Asset and liability management is a complex process requiring sophisticated capabilities and deep market knowledge.Spiro Pappas (left) and Laurent Garret of ABN AMRO explain how establishing a partnership can help regional and local financial institutions.
The increasing complexity of financial markets cannot have escaped the attention of anyone active in the banking industry today. The growing number of financial instruments, the increasing compliance burden, and the constantly shifting regulatory landscape have impacted banks everywhere.
Shareholder demands have mounted as exposures, efficiencies and liabilities have been subjected to an unprecedented level of scrutiny; reporting requirements are ever changing and the capital adequacy regime is about to do so as well. Managing a banking business is more testing and complex than it has ever been – and no institution, irrespective of size or geography, is able to escape this.
In the light of this, the need for a robust group-wide approach to asset and liability management has never been more pressing. Due to the global scale and complexity of its banking operations, ABN AMRO continues to be at the forefront of developments in the field of bank ALM. Local and regional banks can partner with ABN AMRO to benefit from the latest techniques and solutions.
Best market practice for bank ALM
An effective group-wide approach to ALM for banks requires sound centralised oversight of these three key areas:
- capital management;
- funding and liquidity risk management; and
- interest rate risk management/currency risk hedging.
Capital management deals with all regulatory, rating and economic aspects of capital. The main objective is to optimise the usage of capital within the various business units to generate the maximum return to shareholders. There are a number of tools at banks’ disposal to optimise their capital structures; disposal of assets, issuance of ordinary shares, preference shares/hybrid subordinated capital, securitisation, management of FX exposure related to capital and earnings and so on.
Funding and liquidity management is an essential function of ALM. All banks have to comply with regulatory liquidity ratios, but because liquidity at all times is paramount to the ongoing viability of highly leveraged institutions such as banks, all large banks have established liquidity policies with contingency plans and funding limits (liquidity profile/asset and liability bucketing) over and above the regulatory requirements.
An ALM team will also focus on medium and long-term liquidity in all markets and all currencies to best diversify its funding sources. This function is typically centralised and the proceeds are lent on to the various divisions via a transfer pricing mechanism.
The last function performed by ALM is interest rate risk management and FX hedging. ALM uses a large variety of financial instruments to deal with asset and liability duration mismatches and optionality, equity capital at risk and earnings at risk. FX hedging relates to the protection of capital earnings against adverse FX changes.
Challenges, opportunities and costs
The multifaceted nature of each of the three ALM areas, combined with their strong inter-relationships, makes for complex modelling challenges. Fundamental questions need to be asked of the individual business lines to ensure the accuracy of the ALM simulations. Banks need to examine and model their assets and liabilities, both present and projected. This is a complex process that requires sophisticated capabilities and a sound knowledge of all the intricacies involved.
The complexity is further compounded by the multitude of tools available to manage the identified risks and exposures. The range of financing methods available is equally astounding, and can be off-putting to those unacquainted with the different markets and products. There is no longer a single choice between debt and equity – but subsets of these two methods, as well as structured or hybrid issuance and derivative-based products. Selecting the best solution demands informed insight.
A host of practical management challenges is also created by adopting a centralised ALM approach. For instance, management will need to clearly define the role and responsibilities of the ALM team. Decisions will have to be taken on whether the team is a profit or cost centre and appropriate performance measurement targets need to be set. Many banks have now converted their ALM group function into a profit centre. Our experience suggests that an effectively managed Bank Group ALM can add more than 10% to bottom line performance.
Cost control
Having said this, the costs of establishing and keeping ALM systems up to date are impressive – typically becoming prohibitive for the less active users of advanced financing and hedging techniques. Independent pricing needs to be sourced, trades collateralised, and margins updated daily, credit exposures closely monitored, and positions marked to market.
By partnering with entities that have established derivatives and risk management practices, regional and local financial institutions can reduce their associated costs, avoid some of the pitfalls that might otherwise await them, operate in strict accordance with regulatory requirements and secure best pricing at all times.
ABN AMRO’s deep understanding of the issues facing financial institutions, intimate knowledge of global markets and keenly honed risk management expertise place the bank in prime position to act as a global partner in the provision of ALM solutions. ABN AMRO is regularly ranked among the top-tier players in the derivative, structured finance, debt, equity and equity-linked markets for financial institutions.
Spiro Pappas, Managing Director, Head of European Banks. spiro.pappas@uk.abnamro.com Laurent Garret, Managing Director, Head of Capital and ALM Advisory for Banks, ABN AMRO. laurent.garret@fr.abnamro.com
