet trends

Forecast funding needs

Identify alternative sources of funds

Asset liquidity vs liability liquidity

Stress testing

Peer analysis

98

Liquidity Risk Monitoring: Minimum MIS/Reports

Liquidity gap limits

Sources of funds

Maturity distribution

Volatile funds dependency

Stress testing using assumptions of funding attrition

Contingency plan

99

Liquidity risk management is a continuous process

.Quantity of Risk

Identify:What kind of risks?Where do they exist in our bank?How much risk?

Quality of Liquidity Risk Management

Determine:How diversified are our sources of funds –assets and liabilities?

Strategies for Managing Risk

Assure:That plans are sufficient to avert funding crises and to gain a fair return for liquid assets

Monitor Risks

Continue:Regular, ongoing evaluation of quantity and quality of liquidity and management practices

100

Liquidity Risk Identification

AssetsO/N 2-30 31-180 181-360 Over Total

Cash 35 35

Interbank 220 70 43 333

Securities 118 357 108 219 802

Investments 60 36 96

Loans 62 158 275 288 102 885

Other 24 330 107 131 687

Total 341 726 880 396 495 2838

101

Liquidity Risk Identification

LiabilitiesO/N 2-30 31-180 181-360 Over Total

Deposits 327 327

Interbank 33 33

Term Deposits 4 109 233 142 14 502

Notes 20 75 132 14 241

Other Borrow. 257 480 523 222 4 1486

Other 85 46 107 118 249

Total 726 710 888 378 136 2838

102

Liquidity Risk Identification

Net Liquidity Gap

O/N 2-30 31-180 181-360 Over Total

Assets 341 726 880 396 495 2838

Liabilities 726 710 888 378 136 2838

Gap(A-L) -385 16 -8 18 359

Cumulative -385 -369 -377 -359

103

Short-Term Liquidity Plan

0. Initial Liquid Assets1. Inflows

1.1 Certain cash inflows1.2 Uncertain cash inflows

2. Outflows2.1 Certain outflows2.2 Uncertain outflows

3. Assets - Level 1 (= 0. + 1. - 2.)4. Minimum required reserves

4.1 Required reserves at Central Bank4.2 Required internal reserves

5. Excess or Gap (=3. - 4.)6. Used sources7. Funds - Level 11 (=5. + 6.)

8. Funding sources6. Used sources9. Potential funding sources (= 8. - 6.)4.2 Required internal reserves10. Excess Potential Funding Sources (9. +4.2.)

Liquidity Plan from .... to .... TDM ExpectedAmount

WorstCase

104

5. Interest Rate Risk Management

105

What happens if interest rates increase/decrease?

Assume gap in previous exercise reflects repricing schedules

Interest rate risk occurs because interest rates change, and there is a yield curve

Net Liquidity Gap

O/N 2-30 31-180 181-360 Over Total

Assets 341 726 880 396 495 2838

Liabilities 726 710 401 378 136 2838

Gap(A-L) -385 16 -8 18 359

Cumulative -385 -369 -377 -359

The Yield Curve – Positively Sloped--Normal

Generally implies:Growing economyModerate Central Bank policyExpectation of some future rate increases

22.5

33.5

44.5

55.5

66.5

77.5

8

3 6 12 24 36 60 120 360

Maturity (in months)

Inte

rest

Rat

es

The Yield Curve – Positively Sloped-Steep

22.5

33.5

44.5

55.5

66.5

77.5

8

3 6 12 24 36 60 120 360Maturity (in months)

Inte

rest

Rat

es

Generally implies:Economy rebounding from recession Easy Central Bank policyExpectation of significant future rate increases

The Yield Curve – A Flat Yield Curve

22.5

33.5

44.5

55.5

66.5

77.5

8

3 6 12 24 36 60 120 360Maturity (in months)

Inte

rest

Rat

es

Generally implies:High growth economyCB tightening to reduce growth and inflationExpectation of falling future rates

The Yield Curve – Inverted Yield Curve

66.5

77.5

88.5

99.510

10.511

11.512

12.5

3 12 36 120

Inte

rest

Rat

esGenerally implies:Unsustainably high growth economyAggressive Central Bank tighteningExpectation of significantly lower future rates

Maturity (in months)

Relative interest rates reflect a risk-reward tradeoff

CompoundingBenefit of compounding available in shorter maturities must be incorporated in the rate for longer maturities

Liquidity Price RiskInvestors will accept a lower yield over time to have access to their money more often

Credit RiskLonger the maturity of a loan, the higher the uncertainty as to the borrower’s ability to repay the debtInvestors believe that the risk of a company defaulting on its debt grows over time

The Yield Curve - Credit Differences

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88.5

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Maturity (in months)

Inte

rest

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es

US TreasuryA Rated

112

What is interest rate risk?

The volatility in earnings or economic capital of the bank due to a change in the level of

interest rates, interest rate spreads or shifts in the yield curve.

113

Volatility in earnings or economic capital are inversely related

Changes in market rates cause a change in interest income and expense of the portfolio

Changes in market rates cause a change in the opposite direction in market value of assets and liabilities

Increase in asset values mean reinvestment of funds at lower rates

Interest income is lowerMaturing values must be reinvestedAsset sales look good, but future income could be lower

114

Examples of interest rate risk on earnings

Earnings are affected if assets and liabilities have different interest

ases if the variable rate

rate sensitivity.

§Example: 10 million loan @ 8% fixed for one year10 million 3-month deposit at variable rate currently 4%

§Interest margin of 4% or 400,000 decreincreases during the year.

115

Examples of interest rate risk on EVE

Capital or EVE is affected if fixed rate assets are marked-to-market and interest rates change.

§Example: 10 million 6% due 2006 currently selling at par (ie., market yield is 6%)

§If interest rates increase 1% (100 basis points), the market value of the bond decreases to 9.59 million for a loss of 410,000.

116

Interest Rate Risk is identified by gaps

GAP = Rate Sensitive Assets - Rate Sensitive Liabilities

Assets which reprice in a given time period if interest rates change

–maturing assets–principal payments on assets

–variable rate assets

Rate Sensitive Assets

Liabilities which reprice in a given time period if interest rates change

–maturing liabilities–principal payments on liabilities

–variable rate liabilities

Rate Sensitive Liabilities

117

Positive Gap exists when sensitive assets exceed sensitive liabilities

Example

(RSA) Assets = 400,000(RSL) Liabilities = 350,000Repricing Gap = 50,000

If interest rates rise, more assets will reprice than liabilities. Therefore, expect interest income to increase in the short run more quickly than interest expense.

If rates fall, the reverse will occur. Therefore, when rates rise, expect profits to rise; and when rates fall, expect profits to fall.

118

Negative Gap exists when sensitive assets are less than sensitive liabilities

Example

(RSA) Assets = 350,000(RSL) Liabilities = 400,000Funding Gap = -50,000

If interest rates rise, more liabilities will reprice than f assets. Therefore, expect interest expense to increase in the short run more quickly than interest income.

If rates fall, the reverse will occur. Therefore, when rates rise, expect profits to fall; and when rates fall, expect profits to rise.

119

Interest Mismatch Ladder

PERIOD TO MATURITYOR ROLLOVER DATE

LIABILITIES ASSETS MISMATCH

Non-interest bearing

Up to 1 month1-3 months3-6 months

An analysis of the mismatches (gaps) between assets and liabilities at each value date will show the bank’s exposure to both liquidity risk (i.e., the risk of being unable to raise funds to meet payment obligations at a future date) and interest risk.

(1,500)-18,000

9,00022,000

(1,500)

(9,600)(18,000)

(17,000) 1,000(600)

4,000

120

Interest Rate Risk Measurement: Exercise

Measuring the impact of different % of Rate Sensitive Assetson Interest Revenue With an Increase in the General Level of Interest Rates

Earning Assets(000)

15,50915,50915,509

Interest Revenue

Beginning After increase

129,241 155,091129,241 142,166129,241 135,704

% Change

20%10%5%

% of AssetsRepriced

1005025

Rate Sensitive (%)

General Level of Interest Rates

Beginning(%)

After increase(%)

Change(%)

10 12 2010 12 2010 12 20

Measuring the impact of different % of Rate Sensitive Liabilitieson Interest Expense With an Increase in the General Level of Interest Rates

General Level of Interest Rates Liabilities(000)

10 12 2010 12 2010 12 20

14,01114,01114,011

Beginning(%)

After increase(%)

Change(%)

1005025

% of LiabilitiesRepriced

Rate Sensitive (%)

Interest Expense

Beginning % Change

116,758 140,110 20%116,758 128,434 10%116,758 122,596 5%

After increase

121

Interest Rate Risk Measurement: Exercise

Beginning Level of Rates (Base Case)

Interest Income 129,241Interest Expense 116,758Net Interest Income 12,483

Interest Rates Increase 20% RSA 50% RSA 100%RSL 100% RSL 50%

Interest Income 142,166 155,091Interest Expense 140,110 128,434Net Interest Income 2,056 26,657Change from Base (85)% 114%

Interest Rates Decrease 20% RSA 50% RSA 100%RSL 100% RSL 50%

Interest Income ________ _______Interest Expense ________ _______Net Interest Income ________ _______Change from Base ____% ____%

122

Losing Money with Gap StrategiesConsider the following maturity/rate structure

Interest Rates

1-year maturity

2-year maturity

3-year maturity

Assets:Loans

8.5%

9.5%

10.5%

Liabilities:Deposits

5.5%

6.5%

7.5%

Interest rates are expected to increase in the futureAppropriate Gap strategy for a rising rate environment

Hold positive GapInvest in short-term assetsFund with long-term liabilities

123

Losing Money with Gap Strategies

Suppose rates do increaseOne-year rates one year from now have increased 1.5%One-year rates two years from now have increased another 1%, or 2.5% higher than current ratesAssume that the yield curves for assets and liabilities increase by equal amounts

Calculate the three-year income performance for this bank for a strategy of a positive Gap.

124

What is the performance with a zero Gap or negative Gap?

StrategyInterestIncome

InterestExpense

Net InterestIncome

Zero Gap:(1-yr assets &1-yr liabilities) ____.__ ____.__

____.______.__

Negative Gap:(3-yr assets &1-yr liabilities)

____.__

____.__

125

Duration is a common measure of interest rate risk from a capital perspective

10%, 2 year

Zero Coupon, 2 year

0

+3.90

+3.63

-3.46

-3.72

8.0 10.0 12.0 Required Yield (Percent)

Market Rate8.0%10.0%12.0%

Price of 10% Bonds$1,036.30

1,000.00965.36

Price of Zero Coupon$854.80822.70792.09

Change in Pricefrom Initial

Price at 10%Interest Rate

(Percent)

126

Simulation is used to test IRR limitsRate Shock Exposure

Net Interest Income Current Market Value Change in

Rates (b.p.) Estimated

Value Change

From Base % Change from Base

Estimated Value

Change From Base

% Change from Base

+ 400 6,155 476 8.4 10,812 (2,875) (21.0)

+ 200 5,969 290 5.1 12,741 (946) (6.9)

Base 5,679 0 0.0 13,686 0 0.0

-200 5,401 (278) (4.9) 14,565 879 6.4

-400 4,978 (701) (12.3) 16,426 2,740 20.0

Rate Cycle Exposure

Net Interest Income Current Market Value Y/Curve

Type Estimated

Value Change

From Base % Change from Base

Estimated Value

Change From Base

% Change from Base

Fully Inverted

7,111 1,414 24.8 9,409 (4,277) (31.3)

Semi Inverted

6,641 944 16.6 11,052 (2,634) (19.2)

Flattening 5,762 65 1.1 13,237 (449) (3.3)

Base 5,697 0 0.0 13,686 0 0.0

Steepening 5,148 (549) (9.6) 14,790 1,103 8.1

Rate Forecast Exposure

Net Interest Income Current Market Value Change in

Rates (b.p.) Estimated

Value Change

From Base % Change from Base

Estimated Value

Change From Base

% Change from Base

Rising 5,829 129 2.3 17,102 (1,043) (5.7)

Most Likely 5,691 (9) (0.2) 18,461 316 1.7

Base 5,700 0 0.0 18,145 0 0.0

Declining 5,536 (164) (2.9) 19,412 1,267 7.0

127

Interest rate risk management has evolved…

Stage 2 Create history of rates and data base

STATIC GAPANALYSIS Stage 1 Develop Gap analysis - basic approach

DYNAMIC GAPANALYSIS

SIMULATIONMODELING

VALUE ATRISK

ANALYSIS

HISTORY OFRATE

VOLATILITYDATA BASESUPPORT

DETERMINERISK

TOLERANCE

SET TRADING LIMITS

DETERMINEBALANCE SHEET

TARGETS

Stage 3 Create modelsand begin VaR analysis

State 4 Utilize all of the tools to manage limits and balance sheet

128

Interest Risk Management: Difficulties

Forecast the direction and magnitude of interest rate changes

GAP measures do not accurately indicate interest rate and do not recognize the timing differences in cash flows for assets and liabilities within the same maturity groupings

Duration is a good measure only for small changes in interest rates

What is ideal for the customers is not ideal for the bank

129

Interest Rate Risk Management: Monitoring of MIS/Reports

Asset yields, liability costs

NIM, variances from prior period and budget

Longer term interest margin trends

Rate sensitivity position

Static and dynamic gap

Exceptions to policy guidelinesABC DEF GHI JKL MNO

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19 14 33 22 1

ABC DEF GHI JKL MNO19 14 33 22 130 18 42 26 2449 32 75 48 2519 14 33 22 111 4 9 4 235 4 4 4 5

133 86 196 126 79

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ABC DEF GHI JKL MNO19 14 33 22 130 18 42 26 2449 32 75 48 2519 14 33 22 111 4 9 4 235 4 4 4 5

133 86 196 126 79

19 14 33 22 1

ABC DEF GHI JKL MNO19 14 33 22 130 18 42 26 2449 32 75 48 2519 14 33 22 111 4 9 4 235 4 4 4 5

133 86 196 126 79

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ABC DEF GHI JKL MNO19 14 33 22 130 18 42 26 2449 32 75 48 2519 14 33 22 111 4 9 4 235 4 4 4 5

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ABC DEF GHI JKL MNO19 14 33 22 130 18 42 26 2449 32 75 48 2519 14 33 22 111 4 9 4 235 4 4 4 5

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130

6. Foreign Exchange Risk Management

131

What is foreign currency risk?

The volatility in income or economic value of equity due to movements in foreign currency

exchange rates

The volatility in income or economic value of equity due to movements in foreign currency

exchange rates

132

Foreign currency risk arises from movements in exchange rates

Cash Market

Derivative Market

Forwardrate

Spotrate

Transaction Translation

Economic

FX risk comes in two forms

Translation risk:

Balance sheet assets and liabilities translated at FX rate prevailing on date of the balance sheet. Income statements translated at an average FX rate prevailing over the measurement period

Measures impact of a change in exchange rates on a company’s financial statements

Transaction risk:

Potential gains or losses on future settlements of outstanding obligations denominated in a foreign currency, ie., booked sales may be paid in different actual amounts

Measures impact of a change in exchange rates on actual collections (the difference between receivables and payables)

Like interest rates, risk arises from a mismatch of assets and liabilities

ASSETS LIABILITIES

Foreigncurrencyappreciates

Foreigncurrencydepreciates

gain loss

gainloss

What is an institution’s FX Position

The Balance Sheet position in a particular currency is a function of total assets and total liabilities in that currency

When assets in a currency exceed liabilities in that currency, there is a long (or overbought) position in the currency

When liabilities in a currency exceed assets in that currency, there is a short (or oversold) position in the currency

FX position can be determined by analyzing the balance sheet

The total of :(A) FX Assets + contingent FX bought Less(B) FX Liabilities + contingent FX sold

Equals the Foreign Exchange Position

137

FX exposure is identified in the banking and the trading book by open positions

Foreign Currency Risk

RMB $US JPY GBP EuroBanking Assets 808688 3863 30000 200 28

Banking Liabilites 754088 3692 66 200 45000

On-balance sheet position 54600 171 29934 0 -44972

Off-balance sheet position -4568 230000

Net exposure 54600 -4397 29934 0 185028

Exchange Rate 8.17 0.067 11.753 7.242

RMB Equivalent (millions) -35923 2006 0 1339973

The FX position includes the Forward Position

Forward contracts represent the obligations to purchase or sell a specific amount of a currency at a specific future date

When a bank dealer executes a forward FX deal, the bank's actual assets and liabilities in the deal currencies do not change until the deal is settled on the specified date (typically in 1, 2, 3, 6, 9 or 12 months)

What is the exposure effect?

A Chinese company sells hospital diagnostic equipment. Most of its revenues are in China, but about half its expenses are in EUR, because the company buys many components abroad. Its primary competition is from Chinese companies with no international business at all.

How will a strengthening of the EUR affect this company?

Another example: Japanese TVs

A Japanese firm sells television sets to an American importer for JPY 1 billion payable in 90 days.

What is the importer’s risk?

How should the importer protect against it?

FX risk is measured like interest rate risk

Foreign exchange gap analysis

Foreign exchange duration analysis

Foreign exchange rate simulation

Rate volatility analysis

142

FX risk is managed with effective policies

Objectives and principles of FX risk management

Measurement of risk

Risk exposure limits

Net open position limits

Currency position limits

Other position limits

Stop-loss provisions

Concentration limits

Revaluation procedures

FX risk management tools are available in some markets

Contractual hedgesForwardsMoneyFuturesOptions

Natural hedgesPayment leads and lagsMatching

Forward exchange rates are derived from relative interest rates

The spot USD/CHF rate is 1.40. Six month interest rates are 6% on the dollar and 4% on the Swiss Franc. (The six month interest period is 184 days.)An organization with USD 1 million and a requirement for Swiss Francs in six months should be indifferent, financially speaking, as to whether it:

Invests the USD 1 million for six months and converts the dollars (plus interest) into CHF at the end of this timeSells the USD 1 million spot for CHF, and invests the CHF for six months until they are needed

Derivation of Forward Exchange Rates

Invest USD 1 million at 6%for 6 months (184 days)

Interest earned USD30,666.67

Value after 6 monthsUSD 1,030,666.67

Sell USD 1 million spot at 1.40Buy CHF 1.4 million

Invest CHF for 6 months at 4%

Interest earned CHF28,622.22

(1.4 million x 4% x 184/360)

Value after 6 monthsCHF 1,428,622.22

OPTION 1 OPTION 2

Exchange Rate: 1.3861

146

Value at risk (VaR) is a common market risk measure

0

Tail Probability = 2.5%

“Value at Risk”

Position size

Value sensitivity to price movements

Probability distribution of price movements

CapturesCaptures

Daily Changes in Position Value

The historical volatility of exchange rates determines the risk

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£/$ RETURNS

The returns can then be plotted in a histogram

DM/$ RETURNSHISTOGRAM

Price Change (%)

Frequency

£/$ RETURNS

0

5

10

15

20

25

30

35

-5.43% -3.46% -1.48% 0.49% 2.47% 4.45% 6.42% 8.40% More

Price Change (%)

Frequency

The greater the number of observations, the more normal the distribution

-4 -3 -2 -1 0 1 2 3 4Change in Portfolio Value

StandardDeviation

2.5% of Distribution

The standard deviation is a measure of dispersion

Assume an asset returns the following over three periods:10% 15% 20%

What is the standard deviation/volatility?

(10% - 15%)2 + (15% - 15%)2 + (20% - 15%) 2 = 5%2

The number of standard deviations varies depending on how sure you want to be

How much we can expect to lose over a given period of time at a certain confidence level?

VaR = Position in Portfolio (i.e., $100) * Volatility (i.e., standard deviation) * No. of Standard Deviations specified(i.e., 95% = 2)

Note: The 95% confidence is for a +/- 2 standard deviations. For a one-tailed test (- 2 standard deviations), we are 97.5% (or rounding 98%) confident.

An example of VAR

Assume:• Monthly Volatility of $/Sterling is 3.3%• Current Spot Rate = $1.6/Sterling• Current Position = GBP 10 Million

The most we can lose over the next month with 98% confidence is 10*1.6*3.3*2 is $1,056,000

Exercise

AssumeMonthly volatility of $/EUR is 2%Current spot rate = .9 EUR/$Current position = EUR 20 million

What is the most we can lose in $’s over the next month with 98% confidence?What is the most we can lose in $’s over the next month with 99% confidence?

VaR can be calculated for individual asset or portfolio of assets

JPMorganChase’s RiskMetricsNon-simulation variance/covariance approachUses daily volatility and correlation estimatesSystem implementation from 3rd parties

Historical simulationPortfolio aggregationMonte Carlo simulation

155

The best VaR models use a combination of methods

Historical SimulationHistorical Simulation

Parametric VARParametric VAR

Normal distribution assumption

Easy to calculate

No event risk capabilities

No compensation for “fat tails”

No ability to fully calculate non-linear instruments

Normal distribution assumption

Easy to calculate

No event risk capabilities

No compensation for “fat tails”

No ability to fully calculate non-linear instruments

Monte Carlo Simulation

Monte Carlo Simulation

Can simulate many price paths

Limits model risk

Accounts for non-linearity and non-normality

Computationally expensive

Can simulate many price paths

Limits model risk

Accounts for non-linearity and non-normality

Computationally expensive

Can test current portfolio over past periods (even crash conditions)

Relies on the existence of historical price series

Incorporates non-linearities and non-normal distributions

Doesn’t necessarily reflect future conditions

Can test current portfolio over past periods (even crash conditions)

Relies on the existence of historical price series

Incorporates non-linearities and non-normal distributions

Doesn’t necessarily reflect future conditions

156

Jan-Peter Onstwedder, The Royal Bank of Scotland

Judgment still must be applied to the VaR process of setting limits and watching or forecasting changing economic conditions. Changes in fundamental economic conditions (even less dramatic than the 1991 events in Eastern Europe) can cause losses that exceed the levels of risk tolerance—such as the unwinding of the Asian economies and its impact on the securities of developing economies. VaR is a valuable tool because it attempts to quantify a process that would otherwise be purely judgmental. It should be used along with interest sensitivity dynamic Gap analysis.

157

7. Credit Risk Management

158

What is credit risk?

The volatility in income or economic value of equity due to movements in foreign currency

exchange rates

The volatility in income or economic value of equity due to non-performance by a debtor

or counter-party

159

That means a number of things

“The risk that a borrower will not pay what was lent – in full and on time”

The potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms

“Principles for the Management of Credit Risk” - BIS 1999

Must also include all threats to value, in a probability / net present value sense; e.g. deterioration in quality throughout the life of the loan is a credit risk in itself

160

Credit risk is typically the greatest threat to capital health in the banking business

ROE

plus

less

less

less

Net Int. Income

Other income

Op. Expense

Provisions

Tax

Credit risk

Int. Income

Int. Expense

161

Successful credit risk is a competitive advantage

Identify

Measure

Monitor

Control

And price appropriately!

162

There are two major factors to consider with as much confidence as possible

What is the likelihood a borrower will default?

Probability [%]

If the borrower defaults, how much are we likely to lose?

Amount [$ / € / $ or %]

163

Credit analysis, ratings, pricing and controls focus on these two factors

What is the likelihood a borrower will default?

Probability [%]

If the borrower defaults, how much are we likely to lose?

Amount [$ / € / $ or %]

What is the likelihood a borrower will default?

• Financial strength• Management quality• Market and economy• Other factors

Likelihood that cash flow will sustain through life of credit:

• Exposure at default• Compromised financial strength• Guarantees or security• Other factors

Value of distressed credit:

If the borrower defaults, how much are we likely to lose?

164

Credit risk affects both capital and earnings

The primary objective is to minimize the volatility of earnings and capital (hence the risk as perceived by investors) and at the same time earn a ROE to maintain the value of the common equity.

Foregone Interest and provisions

And mark-to-market losses

Losses in economic capital

165

Financial success in any enterprise means – at the least – breaking even

Breakeven

Manufacturer nOther costs

Operating Costs

Cost of Goods Sold

Profit

How is a Financial Institution different

from a manufacturer?

166

For a financial institution, this means effectively managing credit risks . . .

Profit

Why we need capital

Margin forExpected

Credit Losses

Reserves forUnexpected

Losses

Operating Costs

Financial Institution “Predictable” losses that

can be built into pricing

Losses resulting from volatility – “true” risk

Cost of Funds

167

Credit risk measurement takes different forms

Expert systems

Credit scoring models

Rating systemsCAMELS

Pass, OLEM, Substandard, Doubtful, Loss

Public bond ratings

168

Credit analysis drives the credit risk assessment of all methods

Both the ability and the willingness to pay are key

169

There are several indicators of future ability and willingness to pay

Past record of meeting debt payments, particularly in stress situation like a recession

Proven record of careful financial management

Adequate financial reserves or other liquid assets

Fiscal flexibility ….or the ability toRaise funds or sell assetsAccess bank lines on short noticeDraw on cash reservesCut discretionary spendingAlter the business plan or delay capital expenditures

170

Credit risk analysis is an evolving field using basic quantitative methods

Basic algebraEquations define relationship among variablesSolving 2 unknowns with 2 equationsExpected value

Present value vs future valueOpportunity cost of $ todayInverse relationship between rates and prices

StatisticsVariables describing a sampleMeasures of central tendency (Median, mean and mode)Measures of dispersion (Range and std deviation)Regression analysis and correlation

171

There are two basic aspects of credit risk

Standalone risksDefault probability Loss given defaultMigration risk

Portfolio risksDefault correlationsExposure

Credit risk management means diversifying and transferring risk

172

Standalone creditworthiness depends on many factors

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173

Data drives the credit analysis

SAMPLE DATA COLLECTIONexamples

Category

Industry

FinancialCondition

¨ Industry profile -- 3 yearsà Size, growthà Concentrationsà Cyclicality/seasonalityà Explanation of trends

¨ Industry outlook¨ Profiles of key competitors (top two)¨ Regulatory profile -- current, recent changes,

expected changes¨ Borrower’s strategy¨ Key alliances:

à With government à With private sectorà With other influential players

¨ Company financials -- 3 yearsà Profit & loss statements, balance

sheetsà Supplementary statements --

reconciliation of net worth, fixed assets\à Audited where possible

¨ Creditor facilitiesà Banksà Suppliers

Data Required Data Sources

¨ Internalà Filesà Research departmentà Other managers familiar with industry

¨ Third partiesà Ministriesà Multilateral agencies -- World Bank,

IADB, etc.à Other government organizationsà Trade associationsà Other banksà Other companies in industries

¨ External -- customer calls¨ Business press

¨ Internalà Filesà Other managers familiar with borrower

¨ Issuerà In person callsà Site visits

amounts and condition of facilities

174

Financial ratio analysis provides the basis for ability to pay

RATIOSRATIOS

Liquidity (Cash/Current Liabilities)

Cashflow-Measures (Repayment) (e.g. CF/interest, CF/liabilities)

Profitability (e.g. pre-tax profit/assets)

Activity (e.g. Revenues/Assets)

Leverage (e.g. equity/liabilities)

Size (e.g. Sales)

Growth (e.g. Revenue growth)

SELECTIONSELECTION

Financial statements relevant (even) in emerging economies

Depending on maturity of economy and reporting systems different factors are dominant

Liquidity and Cashflow measures likely to dominate a rating

Precise definition of factor will depend on consistent availability of data

Need to test numerous ratios given sufficient data

175

Both quantitative and qualitative analyses are required

Financial factorsFinancial factors Non-financial factors

Non-financial factors

Warning signals /Behavioral factorsWarning signals /Behavioral factors

Financial ratingFinancial rating Warning signal ratingWarning signal ratingNon-financial ratingNon-financial rating

Issurer ratingIssurer rating

176

Their relative importance typically varies according to the issuer segment

- ILLUSTRATIVE -FACTOR WEIGHTS

Financial Non-Financial Behavioural

Large Corporate

Small Business

• Profitability

• Leverage

• Growth

• Liquidity

• Mgt quality

• Industry outlook

• Insider transactions

• Evergreen loans

SIZE SEGMENT

177

Credit ratings are an assessment of management—a leading indicator

Management (not external conditions) drives performance

How cope in periods of rapid change

Attitudes toward risk, a focus on fundamentals

Corporate culture: how motivated and promoted

Collegial versus dictatorial decision making

Quality of management information systems

Realism of long-term strategies and goals

178

Ratios are tools in the rating process

Absolute and relative trendPeer group comparisonsNot the final step or whole answerRatios put you in the right neighborhood, but you need the right address Non-quantifiable (subjective) side of the analysis just as important as the numbers

179

A credit analysis is essentially a bottom-up pyramid analysis

AAA?Qualitative Analysis

-Management-Financial Flexibility

Quantitative Analysis-Financial Statements

-Past/Future PerformanceMarket Position

Competitive Trends (domestic/global)Regulatory Environment

Industry AnalysisSovereign Macroeconomic Analysis

180

BIS II has led to a new generation of statistical rating models

Capital required to support risk-weighted assets

Three measures for credit riskStandardized using external ratings for risk weights

IRB: Foundation and Advanced

IRB uses banks’ own rating systems with required features

Provisions should equal expected losses

Capital must be held for UL

181

Traditional credit risk measurement has not been discriminate

Not compensating for risk

Evolved to KMV Credit Monitor Model

Loans as options using Black-Scholes

JP Morgan’s CreditMetrics and other models

Risk neutral valuation approach

Differ in terms of definition of risk (MTM or DM); risk drivers; volatility and correlation of credit events; recovery rates; simulation or analytic

182

BIS II’s objective is to have same level of capital in the system as a whole

Source: Bank of England Spring Quarterly Report, 2001

183

Probability of Default (PD) is based on historical experience

X Corporate Loans

Y Credit Cards

-4 -3 -2 -1 0 1 2 3 4StandardDeviation

X = 2%

Y = 4%

X = 4%

Y = 5%

184

Which loan type is more risky….X or Y?

X Corporate Loans

Y Credit Cards

-4 -3 -2 -1 0 1 2 3 4StandardDeviation

X = 2%

Y = 4%

X = 4%

Y = 5%

185

Databases of historical defaults are maintained by international CRAs

S&P

Moody’s

Fitch

Dun & Bradstreet

Others

186

Default histories drive PD

S & P RATING MOODY’S EQUIVALENT

DEFAULT PROBABILITY (SUBSEQUENT YEAR)

AAA Aaa 0.01%

AA Aa3/A1 0.03% A As/A3 0.10%

BBB Baa2 0.30% BB Ba1/Ba2 0.81% B Ba3/B1 2.21%

CCC B2/B3 6.00% CC B3/Caa 11.68% C Caa/Ca 16.29%

187

Raw dataRaw data IndividualScores

IndividualScores

EconomicInterpretation

EconomicInterpretation

CalibratedRating (PD)Calibrated

Rating (PD)Aggregation tooverall Score

Aggregation tooverall Score

Input Calculation Output

• Financials• Assessment of

qualitative Factors

• Ratios • Scale comparable for all factors

• Weights fixed (e.g. linear algorithm)

• Calibration fixed

May be different by segment (size, state -owned /private, industry, available information)

Quantitative modeling provides the basis of the analysis

188

The oldest and simplest model is Altman’s Z Score

Overall profitability (ROA)

Sales to Total Assets

Leverage (Market Value of Equity to Debt)

Working Capital to Total Assets

Cumulative profitability (Retained earnings/Total Assets)

189

A Z score below 2.99 could be an early warning sign of default

RATIO FORMULA WEIGHT FACTOR WEIGHTED RATIO

Return on Total Assets Earnings Before Interest and

Taxes ----------------------------------------

- Total Assets

x. 3.3 -4 to +8.0

Sales to Total Assets Net Sales

-----------------------------------------

Total Assets x 0.999 -4 to +8.0

Equity to Debt Market Value of Equity

-----------------------------------------

Total Liabilities x 0.6 -4 to +8.0

Working Capital to Total Assets

Working Capital ----------------------------------------

- Total Assets

x 1.2 -4 to +8.0

Retained Earnings to Total Assets

Retained Earnings ----------------------------------------

- Total Assets

x1.4 -4 to +8.0

190

Hindsight is perfect….but how do we predict default

191

If we have the data, we can begin to generalize about a similar population

Example: Life insurance company

How we can we classify individuals into broad risk bands to manage our actuarial risk?

?

192

What would be a logical process for discerning the predictive risk variables?

Example: Life insurance company

Set hypothesis

Examine experience

Select variables

Test predictability

Test and Calibrate

• Age• Male / female• Smoker / non-smoker• Obesity• Family history

193

What would be a logical process for discerning the predictive risk variables?

Risk factor: ObesitySet

hypothesis

Examine experience

Select variables

Test predictability

Test and Calibrate

0

10

20

30

40

50

60

70

80

90

40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

0

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40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

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30

40

50

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70

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90

40 k 60 k 80 k 100 k 120 k 140 k 160 k 180 k

194

The larger the data population, and the more reliable the data, the more confident

195

… and the easier to test the predictability of our data points

0.00

10.00

20.00

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40.00

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1 2 3 4 5 6 7 8 9 10

196

The most reliable credit risk models are from consumer credit scoring models

0

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40

60

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100

1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 10

Example:Credit Cards

Examples of predictive factors for credit cards

197

Not surprisingly, for such credits, the models drive the whole credit process

0

20

40

60

80

100

1 2 3 4 5 6 7 8 9 100

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40

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1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 100

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40

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1 2 3 4 5 6 7 8 9 100

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40

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1 2 3 4 5 6 7 8 9 10

• Planning• Marketing• Approval• Pricing• Monitoring• Collections• Provisioning

198

Design, integrity, maintenance, and validity of the model is the core

0

20

40

60

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100

1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 100

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1 2 3 4 5 6 7 8 9 100

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199

Risk managers always try to evolve towards a “model” approach – if practical

ModelScoringTemplateJudgment

200

But by their nature, different risks lend themselves to different levels of prototyping

Judgment Template Scoring Model

Large unique risks, small populations, variable characteristics

Medium-sized risks, average populations, predictable characteristics

Small individual risk, large populations, homogenous characteristics

Large corporates, sovereigns, banks, project finance

Small business, high-end consumer, homogenous commercial

Credit cards, home mortgages, car and student loans

201

If we can predict our potential losses we can price them in our rates

Expected loss = ?

How much we expect to lose (probability) on a credit or group of credits

May be expressed as a per cent or an absolute number

Often abbreviated as “EL” – also known as “ROL” (risk of loss)

202

Let’s calculate a simple example

Expected loss

Probability of default

Loss given default

Exposure at defaultx x=

1 0.012 0.033 0.054 0.255 0.706 1.507 6.008 20.09 50.0

10 100.0

Rating PD %

0

10

25

50

75

100

LGD %

100

EaD %

203

In per cent…

Expected loss

Probability of default

Loss given default

Exposure at default= x x.03 or 3% .06 .50 1.00= x x

1 0.012 0.033 0.054 0.255 0.706 1.507 6.008 20.09 50.0

10 100.0

Rating PD %

0

10

25

50

75

100

LGD %

100

EaD %So if the credit is $ 7,000, EL for that credit is $ 210 (3% x $ 7,000)

204

… or in numbers

3% .06 .50 1.00$ 210 .06 .50 $ 7,000= x x

1 0.012 0.033 0.054 0.255 0.706 1.507 6.008 20.09 50.0

10 100.0

Rating PD %

0

10

25

50

75

100

LGD %

100

EaD %

205

Expected loss is a function of three variables

Probability of default

Loss given default

Expected loss

Exposure at default

x x=

206

The standalone EL’s can be aggregated for for the whole portfolio

Losses

Probability

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0102030405060708090

1 2 3 4 5 6 7 8 9

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

207

Active portfolio management has become best practice

Modern portfolio theory used to reduce risk

Based on Capital Asset Pricing Model (CAPM)Specific risks of different assets can be diversified in a

portfolio

Market or systematic risk cannot be diversified

Required return = Rf + β(Market return – Rf)

208

Portfolios are managed to maximize returns at a given level of risk

The variance-covariance of different assets reduce the portfolio variance

Relatively riskier assets, depending on correlation with portfolio, can be added to portfolio and reduce the aggregate variance

Marginal risk may be additive

But may be less than standalone risk

Returns on the portfolio can be enhanced

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

209

Over time actual can be compared to expected losses

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0102030405060708090

1 2 3 4 5 6 7 8 9

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

0

2 0

4 0

6 0

8 0

1 0 0

1 2 3 4 5 6 7 8 9

?

Models must be recalibrated, back-tested and stress-tested

210

Models must be recalibrated, back-tested and stress-tested

0102030405060708090

100

1 2 3 4 5 6 7 8 9 10

010

20304050607080

90

1 2 3 4 5 6 7 8 9

0102030405060708090

100

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0102030405060708090

100

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0102030405060708090

100

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100

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0

2 0

4 0

6 0

8 0

1 0 0

1 2 3 4 5 6 7 8 9

How did we do? What should we change?How sensitive is the output to different assumptions?How does our risk change with worst case scenarios?

211

EL are “predictable” – UL losses (i.e. volatility) represent true risk

Expected Loss (EL)Expected Loss (EL)• Anticipated average loss

rate• Foreseeable “cost”• Charged through

income statement

• Anticipated average loss rate

• Foreseeable “cost”• Charged through

income statement

Unexpected Loss (UL)Unexpected Loss (UL)• Anticipated volatility of

loss rate• True “risk”• Captured through

assignment of capital

• Anticipated volatility of loss rate

• True “risk”• Captured through

assignment of capital

212

The greater the variance, the more capital required

Amount of Loss

Probability of Loss

Unexpected Loss (Standard Deviation)

Unexpected Loss Requires capital support - as a cushion

Mean “expected” Loss

213

The amount of capital depends on target debt rating

Required Capital

Mean “expected” Loss

AA AAA.003 .001

BBB A.03 .01

SolvencyStandard

Unexpected Loss( 1 Standard Deviation)

Uncovered RiskTotal “Economic” Capital = Reserves + Equity

214

In summary, credit analysis drives the PD but is only one component of risk

Credit Analysis and Structuring

Probability of Default

Expected Loss

Loss Given DefaultRisk Rating:

Borrower and Facility

Based on historical risk

rating data

A function of analysis andstructuring

Feedback process: annual review &

experience

EL=PD x LGD x EAD

Based on analysis & identified

comparative standards

Feedback loop

Exposure at Default

215

Credit risk analysis is an evolving field

Quantitative modeling includes structural and reduced form models

Credit risk management means diversifying and transferring risk

Research continues to integrate new asset classes and correlations

216

Over-reliance on models can be risky

Loan uniformity is a problem

Correlation analysis for loans is in its infancy and correlations change over time

The industry knows less than it thinks about actual loss probabilities and little of migration

Volatility measures are unstable and differ across time horizons

Operational risk increases

217

Daniel Mudge, Bankers Trust (from Risk Magazine, 1994)

I would prefer a C-rated model with weaknesses and have people with experience and intuition than an A-rated model with a C-rate team of people who are unable to question the numbers that the system generates.

218

8. Summary and Review

219

Before we discuss the final case let’s summarize some concepts

Overview of Risk and Risk Management

ALM Overview

Funds (Liquidity risk) Management

IRR Management

FX Risk Management

Credit Risk Management

220

Banks assume credit, liquidity, interest rate, FX and capital risks

Economic Sectors

Assets Liabilities

Demand Deposits

Businesses

Governments

Households

Time Deposits

Other Borrowings

Assets Loans, leases and Investments

Borrowings

221

Bank management must satisfy many stakeholders

Shareholders

Regulators/Rating Agencies Employees

Return

Loans/services

Safety/Soundness

Employment

Customers

222

Risk management is the key to success along with good governance practices

.Quantity of Risk

What kind of risks does the bank have?

Where do they exist?

How is risk measured?

Quality of Risk Management

Risk control processes

Risk appetite and limits

Strategies for Managing Risk

What are the policies?

Last reviewed?

Risk mitigation strategies?

Monitor Risks

How are exposures monitored?

What is role of the internal auditor?

223

We looked at risk and risk management

What is risk?

Managing the risk/reward tradeoff is the business of banking, particularly ALM

Risk management systemIdentificationMeasurementManagementMonitoring

Financial statements, annual plans and ALM strategies

224

Rational investors require a return commensurate with risk

Rate of ReturnRiskPremium

Risk FreeRate

Common Stock

Level of Risk

Treasury Bonds

First Mortgage Bonds

2nd Mortgage BondsSubordinated Debentures

Income BondsPreferred Stock

Conv. Preferred

AAAAA

ABBB

BB

B

CCC

Non-linear

225

ALM manages the non-credit financial risks

Liquidity riskLow-cost, predictable funding sourcesAsset vs Liability liquidityFinancial flexibility and optimal distribution/pricing of

securities

Interest rate riskGap and duration analysisCaR

FX riskLong and short positionsVaR

Capital riskPortfolio management

226

Credit worthiness plays an important role

Both the ability and the willingness to pay debt

obligations in full and on time

227

Both quantitative and qualitative analyses are inputs in the credit rating process

Financial factorsFinancial factors Non-financial factors

Non-financial factors

Warning signals /Behavioral factorsWarning signals /Behavioral factors

Financial inputFinancial input CreditWatches or outlook changes

CreditWatches or outlook changesNon-financial inputNon-financial input

Issuer ratingIssuer rating

228

Risk measurement determines how much capital is at risk

Capital represents net assets or shareholder ownershipCapital serves to absorb losses

Operating or financial lossesProtects other creditorsPermits growthEquity is the most costly source of capital

RAROC is used to allocate capital based on risk/reward trade-off

229

PD, LGD estimation and verification help determine capital at risk

BIS definition of default and loss given defaultExplanatory inputs

Company, sector/country or economic specificRelevant and logic

Data collection for model fittingModeling (Private, public)

Altman Z-score Merton model Most commercial PD models are variants of these

230

BIS II has led to a new generation of statistical rating models

Saying “don’t take too much risk”

is like saying “don’t swim too far from shore”

231

Successful risk management is an integrated process

Systems• Data extraction• Data transfer links• Data mapping• MIS support

Policies & Processes

• Approval• Limits / Control• Reports• Disclosure

Risk Management

Organization• Independence• Audit• Education• Performance Evaluation

Methodologies• Grading / Scoring

• Calculators

• Capital attribution

232

Let’s put all this in context with International Azeri Bank case

Break into groupsRead case facts and make assumptions as necessaryYou are a new member of ALCO and have been asked to provide an assessment of IZBAnalyze IZB’s performance and plansProvide critical observations Formulate recommendations to improve positioning of the bankMake any additional assumptions as necessary

233

Balance Sheet Analysis

BALANCE SHEET 2005 2004% Index % Base

AssetsCash 27552 3.0% 100 27494 3.4% 100Deposits at Banks 0.0% 0.0% 100Net Loans to Customers 684205 75.4% 118 578974 72.5% 100Interest in Joint Venture 0.0% 0.0% 100Trading 0.0% 0.0% 100Investments 151729 16.7% 99 152641 19.1% 100

0.0% 0 0 0.0% 100Premises 9470 1.0% 9673 1.2% 100Other Assets 34063 3.8% 0 29873 3.7% 100Total Assets 907019 100.0% 114 798655 100.0% 100

LiabilitiesDemand deposits 185862 20.5% 101 184844 23.1% 100Savings deposits 165502 18.2% 99 167247 20.9% 100Core Time 192100 21.2% 110 173892 21.8% 100Volatile time 109194 12.0% 132 82600 10.3% 100Total deposits 652658 72.0% 107 608583 76.2% 100Other liabilities 34998 3.9% 109 32055 4.0% 100Interbank borrowed 148823 16.4% 155 96155 12.0% 100Repos 30624 3.4% 150 20400 2.6% 100LTD 5000 0.6% 100 5000 0.6% 100Total Liabilities 872103 96.2% 114 762193 95.4% 100Stockholders' Equity 34916 3.8% 96 36462 4.6% 100Total Liabilities & NW 907019 100.0% 114 798655 100.0% 100

International Azeri Bank

234

Profit and Loss Statement 2005 2004% Index % Base

Interest Income 90684 267% 10.6% 71732 212% 100Interest Expense 57640 170% 6.8% 43644 129% 100Net Interest Income 33044 97% 3.9% 28088 83% 100Provision for credit losses 8056 24% 0.9% 6460 19% 100Net Interest after provision 24988 73% 2.9% 21628 64% 100Fee and commission income 960 3% 0.1% 5788 17% 100Fee and commission expense 0% 0.0% 0% 100Net Fees and commissions 960 3% 0.1% 5788 17% 100Trading Profits 0% 0.0% 0 0% 100Operating Leases 0% 0.0% 0% 100Other income 0% 0.0% 0% 100Total Non-interest Income 960 3% 0.1% 5788 17% 100Overhead 25592 75% 3.0% 25844 76% 100Pre-Tax Profit 356 1% 0.0% 1572 5% 100Taxation 0% 0.0% 628 2% 100Net Profit 356 1% 0.0% 944 3% 100

Average Assets* 852837 1562074Average Equity* 35689 109735Avg. Earning Assets* 793346 1336493Avg Interest Bearing Liabilities* 351728 1215379

ROA 0.04% 0.10%ROE 1.0% 1.4%Leverage 23.90 14.23Spread -0.79% 3.88%Net interest margin 4.2% 2.1%Other operating margin 0.11% 0.37%Efficiency Ratio 98.6% 94.3%Overhead/Avg assets 3.0% 1.7%Provisions/Avg Assets 0.9% 0.4%Yield on EA 15.6% 7.5%Cost of Funds 16.4% 3.6%EA Ratio 93.0% 85.6%Capital Ratio 3.8% 4.6%Loans/Deposits 104.8% 95.1%

Income Statements

Profitability Analysis

235

Thank you for your attention!

236

Funds Management

for

Financial Institutions

Additional ExamplesFebruary 8-10, 2006

237

Net interest income is usually the most predicable source of earnings

Cost ofInterest-paying

Liabilities

Net Interest Spread

Gain (Loss)

Net InterestMargin on EarningAssets

Earning AssetsTotal Assets

(x)Earning Assets -Interest BearingLiabilities

Cost ofInterest-payingLiabilities

Interest Yield onEarning Assets

(-)

(+/-)

(x)

NIM

238

Examples of Calculation of Gains/LossesI Income Expense NII NIM

Earning Assets 100 10% 10 4.5 5.5 5.5%Interest-bearing Liabilities 90 5%Spread 10 5% 0.5 5.5%

I Income Expense NII NIMEarning Assets 100 10% 10 6 4.0 4.0%Interest-bearing Liabilities 120 5%Spread -20 5% -1 4.0%

I Income Expense NII NIMEarning Assets 200 10% 20 5 15.0 7.5%Interest-bearing Liabilities 100 5%Spread 100 5% 2.5 7.5%

I Income Expense NII NIMEarning Assets 350 10% 35 20 15.0 4.3%Interest-bearing Liabilities 400 5%Spread -50 5% -0.714 4.286%

It is the relative proportion of earning assets and interest-bearing liabilities

239

Liquidity Planning: Gap Analysis 0-30 Days 31-90 Days 91-365 Days Potential Uses of Funds Add: Maturing time deposits Small time deposits $ 5.5 $ 8.0 $ 34.0 Certificates of deposit over $100,000 40.0 70.0 100.0 Eurodollar deposits 10.0 10.0 30.0 Plus: Forecast new loans Commercial loans 60.0 112.0 686.0 Consumer loans 22.0 46.0 210.0 Real estate and other loans 31.0 23.0 223.0 Minus: Forecast net change in transactional accountsa Demand deposits -6.5 105.5 10.0 NOW accounts 0.3 4.5 5.0 Super NOW accounts 0.1 1.0 2.0 Money market deposit accounts 1.6 3.0 6.0 Total uses $173.0 $155.0 $1,260.0

Potential Sources of Funds Add: Maturing investments Money market instruments $ 8.0 $ 16.5 $ 36.5 US Treasury and agency securities 7.5 10.5 40.0 Municipal securities 2.5 1.0 12.5 Plus: Principal payments on loans 80.0 262.0 903.0 Total sources $98.0 $290.0 $ 992.0 Periodic Liquidity Gapb $75.0 -$135.0 $ 268.0 Cumulative Liquidity Gap 75.0 -60.0 208.0

240

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

Liquidity Planning: Potential Funding Sources

241

Liquidity Guidelines for Major Regional Bank

Guideline200%

10%

15%

ConsolidatedRatio of Available Sources/Potential Funding Needs over 6 month period

Liquid Assets/Market Sources < 6 months (min)

Market Sources/Total Assets Maturing in 1 month (max)

Holding CompanyMarket sources/Backup facilities (max)

Liquid Assets/Market Sources < 1 months (min)

Backup Facilities (min) Higher ofTotal commercial paper o/s or

Assets > 9 months funded by sources < 9 months

Guideline40%

25%

50%

75%

242

ALM Report at xxx, 20xx

xxxx, 20xxLiquidity Management ($millions) Poicy Guideline $ Limit Actual

Liability Coverage Ratio1 Consolidated over 6 month period 200% 5,342 10,862

Maturity Structure of Net Market Sources2 Consolidated within 1 month 15% 6,824 2,4913 HC within 1 month 40% 280 -713

Liquid Assets as % of Market Sources4 Consolidated market sources < 6 months 10% 420 30735 HC market sources < 1 month 25% 54 854

Commercial Paper Backup Facilities6 Greater of

CP outstandings 50% 338700

Assets > 9 months supported by funding < 9 months 75% -396

243

Other Risk Guidelines

Poicy Guideline RegulatoryMidpoint Range Well-capitalized

Tier 1 Leverage 7% 6.3- 7.7% 5%

Total Risk-adjusted Capital 12% 11.4- 12.6% 10%

Tier 1 Risk-adjusted Capital 6%

Double Leverage 120- 125%

244

Moody’s has traditionally focused on twelve ratios in four categories

Earnings

Asset Quality

Capital

Liquidity

245

Earnings are the “first line of defense against losses”

PPP-Pfd. Dividends-CNCO/BIS RWA + SA

Return on BIS RW + SA

Efficiency ratio (Operating expense/Operating income)

Net interest margin

246

Asset quality needs to be adjusted for seasoning of loans and reserves

Non-performing assets/PPP

Non-performing assets/TCE + SA

Provisions/PPP

247

Capital is important but less so than ability to earn capital

CapitalTCE/BIS RWA + SA

LiquidityNet-cash capital position at bank level/bank assets

Core deposits/Loans

Net Short-term position at BHC/NI

Double Leverage (Investments/TCE)

248

The primary ratios looked at reflect these factors

Median Aa2 Aa3 A1 A2 A3 Baa1

Size (PPP in millions) 384 7,677 4,474 931 551 268 105

LiquidityCore deposits/Loans 76.6 69.2 55.2 70 79 75.7 91.1Liquid assets/ST Loans 72.2 66.0 33.1 62.6 62 36.3 99.1

CapitalTCE/RWA+SS 7 5.8 4.5 5.8 8.75 8.47 8.2

Double Leverage 112.5 116.8 125.7 120.1 115.1 107.1 104

ROA 1.63 1.58 1.52 0.9 2.1 1.63 1.93ROE 21.5 26.8 23.5 15.8 22.1 18.7 23.2

NPA/TCE + Reserves 7.7 11.7 9.8 7.4 3.2 24.3 4.6

Source: Moody’s

(Ratings as of 12/21/2000 and Balance Sheet and income data YTD 6/00.)

249

Financial Overview: Major Regional Bank

Per Share:$3.82 earnings per share$1.88 dividend per share (49% payout)$18.90 book value per share (estimated)$80 acquisition value (4x book)

Operating PerformanceROA 1.8%ROE 23.2%Net interest margin 5.32%Interest spread 4.62%Loans/Deposits 106%Efficiency ratio 53.6%Annual growth rate (1992-1996): Less than 1%in assets due to pooling accounting; equity at 3%Branches: 550Employees: 19, 340 (at 2/28/97including 3,505 FTE)

Assets : $47.6 billion72% Customer Loans7% Interbank8% Securities (1% Trading)7% Cash and Short-term Equivalents1% Fixed Assets

Total Liabilities: $44.5 billion19% Non-interest bearing deposits3% Interbank49% Customer deposits9% Short-term borrowings8% Long-term debtOff-balance sheet commitments andfinancial instruments:$49 billion (110% of total liabilities)

Shareholders’ Equity: $3.1 billion6.5% of assetsTier I Capital: 9.45%Total Capital: 13.23%

250

Financial Overview: Russian Bank

Assets: $1.09 billion49% Customer Loans9.6% Interbank23.4% Securities (19% Trading)8.7% Cash and Short-term Equivalents4.6% Fixed Assets

Total Liabilities: $.926 billion30.8% Interbank42.7% Customer deposits0% Short-term borrowings0% Long-term debtOff-balance sheet commitments andfinancial instruments: $629 million(68% of total liabilities)

Shareholders’ Equity: $164.1 million15.1% of assetsTier I Capital: 12%Total Capital: 28.5%

Per Share: N/A

Operating PerformanceROA 3.3%ROE 18.9%Net interest margin 2.7%Interest spread 2.8%Loans/Deposits 115%Efficiency ratio 62.3%Annual growth rate (1995-1996): 44%Branches: 19Employees: 1,012

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Financial Overview: Major Money Center Bank

Assets at 9/30/97: $118.3 billion53% Customer Loans20% Interbank15% Securities (1% Trading)2% Cash and Short-term Equivalent1.5% Fixed Assets

Total Liabilities: $113.4 billion8.3% Interbank65.5% Customer deposits6.9% Short-term borrowings3.8% Long-term debt and MIOff-balance sheet commitments andfinancial instruments: $32 billion(28% of total liabilities)

Shareholders’ Equity: $4.9 billion4.2% of AssetsTier I Capital: 6.8%Total Capital: 11.6%

Per Share:$.90 earnings per share$.35 dividend per share (39% payout)$4.37 book value per share$11.25 acquisition value (2.6x book)

Operating PerformanceROA .8%ROE 22.6%Net interest margin 2.5%Interest Spread 2.0%Loans/deposits 81% (excluding interbank)Efficiency ratio 52.5%Annual growth rate (1992-1996): 18%in assets; equity at 14%Branches: 1,026Employees: 30,900

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Year 2001DTB ABN HSB CIT JPM BAR WAC

A Size1 Total Assets 813,545 529,264 698,312 452,343 693,575 517,676 330,452 2 Risk -Weighted Assets (RWA) 288,532 242,232 391,478 344,950 455,123 230,604 269,726 3 Total Employees 94,782 112,206 171,049 117,103 95,812 78,600 84,046 4 Market Capitalization 43,237 25,340 109,000 - 76,254 - 42,701 5 Market Value / Book Value 1.2 2.5 2.3 - 1.9 - 1.5

B Profitability1 Return on Equity 0.4 20.5 10.2 16.3 3.9 19.0 8.0 2 Return on Assets 0.0 0.6 0.7 1.3 0.2 0.6 0.6 3 Net Interest Income on Assets 0.9 1.8 2.2 3.3 1.5 1.8 2.9 4 Net Interest Margin 1.0 1.9 2.5 3.7 2.0 1.7 3.6 5 Yield on Earning Assets 6.1 6.7 6.1 7.3 5.9 5.6 7.3 6 Funding Cost 5.7 6.6 (4.0) 4.1 4.2 4.2 4.2 7 Spread 0.4 0.1 2.1 3.3 1.7 1.4 3.2 8 Efficiency Ratio 90.4 71.5 56.4 59.4 67.0 57.9 63.6 9 Operating Cost Ratio 2.9 2.3 1.7 3.7 3.2 1.9 3.4

10 Provisions / Average Assets 0.1 0.3 0.3 0.6 0.4 0.3 0.4 11 Earning Assets / Average Assets 85.8 91.8 84.6 87.8 73.3 94.7 -

C Capital Adequacy1 BIS Tier 1 / Total RWA 8.1 7.0 9.0 9.2 8.3 7.8 7.0 2 BIS Total / Total RWA 12.1 10.9 13.0 13.6 11.9 12.5 11.1 3 Leverage 4.4 7.3 6.8 7.0 5.2 3.4 6.2 4 RWA / Total Assets 35.5 45.8 56.1 76.3 65.6 44.5 81.6

D Liquidity1 Net Loans to Total Deposits 69.5 91.0 82.1 91.0 72.5 98.8 85.8 2 Net Loans to Capital (times) 6.5 6.8 6.7 7.4 5.3 15.7 5.7 3 Liquid Asset Ratio 38.7 13.4 3.7 10.8 11.5 3.1 22.6

E Asset Quality1 NPL / Total Loans 4.2 2.2 3.4 3.6 1.3 2.9 1.1 2 ALLL / NPLs 34.5 76.1 77.4 53.4 119.2 51.5 175.0 3 ALLL / Total Loans 1.4 1.7 2.6 1.9 2.1 1.2 1.8 4 Net Charge-offs / Average Loans 0.7 0.3 - 1.0 1.1 0.4 0.7 5 Open Loan Exposure 17.6 11.9 4.9 12.6 (1.8) 17.6 (3.7)

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Target Spread on a Loan

Required RAROC (Hurdle Rate) 20%Allocated Capital 8

Net income 2 Pretax income 4Plus non interest expenses 10Plus EL 1Required NIM 15Cost of Funds 10

Interest rate required 25%

Required RAROC (Hurdle Rate) 20%Allocated Capital 8

Net income 2 Pretax income 4Plus non interest expenses 10Plus EL 1Required NIM 15Cost of Funds 10

Interest rate required 25%

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Example

Operating Expenses LoadCommercial Loan Department 300 33% 66 0.22Retail Branches 600 67% 134Administration 200Total 1100 100% 200

Commercial Loan 100,000Interest 25,000FTP 10,000NII 15,000EL 1,000Direct Costs 8,200Allocated Costs 1,800Pre-tax 4,000After-tax 2,000

Allocated capital 8,000RAROC 25%

Allocated

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Transfer Pricing

Rate risk spread

Credit spreadLending Unit

Treasury/ALM

987654321

Term in Years

Rate in %

Example of a Funds Transfer Pricing Yield Curve

256

Formulas

Formulas for the Varianceoror

Formulas for the Standard Deviation

Formulas for the Covarianceoror

257

References and further information

Credit Risk Measurement by A. Saunders, Wiley, 1999

Plain English Guide to ALM for Community Banks, Profitstar, Inc. (www.profitstar.com)

www.rmahq.org

www.riskmetrics.com

www.defaultrisk.com

Search other risk sites.

Analyze other bank financial statements

Web pages of Moodys, S&P and Fitch