gautam mitra forum on asset liability management

Gautam Mitra

Forum on Asset Liability Management

• Background and overview of Asset and Liability Management• Asset and Liability Management applied to Banks• Asset and Liability Management applied to Insurance

Companies• Asset and Liability Management applied to Pension Funds• Asset and Liability Management: Other application areas• Industry insights, technology, products and services• Directory of Asset Liability Management Solution and Service

Providers• Bibliography


Con Keating


5

London November 2009Con Keating

Asset and Liability Management

Some Issues

It is impossible to achieve demonstrably true knowledge about our universe or ourselves.

Nor is logic decisive. No kind of reasoning can ever give rise to a new idea.

Hume

Liability Driven InvestmentThe PPF

• The PPF reported investment returns for 2008/9 of 13.4% including swaps versus a target of 6.2%

• Ex swaps the return was -3.4%• Long dated gilts moved just 3 basis points in this year• But swaps versus gilts (25 year) compressed by 61 basis points• This is a return equivalent of 14.5%• This is the principal source of the swap performance.• Swaps were trading 45 basis points through gilts• Having been 100 basis points through earlier in the crisis• It is a staggering basis risk for the ALM position.• Why does the PPF own swaps which yield less than gilts?

Hedging

• A UK corporate borrowed £100 million as a 12 year floating rate note paying 5/8% over interbank offered two years ago.

• They swapped this for fixed paying 5.5% • They entered a credit support agreement for the swap, under which

cash collateral could be called.• Swap rates declined to 4.00%• They were called for collateral of £12.2 million• This was cash they did not have and were forced to borrow from

their bank on adverse terms• The cost of the financing has risen dramatically• The effective term of the financing has shortened• The basis risk is enormous

The individual

• Only 20% of personal wealth takes the form of financial assets and property.

• 80% is human capital to be consumed and converted to other wealth over the future life time.

• Many other institutions share this property of future income

• Pension schemes are one example

• The status quo is simply an accrued endowment - the present value of future contributions can dominate this entirely.

A pension scheme

• Once future contributions are considered• The optimisation problem is no longer maximisation of current asset

values at either short or long horizons• The new contributions can be thought of as consuming investments• And for those we want the price of investments to remain low• The ALM problem is dramatically different• Think about a coupon bond when prices decline and yields rise• The realised total return increases due to the higher reinvestment

rates• We no longer want high market (beta) returns since these hurt our

new money contributions• But we do want returns which are independent of the market• And that is the case for Alpha

BrightonRock Policy

• Institutionalises this insight contractually• It stabilises the current value of the portfolio• By removing short term concerns• Allowing long term investment• And lowering scheme financing costs

Michael Dempster


Elena Medova


Moorad Choudhry


Bank Liquidity Risk Management: Reporting and MetricsAsset Liability Management ForumMWB, Canary Wharf17 November 2009

Professor Moorad Choudhry

Europe Arab Bank

15

Agenda

• A common approach

• Five liquidity risk metrics• Reporting considerations

Email: [email protected]

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

mailto:[email protected]

16

Introduction

• Liquidity management has emerged as the dominant element of bank asset-liability management in the post 2007-08 crisis era

• Measuring and managing liquidity risk is an art rather than a science and should be undertaken with prudence and a close eye to the particular bank’s own risk-reward profile and operating model

17

A common approach…

• Management often direct Treasury and money market desk behaviour by assigning simple targets (e.g. the Loan-to-Deposit ratio, or target deposit levels)

• Market best practice is for more than the single liquidity metric (LTD), to a broader set of measurements and reports (to complement the LTD).

• For instance, the LTD is the best metric to measure the contribution of customer funding. The LTD, however, is not predictive, and is blind to duration, concentration and volatility, three critical aspects of liquidity. Finally, it is not always “aggregatable”.

• Liquidity forecasts should be upgraded to incorporate better estimates of deposits/withdrawals on the deposit side, drawings of unused direct commitments on the loan side, and assessment of the quality/liquidity of our near-cash assets.

• Post-Lehmans, a bank ALM crisis may arise from a negative gap situation, a withdrawal of customer deposits or loss of interbank liquidity, among other scenarios

18

What to Look For from Liquidity Data

Self-sufficiency and supportiveness of a business unit– Its ability to operate without support of other Group businesses– Evidence of focus on both sides of the balance sheet – The level to which it creates or relieves liquidity risk– Measure of value of the business unit to the Group, in non-P&L

terms

Overall level of exposure to roll risk – Measuring asset liability mismatch– Each liability roll is an opportunity to lose funding

Early warning of funding stress points– Analysing the cash effects of liquidity gaps– Examining the near term effects of the asset liability mismatch

Specific daily funding needs– For planning & managing daily operational funding requirements– For advanced planning of cash or collateral action

19

Metrics: Five Liquidity Reports

• Loan-to-Deposit Ratio

• 1 Week & 1 Month Liquidity Ratios

• Cumulative Liquidity Model

• Inter-company Lending Report

• Liquidity Risk Factor

These reports measure and illustrate different elements of liquidity risk:

• Reports at country level, legal entity level and Group Level• Risk appetite should be determined by the ALCO or (at Group level) High

ALCO• Assumptions will be reviewed by Treasury & Risk Management• Stress testing will be performed by Risk Management

20

Loan to Deposit Ratio

1 Week & 1 Month Liquidity

Ratios

Cumulative Liquidity

Model

Intercompany

Lending Report

Liquidity Risk Factor

Self-sufficiency

of a business

unit

Supportiveness of a business

unit

Overall level of exposure to roll risk

Early warning of

funding stress points

Specific daily

funding needs

Ways to Examine Liquidity Risk

21

Characteristics• The relationship between lending and customer

deposits• Measure of the self-sustainability of the bank (or

each branch / subsidiary)• A very common metric, usually reported monthly

Points to note• Differentiate between stand-alone and aggregate-able LTD

(depends on transferability and currency)• Branch / sub targets: to improve the LTD when it’s over a

certain threshold (e.g. 70%), and to maintain their LTD when it’s under that threshold

• Exceptions can be granted to certain countries in local currency (LCY) when they are below the threshold and when the use of their excess liquidity is constrained

Loan-to-Deposit Ratio

22

1-Week & 1-Month Liquidity Ratios

Characteristics• Shows net cash flows, including the cash effect of liquidating

“liquid” securities, as a percentage of liabilities• An effective measure of structural liquidity, with early warning of

likely stress points• Produced weekly, one week in arrears• Follows a Regulatory Authority limit structure for 1 Week and 1

Month ratios• It is important to review assumptions including “stickiness”

assumptions regularly• Review Limits regularly

Country 1-week Gap 1-week Liquidity 1-month LiquidityUSD mm This week Limit Excess This week Limit Excess

F -1586 -22.83% -30.00% -39.11% -50.00%D 188 15.26% 0.00% 1.62% -5.00%H 786 22.57% 0.00% 19.12% -5.00%G 550 53.27% 25.00% 69.83% 25.00%

Regional Total -62 -0.48% -10.64%

23

Cumulative Liquidity Model

$mm T+1 T+2 1 Week 2 Weeks 1 Month 2 Month 3 Months 6 Months 12 Months

a Cumulative Net Cash Balance $2,000 $1,550 $250 -$300 -$2,500 -$3,000 -$5,000 -$6,000 -$8,000 b Other Forecast Inflows $0 $10 $25 $50 $75 $125 $350 $800 $1,000c Other Forecast Outflows $0 -$10 -$20 -$50 -$100 -$250 -$1,000 -$1,100 -$1,250

a+b+c=d Cumulative Cash Gap $2,000 $1,550 $255 -$300 -$2,525 -$3,125 -$5,650 -$6,300 -$8,250

e Counterbalancing Capacity $500 $1,000 $1,500 $2,000 $3,000 $5,000 $6,000 $7,000 $7,500

d+e=f Liquidity Gap $2,500 $2,550 $1,750 $1,700 $500 $2,000 $1,000 $1,000 -$500

g Limit $2,000 $1,500 $1,000 $1,000 $0 $0 $0 -$1,000 -$3,000

f-g=h Variance $500 $1,050 $750 $700 $500 $2,000 $1,000 $2,000 $2,500

Dummy Data

Characteristics• Forward looking model of inflows, outflows and available liquidity• Recognises and predicts liquidity stress points on a cash basis• Prepared daily, at legal entity level, and Group level• Prepared for material original currencies and at consolidated

currency level Note• Revised assumptions on deposit stickiness, liquidity of “liquid”

securities, and committed facilities will be included here

24

Intercompany Lending Report

Characteristics• This shows the net

intercompany lending position of each branch / sub

• Measure of the self-sustainability of each branch / sub

• Clearly displays cash contributors and cash users

• Major KPI for Treasurers• Produced monthly

Group Treasury

As at (date) Total Borrowing Total Lending Net Intergroup Lending

London subsidiary 1,713,280 883,123 -830,157

Europe branches-- X 3,345,986 978,369 -2,367,617-- Y 17,026 195,096 178,089-- Z 453,490 83,420 -370,070

Asia 0 162,000 162,000

NY 690,949 1,516,251 825,302

25

Characteristics• Shows the aggregate size of the liquidity gap in each

branch / sub• Compares average remaining duration of assets to average

tenor of liabilities• For example,

– Average asset duration 5.00 years– Average liability tenor 3 months = 0.25 years– 5.00/0.25 = Liquidity Risk Factor of 20

• The higher the LRF, the larger the liquidity gap, and the greater the liquidity risk

• Tenor of liabilities will incorporate revised stickiness assumptions

• Report weekly and monthly• Observe the trend over time and change to long-run

averages

Liquidity Risk Factor

26

Sharing of Information: effective MI

Presentation of Information• All outputs presented with a common look• Reports designed for simplicity, with unnecessary detail

removed• Trends and limits incorporated• Information will be shared at operating unit level,

headquarters level, and at Group level• Reports will be published initially on a shared online

directory, ensuring the latest versions are available in the same place.

27

Risk reports 1: the weekly Qualitative

• As important: the weekly qualitative report for Group Treasury (who summarises all for High ALCO)

• Content:• Explain significant changes in your 1 week and 1 month liquidity

ratios• Explain any changes to your cash and liquidity gap in your

Cumulative Liquidity model• Explain significant changes to the Liquidity Risk Factor • Explain growth or shrinkage of asset books• Detail any changes to intergroup borrowing/lending position; detail

the counterparties for any large-size deals• Any increase/decrease in corporate deposits, detail large dated

transactions with an estimated confidence level of roll over• Any increase/decrease in retail deposits• Average daily opening cash position

28

Risk reports 2: Monthly Liquidity Snapshot

• Simply a MI summary for Group-wide dissemination • Content:

– The Cumulative Liquidity Report summary (cash gap and liquidity gap)

– 1-week and 1-month Liquidity Ratios performance against limits

– Liquidity ratio current to previous month– LTD current to previous month– Net intergroup lending current to previous month

29

Four frameworks to monitor and control current and future liquidity risk...

Maturity mismatch

Asset / liability liquidity ladder

FX mismatch

Funding concentration

Purpose: To measure the net funding requirement (or surplus) per maturity bucket. This is the main regulatory requirement for liquidity measurement.

Measure: Measures the net cash flow for each maturity bucket.

Analysis: In the short-term, when commitments (cash outflows) exceed liquid assets (cash inflows) the Money Markets desk need to raise additional funding. In the longer-term, structural imbalances, ALCO will determine the appropriate funding strategy.

Maturity Mismatch Ladder

Sight 8 Day1

month3 mo 6 mo 1 year

3 years

5 years

5 years

+TOTAL

Inflows 805 383 273 268 143 129 276 657 7423,67

5Outflows 980 813 838

1,563

277 52 11 0 04,53

3Mismatch (175)

(430)

(570)(1,29

5)(134) 77 265 657 742 (858)

Purpose: To measure the gap between funding and lending in each currency.

Measure: Funding minus lending, per currency.

Analysis: By measuring FX mismatch, the bank gains an understanding of its exposure to the risk that FX swap markets become illiquid which could force a large open FX position or make it difficult to meet commitments in a particular currency.

Purpose: To measure the asset liquidity and likely stickiness of liabilities.

Measure: Each asset/liability type (per COA) is rated based on size of holding, contractual maturity, behavioural stickiness, yield, cost to liquidate.

Analysis: A detailed understanding of the attributes and behaviour of the bank’s balance sheet allows ALCO to make better informed strategic choices.

Purpose: To measure the relative concentration of each funding source.

Measure: % concentration of each funding source per maturity bucket.

Analysis: Analysing funding concentration risk allows the bank to develop effective diversification strategies.

USDUSDEUREUR

GBP GBP

FX mismatch

- =Currency

Mismatch

USD 956

EUR (150)GBP (450)

Asset

Liability

Liquid Illiquid

Cash

GiltsFI F

RNs

CDsECB

Elig

ible

ABS

Other

A

BSCor

p

L

oans

LGs

Prope

rty

Bank

depo

sits

Custo

mer

d

epos

its

(10

%)

Insti

tutio

nal

depo

sits

Custo

mer

d

epos

its

(9

0%)

Short-term Long-term

Customer deposits

Inter-bank deposits

Group deposits

Group deposits

Group deposits

Inter-bank deposits

Inter-bank deposits

Customer deposits

Customer deposits

Funding Lending

Sight – 8 days 1 month 1 year

ILLUSTRATIVE

ILLUSTRATIVE

ILLUSTRATIVE

30

Regulatory and Management reporting is key to successful liquidity management Liquidity Reporting

Branch liquidity

Regulatory

Category Measures

Report Audience / Frequency

• Consolidated basis - FSA Form LR is the key daily report this is based around the maturity mismatch framework.

• Daily Liquidity Report

Management Reporting Leading and lagging risk indicators to provide a 360° view of the bank’s liquidity.

Prepared by: Finance Regulatory Reporting Team

Maturity transformation

• Average asset tenor < 24x average liability tenor

Funding source concentration limits

• No individual counterparty > 5% of funding

• No source > 25% (except customer deposits)

• Customer deposits > 33% of funding

FX mismatch limit

• No mismatch > 25% of currency volume (G7)

• No mismatch > €10mn for non-G7 currencies

Minimum cash buffer

• Cash buffer > 2% of liabilities at all times

Maturity mismatch

• Sight – 8 days > 0.00%

• Sight – 1 month > -5.00%

Prepared by: Finance Regulatory Reporting Team

Prepared by: Finance Management Information Team

• DLR = Daily to management

• Form LR = Monthly to FSA

• Consolidated basis - FSA Form LR is the key daily report this is based around the maturity mismatch framework.

• Daily Liquidity Report

Five Liquidity Metrics • Monthly to management• Copy of monthly reports send to each host regulator (tbc)

• Daily to Finance + Treasury

• Monthly to management

• Maturity mismatch framework

• FX mismatch

• Asset / Liability liquidity ladder

• Funding concentration

31

Bibliography

• Choudhry, M., et al, Capital Market Instruments: Analysis and Valuation, 3rd edition, Basingstoke: Palgrave MacMillan

• Choudhry, M., Bank Asset and Liability Management, Singapore: John Wiley & Sons 2007

• Choudhry, M., The Money Markets Handbook, Singapore: John Wiley & Sons 2004

32

DISCLAIMERThe 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 Europe Arab Bank or Arab Bank Group, any affiliated body, including London Metropolitan University and YieldCurve.com, or of Moorad Choudhry as an employee of Europe Arab Bank or representative of 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 2009. 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.

Stuart Jarvis


Asset Liability ManagementForum event

ALM for pension plans

Stuart JarvisDirector of research, Client Solutions

17 November 2009

Private and confidential. Not for public distribution. Professional investors only.

34


Summary

• Funding challenges for UK pension plans

• Constructing asset liability solutions for pension plans

• Asset liability management in practice

35

Private and confidential. Not for public distribution. Professional investors only.36

Funding challenge

PPF 7800 Index

- 300

- 250

- 200

- 150

- 100

- 50

0

50

100

150

Mar

-03

Jul-

03

Nov

-03

Mar

-04

Jul-

04

Nov

-04

Mar

-05

Jul-

05

Nov

-05

Mar

-06

Jul-

06

Nov

-06

Mar

-07

Jul-

07

Nov

-07

Mar

-08

Jul-

08

Nov

-08

Mar

-09

Jul-

09

Surp

lus/

Defi

cit

(£bn)

Source: Pension Protection Fund

• Since a peak in mid 2007, funding positions have worsened considerably

• UK plans have historically takena lot of risk

• Now widely accepted that strategiesneed to be more liability-led anddynamic


Evolution of investment strategy

37

Equity β and constrained α

Typical current investment policy

BondsDiversified β and α

Possible intermediate solution ‘Ideal’ future investment policy

Bond α

Liability hedge

Diversified β

Liability hedge

Diversified α

8202

39

Simple Unrewarded risks

unhedged Constraints inhibit

performance

Hedge unrewarded risksDiversified betaDiversified alpha

Hedge unrewarded risksDiversify risk budget Constrained ability to

grasp opportunities

Static perspective: spend risk budget as efficiently as possible


Eyes on the prize

38

Dynamic perspective: risk is being taken in order to bring assets into balance with liabilities

70%

80%

90%

100%

110%

Start Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Realised performance

60%

3% p.a.

2% p.a.

If realised returns above target, can afford to target lower return

(And if returns below target, may need to target higher return)

New target path

Initial target path


Dynamic portfolio allocation process

39

Return

Risk

Private Equity

Equity

High Yield Bonds

Emerging Market Debt

Property

Infrastructure Commodities

Emerging Market Equity

Gilts & Swaps

Corporate Bonds

Dynamic rather than static portfolio

As the return target changes, so must the portfolio allocation


Cumulative impact of dynamic asset allocation policy

40

Distribution of outcomes no longer so wide; significant downside benefit

60

80

100

120

140

160

60 80 100 120 140 160

Funding level with static allocation weightsFu

ndin

g le

vel w

ith

dyn

am

ic w

eig

hts

60% 70% 80% 90% 100% 110% 120% 130% 140%

Funding level

Fre

qu

en

cy

Fixed weight Dynamic weights

Private and confidential. Not for public distribution. Professional investors only.41

Practical considerations


Adding a floor

42

Minimum as well as target funding level

Strategy outcomes

50%

60%

70%

80%

90%

100%

110%

120%

Cumulative growth asset return

Fundin

g le

vel

Target Funding target Static weights Funding target + floor


Contributions

43

This is not just an investment problem

Contributions

Sponsorcovenant

Investmentpolicy


Putting it all together

• Overall framework is best set in advance

• Clear goal

• Create framework for appropriate real-time engagement

• Delegation

• Market opportunities

• Beyond capital allocation

• Some assets easier to move than others -> use derivatives

• Monitoring and reporting framework crucial

• Aggregation

44

Monitoring and action


Conclusions

• Pension plans changing their focus from static weights to fixed target

• Dynamic strategies to support this are intuitive

• Complex dynamics

45

Marcus Hurd


Pensions – Asset Liability Modelling

Traditional deterministic

Simple Stochastic

Pensions – Asset Liability Modelling

Investment optimisation

Contribution optimisation

Asset and Liability Management: HandbookAsset and Liability Management: Handbook

Contributors:Contributors:• Dr. Moorad Choudhry, Europe Arab Bank • Prof. Michael Dempster, Judge Business School, Cambridge University • Dan diBartolomeo, Northfield Information Services • Con Keating, Head of Research, BrightonRock Group • Prof. Lionel Martellini et al., EDHEC Business School • Dr. Elena Medova, Judge Business School, Cambridge University • Prof. Gautam Mitra, CARISMA, Brunel University and OptiRisk Systems• Dr. H Sadhak, CEO Life Insurance Corporation, India • Dr. Katharina Schwaiger, CARISMA, Brunel University and OptiRisk

Systems• Prof. Frank Sortino, Emeritus Professor in Finance, San Francisco State

University and Director of the Pension Research Institute

• Sponsorship Opportunity

• Contact us:[email protected]

Asset and Liability Management: HandbookAsset and Liability Management: Handbook

gautam mitra forum on asset liability management

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