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Asset Liability Management CEO Letter

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Published: 2nd February 2011 by William Webster

On 17th January 2011 the FSA released a "Dear CEO letter" on Asset & Liability Management.  So what are the "good practices" that are recommended in order to make your ALM function more effective?  Here are 20 of the main points.

  1. What's does the AL committee manage? The balance sheet. Particularly liquidity, funding and interest rate risk in the banking book. Although the remit can go much wider to include capital, RWA, market and credit risk.
  2. What's the purpose? To ensure ALM risks are within the Board's appetite and to identify and assess the cause of earnings volatility, (eg competition and margin pressure).
  3. Who's there? Effective ALM committees are attended or chaired by the CEO or CFO. Business line heads are present as are the Treasurer, Chief Risk Officer, Heads of Market Risk and ALM, the Chief Economist and Head of Internal Audit. In small firms NEDs may also attend.
  4. Reporting past performance should not preoccupy ALM. Focus should be on how future plans and strategy affect assets and liabilities and in turn influence the risks being run. Action should be taken by the ALM committee to manage forward risks that lie outside the firm's risk appetite and before they become a reality. This may include escalation to a higher committee (eg EXCO or Board).
  5. Decision making is improved when senior ALM committee members listen to the debate rather than influence it at an early stage. The debate may be improved by using a sub committee that excludes the CEO and Senior Executives. Recommendations are then fed to the main committee for consideration.
  6. Challenge formulates decision making and it should be documented. A non-attendee to the meeting should be able to understand from the minutes the arguments involved and the degree and extent of any challenge that occurred.
  7. ALM packs should show key liquidity and structural funding ratios including funding concentration risks. The plans of each business line should be used to project these ratios forward. The result should show the firm remains within the Board's risk appetite.
  8. Funding plans should be considered in the light of the firm's economic outlook and any potential rating agency downgrades. They should also show how the funding plan impacts on the NII in a base case that is consistent with the firm's economic outlook and also under stressed economic conditions.  
  9. Liquidity reporting should include a contractual mismatch ladder and one based on behavioural assumptions where those assumptions are clearly defined.
  10. Significant key liquidity and structural funding ratios should be shown by currency.
  11. The corporate plan should be on a rolling update. This should feed into the business lines so that forward risks are also updated.
  12. The base case economic outlook used in the corporate plan should be compared with the current economic outlook. Vulnerability as a result of unanticipated changes to the outlook should be identified and acted upon.
  13. The ALM committee can improve its understanding of the risks in the banking book by using a number of different risk measures. These may include gap analysis, VaR, NII sensitivity, stress testing and analysis of basis risks. 
  14. The FSA endorses making "non-traded" market risk in the Banking Book outside the scope of the ALM committee to be managed by a market risk committee. Behavioural assumptions and their affect on non-traded market risk should be reported to the ALM committee.
  15. NII volatility in the banking book can arise from a number of causes. These include non-traded market risk, changes in product margins, behavioural factors and changes in the competitive environment. ALM committees that can identify effects of the individual drivers will better understand these risks.
  16. Market risk can overshadow the other structural risks. In order to understand its impact you need to consider each risk driver in isolation. For example changing the yield curve will potentially lead to changes in the NII. But it is difficult to isolate what proportion of the change in the NII is due to the yield curve shift and what is due to other factors like margin widening/compression.
  17. Significant structural foreign exchange risk should be reported. A firm that for example faces a basis risk in swapping foreign currency assets or liabilities to its base currency should undertake an analysis of this risk just as if it was running a Sterling basis risk.
  18. Reverse stress testing of liquidity should be in place. This means using scenarios that involve successive years of negative NII and the resultant effect on the ability of the firm to fund itself. ALM committees can then inform the board whether the reverse stress scenarios are sufficiently remote to remain within the board's risk appetite.
  19. Some ALM committees also produce scenarios then go beyond the firm's risk appetite but do not result in failure. The purpose being to identify vulnerability.
  20. Contingency funding plans should be assessed for their effectiveness and be factored into reverse stress testing. The CFP should where possible be operationally tested.

Comment

  • The FSA is raising the standards for ALM. So expect more challenge from the regulator. If you compare what you do with their letter you will almost certainly improve your ALM.
  • The FSA should be far more forthcoming as to what it considers to be the root causes of the issues it raises. It should have considered the way ALM committees and risk management work together. Failures can occur where senior executives expect risk managers to "lead the way". Similarly when risk managers expect direction from senior executives. Would the FSA have found collaboration in the best firms? Most likely. This is instructive.
  • The section of the letter dealing with "Interest Rate Risk in the Banking Book and other drivers of the net income (NII) sensitivity" raises important issues but the FSA is unable to clearly articulate what it means. This CEO letter should not have gone out without substantial re-drafting of this section. Perhaps the FSA's forthcoming IRRBB discussion paper will help clarify its thinking?
  • Finally "proportionality" is important for smaller firms. Let's hope this isn’t forgotten.     

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