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FMB1, ALM (ALM is the process to manage the mismatches that arise in the…
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ALM
ALM is the process to manage the mismatches that arise in the on-and-off balance sheet positions of the bank or a financial institution as a results of the intermediation provided to its clientsObjectives:
- Management of the Interest Rate risk in the banking book
- Management of Liquidity risk in both the trading and banking book
- Management of the FX risk in the banking book
- Manage regulatory and capital planning by focusing mainly on cost effective ways of raising capital
ALCO-Assets Liability Committee
Executive Management Committee of a bank tasked to evaluate, monitor and approve practises relating to market risk caused by funding-lending imbalances
PRINCIPLES OF A/L MGMT
Stay liquid: liquidity management
Make highest return for level of risk undertaken (asset management
Acquire funds at low cost: liability management
Have enough but not too much capital to undertake above: capital adequacy
Bank A/L management is typically performed by its ALCO
It operates just below the Board of Directors. The Committee is composed of senior management and representatives from major functional areas of the bank.
LIQUIDITY MANAGEMENT
- Have enough liquid assets to meet obligations to depositors at all times
- Stay liquid but not at too high a cost
- Liquid assets have ready market, have reasonably stable value and easily reversible (recover original investment with little risk of loss)
LIQUIDITY AND RESERVESExcess reserves are insurance against costs associated with deposit outflows Demands on liquidity arise from:Deposit withdrawals
Credit requests from customers bank wishes to keep
Obligations arising from bank borrowings
Tax payments
Dividend paymentsSupply of liquidityCustomer deposits
Customer loan servicing
Sale of marketable securitiesWhy banks may face liquidity problems
- Tendency to borrow short and lend long
- Sensitivity to interest rate changes: deposit withdrawals, withdrawals on previously approved loans, impact on market value of assets that can sell for cash, cost of bank borrowing
STRATEGIES
- Store liquidity on B/S
- Borrow to stay liquid
- Match assets and liability
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BANK RISKS
Risk Management: Systematically studying things that may go wrong and designing safeguards to minimize damage.
Credit risk: that wont get money back, or on time
Firm specific credit risk
Systematic credit risk – economy wide
Interest rate risk: that changes in interest rates will impact bank performance and value of assets
Interest income
Refinancing/re-pricing and reinvestment risk
Liquidity risk: meeting depositors’ demand for withdrawals
Operational risk: operating expenses may adversely affect the bank
Technology risk. Will technological investment produce anticipated results
Capital risk: exposure to other risks may render capital inadequate
Fraud risk: unsound banking practices by staff, employees or others may affect bank adversely
Off balance sheet risks: contingent assets and liabilities may affect future balance sheets
Foreign investment risk: foreign exchange exposure may adversely affect bank.
Foreign exchange risk and Country/Sovereign risk: not faced if operates domestically
Market activity risk: incurred when banks trade in assets, liabilities and derivatives to earn income, rather than for long-term.
COPING WITH RISK
Developing & Implementing program to deal with the risk
Risk Assumption: will bear losses. Must fully estimate potential losses; a function of financial capacity
Self Insurance: pool exposures; make arrangements to pay for losses/liability; pension funds pay-as-you go. No transfer of risk to an external party
Loss reduction: lower frequency or severity of losses
Risk Transfer: a feature of insurance
Hedging and leasing are also risk transfer arrangements
Regularly re-evaluating program
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LIABILITY MANAGEMENT
Take [some] control over sources of funds (quantity and cost) so as to be able to better manage assetsSTRATEGIESOffer different kinds of BANK LIABILITY PRODUCTSUse pricing mechanism – interest rate and other terms
- Raise Offer rates if needs more money
- Lower it otherwise
- (recall when forex bureaux could advertise their rates)
Borrow funds in the market placeLending decision precedes funding decisionAccept all loans and investments which return their costs and whose quality meets the bank’s credit standard. If deposits are not immediately available management should seek lowest-cost source of borrowed funds available”