Asset Liability Mgmt. – Banking Book Risk
Transcript of Asset Liability Mgmt. – Banking Book Risk
Asset Liability Mgmt. – Banking Book Risk
Tom Haczynski SVP – SunTrust Bank Market Risk Management July 2015
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The views expressed in the following material are the
author’s and do not necessarily represent the views of
the Global Association of Risk Professionals (GARP),
its Membership or its Management.
Today’s Agenda
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I. Asset/Liability Management 4-11
II. Interest Rate Risk 12-30
III. Conclusion 31
IV. Acknowledgements 32
I. Asset/Liability Management
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Interest Rate Risk (“IRR”)
Liquidity Risk
Key Objective: Achieve the desired trade-off between risk and return
Funds Transfer Pricing
Non Interest Income/Expense Allocation Methodologies
Capital Attribution
Asset/Liability Management (“A/LM”), the management of long-term balance sheet risks arising from core banking activities, focuses on two major areas of risk:
Performance Measurement ("PM") Methodologies:
Interest Income Loan Interest Income FTP Credit for FundsLess: Interest Expense FTP Charge for Funds Deposit Interest Expense
Equals Net Int Income ("NII") FTP'd NII FTP'd NII
Less: Loan Loss Provision Expected Loss ("EL") + Chge OffsEquals Adjusted NII
Plus: Non Int. IncomeLess: Non Int. Expense
Equals Net Inc Before Taxes
Less: Income TaxesEquals Net Inc After Taxes
Divided by Equity Capital Capital Allocation Methodology
Equals Return on Equity ("ROE")
GAAP-Based Income Statement: PM-Based Income Statement
Regulatory (Advanced, Standard), EC Based
Product NIM, RAROC & NIACC = Bal Sheet Optimization
Income TaxesNet Inc After Taxes
Adjusted NII
Funds Transfer Pricing ("FTP")
Non Int Income/Expense Allocation Methodologies
U/W process creates grids for Pricing Models
Methodologies: ProRata / Direct Costing / Full Absorption / Svce Level Agmts ("SLA's")
Net Inc Before Taxes
Less: Capital Charge (EC * Hurdle Rate)Net Inc After Capital Charge ("NIACC")
I. Asset/Liability Management
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Achieve the desired trade-off between risk and return
Performance Measurement ("PM") Methodologies:
Interest Income Loan Interest Income FTP Credit for FundsLess: Interest Expense FTP Charge for Funds Deposit Interest Expense
Equals Net Int Income ("NII") FTP'd NII FTP'd NII
Less: Loan Loss Provision Expected Loss ("EL") + Chge OffsEquals Adjusted NII
Plus: Non Int. IncomeLess: Non Int. Expense
Equals Net Inc Before Taxes
Less: Income TaxesEquals Net Inc After Taxes
Divided by Equity Capital Capital Allocation Methodology
Equals Return on Equity ("ROE")
GAAP-Based Income Statement: PM-Based Income Statement
Regulatory (Advanced, Standard), EC Based
Product NIM, RAROC & NIACC = Bal Sheet Optimization
Income TaxesNet Inc After Taxes
Adjusted NII
Funds Transfer Pricing ("FTP")
Non Int Income/Expense Allocation Methodologies
U/W process creates grids for Pricing Models
Methodologies: ProRata / Direct Costing / Full Absorption / Svce Level Agmts ("SLA's")
Net Inc Before Taxes
Less: Capital Charge (EC * Hurdle Rate)Net Inc After Capital Charge ("NIACC")
I. Asset/Liability Management
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Achieve the desired trade-off between risk and return
Performance Measurement ("PM") Methodologies:
Interest Income Loan Interest Income FTP Credit for FundsLess: Interest Expense FTP Charge for Funds Deposit Interest Expense
Equals Net Int Income ("NII") FTP'd NII FTP'd NII
Less: Loan Loss Provision Expected Loss ("EL") + Chge OffsEquals Adjusted NII
Plus: Non Int. IncomeLess: Non Int. Expense
Equals Net Inc Before Taxes
Less: Income TaxesEquals Net Inc After Taxes
Divided by Equity Capital Capital Allocation Methodology
Equals Return on Equity ("ROE")
GAAP-Based Income Statement: PM-Based Income Statement
Regulatory (Advanced, Standard), EC Based
Product NIM, RAROC & NIACC = Bal Sheet Optimization
Income TaxesNet Inc After Taxes
Adjusted NII
Funds Transfer Pricing ("FTP")
Non Int Income/Expense Allocation Methodologies
U/W process creates grids for Pricing Models
Methodologies: ProRata / Direct Costing / Full Absorption / Svce Level Agmts ("SLA's")
Net Inc Before Taxes
Less: Capital Charge (EC * Hurdle Rate)Net Inc After Capital Charge ("NIACC")
I. Asset/Liability Management
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Achieve the desired trade-off between risk and return
I. Asset/Liability Management
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Loan Pricing Example
Loan A Loan B
Interest Income 5.00% 7.00%Interest Expense -2.00% -3.00% Net Int Income ("NII") 3.00% 4.00%Loan Loss Provision -0.20% -0.40% Adjusted NII 2.80% 3.60%
Non Interest Income 0.40% 0.40%Non Interest Expense -0.80% -1.00% Net Income Before Taxes 2.40% 3.00%
Income Taxes 33% -0.80% -1.00% Net Income After Taxes 1.60% 2.00%
Equity Capital 8.00% 16.00%
Return on Equity ("ROE") 20.00% 12.50%
I. Asset/Liability Management
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Loan Pricing Example
Loan A Loan B
Interest Income 5.00% 7.00%Interest Expense -2.00% -3.00% Net Int Income ("NII") 3.00% 4.00%Loan Loss Provision -0.20% -0.40% Adjusted NII 2.80% 3.60%
Non Interest Income 0.40% 0.40%Non Interest Expense -0.80% -1.00% Net Income Before Taxes 2.40% 3.00%
Income Taxes 33% -0.80% -1.00% Net Income After Taxes 1.60% 2.00%
Equity Capital 8.00% 16.00%
Return on Equity ("ROE") 20.00% 12.50%
I. Asset/Liability Management
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Loan Pricing Example
Loan A Loan B
Interest Income 5.00% 7.00%Interest Expense -2.00% -3.00% Net Int Income ("NII") 3.00% 4.00%Loan Loss Provision -0.20% -0.40% Adjusted NII 2.80% 3.60%
Non Interest Income 0.40% 0.40%Non Interest Expense -0.80% -1.00% Net Income Before Taxes 2.40% 3.00%
Income Taxes 33% -0.80% -1.00% Net Income After Taxes 1.60% 2.00%
Equity Capital 8.00% 16.00%
Return on Equity ("ROE") 20.00% 12.50%
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Financial Intermediation involves a bank’s use of its balance sheet to move funding from depositors (i.e., savers) to borrowers
Savers and borrowers do not know each other; they know only the bank
Liquidity Risk, Interest Rate Risk and Credit Risk are caused by the differing attributes of depositors and borrowers
Bank Risk Management
Depositors Bank Borrowers
Short term, floating rate $ Long term, fixed rate $
Liquidity Risk Credit Risk Interest Rate Risk
I. Asset/Liability Management
II. IRR – Definition
II. Interest Rate RiskInterest Rate Risk in the ALM Context means Adverse Impacts From Changes in Interest Rates On:
Economic Value of Equity(EVE)
Net Interest Income(NII)
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Represents major revenue source for commercial banks
Key area of focus for investor community
Current Income Focus
Based on the discounted Net Present Value (NPV) of the cash flows from all on and off balance sheet items
Not externally reported; indication of economic value
Extremely important concept many have not heard about
Long-Term Shareholder Focus
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Market Value of Equity (“MVE”)
Balance Sheet
Change in the Loan or Deposit mix Acquisitions, divestitures Hedging activity
Yield Curve
Change in the absolute level of rates Change in the steepness
Spread & Basis Risk
Impact of “risk on” vs. “risk off” Index used to price the funding differs from index used to price the asset
Option Risk
Adjustable rate loans with caps or floors Loans which give borrowers the right to prepay IMDs which allow depositors to withdraw funds at any time
II. IRR – Sources & Drivers
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II. IRR – Balance Sheet Composition Measuring the Interest Rate Gap
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Management can alter the rate sensitivity of the Balance Sheet based on desired objective. Objective: Approach: Reduce asset sensitivity Buy longer-term securities Lengthen the maturities of loans Move from floating-rate to fixed-rate loans Enter into a Receive-Fixed-rate swap position Increase asset sensitivity Buy short-term securities Shorten loan maturities Make more loans on a floating-rate basis Terminate an open Receive-Fixed-rate swap position Reduce liability sensitivity Attract longer-term deposits Issue long-term debt Increase liability sensitivity Attract short-term deposits
Borrow more via purchased liabilities
II. IRR – Balance Sheet Composition Levers to Manage the Position
A Tale of Two Banks
II. IRR - Example
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Re-pricing maintains spread and price stability
Normal Inverted
Flat
Potential Shapes
II. IRR - Yield Curve
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Actual Shapes
II. IRR - Yield Curve
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1.0
2.0
3.0
4.0
5.0
6.0
0 5 10 15 20 25 30
Inte
rest
Rat
e (%
)
Tenor (Years)
Steep Curve -- 28 Jul 2003
4.5
4.8
5.0
5.3
5.5
0 5 10 15 20 25 30
Inte
rest
Rat
e (%
)
Tenor (Years)
Inverted Curve -- 27 Nov 2006
6.0
6.5
7.0
7.5
8.0
0 5 10 15 20 25 30
Inte
rest
Rat
e (%
)
Tenor (Years)
Flat Curve -- 12 Jun 2000
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II. IRR - Yield Curve
Generally, the term structure of interest rates is upwardly sloping.
Yield curve reflects expectations -- Fed actions, growth/inflation rates, market supply and demand forces etc.
Yield curve movements can dramatically impact NII and MVE.
Recent Trends
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1
2
3
4
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US Swap Curve (%)
6/30/2010 6/30/2014 6/30/2015
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0.5
1.0
1.5
2.0
2.5
3.0
Swap Curve Steepness (%)
2Y vs. 5Y 2Y vs. 10Y
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II. IRR - Yield Curve Labor Market Trends
Inflation is well-below both the 2% long-term goal and 2.5% top end of FOMC’s target range. Energy prices keep headline inflation low; market-based expectations rise for the first time since Oct-2014. Sustained low inflation measures call into question when the timing of the first Fed Rate hike will occur.
Source: BEA, Moody’s Analytics
Inflation Trends
II. IRR - Yield Curve
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32 22 19 21 15 13 11 9 8 7
Jan-15
Mar-15
May-15
Jun-15
Aug-15
Oct-15
Nov-15
Jan-16
Mar-16
Expected First Fed Rate hike
II. IRR - Yield Curve
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The The Federal Reserve should wait until the first half of 2016 before raising interest rates because inflation remains too low and there are "significant uncertainties as to the future resilience of economic growth," per the IMF on 7/2/2015 in its annual review of the U.S. economy.
Fed Actions Since 1990
II. IRR - Yield Curve
23 Source: FRED, Federal Reserve Economic Data
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A/LM managers rely on a sensitivity framework to measure and monitor IRR.
Framework consists of “what-if” analysis of significant factors that affect IRR across a wide range of potential interest rate environments and business scenarios.
Uses include:
Limit compliance Inform/educate committee members Develop strategies
It is critical to highlight:
Key assumptions and Sensitivity of results
II. IRR Sensitivity
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The analysis includes the following 4 steps:
1. Scenario key inputs & assumptions: Base case rate scenario Current position, new volumes, contractual behavior Optionality (e.g., loan prepayments, deposits withdrawn early, rate caps/floors)
2. Identify major drivers: Assets and Liabilities that will re-price over different time horizons Off-balance sheet items that have cash flow implications
3. Calculate NII & MVE @ Risk under the base case rate scenario
4. Select a new interest rate forecast, re-run the model and compare to Base Case Impact of technology
II. IRR Sensitivity Process
90’s Forward
Advanced Measures
Gap Analysis
Crude Earnings
Simulations
More Robust NII Simulations; Static MVE
Multi-Dimensional NII & MVE Scenario
Analyses
1970’s
Indicators
1980’s
Estimates
Late 80’s - 90’s
Estimates and Measures
Process (continued)
Acc
urac
y &
Sop
hist
icat
ion
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II. IRR Sensitivity SURPRISES!
-6%
-4%
-2%
0%
2%
4%
6%
8%
Year 1 NII Sensitivity
Prior
Current
II. IRR – NII Sensitivity Scenario Results
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II. IRR – NII Sensitivity Scenario Results – “9 Box”
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SCENARIO: Rates Lower Most Likely Rates Higher
Volumes Lower
Base CaseBase Case-Most Likely
Volumes Higher
II. IRR – NII Sensitivity Scenario Results – “35 Box”
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SCENARIO: Down Shock
Flattener Most Likely Steepener Up Shock
Deposit Beta Lower
Deposit Growth Lower
Loan Growth Lower
Base Case Base Case-Most Likely
Loan Growth Higher
Deposit Growth Higher
Deposit Beta Higher
II. IRR – NII Sensitivity Scenario Results
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An effective A/LM process creates value by optimizing the risk/return tradeoff relative to a multitude of competing constraints!
Product Mix
Interest Rate Risk
Liquidity
Regulatory
Client Needs
Infrastructure Capabilities
III. Conclusion
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Aleem Gillani SunTrust Bank Al Kolesar SunTrust Bank Tony Santomero Citigroup
IV. Acknowledgements