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Bank Risk Management > CH7 - Test 3 > Flashcards

CH7 - Test 3 Flashcards

1
Q

Define: Asset and Liability Management (ALM)

A

A managerial process to address the risk faced by banks due to the
mismatch between its assets and liabilities

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2
Q

What does Asset and Liability Management (ALM) do?

A

Manages liquidity and interest rate risk
Help addresses capital adequacy
Assists the treasury department in liquidity and interest rate management process
Assist in hedging and compliance processes

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3
Q

What does ALM help with?

A

Helps to provide better cash flow and liquidity management and control over
NII (Net Interest Income), NIM and EVE (Economic Value of Equity) over the long-run

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4
Q

What are the two types of ALM frameworks?

A

Static
Dynamic

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5
Q

List the three approaches to
liquidity management (strategies) in banking

A

Asset liquidity management strategy
Liability management strategy
Funds management strategy

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6
Q

Explain: Asset liquidity management strategy

A

This strategy calls for storing liquidity in the form of liquid assets and selling them when liquidity is needed.

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7
Q

Explain: Liability management strategy

A

This strategy calls for the bank to purchase or borrow from the money market to cover all of its liquidity needs.

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8
Q

Explain: Funds management strategy

A

The combined use of liquid asset holdings (asset management) and borrowed
liquidity (liability management) to meet liquidity needs.

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9
Q

Explain: Static

A

Identifying and managing current existing risks to maximizing profits

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10
Q

Explain: Dynamic

A

Identifying and managing future events and to manage the mix of assets and liabilities

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11
Q

Define: Structure of interest rates

A

The difference in yields between various debt
instruments

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12
Q

Why do interest rates differ between securities?

A

The loanable funds framework focuses on a single risk free rate of interest

There are many securities with different features and varying degrees of risk

Debt instruments mature at different intervals, pay interest that may or may not be subject to income taxes, have call or put call options and may be convertible to common stocks

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13
Q

Define: Yield Curve

A

a diagram that compares the market yields on securities that differ only in terms of maturity

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14
Q

List: The three common theories of the term structure of interest rates

A
  1. the pure expectations theory (PET),
  2. the liquidity premium theory
  3. the market segmentation theory.
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15
Q

Define: Liquidity premium theory

A

Long term rates are an average of current and expected short term rate and liquidity premiums. The forward rate equals the expected rate plus a liquidity premium

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16
Q

What does the unbiased expectations theory assume?

A

assumes that securities that differ only in terms of maturity are perfect substitutes

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17
Q

Does the liquidity premium theory extent the unbiased expectations theory?

A

Yes, it extends the unbiased expectations theory by incorporating investor
expectations of price risk in establishing market rates

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18
Q

When will investors prefer short-term securities?

A

If the expected return on a series of short term securities equals the expected return on a long-term security

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19
Q

What determines the basic shape of the yield curve? How are forward and long term interest rates estimated?

A

expectations determines the basic shape of the yield curve, but the only difference is that a liquidity premium must also be incorporated in the estimations of the forward interest rate and long-term interest rates

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20
Q

What does the liquidity premium theory suggest?

A

Suggests that the forward rate can be decomposed into two parts: the expected future short term rate and the liquidity premium

21
Q

What happens when expected returns are the same on long term VS a series of short term securities?

A

borrowers must pay investors a risk premium to induce them to buy long term securities

22
Q

Liquidity premium theory: How are long term interest rates determined?

A

average of the current and expected short-term interest rates and the liquidity
premium.

23
Q

Liquidity premium theory: How are long term rates determined?

A

average of current rates, expected short-term rates, and liquidity premiums (r)

24
Q

Liquidity premium theory: How are forward rates determined?

A

expected rate plus a liquidity premium

25
Q

Liquidity premium theory problems

A

Firstly, even if the consensus is that the expected short-term interest rates will remain constant, the yield curve will always illustrate a positive slope due to the inclusion of a liquidity premium.

Secondly, the liquidity premium will cause an upward bias to long-term
interest rates compared to short-term interest rates, which imply that the
normal shape of the yield curve will always be positive under the liquidity
premium theory

Thirdly, the liquidity differences between long-term securities should
disappear, which is why the yield curve tends to flatten out over longer
maturities as the price risk decreases.

Finally, if the yield curve is inverted short-term interest rates are expected
to decline sharply, because as the maturity increases the liquidity
premium must also increase, which must be offset by the decrease in the
interest rate.

26
Q

Define: The ALCO process

A

The Asset and Liability management (ALCO), conducted by Executive Management, is the most strategic meeting for financial institutions where they deliberately posture the mix of assets and liabilities in anticipation of likely future events (1½) and the potential consequences to interest rate movements, liquidity constraints, foreign exchange exposure and capital adequacy.

27
Q

Steps in the ALCO process

A
  1. Review the previous month’s results
  2. Assess the current balance sheet
  3. project the exogenous factors
  4. Developing asset and liability strategies
  5. Stimulating asset and liabilities strategies
  6. Determining the most appropriate strategy
  7. Setting measurable targets
  8. Communicating the targets to the appropriate managers
  9. Monitoring the actions on a regular basis and evaluating success
  10. Meet weekly or monthly to determine if the current strategy is still appropriate
28
Q

What is the role of ALCO?

A

Responsible for the implementation of ALM and they set up guidelines and policies with regard to interest rate and liquidity risk for the banking
profile.

Make recommendations with respect to business policies

29
Q

Why is ALCO important?

A

It is the only process for strategic risk management in the bank.

It is important for managing the balance sheet.

It is important to inform board about the bank’s total risk profile

30
Q

List the two approaches that ALCO uses as a risk management tool

A

The interest rate sensitive gap analysis
Duration gap analysis

31
Q

Distinguish between Duration and Interest sensitivity gap

A

Duration - It is a measure of the average time needed to recover the
funds committed to an investment

Interest sensitivity gap - The interest sensitivity gap is the difference between the interest sensitive assets and interest sensitive liabilities of a bank in a certain time period.

32
Q

What does it mean when a bank is Asset-Sensitive?

A

Positive Interest-Sensitive Gap
Positive Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Greater Than One

33
Q

What does it mean when a bank is Liability-Sensitive?

A

Negative Dollar Interest-Sensitive Gap
Negative Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Less Than One

34
Q

Asset-Sensitive Bank : How does interest rates affect NIM?

A

Interest Rates Rise , NIM Rises

Interest Rates Fall, NIM Falls

35
Q

Liability-Sensitive Bank : How does interest rates affect NIM?

A

Interest Rates Rise , NIM Falls

Interest Rates Fall, NIM Rises

36
Q

Aggressive Interest-Sensitive Gap Management: How will rising market interest rates affect IS GAP? What is the most likely action?

A

When market interest rates rise, with Positive IS GAP, the most likely action will be to Increase interest sensitive assets and decrease interest sensitive liabilities

When market interest rates fall, with Negative IS GAP, the most likely action will be to decrease interest sensitive assets and increase interest sensitive liabilities

37
Q

Name the four approaches to change the interest rate sensitivity

A

Reduce asset sensitivity
Increase asset sensitivity
Reduce liability sensitivity
Increase liability sensitivity

38
Q

Elaborate: Reduce asset sensitivity

A

(1) Buy longer-term securities
(2) Lengthen the maturities on loans.
(3) Move from floating-rate loans to term loans.

39
Q

Elaborate: Increase asset sensitivity

A

(1) Buy short-term securities.
(2) Shorten loan maturities.
(3) Make more loans on a floating-rate basis.

40
Q

Elaborate: Reduce liability sensitivity

A

(1) Pay premiums to attract longer-term deposit instruments.
(2) Issue long-term subordinated debt.

41
Q

Elaborate: Increase liability sensitivity

A

(1) Pay premiums to attract short-term deposits instruments.
(2) Borrow more via non-core purchased liabilities

42
Q

Leverage adjusted duration gap (D): How will the change in interest rates affect the net worth? with a Positive D

A

With Positive D, and a rise in interest rates then net worth will decrease

With Positive D, and a fall in interest rates then net worth will increase

43
Q

Leverage adjusted duration gap (D): How will the change in interest rates affect the net worth? with a Negative D

A

With Positive D, and a rise in interest rates then net worth will increase

With Positive D, and a fall in interest rates then net worth will decrease

44
Q

Leverage adjusted duration gap (D): How will the change in interest rates affect the net worth? with D=0

A

With D=0, and a rise in interest rates then net worth will not change

With D=0, and a fall in interest rates then net worth will not change

45
Q

Application question: If the yield curve takes on a negative slope shape with a positive duration gap, specify what will happen with interest rates. Also, specify whether the bank’s market value of equity will decrease or increase. Then, compile an action plan on how the bank must go about immunizing its portfolio.

A

Awesome Bank has a positive duration gap, which implies that if interest rates decrease (which a downward sloping yield curve implies), the net worth of the bank will increase.

To immunize the portfolio, the duration gap must equal zero, thus the duration of liabilities should increase and the duration of assets should decrease.

46
Q

Application question: what is the best interest sensitive gap (IS-Gap) position to be in, when interest rates are expected to change and if the yield curve will take on the form of a negative slop? Also, formulate the most appropriate action plan in terms of the bank’s assets and liabilities if the interest rate were to increase

A

If market rates decrease the best interest sensitive position to be in is a negative IS-Gap. Aggressive management’s most likely action will be to decrease interest-sensitive assets and increase interest-sensitive liabilities.

If market rates were to increase - aggressive management’s most likely action will be to decrease interest-sensitive liabilities and increase interest-sensitive assets.

47
Q

Application question: What is an approach that has the ability to provide more insight to the bank on its interest rate risk exposure for both the intermediate and long-term position of the bank, while also highlighting the benefit of such a measure.

A

Economic value of Equity (EVE) approach can be used to determine the value of GNB in terms of today’s market interest rate environment and the sensitivity of that value to changes
in market interest rates.

One of the benefits of measuring EVE is that it captures changes in the economic value of the bank that may not always be reflected in the bank’s financial records.

48
Q

Application question: You are appointed as the head of MMZ Bank’s interest rate risk section. The bank currently uses duration gap analysis to manage their interest rate risk exposure. Explain the influence of interest rate changes when the duration gap is not zero and how you will go about immunizing the bank’s portfolio.

A

If the duration gap is positive:
-If interest rates rise, the net worth of the bank will decline
-if interest rate decrease, the net worth will increase.
-To immunize the portfolio, the duration gap must equal zero, thus the duration of assets should decrease, or the duration of liabilities should increase

If the duration gap is negative:
-If interest rates rise, the net worth of the bank will increase
-if interest rate decrease, the net worth will decrease.
-To immunize the portfolio, the duration gap must equal zero, thus the duration of assets should increase, or the duration of liabilities should decrease

Bank Risk Management (4 decks)

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