Managing gaps

The objective of this aspect of ALM, is to measure and then manage the direction and extent of any asset-liability mismatch, so as to maintain adequate profitability. The result will be expressed as a funding or "maturity gap" (see duration gap for discussion).

This exercise will have the joint objectives of balancing maturities, cash-flows and / or interest rates, for a particular time horizon. The management thus takes the form of:

• matching the maturities of loans and investments with the maturities of deposits, equity, and external credit; the techniques commonly employed are immunization and cashflow matching.
• managing the spread between interest rate sensitive assets and interest rate sensitive liabilities; see Corporate bond § Risk analysis and Yield spread § Yield spread analysis.

The above "static" gap analysis considers any future gaps due to current, i.e. existing, exposures, and any related exercise of (embedded) options - usually prepayments - at different points in time.

"Dynamic gap analysis" enlarges the scope by including "what if" scenarios, testing potential changes in business activity (new volumes, additional prepayment transactions, potential hedging transactions), and considering unusual interest rate scenarios, with their associated shape of the yield curve and resultant changes in pricing.

Depending on deal-stage and likelihood, analysts will incorporate expected capital investments and their required funding under either approach, as appropriate.

Actions to perform

• Determining the number or the length of each relevant time interval (time bucket)
• Defining the relevant maturities of the assets and liabilities where a maturing liability will be a cash outflow while a maturing asset will be a cash inflow (based on effective maturities or the 'liquidity duration': estimated time to dispose of the instruments in a crisis situation such as withdrawal from the business). For non maturity assets (such as overdrafts, credit card balances, drawn and undrawn lines of credit or any other off-balance sheet commitments), their movements as well as volume can be predict by making assumptions derived from examining historic data on client's behaviour.
• Slotting every asset, liability and off-balance sheet items into corresponding time bucket based on effective or liquidity duration maturity

In dealing with the liquidity gap, the bank main concern is to deal with a surplus of long-term assets over short-term liabilities and thus continuously to finance the assets with the risk that required funds will not be available or into prohibitive level.

Before any remediation actions, the bank will ensure first to :

1. Spread the liability maturity profile across many time intervals to avoid concentration of most of the funding in overnight to few days time buckets (standard prudent practices admit that no more than 20% of the total funding should be in the overnight to one-week period)
2. Plan any large size funding operation in advance
3. Hold a significant productions of high liquid assets (favorable conversion rate into cash in case distressed liquidity conditions)
4. Put limits for each time bucket and monitor to stay within a comfortable level around these limits (mainly expressed as a ratio where mismatch may not exceed X% of the total cash outflows for a given time interval)

Remediation actions

• A surplus of assets creates a funding requirement, i.e. a negative mismatch that can be financed
  • By long-term borrowings (typically costlier) : long-term debt, preferred stock, equity or demand deposit
  • By short-term borrowings (cheaper but with higher uncertainty level in term of availability and cost)  : collateralized borrowings (repo), money market
  • By asset sales : distressed sales (at loss) but sales induce drastic changes in the bank's strategy
• A surplus of liabilities over assets creates the need to find efficient uses for those funds, i.e. a positive mismatch that is not a wrong signal (generally a rare scenario in a bank as the bank always has a target return on capital to achieve and so requires funds to be put to work by acquiring assets) but only means that the bank is sacrificing profits unnecessarily to achieve a liquidity position that is too liquid. This excess of liquidity can be deployed in money market instruments or risk-free assets such as government T-bills or bank certificate of deposit (CDs) if this liability excess belongs to bank's capital (the ALM desk will not take the risk of putting capital in a credit-risk investment).

Asset-based funding sources

The asset contribution to funding requirement depends on the bank ability to convert easily its assets to cash without loss.

• Cash-flows : as the primary source of asset side funding, occur when investments mature or through amortization of loans (periodic principal and interest cash-flows) and mortgage-backed securities
• Pledging of assets: in order to secure borrowings or line commitments. This practice induces a close management of these assets hold as collateral
• Liquidation of assets or sale of subsidiaries or lines of business (other form of shortening of assets can be also to reduce new loans origination)
• Securitization of assets as the bank originates loans with the intent to transform into pools of loans and selling them to investors

Liability and equity funding sources

Assessment of possible funding sources

Funding requirement-liability sensitivity table

Main characteristics :

• Concentrations level between funding sources
• Sensitivity to interest-rate and credit risk volatility
• Ability and speed to renew or replace the funding source at favorable terms (evaluation of the possibility to lengthening its maturity for liability source)
• For borrowed funds, documentation of a plan defining repayment of the funds and terms including call features, prepayment penalties, debt covenants...
• Possible early redemption option of the source
• Diversification of sources, tenors, investors base and types, currencies and to collateralization requirements (with limits by counterparty, secured versus unsecured level of the market funding, instrument types, securitization vehicles, geographic market and investor types)
• Costs  : a bank can privilegiate interest bearing deposit products for retail clients as it is still considered as a cheap form of stable funding but the fierce competition between banks to attract a big market share has increased the acquisition and operational costs generated to manage large volume treatment (personnel, advertising...)

Dependencies to endogenous (bank specific events such as formulas, asset allocation, funding methods...) / exogenous (investment returns, market volatility, inflation, bank ratings...) factors that will influence the bank ability to access one particular source.

Setting for each source an action plan and assessment of the bank's exposure to changes

Once the bank has established a list of potential sources based on their characteristics and risk/ reward analysis, it should monitor the link between its funding strategy and market conditions or systemic events.

For simplification, the diversify available sources are divided into 3 main time categories:

• Short-term
• Medium-term
• Long-term period

Key aspects to take into account :

1. Assessment of the likehood of funding deficiencies or cost increase across time periods. In case for example, position on the wholesale funding, providers often require liquid assets as collateral. If that collaterals become less liquid or difficult to evaluate, wholesale funds providers may arbitrate no more funding extension maturity
2. Explanation of the objective, purpose and strategy behind each funding source chosen  : a bank may borrow on a long-term basis to fund real estate loans
3. Monitoring of the bank capacity to raise each funds quickly and without bad cost effects as well as the monitoring of the dependence factors affecting its capacity to raise them
4. Maintenance of a constant relation with funding market as market access is critical and affects the ability to both raise new funds and liquid assets. This access to market is expressed first by identification and building of strong relationships with current and potential key providers of funding (even if the bank is soliciting also brokers or third parties to raise funds)
5. As a prudent measure, the choice of any source has to be demonstrated with the effective ability to access the source for the bank. If the bank has never experienced to sold loans in the past or securitization program, it should not anticipate using such funding strategies as a primary source of liquidity

Liquidity reserve or highly liquid assets stock

This reserve can also referred to liquidity buffer and represents as the first line of defense in a liquidity crisis before intervention of any measures of the contingency funding plan. It consists of a stock of highly liquid assets without legal, regulatory constraints (the assets need to be readily available and not pledged to payments or clearing houses, we call them cashlike assets). They can include  :

• High grade collateral received under repo
• Collateral pledged to the central bank for emergency situation
• Trading assets if they are freely disposable (not used as collateral)

Key actions to undertake :

1. To maintain a central data repository of these unencumbered liquid assets
2. To invest in liquid assets for purely precautionary motives during normal time of business and not during first signs of market turbulence
3. To apply, if possible (smaller banks may suffer from a lack of internal model intelligence), both an economic and regulatory liquidity assets holding position. The LCR (Liquidity Coverage Ratio), one of the new Basel III ratios in that context can represent an excellent 'warning indicator' for monitoring the dedicated level and evolution of the dedicated stock of liquid assets. Indeed, the LCR addresses the sufficiency of a stock of high quality liquid assets to meet short-term liquidity needs under a specified acute stress scenario. It identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute 30-days stress scenario specified by supervisors. In light of the stricter LCR eligible assets definition, the economic approach could include a larger bulk of other liquid assets (in particular in the trading book)
4. To adapt (scalability approach) the stock of the cushion of liquid assets according to stress scenarios (scenarios including estimation on loss or impairment of unsecured/ secured funding sources, contractual or non contractual cash-flows as well as among others withdrawal stickiness measures). As an example, a bank may decide to use high liquid sovereign debt instruments in entering into repurchase transaction in response to one severe stress scenario
5. To evaluate the cost of maintening dedicated stock of liquid assets portfolio as the negative carry between the yield of this portfolio and its penalty rate (cost of funding or rate at which the bank may obtain funding on the financial markets or the interbank market). This negative carry of this high liquid portfolio assets will be then allocated to the respective business lines that are creating the need for such liquidity reserve

Identification of plausible stress events

Bank specific events : generally linked to bank's business activities and arising from credit, market, operational, reputation or strategic risk. These aspects can be expressed as the inability  :

• To fund asset growth
• To renew or replace maturing liabilities
• To use off-balance sheet commitments given
• To hold back unexpected large deposit withdrawals

External events :

• Changes in economic conditions
  • Changes in price volatility of securities
  • Negative press coverage
  • Disruption in the markets from which the bank obtains funds

Estimation of the severity levels, occurrence and duration of those stress events on the bank funding structure

Examples of Contingent Funding Plan stress events

This assessment is realised in accordance with the bank current funding structure to establish a clear view on their impacts on the 'normal' funding plan and therefore evaluate the need for extra funding.

This quantitative estimation of additional funding resources under stress events is declined for:

• Each relevant level of the bank (consolidated level to solo and business lines ones)
• Within the 3 main time categories horizon : short-term (focus on intraday, daily, weekly operations), medium to long-term

In addition, analysis are conducted to evaluate the threat of those stress events on the bank earnings, capital level, business activities as well as the balance sheet composition.

The bank need, in accordance, to develop a monitoring process to :

• Detect early sign of events that could degenerate into crisis situation through set of warning indicators or triggers
• Build an escalation scheme via reporting and action plan in order to provide precautionary measure before any material risk materialized

Overview of potential and viable contingent funding sources and build up of a central inventory

Such inventory includes :

• The dedicated liquidity reserve (stock of highly liquid assets that can follow the Basel III new liquidity ratios LCR/ NSFR strict liquid asset definition)
• Other unencumbered liquid assets (i.e.,those contained in the trading book) and in relation to economic liquidity reserve view. They can represent :
  • Additional unsecured or secured funding (possible use of securities lending and borrowing)
  • Access to central bank reserves
  • Reduction plan of assets
  • Additional sale plan of unencumbered assets

Determination of the contingent funding sources value according to stressed scenario events

• Stressed haircut applied
• Variation around cash-flow projection
• Erosion level of the funding resources
• Confidence level to gain access to the funding markets (tested market access)
• Monetization possibility of less liquid assets such as real-estate or mortgage loans with linked operational procedures and legal structure to put in place if any (as well as investor base, prices applied, transfer of servicing rights, recourse debt or not)

Setting of an administrative structure and crisis-management team

The last key aspect of an effective Contingency Funding Plan relates to the management of potential crisis with a dedicated team in charge to provide :

• Action plan to take during a given level of stress
• Communication scheme with counterparties, large investors, Central Bank and regulators involved
• Reports and escalation process
• Link with other contingent activities such as the Business Continuity Planning of the bank

ALM report

Funding report summarises the total funding needs and sources with the objective to dispose of a global view where the forward funding requirement lies at the time of the snapshot. The report breakdown is at business line level to a consolidatedone on the firm-wide level. As a widespread standard, a 20% gap tolerance level is applied in each time bucket meaning that gap within each time period defined can support no more than 20% of total funding.

• Marginal gap : difference between change in assets and change in liabilities for a given time period to the next (known also as incremental gap)
• Gap as % of total gap : to prevent an excessive forward gap developing in one time period

Funding cost allocation or Fund Transfer Pricing concept

The effect of terming out funding is to produce a cost of funds, the objective is to :

• Set an internal price estimation of the cost of financing needed for the coming periods
• Assign it to users of funds

This is the concept of Fund Transfer Pricing (FTP) a process within ALM context to ensure that business lines are funded with adequate tenors and that are charged and accountable in adequation to their current or future estimated situation.