Liquidity risk (the potential for loss to the organization arising from either its inability to meet its financial obligations as they fall due or to fund increases in assets without incurring unacceptable loss) is considered one of the major risks for financial institutions.
The primary responsibility of the Liquidity Risk Manager is, therefore, to maintain adequate liquidity at all times so that the bank is in a position (in the normal course of business) to meet all its obligations, to repay depositors, to fulfill commitments to lend and to meet any other commitments it may have made. Further, they must plan for unforeseen events that may cause a liquidity crisis.
The ALM Section enables the liquidity risk manager to identify potential liquidity risk and areas of vulnerability by providing the following functionality:
Liquidity risk is measured by conducting an analysis of net funding requirements, which is determined by analysing future cash flows based on the assumptions about changes in rates an the expected behaviour of assets and liabilities, as well as off-balance sheet items.
In its essence, the “engine room” of the Treasury Platform is the modelling of these future cash flows. By running (an unlimited number of) different rate view / strategy / behavioural combination models, the ALM Section evaluates the results under different scenarios, namely going concern / business as usual and stress situation. Each scenario will consider significant positive and negative liquidity
movements that could occur.
The ALM Section not only measures and reports on mismatches between assets and liabilities on a contractual basis (to meet Regulatory reporting requirements).
In practice, current accounts and savings deposits are not withdrawn the next day and overdrafts are not repaid on demand. The ALM Section caters for this “real life” situation by also calculating these mismatches on a ‘business as usual’ basis. The “business as usual” mismatch calculation predicts future cash flow patterns based on past behavioural patterns as specified by the user.
In addition to mismatch calculations, the ALM Section allows the user to calculate “net liquid assets”, which the difference between liquid assets and volatile liabilities within the portfolio. This is referred to as the liquidity gap. The ALM Section offers facilities for stress testing, in order to assess the extent of the bank’s exposure to liquidity risk. To determine net liquidity under stressed conditions, liquidity outflow is quantified for each scenario, and cash inflows to mitigate liquidity shortfalls are identified.
This also assists the Liquidity Risk manager in assessing adequacy of liquidity cushion and contingency funding. Sound liquidity risk management requires that sources of available funds must be diversified in order for the organisation to capitalise on changes in market conditions and to be more resilient in tight market conditions. The ALM Section allows for the modelling of any combination of funding sources, to see the effect of different funding mixes.
The ALM Section ensures that modelling of future cash flows meet all existing (or perceived future) regulatory requirements in terms of minimum liquid asset holdings. The ALM Section enables continuous monitoring of liabilities (e.g. deposits from the public) to assess the bank’s ability to raise funds. Future cash flow projections calculate and highlight the funding shortfall or surplus (for each month in the modelling horizon) that will result from each modelling scenario.
The ALM Section offers the following standard Liquidity reports:
Furthermore, by virtue of the fact that all modelling results are stored on a database in the Treasury Platform, it allows the Liquidity Risk manager to create an unlimited number of user-defined reports using its powerful report writer.
Examples of reports that can be generated using this facility:
By defining reports in the ALM Section the Liquidity Risk manager can create a report suite that will serve as early warning monitor for liquidity concerns such as:
By virtue of the fact that an unlimited number of future scenarios can be modelled in the ALM Section, stress testing can be conducted to assess the ability of the bank to withstand stressed liquidity conditions and to determine how it will cope in such a situation. This allows for the identification of expected losses and assessing the impact of unlikely but still plausible events. Stress testing in the ALM Section allows for any (user-specified) upward and downward basis point rate shock. Stress
tests can also be performed to measure the effect of any (user-specified) reduction in deposit base.
The ALM Section’s “what-if” scenario modelling facilities can also model the effects of different potential sources of funding available, e.g.
Interest rate risk is the risk that the company will experience deterioration in its financial position as interest rates move over time. The ALM Section enables the IRR manager to identify, measure and monitor the following sources of interest rate risk:
The following standard IRR reports are available in the ALM Section:
A myriad of stress testing facilities exists on the platform to provide information on the kinds of conditions under which the bank’s strategies would be most vulnerable. Examples include:
By modeling different strategies, the ALM Section will enable the IRR manager to minimize risk while maximizing earnings and net worth. This is done by means of measuring the projected earnings for different product mixes, with strategies such as:
The ALM Section will identify the appropriate strategy, which will depend on the current level of risk, the time frame, and the current interest rate environment, as a strategy for an expected increasing interest rate cycle will not be appropriate for a decreasing interest rate cycle.
Foreign exchange (“FX”) risk management may be defined as managing exposure to adverse exchange rate fluctuations within an acceptable range at an acceptable cost. The ALM Section allows the FXR manager to model an unlimited number of foreign exchange rate views. These can be defined for all of the currencies that the bank are currently trading in, as well as currencies which are considered for future trading. As is the case with Interest Rate Risk modeling, the ALM Section calculation engine will produce results for strategies based on any number of FX rate views to measure the effect of changes in exchange rates on future projected cash flows.
The ALM Section allows the modeller to define each product in terms of a selected currency and thus reporting is done taking cognizance of current and future FX rates. This allows for reporting based on (current and projected future) cash flows as converted to the base currency. The user can specify currency conversions as direct (e.g. 1 ZAR = 0.1 EURO) or indirect (e.g. 1 USD = 6 ZAR). In a multi-currency model, all reports (standard ALM Section reports as well as user-defined reports) can be produced for one or more selected currencies only. This enables the FX Risk manager to analyze that portion of their portfolio (or the whole book) that pertains to one currency only, so as see the effect of perceived changes in FX rates on the cash flows (and future profitability of the bank).
The ALM Section also caters for the following FX derivatives to measure their effectiveness in terms of hedging FX risk:
These deals can be specified as off-balance sheet items so as not to affect the future balance sheet projection reports. The ALM Section calculates (and reports on) swap costs and accumulated interest swap costs (for FX swaps) and premium costs (for FECs) are calculated. To further assist the FX Risk manager in evaluating possible hedges, the ALM Section offers the facility to view each hedging contract in terms of: For FX swaps:
The effect of changes in future exchange rates (FX risk) is reflected in each of the standard risk reports in the ALM Section. In addition, the ALM Section has a standard Hedge Effectiveness report, which shows:
The ALM Section is effectively a management decision support system that will provide the Finance Department with the capability to do inter alia the following:
The ALM Section allows its user to simulate an indefinite number of Balance Sheets, Income Statements, Cash flow statements and User-Defined Reports into the future.
The YTD figures can be used for the following:
The major advantage of using the ALM Section is the quantification of management decisions, for example, the volume of time (fixed) deposits by tenure required on a monthly basis or the new business (production) to be written on mortgages on a monthly basis.
The ALM Section allows management to analyze the impact of any defined (internal) or external (interest and currency rates) factors on funding requirements, debt management, and cash flow.
The ALM Section is an integrated system complying with general acceptable accounting principles. This allows the user to refer to any of the financial report lines and specific variables.
The ALM Section has a vast number of standard reports besides the risk and financial reports covered above providing the following type of management information:
The ALM Section can do funds transfer pricing (FTP). FTP refers to:
Future cash flows of all instruments are “present valued” at a rate determined by a yield curve. For a product with an indeterminate maturity date (such as “standard products”), the future flows are not considered. Instead, the product’s capital (face value) is taken as the fair value. Fair value calculations in the ALM Section are very much influenced by the type of interest calculation that is set by the user. The setting of fair value calculations in the ALM Section is based on the selection of the mark-to-market calculation.
Within the ALM Section the following instrument types are specifically influenced by this of type calculation, namely:
In essence, the budgeting process is the primary strategy for achieving the organisation’s objectives – be it growth, maximising profit, achieving sales targets, or any combination thereof. Underpinning the budgeting process is the production requirements for meeting the budget. It is essential that those who are responsible for managing production (sales) and controlling expenses, understand what the capital requirements are in order to “make the budget”. A budget is said to be “out of date” as soon the first set of actual results become available. As such, it requires performance measuring on a regular basis and access to information such as:
Adjusting the budget is a reality. It is no use to ignore variances (between the actual results and budget/targeted), or to be unrealistic in believing that those variances will somehow disappear. Early warning signals should be recognised and strategies put in place to address the variances. Most
importantly, senior management must be forewarned as soon as it becomes clear that targets may not be achieved. Modern budgeting techniques make extensive use of modelling for the forward projection of the organisation’s Balance sheet, Income statement and Cash flow statement to see what the financial effects will be if the budget targets are reached. Best-practice models will allow the comparison of different strategies for reaching the targets and measuring the effectiveness of each planned strategy.
In order to refrain from repeating most of the items listed above which could very well be used in the
corporate and institutional department it might be worth highlighting some aspects such as: