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TREASURY MANAGEMENT

Topic 3ALM Trading Principles

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Introduction

• Liquidity management has emerged as the dominant element of bank asset-liability management in the post 2007-08 crisis era

• Measuring and managing liquidity risk is an art rather than a science and should be undertaken with prudence and a close eye to the particular bank’s own risk-reward profile and operating model

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A common approach…

• Management often direct Treasury and money market desk behaviour by assigning simple targets (e.g. the Loan-to-Deposit ratio, or target deposit levels)

• Market best practice is for more than the single liquidity metric (LTD), to a broader set of measurements and reports (to complement the LTD).

• For instance, the LTD is the best metric to measure the contribution of customer funding. The LTD, however, is not predictive, and is blind to duration, concentration and volatility, three critical aspects of liquidity. Finally, it is not always “aggregatable”.

• Liquidity forecasts should be upgraded to incorporate better estimates of deposits/withdrawals on the deposit side, drawings of unused direct commitments on the loan side, and assessment of the quality/liquidity of our near-cash assets.

• Post-Lehmans, a bank ALM crisis may arise from a negative gap situation, a withdrawal of customer deposits or loss of interbank liquidity, among other scenarios

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What to Look For from Liquidity Data

Self-sufficiency and supportiveness of a business unit

– Its ability to operate without support of other Group businesses

– Evidence of focus on both sides of the balance sheet – The level to which it creates or relieves liquidity risk– Measure of value of the business unit to the Group, in non-

P&L termsOverall level of exposure to roll risk

– Measuring asset liability mismatch– Each liability roll is an opportunity to lose funding

Early warning of funding stress points– Analysing the cash effects of liquidity gaps– Examining the near term effects of the asset liability

mismatchSpecific daily funding needs

– For planning & managing daily operational funding requirements

– For advanced planning of cash or collateral action

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Metrics: Five Liquidity Reports

• Loan-to-Deposit Ratio

• 1 Week & 1 Month Liquidity Ratios

• Cumulative Liquidity Model

• Inter-company Lending Report

• Liquidity Risk Factor

These reports measure and illustrate different elements of liquidity risk:

• Reports at country level, legal entity level and Group Level• Risk appetite should be determined by the ALCO or (at Group level) High ALCO• Assumptions will be reviewed by Treasury & Risk Management• Stress testing will be performed by Risk Management

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Loan to Deposit Ratio

1 Week & 1

Month Liquidity Ratios

Cumulative

Liquidity Model

Intercompany

Lending Report

Liquidity Risk

Factor

Self-sufficiency of

a business unit

Supportiveness of a business

unit

Overall level of exposure to

roll risk

Early warning of funding

stress points

Specific daily funding needs

Ways to Examine Liquidity Risk

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Characteristics• The relationship between lending and customer deposits• Measure of the self-sustainability of the bank (or each

branch / subsidiary)• A very common metric, usually reported monthly Points to note• Differentiate between stand-alone and aggregate-able LTD

(depends on transferability and currency)• Branch / sub targets: to improve the LTD when it’s over a

certain threshold (e.g. 70%), and to maintain their LTD when it’s under that threshold

• Exceptions can be granted to certain countries in local currency (LCY) when they are below the threshold and when the use of their excess liquidity is constrained

Loan-to-Deposit Ratio

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1-Week & 1-Month Liquidity RatiosCharacteristics• Shows net cash flows, including the cash effect of liquidating “liquid”

securities, as a percentage of liabilities• An effective measure of structural liquidity, with early warning of likely

stress points• Produced weekly, one week in arrears• Follows a Regulatory Authority limit structure for 1 Week and 1 Month

ratios• It is important to review assumptions including “stickiness” assumptions

regularly• Review Limits regularly

Country 1-week Gap 1-week Liquidity 1-month LiquidityUSD mm This week Limit Excess This week Limit Excess

F -1586 -22.83% -30.00% -39.11% -50.00%D 188 15.26% 0.00% 1.62% -5.00%H 786 22.57% 0.00% 19.12% -5.00%G 550 53.27% 25.00% 69.83% 25.00%

Regional Total -62 -0.48% -10.64%

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Cumulative Liquidity Model

$mm T+1 T+2 1 Week 2 Weeks 1 Month 2 Month 3 Months 6 Months 12 Months

a Cumulative Net Cash Balance $2,000 $1,550 $250 -$300 -$2,500 -$3,000 -$5,000 -$6,000 -$8,000 b Other Forecast Inflows $0 $10 $25 $50 $75 $125 $350 $800 $1,000c Other Forecast Outflows $0 -$10 -$20 -$50 -$100 -$250 -$1,000 -$1,100 -$1,250

a+b+c=d Cumulative Cash Gap $2,000 $1,550 $255 -$300 -$2,525 -$3,125 -$5,650 -$6,300 -$8,250

e Counterbalancing Capacity $500 $1,000 $1,500 $2,000 $3,000 $5,000 $6,000 $7,000 $7,500

d+e=f Liquidity Gap $2,500 $2,550 $1,750 $1,700 $500 $2,000 $1,000 $1,000 -$500

g Limit $2,000 $1,500 $1,000 $1,000 $0 $0 $0 -$1,000 -$3,000

f-g=h Variance $500 $1,050 $750 $700 $500 $2,000 $1,000 $2,000 $2,500

Characteristics• Forward looking model of inflows, outflows and available liquidity• Recognises and predicts liquidity stress points on a cash basis• Prepared daily, at legal entity level, and Group level• Prepared for material original currencies and at consolidated

currency level Note• Revised assumptions on deposit stickiness, liquidity of “liquid”

securities, and committed facilities will be included here

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Intercompany Lending Report

Characteristics• This shows the net

intercompany lending position of each branch / sub

• Measure of the self-sustainability of each branch / sub

• Clearly displays cash contributors and cash users

• Major KPI for Treasurers• Produced monthly

Group Treasury

As at (date) Total Borrowing Total Lending Net Intergroup Lending

London subsidiary 1,713,280 883,123 -830,157

Europe branches-- X 3,345,986 978,369 -2,367,617-- Y 17,026 195,096 178,089-- Z 453,490 83,420 -370,070

Asia 0 162,000 162,000

NY 690,949 1,516,251 825,302

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Characteristics• Shows the aggregate size of the liquidity gap in each

branch / sub• Compares average remaining duration of assets to average

tenor of liabilities• For example,

– Average asset duration 5.00 years– Average liability tenor 3 months = 0.25 years– 5.00/0.25 = Liquidity Risk Factor of 20

• The higher the LRF, the larger the liquidity gap, and the greater the liquidity risk

• Tenor of liabilities will incorporate revised stickiness assumptions

• Report weekly and monthly• Observe the trend over time and change to long-run

averages

Liquidity Risk Factor

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Risk reports 1: the weekly Qualitative • As important: the weekly qualitative report for Group

Treasury (who summarises all for High ALCO)• Explain significant changes in your 1 week and 1 month liquidity

ratios• Explain any changes to your cash and liquidity gap in your

Cumulative Liquidity model• Explain significant changes to the Liquidity Risk Factor • Explain growth or shrinkage of asset books• Detail any changes to intergroup borrowing/lending position;

detail the counterparties for any large-size deals• Any increase/decrease in corporate deposits, detail large dated

transactions with an estimated confidence level of roll over• Any increase/decrease in retail deposits• Average daily opening cash position

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Risk reports 2: Monthly Liquidity Snapshot

• Simply a MI summary for Group-wide dissemination

• Content:– The Cumulative Liquidity Report summary (cash gap

and liquidity gap)– 1-week and 1-month Liquidity Ratios performance

against limits– Liquidity ratio current to previous month– LTD current to previous month– Net intergroup lending current to previous month

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Four frameworks to monitor and control current and future liquidity risk...

Maturity mismatch

Asset / liability liquidity ladder

FX mismatch

Funding concentration

Purpose: To measure the net funding requirement (or surplus) per maturity bucket. This is the main regulatory requirement for liquidity measurement.

Measure: Measures the net cash flow for each maturity bucket.

Analysis: In the short-term, when commitments (cash outflows) exceed liquid assets (cash inflows) the Money Markets desk need to raise additional funding. In the longer-term, structural imbalances, ALCO will determine the appropriate funding strategy.

Maturity Mismatch Ladder

Sight8

Day

1 mont

h3 mo 6 mo

1 year

3 years

5 years

5 years

+

TOTAL

Inflows 805 383 273 268 143 129 276 657 7423,67

5Outflows 980 813 838

1,563

277 52 11 0 04,53

3Mismatch

(175)

(430)

(570)

(1,295)

(134)

77 265 657 742(858

)

Purpose: To measure the gap between funding and lending in each currency.

Measure: Funding minus lending, per currency.

Analysis: By measuring FX mismatch, the bank gains an understanding of its exposure to the risk that FX swap markets become illiquid which could force a large open FX position or make it difficult to meet commitments in a particular currency.

Purpose: To measure the asset liquidity and likely stickiness of liabilities.

Measure: Each asset/liability type (per COA) is rated based on size of holding, contractual maturity, behavioural stickiness, yield, cost to liquidate.

Analysis: A detailed understanding of the attributes and behaviour of the bank’s balance sheet allows ALCO to make better informed strategic choices.

Purpose: To measure the relative concentration of each funding source.

Measure: % concentration of each funding source per maturity bucket.

Analysis: Analysing funding concentration risk allows the bank to develop effective diversification strategies.

USDUSDEUREUR

GBP GBP

FX mismatch

- =Currency

Mismatch

USD 956

EUR (150)

GBP (450)

Asset

Liability

Liquid Illiquid

Cash

GiltsFI F

RNs

CDsECB

Elig

ible

ABS

Other

A

BSCor

p

L

oans

LGs

Prope

rty

Bank

depo

sits

Custo

mer

d

epos

its

(10

%)

Insti

tutio

nal

depo

sits

Custo

mer

d

epos

its

(9

0%)

Short-term Long-term

Customer deposits

Inter-bank deposits

Group deposits

Group deposits

Group deposits

Inter-bank deposits

Inter-bank deposits

Customer deposits

Customer deposits

Funding Lending

Sight – 8 days 1 month 1 year

ILLUSTRATIVE

ILLUSTRATIVE

ILLUSTRATIVE

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Regulatory and Management reporting is key to successful liquidity management. Liquidity Reporting

Branch liquidity

Regulatory

Category Measures

Report Audience / Frequency

• Consolidated basis - FSA Form LR is the key daily report this is based around the maturity mismatch framework.

• Daily Liquidity Report

Management Reporting Leading and lagging risk indicators to provide a 360° view of the bank’s liquidity.

Prepared by: Finance Regulatory Reporting Team

Maturity transformation

• Average asset tenor < 24x average liability tenor

Funding source concentration limits

• No individual counterparty > 5% of funding

• No source > 25% (except customer deposits)

• Customer deposits > 33% of funding

FX mismatch limit

• No mismatch > 25% of currency volume (G7)

• No mismatch > €10mn for non-G7 currencies

Minimum cash buffer

• Cash buffer > 2% of liabilities at all times

Maturity mismatch

• Sight – 8 days > 0.00%

• Sight – 1 month > -5.00%

Prepared by: Finance Regulatory Reporting Team

Prepared by: Finance Management Information Team

• DLR = Daily to management

• Form LR = Monthly to FSA

• Consolidated basis - FSA Form LR is the key daily report this is based around the maturity mismatch framework.

• Daily Liquidity Report

Five Liquidity Metrics • Monthly to management• Copy of monthly reports send to each host regulator (tbc)

• Daily to Finance + Treasury

• Monthly to management

• Maturity mismatch framework

• FX mismatch

• Asset / Liability liquidity ladder

• Funding concentration

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Learning Objectives

• Introduce the basics of trading and hedging as employed by an ALM desko Support the fixed-interest sales desko Hedging new issueso Work with the swap and OTC options desk

• Specific uses of money market products like deposits and repo in the context of yield enhancement and market-making.

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Trading Approach

• The yield curve and Interest rate expectationso When the Yield curve is positively sloped, fund the book at the short end of the curve and lend the long end

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Example

• Funding short: borrow one week funds while lending out at three month (an one week repo and a three-month reverse repo)• Create a tail: roll over funding at one-week intervals for the 3 month period• The “tail” – the gap that the bank exposed to. If the shape, slope the the yield curve changes (flatten out) -> Profit margin shrinks•

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The Yield Curve

• Trading volumes are higher in a positively sloping yield curve environment• In case of an inverted yield curve, lend at the short end and borrow at the longer end – Funding long

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Example

• Short cash position of 2-week against long cash position of 4-month• The interest rate of gap of 10 weeks is the interest rate exposure• Long end interest rate goes up -> Profit margin shrinks• Inverted yield curve, the market expect an inflationary environment

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Credit intermediation – Repo desk

• A repo dealer: lends general collateral currently trading at a spread below Libor; uses the cash to buy CDs trading at smaller spread below Libor• A repo dealer borrows specific collateral in the stock-lending market, paying a fee and sells the stock in the repo market at the general collateral (GC) rate; the cash is then lent in the interbank market at higher rate

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Example – Credit Intermediation

• The potential gains that can be made by a repo dealing bank (market maker) that has access to both the stock loan and GC repo market

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Example – Credit Intermediation

• Potential gain of 17 bps over 3 month• Borrow GC from the stock loan counter party at a fee of 8 bps• Repo the borrowed GC to get cash, pay 5.75%• Take the cash to purchase CDs to receive 6%• 6% - 5.75% - .08% = 17 bps

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Yield curve spread trade

• An example of relative value trading – trade on the spread between pairs of yield curve in different country

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Example – Yield curve spread trade

• Spread between 10-year UK gilts and 10-year German bunds narrowed from 160 bps to 91 bps• A trader expected this spread to correct in the near future -> sell the gilts and buy the bunds• Important factors

– Funding cost– Exchange rate– Implementation of “stop loss;” usually 2:1 potential reward/potential loss

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An Analysis of Special Repo Rates

• The highest rate in the government markets is the GC rate• The repo rate on a bond a becomes special when it is trading at over 10-15 bps below the GC rate for a bond of the same credit from the same issuer.• The special rate indicates high demand for the bond most commonly needed to cover short positions

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The Market-Determined Repo Rate• The overnight GC rate is at or very close to the interbank overnight rate• The overnight GC reflects the supply and demand for short-date repo compared to interbank borrowing and lending• When these two rates diverge from each other, opportunity to put on spread position• Specific repo rate is the market clearing price for supply and demand for that security •

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Matched book trading in repo

• The market making of repo – trade to profit from the bid-ask spread• Traders run a matched book pt on positions to take advantage of

– short term interest rate movements– anticipated supply and demand in the underlying security

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Matched book trading in repo

• Matched book trading strategies– take a view on interest rates; for example, bids for 1-month GC and offers 3-month GC expecting the yield curve to invert– take a view on special; for example, borrows security from the market for use I repo once they expect it goes special– credit intermediation; for example, reverses in Brady bonds at Libor + 200 and offers to a US money market investor at Libor + 20