Executive Certificate

In

Treasury

Management

Liquidity And Interest Risk

Management

Contents

1.0 Introduction2.0 Functions of the Treasury 3.0 The Treasury Function and Volatile Markets4.0 The Structure of the Treasury5.0 Risk Defined6.0 Primary Risks7.0 Treasury and Liquidity Risk8.0 Liquidity Determinants9.0 Liquidity Risk Dynamics10.0 Liquidity Management Policies10.1 Typical internal liquidity guidelines encompass the following:11.0 Foreign currencies12.0 Liquidity Risk Management Strategies12.1 Liquidity risk can be determined or measured in different ways Table 1 Maturity Ladder under alternative conditionsTable 2 Liquidity Ratios13.0 Liability Side Risk 13.1 Asset Side13.2 How to meet liquidity calls14.0 What is Asset Liability Management? 14.1 ALM Focus will be on Balancing:15.0 Liquidity Planning16.0 Interest Rate Risk Management 16.1 Repricing risk:16.2 Yield Curve risk:16.3 Basis Risk (spread risk):16.4 Optionality: 17.0 Framework for IRM18.0 Risk Measurement and Management19 0 Repricing Gap Method Table 3 Gap ModelTable 4 Repricing Gap Model Impact of changes in interest rateActivityMaturity Method How to extend the concept to a Portfolio?

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Deficiency of Maturity Model :Modified DurationOther Interest ate Risk Management StrategiesReferences

1.0 Introduction

Treasury is the integral function in the management of liquidity in a

financial institution or any organization. It is the heart of the organization.

Treasury involves the management of funds, i.e. investment of excess

liquidity and borrowing to cover any short positions. Any profitable

opportunities that arise during the process of managing liquidity can be

exploited for the benefit of the institution/organization.

2.0 Functions of the Treasury

Treasury functions can be summarized as follows:

Cash Flow Management and Position Funding

Maturity Transformation

Gap Management

Trading and investment (income generation)

Liquidity Risk Management

3.0 The Treasury Function and Volatile Markets

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Money markets have become volatile in Zimbabwe. Such volatility points to

strategies that avoid the mismatch between assets and liabilities. Strategies

that advocate for a mismatch in the trading book could potentially be

catastrophic.

4.0 The Structure of the Treasury

Policy

Framework

Market

Operations

Risk

Analytics

and

Compliance

Treasury

Operations

Investment and

Trading

Guidelines

(ALCO)

Trading and

Funding

activities

(Front office)

Middle office,

Compliance and

risk

measurement.

Settlements,

cash

management,

accounting, and

reporting

5.0 Risk Defined

Risk is the probability or chance of incurring a loss due the the variability of

future outcomes. Because we cannot be 100% sure of likely future

outcomes, there is always a chance (no matter how small) thet the actual

outcome may be adverse.

6.0 Primary Risks

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7.0 Treasury and Liquidity RiskLiquidity risk is the

chance that the bank may fail to honour its short-term financial

obligations. Such risk usually arises from the mismatch between

assets and liabilities. The treasury function comes in, bridging the

gap that may arise between the maturity of assets and liabilities.In

essence, the role of managing liquidity risk lies with

the treasury division even where the risk

management function may be centralized. This

liquidity risk is managed on a daily basis and it is

important for the treasury dealers to understand the

dynamics of the financial markets and anticipate any

future movements in interest rates.8.0 Liquidity

DeterminantsLiquidity risk is not necessarily the lack of assets

but rather the inability to honour obligations arising from the

difficulty in converting long term or illiquid assets into liquid

assets. Markets can be illiquid due to shallowness in the sub

markets, volumes being traded and transaction costs involved.An

organisation has adequate liquidity potential when it can obtain

funds (by increasing liabilities, securitising or selling assets)

promptly and at a reasonable cost. An organisation’s net funding

includes its maturing assets, existing liabilities and standby

facilities with other institutions The price of liquidity is a function

of market conditions and the market perception of the inherent

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riskiness of the borrowing institution.The importance of liquidity

transcends the individual institution because of the systemic

effect.9.0 Liquidity Risk DynamicsUnlike other risks

that threaten the solvency of an institution, liquidity

risk is a normal aspect of every day life. In extreme

cases liquidity can translate into solvency risk

problems. Banks usually run maximum exposure to

liquidity risk, with insurance companies in the middle

and the pension funds with low risk. Funding structure is a

key aspect in liquidity management. The assessment of the

structure and type of deposit base and evaluation of the condition

(i.e. stability and quality) of the deposits are the starting point for

liquidity assessment. The type of information that is necessary to

conduct this assessment includes the following:a. Product range

i.e. savings, current accounts, retail corporate etcb. Deposit

concentration, including itemization for all customers with

deposits that aggregate to more than a certain amount of total assets

with term and pricing shown on each.c. Deposit administration,

including information on the adequacy of the system that record

and control depositor transactions and internal access to customer

accounts, as well as on the calculation and form of payment of

interest10.0 Liquidity Management PoliciesLiquidity

management policies of a bank normally comprise a

decision making structure, an approach to funding

and liquidity operations, a set of limits to liquidity risk

exposure and a set of procedures for liquidity

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planning under alternative scenarios, including crisis

situations.10.1 Typical internal liquidity guidelines encompass

the following: A limit on the loan to deposit ratio A limit on

the loan to capital ratio Guidelines on the sources and uses of

funds Liquidity parameters; for example, that liquid assets

should not fall below a certain percentage or rise above a certain

percentage of the total assets A percentage limit on the

relationship between anticipated funding needs and available

resources to meet these needs A percentage limit on the

reliance on particular liability category Limits on the

minimum/maximum average maturity of different categories of

liabilities11.0 Foreign currenciesThe existence of multiple

currencies may also increase the complexity of liquidity

management, particularly when the domestic currency is not freely

convertible. The organization should have a management system

for its liquidity positions in all major currencies in which it is

active. In addition to assessing its aggregate liquidity needs, it

should also perform a separate analysis of its liquidity strategy for

each currency. The organization should develop a back up liquidity

strategy for circumstances in which its usual approach to liquidity

funding is disrupted. Depending on the size of the foreign

exchange operations and its portfolio in each currency, the bank

may define a backup liquidity strategy for all currencies or may

draw up a separate contingency plan for each.12.0 Liquidity Risk

Management StrategiesLiquidity risk management has three aspects

i.e. measurement and managing net funding requirements, market

access, and contingency planning.The analysis of the net funding

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requirements involves the construction of a maturity ladder and the

calculation of the cumulative net excess or deficit of funds on the

selected dates. An institution should regularly estimate its expected

cash flows instead of focusing only on contractual periods during

which cash may flow in or out.An evaluation of whether or not an

institution is sufficiently liquid depends on the behaviour of each

cash flow under different conditions. Liquidity risk management

must therefore involve various scenarios:The going concern

A crisis situation for the organisation

General market crises

12.1 Liquidity risk can be determined or measured in different ways

The first of these is a Net Liquidity Position statement. The statement takes a

look at sources and uses of liquidity and determines shortages or

surpluses.

The second method is computing key liquidity ratios and comparing them

with peers

A Third method would be to conduct an index of liquidity. It constructs the

fire sale realisable value of the assets as a percentage of its market value.

For a portfolio this is multiplied by the weight.

A fourth method would be computing funding gap. Funding gap may be

defined as loans less average deposits. You may also view it as borrowing

less liquid assets

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Put another way liquid assets +funding gap determines borrowing needs

As the funding gap increases and liquid assets are retained, forcing the bank

to borrow. If borrowing increases, liquidity risk increases as well.

Table 1 Maturity Ladder under alternative conditions

Cash Inflows Normal Conditions

Bank Specific Crisis

Market Crisis

Maturing assets(contractual)Interest receivedAsset salesDraw downsOthers (specify)Total inflowsCash OutflowsMaturing Liabilities (contractual)Interest payableDisbursements on lending commitmentsEarly deposit withdrawalOperating expensesOthers (specify)Total outflowsLiquidity excess (shortfalls)

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Table 2 Liquidity Ratios

Liquidity Ratio Period 1 Period

2

Current

period

Benchmark

Readily marketable assets as percentage of total assets

Volatile liabilities as percentage of total liabilities

Volatility coverage (readily marketable assets as

percentage of volatile liabilities)

Bank run (readily marketable assets as percentage of all

deposit-type liabilities)

Customer loans to customer deposits

Interbank loans as percentage of interbank deposits

Net loans and investments as percentage of total deposits

Demand deposits as percentage of customer deposits

Deposits with maturities longer than three months as

percentage of customer deposits

Less than 90 days deposits as percentage of customer

deposits

Certificates of deposits as percentage of customer

deposits

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Ten largest deposits as percentage of customer deposits

Although the acquisition of funds in a market at a competitive cost enables

profitable banks to meet the expanding customer demand for loans, the

misuse or improper implementation of liability management can have severe

consequences. The following risks are associated with the practice of market

funding-based liquidity management

Purchased funds may not always be available when needed. If the market

loses confidence in a bank, the bank’s liquidity may be threatened

Over-reliance on liability management may cause a tendency to minimize

the holding of short-term securities and to relax asset liquidity standards ,and

may result in a large concentration of short-term liabilities that support

assets with longer maturities .During times of tight money ,this tendency

could squeeze earnings and give rise to illiquid conditions

Due to rate competition in the money market a bank may incur relatively

high costs when obtaining funds ,and may be tempered to lower its credit

standards to invest in high-yielding loans and securities .

If a bank purchased liabilities to support assets that are already on its

books ,the high cost of purchased funds may result in a negative yield spread

When national monetary tightness occurs, interest rate discrimination may

develop, making the cost of purchased funds prohibitive to all but limited

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number of large banks Small banks with restricted funds should therefore

avoid taking excessive loans from money market sources

Preoccupation with obtaining funds at the lowest possible cost and with

insufficient regard to maturity distribution can greatly intensify a bank ‘s

exposure to the interest rate fluctuations.

13.0 Liability Side Risk

Banks in particular fund their assets from deposits But contract deposit

holders can ask for money anytime. Even fixed deposit holders are allowed

to make premature withdrawals subject to a small penalty.

The amounts raised from deposits are invested in assets with varying

maturity Normally deposits withdrawals are replenished by fresh deposits.

On most days the banks will be a net deposit taker. Alternatively there might

be a drain on the deposits.

Net position for most financial institutions (FI)I is that deposits act as core

deposits. This is why confidence of depositors is important to a FI. Net drain

on its liquidity could be managed by either: Purchased Liquidity or Stored

Liquidity

13.1 Asset Side

Similar to Liability Side, risk could arise from assets side. A customer with a

loan commitment might ask for disbursement. A customer due to pay

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money might default or go bankrupt. An investment in a bond might

become worthless. Management of this risk would also be either by

purchased liquidity or releasing stored value.

13.2 How to meet liquidity calls

Use existing cash resources

Sell liquid short term instruments like TB’s with little loss

Call back excess cash reserve maintained

Use lines of credit or issue instruments. Not for immediate

requirements

14.0 What is Asset Liability Management?

Asset. liability management is the management of the net interest margin

and net liquidity gap to ensure that its level and riskness are compatible

with the risk/return objectives of the institution.

Note Carefully:

Net Interest Margin (NIM)

Risk Return Objectives

Every Financial Institution strives to protect:

Interest Spread

Liquidity

Credit Quality

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14.1 ALM Focus will be on Balancing:

The Price to which assets and liabilities are linked .The maturity profile of

assets and liabilities .Since complete balancing is neither practical nor

beneficial the effort is directed at managing the gap within acceptable

levels.

ALM is an integrated approach to financial management

It calls for:

Decision on Asset/Liability Mix and Volume

Understanding financial markets in which the institution operates

How interest rates are determined

15.0 Liquidity Planning

Liquidity planning is one of the key components of liquidity risk

management Planning involves anticipation and preparing for it as well as

setting in place responses to unforeseen contingencies. There must be a

liquidity plan and a contingency plan in place. The plan should specify

managers responsible for different actions in the event of a liquidity

crunch. This will include tapping sources of quick funds , interacting with

the central bank, encashing investments, press information and responding

to queries etc. The plan will also include constant monitoring of deposits.

In the event of any sign of crisis the deposits flight will be in order of:

Institutions and mutual funds

Interbank and correspondent banks

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Business houses

Small business followed by individuals

Depending upon the percentage to total deposits the speed of withdrawal can

be determined and planning should naturally to meet such contingency.

As indicated earlier, a cash flow for three to six months ahead is

necessary. This will be based on:

Ascertained maturity of liabilities

Committed investments and loans

Draw downs on loans sanctioned

Anticipated net withdrawals from withdrawal due to season, tax

payments etc.

New loans-disbursement

Liquidity risk management involves management of both asset side and

liability side. On the asset side the maintenance of liquid assets has to be

traded off with returns. Most central banks specify minimum liquidity to

be maintained by banks. Additional liquid assets will be held if the bank

expects a call on its deposits. As indicated this is normally done during

specific times of expected heavy withdrawals. On the liability side the

bank would strive to issue longer dated paper to meet longer term resource

requirement.

Banks tend to maintain some hidden liquidity in the form and ability to raise

funds quickly. In the event of any liquidity crisis these actions are

triggered They vary in size and dimension from:

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Sale and repurchase of securities-Repos

Private placements of CD’s

Draw down on line of credit

Negotiated loan arrangement

Actual sale of securities

Borrow from the central bank

16.0 Interest Rate Risk Management

Interest rate risk management comprises the various policies, actions and

techniques that an institution can use to reduce the risk of diminution of

its net equity as a result of adverse changes in interest rates.

Various aspects of interest rate risk include the following:

16.1 Repricing risk: Variations in interest rates expose the institution ‘s

income and the underlying value of its instruments to fluctuations. This

arises from timing differences in the maturity of fixed rates and the repricing

of the floating rates of the institution’s assets, liabilities and off-balance

sheet position

16.2 Yield Curve risk: This risk emanates from the changes in the slope and

shape of the yield curve.

16.3 Basis Risk (spread risk): arises when assets and liabilities are priced

off different yield curves and the spread between the these curves shifts.

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When these yield curve spreads change, income and market values may be

negatively affected. Such situations arise when an asset that is repriced

regularly (say) based on the inflation index is funded by a liability that is

repriced based (say) on the central bank accommodation rate

16.4 Optionality: Options may be embedded within otherwise standard

instruments. The latter may include various types of bonds or notes with call

or put provisions, nonmaturity deposit instruments that give the depositors

the right to withdraw their money, or loans that borrowers may prepay

without penalty.

17.0 Framework for IRM

Broad principles to the foundation for interest rate risk management.

Board of Directors to approve strategies and policies for interest Rate

Management.

Senior Management to take steps to monitor and control these risks.

Board to rate exposure in order to monitor and control the same.

Senior management should ensure that structure of the bank’s

business and the level of interest rate is effectively managed.

Appropriate policies and procedures are in place to control these risks

Resources are available for evaluating and controlling this risk.

Banks should clearly define individuals or committees who are

responsible for managing risk.

Risk management function should be independent of position taking

function to avoid conflict of interest.

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IRM policies and procedures are clearly defined and appropriate to the

level of complexity of the operations of the bank.. These be applied on

a consistent base at the group level and as appropriate at the level of

the individual affiliates.

Banks must understand the risk in new products before they are

introduced and subject to adequate controls.

Major hedging or risk management strategies should be approved in

advance, by the Board or appropriate committee.

Banks should have interest rate risk measurement system that captures

all material sources of interest rate risk and that assess the effect of

interest rate changes in ways that are consistent with the scope of their

activities. The assumptions underlying the model should be clearly

understood by the risk managers.

Banks must establish and enforce operating limits and other practices

that maintain exposure within levels consistent internal polices.

Banks must measure their vulnerability to loss under stressful market

conditions. This should include a breakdown of all underlying

assumptions. The result there from must be factored into the policies

and the limits determined.

Banks must have adequate information systems for measuring,

monitoring, controlling and reporting interest rate risk. Timely

reporting to senior management and board cannot be over emphasised.

Banks must have adequate internal control systems including

independent review of the system. Supervisory authorities must obtain

from the bank adequate and timely reports with which to evaluate the

level of interest rate risk. The information must take the range of

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maturities and currencies in each bank’s portfolio. It must include all

off balance sheet items as well as other well other relevant factors.

Banks must hold capital commensurate with the level of interest rate

risk they run

Banks must release to the public information on the level of interest

rate risk and the policies for its management.

Supervisory authorities should assess the internal measurement

system of banks adequately capture the interest risk in their banking

book. If there is inadequacy then the banks must bring up their

system.

Banks must furnish the results of their internal measurement systems

to the supervisory authority. If the supervisory authority determines

that the bank is not carrying capital commensurate with the risk, is

should direct that the bank either reduce the risk or increase the

capital.

18.0 Risk Measurement and Management

Interest Rate Risk arises due to the difference between rate

Sensitive Assets and Liabilities. At different period various

assets and liabilities will be repriced to the new floating rate. For

each period the gap between the assets and liabilities will give rise to risk.

If assets are more and rate increase then net interest income will increase.

19 0 Repricing Gap Method

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Repricing Gap Model is book value accounting cash flow analysis

of the net interest income over a certain period . Determine the

various time buckets in which you want the analysis to be carried

out. For each asset and liability determine the bucket in which it will be

repriced. Repricing will happen on:

Maturity of an asset or liability

The date on which interest rate is determined

Which ever is earlier

-Plot all assets and liabilities into the respective time buckets

-Determine Gap for each bucket as well as the cumulative Gap

-Cumulative Gap will be Nil for the entire balance sheet

-Gap Statement has information value in ascertaining Net Interest Income

(NII)

NIIi = Change in Interest.Income.in I bucket

Gapi = Dollar Size of Gap in I bucket

Ri = Interest rate change for assets and liabilities in I bucket.

Repricing Gap Method

NIIi = (Gapi)x Ri

= (RSA Ri – RALi)X Ri

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Table 3 Gap Model

Assets Liabilities Spread ZW$ Margin

(Millions)

Matched assets ZW$50 millions at

20%

Matched funds ZW$50

millions at 18%

2.0% 1.0

Variable rate assets ZW$200

millions at 21%

Variable rate funds

ZW$200 million at 18%

3.0% 6.0

Variable rate assets ZW$600

millions at 21%

Fixed rate funds

ZW$600 million at 15%

6.0% 36.0gap

Fixed rate assets ZW$400 million

at 19%

Fixed rate funds

ZW$400 million at15%

4.0% 16.0

(Total) ZW$1.250 million ZW$1.250 million 4.72% 59.0

Table 4 Repricing Gap Model

Short Medium LongFixed rate re-pricingVariable rate re-pricing gapCapital and non rate itemsSubtotalIncrease\decrease in gap as a result of

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derivativesRe-pricing gap after derivativesInterest rate changes –forecastsImpact on income statement of yield curve changes caused by an increase\decrease in bank ratePercentage capital exposed as a result of

potential bank rate change

Impact of changes in interest rate

Gap statement assumes that the change in interest rate is similar for assets

and liabilities. This may not be true and the changes may vary between

assets and liabilities.

Assume a hypothetical case of Assets and Liabilities in a Gap statement

which is equal to say 180 million.

Suppose the interest for the assets changes by 1% for the liabilities changes

by 1.2%.

The impact of this change on interest rate must be carefully determined

Comparing Rate Sensitivity Gap as a percentage of Assets with competitors

and peers in the industry will give insight into the risks being run by the

institution. While the gap method is simple , it has various shortcomings

from the perspectives of a bank.

I It ignores market value effect

II It is over aggregative

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III Fails to deal with asset liability cash flow run offs

IV Ignores cash flow from off balance sheet items

Re-pricing gap model nonetheless are a useful starting point for the

assessment of interest rate exposure . Banks also have over time progressed

from simple gap analysis to more sophisticated techniques. Ideally, a bank’s

interest rate measurement system will take into account the specific

characteristics of each interest-sensitive position and will capture in detail

the full range of potential movements. As this is in practice extremely

difficult to accomplish, in most instances an ALCO will employ a variety of

methodology for strategies for interest risk analysis

Sensitivity analysis. This process applies different interest rate scenarios to

a static gap model of a bank’s balance sheet.

Simulation This process involves construction a large and often complex

model of a bank’s balance sheet. Such a model will be dynamic over time

and will integrate numerous variables. The objective of a simulation exercise

is to measure the sensitivity of net interest income, earnings, and capital to

change in key variables. The risk variables used include varying interest

paths and balance sheet volumes. Simulation is highly dependent on

assumption, and requires significant time before the inputs made yield

meaningful results; it may therefore be more useful as a business planning

tool than for interest rate risk measurement. If it is used as a risk

measurement tool, the parameters should be highly controlled to generate as

objective a measure of risk as possible

Activity

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How can banks change the size and the direction of their repricing gap?

Maturity Method

The Gap method does not take into account the impact on market

value of the assets and liabilities consequent to change in the

interest rates. Maturity Model attempts to overcome this

inadequacy of the Gap method. The market value of assets and

liabilities will change in an inverse relationship to interest rates.

Even within a bucket the value change may be different for assets and

liabilities. There may be no gap but a change in the interest rate might

impact differently

Maturity Model or Method

Asset 100M 5 years term. Annual payment Liab. 100M 5 years term. Half

yearly payment.

Both interest resettle on the same date.

The difference in the cash flow will affect the value of asset and liability

differently

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Under Gap statement this will not show up.

Impact change in value:

A two year bond paying 10% currently at face value of 100

Interest rate changes to 11

Revised value of bond will be 98.29%

%Change is 1.71

Extend the value change to a three year bond

For the same change in the interest rate the new value will be 97.56

The loss is 2.44

Incremental loss is 2.44-1.71=0.73

• A rise in interest rates generally leads to a fall in market value

of an asset or liability and vice versa . The longer the maturity

of a fixed income asset or liability, the larger the fall or rise in

the market value for any given interest rate increase (decrease).

The fall in the value of longer-term securities increases at a diminishing

rate for any given increase in interest rate.

How to extend the concept to a Portfolio?

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The principles apply to a portfolio. Use weighted average of

maturities for assets and liabilities. Once the change or its impact on

assets and liabilities are computed, ascertain effect on equity.

For a given percentage change in interest rates what is the impact

on the equity? Impact will depend on:

Direction

Extent of Maturity Mismatch

Matching asset and liability maturity moves the bank in the direction of

hedging against interest rate risk. This however does not eliminate all

interest rate risk Immunization requires the bank to consider:

Degree of leverage –Assets/ Liabilities Duration

Maturity Model or Method

A simple illustration:

Assets 100M (1Yr) Lib. 90M (1Yr)

Eq. 10M

Both pay 10% and interest rates increase to11%

Asset 90.09 Lib 81.08

Eq. 9.01

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Deficiency of Maturity Model :

Ignores the degree of leverage in the banks balance sheet and consequential

impact on the value of equity due to changes in interest rate.

Ignores the timing of cash flows on assts and liabilities-fails to achieve

perfect immunization of value of equity.

Duration Based Model

It is a better measure to determine interest rate sensitivity since it

considers both the time of arrival of cash of cash flows and their

maturity. Duration is the weighted average time to maturity

using relative present value of cash flows as weights. Duration

indicates the average time in which the principal is recovered. All cash

flow subsequently is effective cash flow profit.

Modified Duration

Modified duration is a measure of price sensitivity to changes in interest

rates. Specifically, modified duration gives the percentage change in the

price of a fixed income security for a one basis point change in interest rates.

This measure has become the single most common measure of interest rate

risk for fixed income investment portfolios and proprietary trading positions,

and originally was used exclusively for these portfolios because they were

marked to market and the change in the market value would flow through

income

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Other Interest ate Risk Management Strategies

Diversification

Floors

Caps

FRAs

Futures

Swaps

Options

References

A Kurten , 2005, Mathematics of the Money and Bond Markets Zimbabwe

ACI Institute Limited (2000) An Introduction to Foreign Exchange and Money Markets, London: BP Training Consultancy.

Cartledge, PC (1998) The Handbook of Financial Mathematics 3rd Edition, London, Hobbs Printers

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