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net

Chapter first published in:

The Handbook of ALM in Banking

Edited by Andreas Bohn and Marije Elkenbracht-Huizing

First published:
12 JAN 2018

ISBN: 9781782723455

ALM in the Context of Enterprise Risk

Management
Koos Timmermans, Wessel Douma

One of the lessons learned by banks during the global financial crisis in 2008–9
was that banks need to have in place a comprehensive risk appetite framework,
which is based on the principle that banks should be able to restore their capital
and liquidity positions following a stress situation, as it may take years before full
access to capital and funding markets is re-established. Regulators picked up on
this by implementing, for example, the Capital Requirements Regulation (CRR) and
the Capital Requirements Directive IV (CRD IV), which led to new and much stricter
capital and liquidity requirements than before. Furthermore, national competent
authorities and the European Central Bank have raised the bar significantly with
respect to the required quality of the banks’ risk appetite frameworks. Therefore,
most banks have put a considerable amount of effort in the improvement of their
risk and asset and liability management (ALM) processes, frameworks and
governance.

In this chapter we provide an insight into the main solvency risks banks are
confronted with, and the necessary components of the processes to deal with
these. The first section is dedicated to the governance: how can banks make sure
that their risk appetite and ALM remains up-to-date, taking into account all the
relevant risks given the prevailing macroeconomic and geopolitical situation, and
who should be involved in this process? In the second section, we zoom in on the
balance sheet of a typical large bank, and describe the main sensitivities such a
bank needs to manage in order to protect itself against potential adverse
developments. Then, in the third section, we describe the high-level design of an

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enterprise-wide risk appetite framework that banks can consider in order to

manage these risks, and of the metrics needed for such a framework.

THE ANNUAL RISK MANAGEMENT CYCLE

Perhaps just as important as the technical design of ALM and risk appetite
frameworks, and the conceptual and mathematical approaches used therein, is
how the risk process is organised, and who is involved. Risk appetite frameworks
need to be maintained and regularly updated as the environment in which banks
operate changes and new risks may emerge.

Banks can use a step-by-step risk management approach to identify, monitor,

mitigate and manage their financial and non-financial risks. The approach consists
of a cycle of five recurrent activities.

Determine the potential risks, by, for example, interviewing a number of senior
employees, and/or by reviewing externally published risk assessments.
Select the risks that could actually have a significant impact on the capital or liquidity
position of the bank.
Make sure that the relevant risks are controlled and incorporated into the risk
appetite framework. Furthermore, the scenario selection for the stress testing
programme should also be based on the risk identification and assessment.
Monitor the actual risk profile with respect to the risk appetite.
Report the main risk developments to senior management, to enable them to take
timely additional measures, if necessary.

The process described in Figure 2.1 recurs in two different ways.

The identification, assessment and review of the risks and the appetite for these risks
are carried out periodically, and potential mitigating measures are updated.
The periodical monitoring exercise may indicate that new risks are arising, known
risks are changing and assessed risk levels are changing or control measures are
not effective enough. Further analyses of these findings may result in renewed and
more frequent risk identification and/or assessment and/or a change in mitigating
measures.

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In each of the steps in the cycle, the involvement of senior management, including
board members is of paramount importance. For the risk process and the risk
appetite framework to be effective, the board should contribute to, and agree with,
the selection, measurement and management of the relevant risks, and the
accompanying selection of the stress scenarios to be evaluated. They should also
approve the changes to the risk appetite framework, and regularly receive and
discuss risk reports. In this way, the board can take informed decisions to further
mitigate certain risks, if this mitigation is deemed necessary.

The principle that the design of the overarching risk appetite framework, and the
developments of the actual risk profile with respect to the appetite for these risks
should be regularly discussed by senior management can be applied in different
ways. Various committee structures to achieve this are in place for the various
banks, but generally the main risks of the bank are discussed in a dedicated risk
committee, a combined finance and risk committee, or in an asset and liability
committee (ALCO). In any case, board members are represented in these
committees.

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THE BUSINESS MODEL AND MAIN RELATED

RISKS OF A TYPICAL LARGE BANK
To obtain insight into the main risks and sensitivities with which most banks are
confronted, a stylised example of the business model of a typical large bank, such
that as shown in Figure 2.2, can be of use.

Usually, the main activity of a bank is to provide loans to customers. To fund these
loans, banks either collect deposits from retail customers, or attract funding from
the professional funding markets. This leads to a balance sheet as shown in the
upper left corner of Figure 2.2.

Normally, banks will ask a higher interest rate to be paid on the loans they grant to
banks than the rates they pay on their own funding. This leads to a positive interest
margin, which is often the most important source of income for banks. The fact that
banks provide loans to customers also means that they accept the risk that clients
may not always pay back these loans. To deal with this, banks must quantify their
risk profile via risk-weighted assets (RWA), calculated as the exposure multiplied
by a risk weight that depends on, eg, the creditworthiness of the client and the
amount of collateral received to cover for the loan. Regulators require banks to hold
a certain percentage of RWA as capital, to ensure that they have a significant
buffer to withstand losses resulting from their activities. These requirements are
defined in terms of the minimum Common Equity Tier 1 (CET1) ratio banks need to
maintain. This is calculated as the available CET1 capital divided by the amount of
RWA.

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Returning to the income side: the annual profit and loss (P&L) of a bank will be less
than the sum of net interest income, trading and sales income and fee income,
because certain expenses and costs need to be deducted from these. Expenses
for banks are primarily salary costs, but also include costs related to the necessary
infrastructure, as well as those related to non-financial risk events (eg,
compensation of clients due to mis-selling, fines from regulators, etc). Furthermore,
credit risk costs (ie, costs incurred when clients default on their loans) negatively
affect the profit and loss as well. Finally, banks have to pay tax over the gross
result

gross result = income − expenses − risk costs

which means that the final net profit and loss that can be used to pay a dividend, or
to strengthen the capital position is equal to

net result = (1 − tax%)(income − expenses − risk costs)

Finally, a highly relevant indicator of bank performance is the return on equity

(RoE), which is calculated as the net results divided by the capital. To remain
attractive for investors, banks need to achieve an RoE of approximately 10%,
which can be achieved by, eg, making sure that net interest income is high enough
and sufficiently stable, the cost-to-income (C/I) ratio and credit risk costs are not
too high and required capital does not increase too much.

If everything goes according to plan, a 10% RoE is certainly achievable for a bank
with a sound client base and efficient processes. However, there are a number of
uncertainties that need to be carefully managed, a process in which the risk
management function plays a key role.

Net interest income can, for example, be lower than expected when interest rates
remain very low for a prolonged period of time. In that case, maturing assets that
originated a long time ago, when interest rates were higher, need to be replaced by
new assets with a significantly lower yield. This can be offset by making sure that
similar rate reductions occur for the liabilities, but the possibility to fully compensate
may be limited if the funding consists mostly of retail deposits. If banks were to
make these rates negative, for example, it is likely that a significant percentage of
such clients would take their money and put it in their safe or in their piggy bank.

Furthermore, many banks have prepayable assets, such as residential mortgages,

on their balance sheets. The related prepayment options can become quite costly
for banks in a low interest rate environment, because higher than expected

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prepayments of loans with higher client rates than the prevailing ones will erode the
net interest margin if the related funding is not prepayable.

Sudden increases in interest rates can also be a threat to the net interest income,
for example, if banks have to translate these market rate increases into significant
deposit rate increases, eg, because new players with no legacy investments enter
the market, or because customers may otherwise decide to move their money to
other products, such as term deposits.

Interest rate risk can be mitigated by making sure that the interest rate typical
maturities of assets and liabilities are to a large extent matched and that
prepayment option risk is hedged and properly priced in, and by reducing the
reliance on interest income by, eg, increasing the share of other types of income,
such as fee income.

Credit risk costs can be higher than expected due to deteriorating economic
circumstances, which will affect the credit risk profile of the bank’s clients. Higher
unemployment rates will normally lead to a higher default percentage for residential
mortgages, for example, while default rates for business lending portfolios typically
go up if the economic growth slows down. Furthermore, under the International
Financial Reporting Standard 9 rules for loan loss provisioning to be implemented
in January 2018, there will be an additional effect from clients for which the credit
profile has deteriorated significantly. For these clients, the loan loss provisions must
be based on lifetime expected loss instead of one-year expected loss, which
means that the provisions must be increased significantly. Obviously, banks will be
faced with more clients with a deteriorating credit profile in times of economic
downturn.

Credit default risk can be partially mitigated by putting in place sound credit
acceptance criteria and policies, while loss risk in the case of a default can be
reduced by making sure that sufficient collateral is obtained. Furthermore, credit
risk can also be reduced by ensuring a sufficient level of diversification in the credit
portfolio, in terms of countries, sectors and asset classes.

Expense risk for banks is primarily related to non-financial risk events. Mis-selling
practices and non-compliance with regulations can lead to hefty fines and
compensation of clients.

These types of risk can be mitigated by making sure that a bank has developed a
strong compliance function and culture.

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Not only the numerator of the CET1 ratio (available capital, influenced by, eg, net
income) but also the denominator (RWA) is subject to uncertainty. Credit-risk-
weighted assets will on average increase in times of economic stress, because
deteriorations in the credit profile of the clients will be translated into higher risk
weights, and consequently greater RWA. Market-risk-weighted assets will increase
as well, as these are influenced by the observed volatility of the market.
Furthermore, RWA are subject to regulatory risk, as well as sensitivity to the
economic and market circumstances. Since the mid-2010s, the confidence of
regulators in the use of internal models for the calculation of RWA has decreased,
which has resulted in proposals for a more standardised approach, with a
potentially significant impact on the risk weights for certain asset classes.

Regulatory risk can be mitigated by reducing the maturities of transactions in asset

classes that are likely candidates for significant RWA increases, and by making
sure that “originate to distribute” capabilities have been developed that enable
banks to offload affected assets from their balance sheets.

Finally, in addition to the risks that could affect the capital ratios, banks are subject
to liquidity risk. The liquidity position of a bank can be negatively affected when, eg,
the professional funding market dries up for them, or when a significant percentage
of customers with a savings account decide to withdraw their money. However, this
chapter focuses solely on solvency risk.

A HIGH-LEVEL SOLVENCY RISK APPETITE

FRAMEWORK
If the risks mentioned above (Figure 2.3) are not carefully managed, banks may
not achieve their target ROE, may not be able to make the intended dividend
payments, and their CET1 ratio may be negatively affected to the extent that
regulatory requirements are no longer met. Therefore, it makes sense to implement
a risk appetite framework from the starting point that the CET1 ratio should not
drop below certain levels in either normal situations or in a (standardised) stress
scenario. The evidence, from previous crises, that banks will often not be able to
obtain new equity from the capital markets in crisis situations, and that they will
have to rely on retained earnings for the restoration of their capital position should
be taken into account here.

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A possible risk appetite statement for solvency risk could therefore be:

in a standardised 1-in-x years scenario, the CET1 ratio should

not drop below a% throughout the scenario horizon, and should
be back at (a + b)% at the end of the scenario horizon, using
retained earnings.

Formulating such a risk appetite statement is of course the first step, but to
implement it, and to be able to measure the potential development of the CET1
ratio in a crisis situation, a number of related risk metrics are needed. To determine
exactly which risk metrics are needed, it is useful to take a look at the stylised
balance sheet of a bank. As will be shown below, the various balance-sheet items
influence the CET1 ratio in different ways.

As can be observed from Figure 2.4, a number of different metrics need to be

incorporated in order to fully capture the potential impact of a stress scenario on
the CET1 ratio.

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The earnings-at-risk value captures the various P&L impacts of a stress scenario,
due to, eg, changing interest rates, equity prices, credit losses and operational risk
losses. Prevailing accounting rules should be followed for the calculation of these
shocks, which means that the calculations for trading books should be based on
economic value, whereas impacts for the banking books should be based on book
value. This means, for example, that, for the assumed interest rate changes in the
stress scenario, the impact on the net interest income rather than the impacts on
value should be calculated.

Another metric necessary for the calculation of the impact on available capital is
revaluation reserve-at-risk. For the investment portfolio (more precisely, the part
that is classified as “available for sale”), value changes will not affect the P&L, but
will affect other comprehensive income via the so-called revaluation reserves. This
metric should capture the impact on value of the stress scenario for the assumed
interest rate, equity, real estate and credit spread shocks.

As already mentioned, in a stress scenario not only the numerator (available CET1
capital) but also the denominator (RWA) will be affected. Therefore, a risk metric
called risk-weighted-assets-at-risk should be included. This should reflect the
credit-risk-weighted assets’ increase due to the negative credit migration of the
lending assets and the bond portfolio. Furthermore, it should measure the potential
value-at-risk increases for the trading book due to increased volatility in the
financial markets, which will influence the market risk RWA.

In order not to overestimate the impact of a stress scenario on the CET1 ratio, it is
very important that the commercial result is also taken into account. This result is
defined as the expected P&L prior to loan loss provisioning, and thus serves as a
buffer for all the negative P&L impacts covered in the earnings-at-risk calculations.

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In Figure 2.5, the potential outcome of the measurement related to the CET1 ratio
risk appetite statement is shown. The graph shows the two dimensions that are
relevant for the CET1 ratio: available CET1 capital on the horizontal axis, and RWA
on the vertical axis. The curve shows a typical development of the RWA and CET1
capital in a medium severe stress scenario, with RWA going up, and CET1 capital
increasing at a slower pace than expected due to negative P&L and valuation
impacts. The dark grey, light grey and white areas, respectively, reflect the levels
where

the CET1 ratio should end up at the end of the scenario horizon (white),

the CET1 ratio may temporarily exist throughout the scenario horizon (light grey),

the CET1 ratio should not exist at all (dark grey).

Finally, for the risk appetite statement as described in this section to be effective, it
should be complemented with a number of more granular supporting risk appetite
statements for individual risk types, countries, businesses, etc. Cascading down

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the overarching risk appetite statements to all levels of the organisation is an

essential part of the risk appetite framework and processes.

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