Day One
How To Run An ALM Optimisation
Introduction
Traditional Asset & Liability Management (ALM) – managing interest rate risk in the banking book (IRRBB), liquidity risk, FX risk and capital risk to comply with risk appetite
What is Economic Value Added (EVA)?
Comparison of accounting profit, ROE, RAROC and EVA. Relationships between them
Moving from traditional ALM (narrower risk management focus) to active balance sheet optimisation to maximise EVA
How assets and liabilities compete for utilization of limits (across capital, liquidity, leverage and other constraints)
ALM as a constrained optimisation problem. Objective: Choose balance sheet assets and liabilities to maximize EVA (or objective variable of choice). Constraint: Subject to balance sheet complying with all external (regulatory) and internal constraints specified. Management actions – move from current balance sheet to ALM optimised one
Why manage balance sheet to maximise EVA?
EVA Calculation
Which capital requirement and cost of capital to use for measuring EVA
Measuring cost of equity and Common Equity Tier 1 (CET1) required
EVA as an extension of funds transfer pricing (FTP)
FTP – motivation; interest rate risk term premium (IRRTP), term liquidity premium (TLP) and liquidity premium (LP); matched maturity and marginal cost principles; FTP curve choices; curve frequency updates; use of cross-currency basis swaps for FTP of non-base currency denominated assets and liabilities
Case Study 1 – Calculation of FTP on: customer loans, customer deposits, off-balance sheet facilities, repo-funded trading book bond positions and derivatives
Calculating EVA – EVA-based customer loan pricing
Case Study 2 – Calculation of EVA-breakeven interest rates and EVA on: customer loans, customer deposits, off-balance sheet facilities. Calculation of EVA on: repo-funded trading book bond positions and derivatives
Case Study 3 – Behavioural modelling of non-maturity deposits for FTP and EVA (and for IRRBB)
EVA Considerations
Aggregation levels at which to measure EVA
Issues to consider when using EVA as performance measure and / or as capital allocation input – cross-subsidisation; temporarily negative EVA; whether to allocate or not the diversification benefit within CET1 requirement to business units, products or customers
Case Study 4 – Reading an EVA analysis of EVA by business unit, product and key customers. Implications for capital allocation, business plan, ICAAP and likely ALM actions to expect from optimisation exercise
Specifying Balance Sheet Constraints
External regulatory constraints – capital ratio requirements and buffers (Pillar 1: CET1, Tier 1, total capital; Pillar 2 Requirement; combined buffer – capital conservation buffer, systemic buffer, countercyclical buffer; Pillar 2 Guidance); bail-inable liabilities requirements (TLAC and MREL); liquidity requirements (LCR, NSFR); leverage ratio
Internal constraints – internal management headroom vs regulatory constraints. Ensuring own risk appetite is factored in on top of external regulatory constraints
Internal constraints – additional common constraints specified in respect of:
Δ EVE (worst change in economic value of equity under Basel 6 IRRBB shock scenarios) as % of Tier 1 capital (not a hard regulatory requirement)
Δ NII (worst change in annual net interest income under Basel 6 IRRBB shock scenarios) as % of baseline annual NII
Diversification – upper and lower bounds to amount of each asset and liability category
Minimum liquidity buffer survival horizon under worst of internal liquidity stress tests
Level of asset encumbrance
Maximum capital ratio deterioration in capital stress test
Running ALM Optimisation
Case Study 5 – Numerical worked example – ALM optimisation for a universal bank with significant trading book activity facing higher market risk capital requirements under FRTB. Management actions, resulting EVA increase and check constraints satisfied
Case Study 6 – Numerical worked example – ALM optimisation for a retail bank anticipating term structure steepening. Management actions, resulting EVA increase and check constraints satisfied
Circumstances in which multiple iterations of optimisation may be needed
Case Study 7 – Numerical worked example – ALM optimisation with maximum permitted capital ratio deterioration in capital stress test set as constraint
Day 2
How ALM Optimisation Is Applied In Practice
From Optimisation Model To ALCO Decision-Making
Stress-testing EVA by applying shocks to optimised balance sheet (e.g. shocks to interest rates, NMD behaviouralised model parameters, funding spreads, ECL provisions and downward credit migration, prepayments, off-balance sheet facility drawdowns)
Robust ALM optimisation when EVA is maximised under baseline and resiliently high across stress scenarios
Case Study 8 – Numerical worked example – Stress-testing EVA of balance sheets optimised in Case Studies 5 & 6
ALCO decision-making. Management overlays: strategy, model risk, execution capacity, customer behaviour, market liquidity and reputation
Why EVA maximisation is part science and part art – management actions recommended by ALM optimisation take time to implement, whilst optimal balance sheet can change during implementation as market pricing evolves
Measuring marginal EVA impact of relaxing a constraint. How does bank set its risk appetite and under what conditions could it reasonably be changed?
Real Bank Case Studies & Results From EVA Optimisation
Typical management actions to improve EVA
Case Study 9 – Challenger bank. ALM optimisation: business model pivot to address negative EVA arising from using Standardised Approach (SA) for credit risk capital vs competitors on Internal Ratings Based Approach (IRB) and high fixed cost base
Case Study 10 – GSIB. ALM optimisation: trading book business model adaptation in response to escalating capital requirements post Basel 2.5 (introduction of CVA volatility capital requirement and inclusion of stressed VAR, Comprehensive Risk Measure and Incremental Risk Charge in market risk capital requirement) and in anticipation of Fundamental Review of Trading Book (FRTB) – shift to asset-specific (longer) liquidity horizons, stressed expected shortfall and default risk charge
Case Study 11 – DSIB. ALM optimisation: synthetic risk transfer transactions to reduce CET1 required and capital volatility from IFRS 9 ECL provisioning
Case Study 12 – ALM optimisation results. To what extent have our banking clients seen EVA and ROE improvement?
Other ALM optimisation use cases:
What to do when CET1 is tight
What to do if price competition for deposits is high
High Quality Liquid Assets (HQLA) optimisation
What to do when IRRBB Δ EVE as % of Tier 1 capital is close to or beyond 15% supervisory outlier test
Understanding Product Level & Customer Level EVA And Cross-Subsidisation
Case Study 13 – Illustrative product level EVA on: current accounts; other non-maturity deposits; residential mortgages; credit cards; consumer unsecured loans; SME loans; corporate loans; derivative hedging for corporates. Understanding product level cross-subsidisation relationships
Case Study 14 – Illustrative customer level EVA for: retail customer; corporate customer. Understanding cross-subsidisation across a customer’s full range of products
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