Strategic Balance Sheet Management by CFOs

Market Risk and Liquidity Risk

B. Mahapatra

Reserve Bank of India

Structure

• Introduction

• Market risk management

• Conclusion

• Liquidity risk management

• Conclusion

Introduction–What does a CFO do?

• Traditional view • Financial gate keeper

• Managing financial risks of a corporation (bank)

• Financial planning, reporting, analysis, etc.

• Contemporary view • Strategic partner and adviser as per McKinsey survey

• Blend of the two

Introduction - Risks in banking • Primordial risks – God-made – for good

society – intermediation function

– Credit risk

– Liquidity risk – maturity transformation

• Man-made risks – for what? – deregulation - efficiency? – competition? – free market economy?

– Market risk – end of 3-6-3 banking and fixed Fx rates

Typical Balance Sheet Structure

LIABITIES ASSETS

Capital 1% Cash & Balances with RBI 6%

Reserves & Surplus 6% Balances with Banks and Money at Call and Short notice 3%

Deposits 79% Investments 29%

Borrowings 9% Loans and Advances 58%

Other Liabilities & Provisions 5% Fixed Assets 1%

Other Assets 3%

100% 100%

5

(Based on March 31, 2011 figures from RBI website)

• 90% of liabilities and 95% of assets are exposed to market risk and liquidity risk

• Inflexibility or rigidity of the balance sheet

• Assets and liabilities – many items – different amounts – different maturities – with different interest rates - how to manage the risks?

• Asset-Liability Management (ALM) or what is called strategic balance sheet risk management entered the lexicon of banking

Market Risk

7

• Market risk is the risk of losses in the on-balance sheet and off-balance sheet positions due to movements in the market prices

• Market risk can come in the form of

– Interest rate risk

– Equity price risk

– Foreign exchange risk

– Commodity price risk, etc.

• In strategic balance sheet risk management or ALM, we are concerned with the banking book, and not so much with the trading book

• Banking book market risks are

– Interest rate risk in the banking book – NII at risk or Earnings at Risk (EaR) than VaR, due to changes in interest rates

– Foreign exchange risk, equity prices risk and commodity prices risk in both banking and trading books

• ALM guidelines of February 1999 – Traditional gap analysis between RSA and RSL

– Impact on NII or earnings – earnings perspective

• ALM guidelines of November 2010 – Duration gap analysis between DA (MDA) and DL

(MDL)

– Duration gap and modified duration gap and duration or modified duration of equity (MDE)

– Impact on market value of equity (MVE) – economic value perspective

Interest Rate Sensitivity • Changes in interest rates impact a bank’s

– Earnings through changes in its Net Interest Income (NII) - earnings perspective, and

– Market Value of Equity (MVE) or net-worth through changes in the economic value of its interest rate sensitive assets, liabilities and off-balance sheet positions – economic value perspective.

• RBI has been monitoring the impact of change in Interest Rate on

banks’ financial position through a set of returns.

• IRS Return, applicable till Feb 2012, captured domestic operations in Rupee only with last reporting Friday as reporting reference date.

• This return basically facilitated to monitor the impact of interest rate change on earnings of banks based on traditional gap analysis approach (earnings perspective).

11

Interest Rate Sensitivity

• To monitor the impact on MVE/Networth (economic value perspective), a new monthly return (quarterly till March 2012), being called as IRSD (Interest Rate Sensitivity Return under Duration Gap Analysis), was introduced recently and which is effective from June 2011

Covers global operations

Currency-wise reporting: All the currencies where the assets/liabilities in that particular currency is more than 5% of bank’s global assets/liabilities

Reporting reference date – month/quarter end

Captures – time bucket wise RSA and RSL, instrument wise weighted average MD, MD gap, and change in MVE for 100, 200, 300 bps change in interest rate

• The IRS was also modified on the same lines of IRSD and was

renamed as IRST

12

Interest Rate Sensitivity

Availability of Data

• IRST – From Mar-12 to May-12 (monthly)

• IRSD- From Jun-11 to Mar-12 (quarterly)

• Certain observations are furnished through

the following slides based on the available data from IRST and IRSD

13

22

9 9

30

36 34

17 18

24

5

10 8 8

9 9

3 3 1 0

5

10

15

20

25

30

35

40

Mar-12 Apr-12 May-12

No

. of

Ban

ks

# Banks: Net Gap as % of Total Assets

less than Zero 0-5 5-15 15-50 50-100 more than 100

Based on IRST Return

14

15

3.74 3.80 3.85

2.15 2.12 2.16

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

Mar/12 Apr/12 May/12

Modified Duration (MD) at System Level

MD of total Invstment Portfolio

MD of HFT and AFS together

Based on IRST Return

16

24 23

22

12 12 10

6 6

9

13 11

14

22

26

23

8 7 7

0

5

10

15

20

25

30

Mar-12 Apr-12 May-12

No

. of

ban

ks

# Banks: Modified Duration of Total Investment Portfolio

upto 1 more than 1 and upto 2 more than 2 and upto 3

more than 3 and upto 4 more than 4 and upto 5 more than 5

Based on IRST Return

17

MD of HFT and AFS portfolio taken together have been below 3 for majority of

banks

The MD has been above 4 for about 3-6 banks

35 33

30

17 19 20 19

23 22

8 7 7 4 1 3 2

2 3

0

5

10

15

20

25

30

35

40

Mar/12 Apr/12 May/12

No

. of

Ban

ks

# Banks: Modified Duration of AFS and HFT together

upto 1 more than 1 and upto 2 more than 2 and upto 3

more than 3 and upto 4 more than 4 and upto 5 more than 5

Based on IRST Return

The MDG reflects the degree of duration mismatch in the Risk Sensitive Assets and

Risk Sensitive Liabilities in a bank’s balance sheet.

If this gap is large, the bank is more exposed to the interest rate shocks.

Vulnerability of SCBs to interest rate shocks has come down in Mar-12 compared to

Dec-11. In fact MDG at system level increased from 0.0356 in Jun-11 to 0.1538 in

Dec-11 and then decreased to 0.0948 in Mar-12.

18

0.0356

0.1074

0.1538

0.0948

Jun/11 Sep/11 Dec/11 Mar/12

0.0000

0.0200

0.0400

0.0600

0.0800

0.1000

0.1200

0.1400

0.1600

0.1800

Modified Duration Gap (MDG) at System level

Based on IRSD Return

The modified duration gap (MDG) between -1 and 1 for most of the banks

indicate that change in interest rate will not have much impact on networth of

banks, at system level.

19

0 1 0 0

25 22 21

27

52 55 55 54

3 5 6 2

0

10

20

30

40

50

60

Jun-11 Sep-11 Dec-11 Mar-12

No

. of

Ban

ks

# Banks based on their Modified Duration Gap (MDG)

less than -1 -1 and above and upto 0 more than 0 and upto 1 more than 1

Based on IRSD Return

The networth of majority of banks (i.e., 54 to 60 banks) would be

negatively impacted with an increase of 100 bps in interest rate. On

the other hand, if the interest rate decreases by 100 bps, the networth

of these banks would be positively impacted

The change in interest rate would have no effect on networth of 5 to

14 banks

What is your position?

20

54

60 58

55

17 20 19

23

14

5 8

5 0

10

20

30

40

50

60

Jun/11 Sep/11 Dec/11 Mar/12

No

. of

Ban

ks

# Banks: Change in Networth on 100 bps increase in Interest Rate

is negative is positive no change Based on IRSD Return

Share of Market Risk related Risk Weight Assets in the Total Risk Weight Assets

of the Scheduled Commercial Banks has been lower at around 6-7%.

21

Market Risk

Operational Risk

Credit Risk

0.00

20.00

40.00

60.00

80.00

100.00

Mar-09 Mar-10 Mar-11 Mar-12

6.80 6.95 6.33 5.68

6.45 6.92 6.79 7.04

86

.75

86

.12

86

.88

87

.28

Share of Capital Charge for different Risks in Total RWAs

Return on Capital Adequacy (Basel-II)

22

In terms of capital charge, at system level,

Interest rate related instruments constitute around 68% to 75% of the Market

Risk.

Around 21% to 28% of the market risk comes from equity.

Foreign exchange and gold contributes less than 3-4% of Market Risk.

0%

20%

40%

60%

80%

100%

Mar-09Mar-10

Mar-11Mar-12

75

.22

68

.62

70

.80

74

.20

21

.16

27

.95

26

.10

22

.99

3.62 3.44 3.10 2.81

Share of different class of Instruments in the Total Capital Charge for Market Risk

Foreign Exchange and Gold Equity Interest rate related instruments

Return on Capital Adequacy (Basel-II)

Conclusion

• The capital charge is for the trading book (AFS and HFT – both interest rate and equity positions) and for both banking and trading book for FX and gold

• Is there a case for Pillar 2 capital charge for interest rate risk in the banking books of banks?

Conclusion

• Portfolio immunization or matched book is an impossibility for banks – if matched book is possible, then banks do not need treasurers or CFOs – clerks can manage banks

• Traditional wisdom says banks should create strategic gaps to make money, based on their views on movement of interest rates

• What does the modern CFO think?

Liquidity Risk

25

• Liquidity risk is the inability to meet obligations as they become due, without adversely affecting a bank’s financial condition

• RBI’s liquidity risk guidelines

– Statutory Liquidity Ratio – stock approach

– ALM circular – February 1999 – Board governance

– Revision in 2008 to make it more granular

– Addressing the issues of inter-connectedness

• Inter-bank liability limit

• Call money borrowing / lending limit, etc.

• Limits on bank’s investments in financial services companies

Liquidity: Indian Banks

• RBI monitors banks’ liquidity strength along with their ALM based on a structural liquidity return submitted fortnightly, with a lag of about one week, by banks.

• While a set of liquidity ratios are used to monitor the liquidity position of banks, time bucket (up to one year) wise cumulative gap in total inflow and outflow is used to monitor ALM of banks.

• This monitoring is basically done for Indian banks. Foreign banks’ funding sources have been different in comparison to Indian banks. Foreign banks rely more on borrowed funds, especially from abroad.

28

Liquidity: Indian Banks

29

Some important Liquidity Ratios

Ratios Formulae

Concentration of

Deposits Deposits of top 20 depositors / Total deposits.

Short Term Deposits to

Total Deposits Total Deposits of Maturity up to 1year / Total Deposits

Customer Deposits & Net

Worth to Total Assets

(Customer Deposits + Net worth) / (Total Assets -

Cash Funds)

Net Loans to Customer

Deposits Net Advances / Customer Deposits

Time Deposits to Total

Deposits Time Deposits / Total Deposits

Market Loan to Total

Assets

(Borrowings from Inter Bank/Call + Borrowings from

RBI + Borrowings from Banks/FIs) / Total Assets

Liquid Assets to Total

Assets

( Cash Funds + Current Account (1 to 28 days) +

Money at Call Short Notice (1 to 28 days) + AFS+

HFT) / Total Assets

30

43.2 43.1 44.0 44.2 44.2 44.5 44.3 43.9 44.0 44.1 44.4

92.8 92.1 91.6 91.7 92.4 91.9 92.2 91.3 90.9 90.8 90.6

74.4 73.2 73.3 73.3 73.8 73.8 74.4 74.6 75.1 76.8 75.3

53.7 55.3 55.3 55.4 55.9 56.3 54.8 55.8 55.6 53.6 55.7

16.0 17.4 15.5 15.5 16.7 16.8 15.6 18.2 17.6 16.0 17.9

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

100.00

Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12

Liquidity Ratios at System Level

Concentration of Deposits Short Term Deposits to Total Deposits

Customer Deposits and Networth to Total Assets Net Loans to Customer Deposits

Time Deposits to Total Deposits Market Loan to Total Assets

Liquid Asset to Total Assets

31

Concentration of deposits is measured by the ratio Deposits of top 20 Depositors to Total Deposits

Banks have reduced their dependence on large deposits. The concentration of deposits has been

weakening over the period. No. of banks with ratio above 20% declined from 7 in June 2011 to 5 in

April 2012. In fact during 2009-10 and 2010-11 the no. of banks with this ratio more than 20% were

in the range of 12-15.

9 11 10 10 11 12 11 11 11 13 14

30 28 29 29 27 28

29 28 28 26

27

6 6 7 7 6

5 5 6 6 6 4 1 1 0 0 2 1 1 1 1 1 1

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

No

. of

Ban

ks

Concentration of Deposits (%)

<=10 10-20 20-30 >30

Short-term deposits are total deposits with residual maturity upto one

year.

Lower ratio indicates better funding quality

In terms of this ratio, 3 to 4 banks’ funding appears to be highly

vulnerable

32

0 0 0 0 0 0 0 0 0 0 0

9 9 6 6 7 8 10

9 9 9 8

21 20 22 22 19 17

16 16 15 16 17

15 15 15 15 17 18 17 18 19 18 17

1 2 3 3 3 3 3 3 3 3 4

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Ma

r-1

2

Ap

r-1

2

No

. of

Ban

ks

Short Term Deposits to Total Deposits (%)

0-10 10-30 30-50 50-70 >70

Higher ratio indicates stable funding. This ratio has not been so impressive

for about 4 banks.

33

0 0 0 0 0 0 0 0 0 0 0 1 1 2 2 2 2 2 2 1 4 3

5 6 6 6

4 5 8 7 9 6 8

18 19 19 19

20 21 15

21 24 23 23

22 20 19 19 20 18 21

16 12 13 12

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Ma

r-1

2

Ap

r-1

2

No

. of

Ban

ks

Customer Deposits and Networth to Total Assets (%)

<=65 65-75 75-85 85-95 >95

This ratio may be treated as a refined version of CD ratio.

While a moderate value of this ratio indicates stable funding of loans and

advances, a very high value indicates funding of loans and advances by

means other than deposits.

34

0 0 0 0 0 0 0 0 0 0 0

11

18 13 13 13

10 9 6 9 5 6

24

19 23 23

26 29

26 31 27

28 25

8 6 8 8 4 4 8 4 6

9 11

3 3 2 2 3 3 3 5 4 4 4

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

No

. of

Ban

ks

Net Loans to Customer Deposits (%)

<=60 60-70 70-80 80-90 >90

A high ratio is supposed to be stable source of funding, but more

expensive.

The ratio has been very poor for few banks indicating volatile deposit

base.

35

0 0 0 0 0 0 0 0 0 0 0 4 3 1 1 1 0 4 4 2 4 2

16 15 17 17 15

14

14 11 13

16 14

17 16 16 16 18

19

20

19 21

18 20

9 12 12 12 12 13

8 12 10 8 10

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

De

c-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

No

. of

Ban

ks

Time Deposits to Total Deposits (%)

<=35 35-45 45-55 55-65 >65

High ratio is an indicator of volatile source of funding.

In terms of this ratio, the source of funds of majority of banks appears to

be stable with ratio less than 5%. However, a few Indian banks rely more

on borrowed funds.

Of late, a number of banks have increased their ratio – Why?

36

38 35 36 36 36 36 35 36 34

30 31

6 8 7 7 8 8

7 5 7 10 9

1 2 2 2 1 1 3 3 4 4 3

1 1 1 1 1 1 1 2 1 2 3

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

De

c-1

1

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

No

. of

Ban

ks

Market Loan to Total Assets (%)

<=5 5-10 10-15 >15

Liquid assets cover – cash fund, investments in AFS and HFT categories,

Current Account (1 to 28 days) and Money at Call Short Notice (1 to 28

days)

The ratio has been quite poor for a few banks and moderate (10-30%) for

majority of banks

37

6 6 5 5 3 4 7 5 6 6

11

31 27

26 26 27 27

28

28 29

32 25

6 9 11 11 13 12

9

6 5

5 6

3 4 4 4 3 3 2 7 6

3 4

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

De

c-1

1

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

No

. of

Ban

ks

Liquid Asset to Total Assets (%)

<=10 10-20 20-30 >30

Lessons from the Global Financial Crisis

• Risky to depend on wholesale funding markets

• Liquidity crisis can lead to insolvency

• Solvent banks went into liquidity problems

• Accounting and valuation issues

• Funding liquidity risk – bank’s inability

• Market liquidity risk – market illiquidity, lack of depth, disruption, etc.

Response to the Crisis

• Basel Committee’s Principles for sound liquidity risk management and supervision (September 2008)

Response to the Crisis - Basel III Liquidity Ratios

• Short horizon (30-day stress period) – Liquidity Coverage Ratio (LCR) = Stock of high quality liquid assets / Total net cash outflows over the next 30-day period = 100%

• Structural or stable liquidity – Net Stable Funding Ratio (NSFR) = Available Stable Funding (ASF) / Required Stable Funding (RSF) > 100%

Basel III – Liquidity Monitoring Tools / Metrics

• Contractual maturity mismatch

• Concentration of funding

• Available unencumbered assets

• LCR by significant currency

• Market related monitoring tools

Conclusion

• Lessons from global financial crisis

– Back to basics

– Find natural hedges than synthetic ones

• Unfinished agenda

– Intra-day liquidity management

– Liquidity management through increasing use of CCPs for OTC transactions – addressing issues of inter-connectedness

• Thank you