Chapter 7

ASSET AND LIABILITY MANAGEMENT III: THE ALCO

The third and final strand of our look at bank ALM considers the reporting process, often overseen by the asset–liability management committee (ALCO). The ALCO has a specific remit to oversee all aspects of asset–liability management, from the front-office money market function to back-office operations and middle-office reporting and risk management. In this chapter we consider the salient features of ALCO procedures.

ALCO policy

The ALM reporting process is often overseen by the bank’s ALCO. It is responsible for setting and implementing ALM policy. Its composition varies in different banks but usually includes heads of business lines as well as director-level staff such as the finance director. It also sets hedging policy.

Typical membership of the ALCO is as follows:

The ALM process may be undertaken by the Treasury desk, the ALM desk or other dedicated function within the bank. In traditional commercial banks it will be responsible for management reporting to the ALCO. The ALCO will consider the report in detail at regular meetings, usually monthly. The main points of interest in the ALCO report include variations in interest income, the areas that are experiencing fluctuations in income and the latest short-term income projections. The ALM report will link these three strands across the group as a whole and to each individual business line as well. That is, it will consider macro-level factors driving variations in interest income as well as specific desk-level factors. The former include changes in the shape and level of the yield curve, while the latter include new business, customer behaviour and so on. Of necessity the ALM report is a detailed, large document.

Table 7.1 is a summary overview of the responsibilities of ALCO.

Table 7.1 ALCO main mission bank ALM strategic overview

The ALCO will meet on a regular basis; the frequency depends on the type of institution but is usually once a month. The composition of the ALCO varies by institution but may comprise the heads of Treasury, trading and risk management, as well as the finance director. Representatives from the credit committee and loan syndication may also be present. A typical agenda would consider all the elements listed in Table 7.1. Thus, the meeting will discuss and generate action points on the following:

• Management reporting – this will entail analysing various management reports and either signing them off or agreeing items to be actioned. The issues to consider include lending margin, interest income, variance from last projection, customer business and future business. Current business policy with regard to lending and portfolio management will be reviewed and either continued or adjusted.
• Business planning – existing asset (and liability) books will be reviewed, and future business directions drawn up. This will consider the performance of existing business, most importantly with regard to return on capital. The existing asset portfolio will be analysed from a risk–reward perspective, and a decision taken to continue or modify all lines of business. Any proposed new business will be discussed and – if accepted – in principle will be moved on to the next stage.1 At this stage any new business will be assessed for projected returns, revenue and risk exposure.
• Hedging policy – overall hedging policy will consider acceptable levels of risk exposure, existing risk limits and use of hedging instruments. Hedging instruments also include derivative instruments. Many bank ALM desks find that their hedging requirements can be met using plain vanilla products such as interest rate swaps and exchange-traded short-money futures contracts. The use of options and especially vanilla instruments such as FRAs2 is much lower than one might think. Hedging policy takes into account the cash book revenue level, current market volatility levels and the overall cost of hedging. On occasion, certain exposures may be left unhedged because the costs associated with hedging them are deemed prohibitive (this includes the actual cost of putting on the hedge as well as the opportunity cost associated with expected reduced income from the cash book). Of course, hedging policy is formulated in coordination with overall funding and liquidity policy. Its final form must consider the bank’s views of the following:
  • expectations on the future level and direction of interest rates;
  • balancing the need to manage and control risk exposure with the need to maximize revenue and income;
  • level of risk aversion, and the level of risk exposure the bank is willing to accept.

The ALCO is dependent on management reporting from the ALM or Treasury desk – reports may be compiled by the Treasury middle office. The main report is the overall ALM report, showing the composition of the bank’s ALM book. Other reports will look at specific business lines and consider the return on capital generated by these businesses. These reports will need to break down aggregate levels of revenue and risk by business line. Reports will also drill down by product type across business lines. Other reports will consider the gap, gap risk, the VaR or DV01 report and credit risk exposures. Overall, the reporting system must be able to isolate revenues, return and risk by country sector, business line and product type. There is usually an element of scenario planning as well, which is expected performance under various specified macro-level and micro-level market conditions.

Figure 7.1 illustrates the general reporting concept.

Figure 7.1 ALCO reporting input and output.

ALCO reporting

We now provide a flavour of the reporting that is provided to and analysed by the ALCO. This is of course a generalization – reports will vary by type of institution and the nature of its business.

In Chapter 5 we showed an example of a macro-level ALM report. The ALCO will also consider macro-level gap and liquidity reports compiled for product and market. The interest rate gap – simply the difference between assets and liabilities – is easily set into these parameters. For management reporting purposes the report will attempt to show a dynamic profile, but its chief limitation is that it is always a snapshot of a fixed point in time, and therefore – strictly speaking – will always be out of date.

Figure 7.2 shows a typical dynamic gap, positioned in a desired ALM ‘smile’, with projected interest rate gaps based on the current snapshot profile. This report shows future funding requirements, on which the ALCO can give guidance reflecting its view on future interest rate levels. It also shows where sensitivity to falling interest rates, in terms of revenue, lies because it shows the volume of assets. Again, the ALCO can give instructions on hedging if it expects interest income to be affected adversely. The -axis indicates time buckets from overnight out to 2 years or more. Banks use different time buckets to suit their own requirements.3

Figure 7.2 ALM, expected liquidity and interest rate gap snapshot profile.

Figure 7.3 shows the same report broken down by product (or market – the report would have a similar layout). We use a hypothetical sample of different business lines. Using this format the ALCO can observe which assets and liabilities are producing the gaps; this is important because it shows if products (or markets) are fitting into overall bank policy. Equally, policy can be adjusted if required in response to what the report shows. So, the ALCO can see what proportion of total assets is represented by each business line, and which line has the greatest forward funding requirement. The same report is shown again in Figure 7.4, but this time the breakdown is by type of interest rate: fixed or variable.

Figure 7.3 ALM breakdown by product (or market) segment.

Figure 7.4 ALM breakdown by type of interest rate.

Another variation of this report under the scrutiny of the ALCO is a breakdown by income and margin, again separated into business lines or markets as required. In a purely commercial banking operation the revenue type mix will comprise the following (among others):

• the bid–offer spread between borrowing and lending in the interbank market;
• corporate lending margin – that is, the loan rate over and above the bank’s cost of funds;
• trading income;
• fixed fees charged for services rendered.

The ALCO will receive an income breakdown report, split by business line. The -axis in such a report would show the margin level for each time period; that is, the margin of the lending rate over the cost of funds by each time bucket. Figure 7.5 is another type of income report, which shows volumes and income spread by business line. The spread is shown in basis points and is an average for that time bucket (across all loans and deposits for that bucket). Volumes will be those reported in the main ALM report (Figure 7.2) but this time with margin contribution per time period. As we might expect, the spread levels per product across time are roughly similar. They will differ more markedly by product time. The latter report is shown at Figure 7.6 (see next page), which is more useful because it shows the performance of each business line. In general, the ALCO will prefer low volumes and high margin as a combination, because lower volumes consume less capital. However, some significant high-volume business (such as interbank money market operations) operates at a relatively low margin.

Figure 7.5 Asset profile volume and average income spread.

Figure 7.6 Business lines and average income spread.

The income and return reports viewed by ALCO are necessary for it to check whether bank policy with regard to lending and money market trading is being adhered to. Essentially, these reports provide information on the risk–return profile of the bank. The ideal combination is the lowest possible risk for the highest possible return, although of course low-risk business carries the lowest return. The level of tradeoff at which the bank is comfortable is what the ALCO will set as its direction and strategy. With regard to volumes and bank business, it might be thought that the optimum mix is high volume mixed with high income margin. However, high-volume business consumes the most capital, so there will be another tradeoff with regard to the use of capital.

1 New business will follow a long process of approval, typically involving all the relevant front-office, middle-office and back-office departments of the bank and culminating in a ‘new products committee’ meeting at which the proposed new line of business will be either approved, sent back to the sponsoring department for modification or rejected.

2 See Chapter 4.

3 For example, a bank may have just the ‘overnight’ time bucket or may incorporate it into an ‘overnight to 1-week’ period. Similarly, banks may have each period from 1 month to 12 months in their own separate buckets or may place some periods into combined time periods. There is no single ‘correct’ way.