A Chief Risk Officer’s Perspective
This article aims to illuminate certain key areas that are fundamental to the establishment and development of a robust and sustainable Enterprise Risk Management (ERM) function in banks. The main aim is to focus on the Asset and Liability Management (ALM) framework based on market experiences and some of the banks’ operating models. Failure to correctly emphasize these areas can have a detrimental effect on an organization.
What is ALM to a Chief Risk Officer (CRO)?
In the eyes of the CRO, ALM is the practice of comprehensively managing the various risks that arise due to mismatches between the assets and liabilities of the bank. Banks face several risks, such as those associated with assets, interest (or profit for Islamic financial institutions) fluctuations, and currency exchange risks. ALM is a tool to manage interest/profit rate risk in the banking book and the liquidity risk faced by banks. It also deals with aspects related to credit risk, as this also manages the impact of the entire credit portfolio (including cash, investments and loans) on the balance sheet. The credit risk, specifically in the loan portfolio, is handled by a separate risk management function (the Portfolio Risk Review (PRR) team), which is one of the main data contributors to the ALM team.
ALM is a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power and the degree of willingness to take on debt. It can also be known as surplus/contingency management.
How Can ALM Be Managed?
Business cycles are becoming aggressive, and global ecosystems and third-party risks are becoming increasingly complex. Regulations are rapidly changing, and compliance enforcement is becoming more stringent. All these factors will continue to create the perfect storm for ALM. In light of these dynamics, adopting an agile ALM framework with a broader perspective is an important step in its management.
Although objectives may differ depending on the circumstances, environment or political dynamics of the bank, the ALM framework had to address the following minimum strategic objectives:
(1) The bank should manage its asset cash flows in relation to its liability cash flows in a manner that contributes adequately to earnings and limits the risk to the financial margin, to the economic value of equity (EVE) (by managing both mark to market and net interest income) and to liquidity.
(2) Product terms, pricing and balance sheet mix must help manage banks’ product demands and the need to protect the equity of the bank.
(3) Most importantly, financial derivatives instruments must only be used to limit interest/profit rate risk and must never be used for speculative investment purposes.
ALCO Composition and Its Role
The Asset & Liability Management Committee (ALCO) is the forum where decisions are made regarding the management of structural mismatch, funding and capital management, as well as interest rates, liquidity (short and long term) and currency risk management regarding the assets and liabilities of the bank.
The role of ALCO and its impact is assessed proactively by stakeholders to achieve an effective and sustainable governance model. In fulfilling its responsibilities, ALCO will review and recommend the following policies, which shall be prepared and implemented by the management for the Board Risk Committee and the Board:
- Investment Policy
- Interest Rate Risk Policy
- Funds Transfer Pricing Policy
- Liquidity Policy
- Capital Policy
- Foreign Exchange Policy
- Asset/Liability Management Policy
The following points describe some of the key risks that are managed by ALCO. These objectives shall be pursued within the framework of the bank’s policies.
- Monitor the liquidity position and the management activities of the bank, including wholesale funding activities, contingency funding and any other relevant liquidity measurements the ALCO deems advisable or appropriate.
- Approve liquidity risk tolerances by reviewing how the bank’s inability to meet its obligations when due may affect the bank’s earnings, capital and/or operations.
Interest rate risk
- Monitor the management of interest rate risk activities and the bank’s overall interest rate risk profile.
- Monitor the sensitivity of the bank’s earnings under varying interest rate scenarios and potential changes in market interest rates.
- Monitor trends in the economy in general and interest rates in particular with a view to limiting any potential adverse impact on the bank’s earnings.
- Monitor the capital position of the bank and the capital management activities undertaken by the bank to ensure that capital levels are maintained in accordance with regulatory requirements and management directives.
- Monitor capital allocation to various lines of business.
Market risk (investments and derivatives)
- Monitor the management’s investment activities, such as purchase, sale, exchange and other disposition of the investments of the bank, including a review of management reports concerning current equity and debt security investment positions.
- Monitor compliance with both external regulations and the ALM Policy governing the bank’s investments and categories of investments, including requirements relating to composition, diversification, credit risk and yield.
- Review the status of the securities portfolios, including performance, appreciation or depreciation, quality, maturity profile and any actions taken by management with respect thereof.
- Review and determine whether to approve the holdings of investment securities (including prudent investments) that are subject to the ALCO’s authority to approve under the ALM Policy or Board of Directors’ resolutions.
- Review significant financial risk exposures facing the bank generally, and in its investment portfolios in particular, and the steps management is taking to monitor and control such exposures.
- Monitor compliance with the provisions of the ALM Policy and applicable standards relating to the management of counterparty credit risk, including, but not limited to, reviewing limits on counterparty exposure and reviewing limits on individual transactions based on risk.
- Approve objectives for the composition of on- and off-balance sheet positions.
- Review and approve procedures and systems the management has established to implement the Board’s objectives and limits for each portfolio, taking into account applicable laws, regulations and current accounting standards for each part of the portfolio.
Policy Management – Learn from the Best Practices
Based on the industry’s best practices, it is recommended that the banks adopt an ALM policy and a Risk Appetite Framework and Policy (RAF) that address the following, at a minimum:
- Limits on the maximum size of major asset/liability categories
- FTP and Capital Management/Allocation
- Pricing loans and deposits
- Correlating maturities and terms
- Controlling interest/profit rate risk and establishing interest/profit rate risk measurement techniques
- Controlling foreign currency risk
- Controlling the use of derivatives, management analysis and expert consultation for derivative transactions
From past experience, it has been noticed that the above recommended objectives have assisted banks to proactively manage a variety of risks.
The following are some useful suggestions on forming a good ALM policy based on industry best practices:
- Outline the role and duties of the Board of Directors and the ALCO, and who should be on the ALCO
- Provide for ongoing education for the Board and the ALCO
- Address all risks (not just interest rate risk)
- Place all measurements in an appendix to the policy for ease of making any changes
- When establishing a reporting mechanism for ALM, the reports should address all the guidelines in the ALM policy. Coordinate the references of the ALM policy to the other policies of the bank (Lending, Investments, Operations, etc.)
- The ALM policy should be guided in a way to deal with exceptions through corrective action under extraordinary circumstances.
By: Venkatesh Kallur
Chief Risk Officer – Finance House