Asset Liability Benchmark Study 2006

Financial Services
Asset/Liability Management
Benchmark Study*
Analysis of a PwC Banking Survey 2006

00 Highlights. ............................................................................................................................................................... 9
01 General information. .................................................................................................................................. 13
02 ALM and ALCO structures.................................................................................................................. 15
03 Policies and responsibilities.............................................................................................................. 21
04 Methodologies................................................................................................................................................ 31
05 Limits framework.......................................................................................................................................... 39
06 Hedging decisions. ..................................................................................................................................... 43
07 Transfer prices................................................................................................................................................. 47
08 Reporting structure. ................................................................................................................................... 51
09 Systems and operational controls. ............................................................................................. 55
10 Impact of IFRS................................................................................................................................................ 61
11 Basel II. ................................................................................................................................................................... 65

The financial services industry faces many new challenges: shareholders continuously ask
for better performance and transparency, regulators enforce new and complex regulations,
senior managers put pressure on staff to be more efficient, and with mergers and acquisitions
expected to increase in the forthcoming years, this too brings challenge and opportunity.
In this changing environment, asset and liability managers need to understand the drivers of
their business in the future and to organise themselves accordingly. New regulations such as
Basel II and complex accounting standards (e.g. IAS 32/39, IFRS 7) impact ALM organisations,
processes and systems. Banks need to identify the impact and develop appropriate new
solutions.
As a leading partner of the financial services industry, PricewaterhouseCoopers has taken the
initiative to conduct this survey, as we believe that the time has come for banks to benchmark
their current ALM organisations and practices.
An overview of ALM in Europe

The objective of this survey was to provide the industry with an overview of ALM organisation
and practices at European banks. The results of the survey are intended to assist financial
institutions by providing peer benchmarks of industry practices. This allows the identification of
areas for improvement and will help asset and liability managers to prepare for the future.
60 European banks participated

The survey was carried out in the summer of 2006 in parallel with a survey of Asian and
Australian banks. In Europe, 60 banks based in 14 countries took part.
Scope of survey
The survey was designed to cover both qualitative and quantitative aspects of ALM
approaches which are currently in place. This report has been organised around the ALM-
related subject matter areas that were the basis of the survey questionnaire, covering:
■ ALM and Asset and Liability Management Committee (ALCO) structures
■ Policies, objectives and responsibilities
■ Methodologies
■ Limits framework
■ Hedging decisions
■ Funds transfer pricing
■ Reporting
■ Systems and Controls
■ Impact of new accounting standards (IFRS)
■ Basel II.

Survey methodology
Each section of this report includes an analysis of the survey results and a discussion of the
underlying issues. Tables and charts are presented to help the reader quickly ascertain the
main findings and issues associated with each topic and to assist in the benchmarking of the
respective institution’s practices.
In order to display the results of the ALM study effectively, PricewaterhouseCoopers designed
a survey methodology that strived to achieve an appropriate balance between:
■ Promoting maximum participation among institutions by using data templates that required
firms to report their actual practices;
■ Ensuring soundness, integrity and comparability of the survey to display results based on the
actual data reported by participants; and
■ Protecting confidentiality of participating institution’s responses while providing maximum
insight into the detailed parameters needed for analysing ALM.
The methodology used was a web-based questionnaire.
Survey confidentiality
The survey results are distributed on a no-name basis. Each institution’s individual results have
been kept strictly confidential and peer responses have been presented in a way that will not
allow an identification of any specific institution based on its submitted data. The results are
based solely on survey responses as provided by each participant to PricewaterhouseCoopers.
We have not subjected the data contained herein to audit, review or compilation procedures
or any other testing to validate the accuracy or reasonableness of the data provided by the
participating organisations.
A word of thanks
We acknowledge that the highly detailed nature of the survey questionnaire required
a considerable amount of effort on the part of each participating institution to provide
commensurately detailed and meaningful responses. We would like to extend our thanks to
those institutions for participating in this study, which we consider to be ground-breaking for
the breath and depth of its qualitative and quantitative coverage of ALM topics across business
segments.
We trust that you will find the survey results insightful and hope that they serve as a catalyst for
discussion and action within your financial institution.
If you have any comment or question regarding this PricewaterhouseCoopers survey, or would
like to request additional copies, please contact:
Rami Feghali
Partner
+33 1 56 57 71 27
e-mail: rami.feghali@fr.pwc.com
or the contact person for your territory as listed on page 71.

We thank Didier Michoud,
for his helpful comments
and valuable contribution
to this study

Highlights form the basis of a sound framework for the
management of interest rate risk. Gaps were
identified at the level of methodologies,
Executive summary governance and policies, controls and
60 European banks from 14 countries covering review of internal audit, as well as reporting.
18 large institutions and 42 smaller institutions 4.When analysing the results of this survey, it
participated in the survey. The survey became clear that the size of the institution
examined in detail all the dimensions of an has a significant influence on the practices
ALM framework (from organisation, policy and in ALM. Generally, large banks are better
methodology to systems and controls) as well organised, use more sophisticated
as related regulatory and accounting issues methodologies and IT systems, and allocate
(IFRS, Basel II). relatively more resources to ALM. A key
This survey provides unique factual area of differentiation is methodologies;
information on every piece of an ALM principally the large banks have developed
framework in a very large panel of banks and and implemented models for embedded
we refer the reader to the main body of this prepayment options, funds transfer
document. pricing, dynamic simulations and stress
testing. Consequently these banks have a
When analysing the results, we identified 4 key
better assessment of both their risks and
areas on the current state of ALM in Europe.
their opportunities. Institutions with such
These are as follows:
advanced solutions have a clear competitive
1. The basic components of an ALM advantage and are in a better position to
framework such as ALCO, ALM policies, enhance the return on their business.
basic measurement methodologies and
We present hereafter some interesting findings
system functionalities are in place for most
of each section of the survey.
institutions. European markets are mature
and banks have been used to managing
ALM risks for a long time. It is therefore ALM and ALCO structures
not surprising to see that appropriate Virtually all banks have a dedicated ALM
frameworks have generally been function led by an ALCO. ALM generally fits
implemented. into the finance, treasury or risk management
2. We think that there are still opportunities to functions. The ubiquitous nature of the ALM
improve the ALM framework and achieve activity results in a wide variety of diverse
revenue growth. We believe in particular organisational models, as confirmed by the
that the most considerable improvement survey.
potential is in the measurement of risks. ALCO in large banks are generally more
The ongoing efforts of leading institutions focused on ‘core’ ALM risks (including
in continuously enhancing dynamic risk inflation risk, interest rate risk of insurance
modelling solutions can truly help in the businesses…) than smaller banks, which tend
generation of a sustainable increase in net to analyse other types of risks as well (credit
interest income. risk, operational risk etc.).
3. Looking at the results of the survey we Smaller banks are also more position-taking
found that there are still, in many banks, oriented than larger banks, and often the
gaps against the Basel Committee treasury has an important role in managing
requirements. The Basel Committee issued the ALM position. Interestingly, as many
the ‘Principles for the Management and as 70% of medium and small banks stated
Supervision of Interest Rate Risk’ in July that their ALM units are organised as profit
2004 to support the Pillar 2 approach on centres. Only 28% of large banks have
interest rate risk of Basel II. These principles adopted this approach for their ALM unit.

Policies and responsibilities We also noted that statistical measures
related to value at risk or economic capital
Many banks are currently working
are increasingly popular among financial
on enhancing compliance with the
institutions for ALM purposes.
recommendations of the Basel Committee.
When analysing the results of the survey, Limits
we identified potential for improvements, for Nearly all banks have limits in place for the
example in the following areas: management of interest rate risk and liquidity
■ Further promotion of the involvement of the risk. Surprisingly, only 72% of medium and
board of directors and senior management small banks claim that their limits cover all
■ Advancement of ALM policies to cover entities with material liquidity risks (versus
additional risk factors (e.g. inflation, credit 94% of large banks).
risk) and additional processes (e.g. new A number of methods are used to measure
products approval, stress testing). interest rate risk. However, only a small set
ALM units are assigned multiple of calculated indicators have attributed
responsibilities that could also be held by limits and the choice of these indicators
other units such as the risk management differs greatly from bank to bank. Limits are
unit (e.g. measurement and reporting on generally set on static indicators.
risk) or the treasury unit. We believe that it
is important to define clearly the respective Hedging
responsibilities of the different parties acting The survey showed that governance around
in ALM to avoid duplication of tasks and to limit breaches and other trigger points is
ensure both independence and completeness well developed. The banks have established
of the tasks and controls. processes with appropriate formal actions
being taken should these events occur.
Methodology
Non-linear financial instruments such as
Participants reported that there is still caps, floors and swaptions are used more
a greater focus on classical re-pricing often for hedging by large banks than by
gap methodologies compared to more medium and smaller institutions. Furthermore,
sophisticated simulation techniques. In many inflation-linked instruments become
instances, there is still room to enhance increasingly popular as hedging instruments
existing measurement methodologies with among the leading banks.
regards to basis risk, embedded optionalities,
use of probabilistic models and other Funds transfer pricing (FTP)
aspects.
FTP frameworks are in place in nearly all
Similarly, validation and assessments of the institutions. The solutions allow the pricing
limits of risk models have been developed of the major components of risk, but
which enable ALM models to be assessed interestingly some key price components are
for effectiveness in different market not always present. For instance prepayment
circumstances. Banks, however, report that risk is taken into account by half of the large
there is still scope for improvement in back banks and only 26% of small and medium
testing and stress testing. This is particularly banks.
relevant for the stress testing of the main
A majority of the large banks use the
assumptions made for the models.
‘matched fund’ method to price their
The survey outlines that most large banks products, i.e. a differentiated transfer rate is
dedicate proportionally more resources to assigned to each source and use of funds
develop their ALM capabilities than smaller at the time of origination. Most medium and
institutions. small banks tend to use simpler methods for
10
pricing and measuring their profitability which A significant portion of respondents (21% of
are often based on a standardised transfer large banks and 31% of smaller banks) do
rate for all products and maturities. not validate their data with the accounting
figures.
Reporting
18% of large banks and 25% of medium
We observed considerable potential for and small banks report that they do not
enhancing liquidity and interest rate risk have procedures for regular examination of
reporting in areas such as: the ALM activity by internal audit. Survey
■ type of measures reported; participants also reported that there is still
■ distribution of the reports in particular to the effort required to ensure that all dimensions of
board and senior management; and ALM recommended by the Basel Committee
are subject to internal auditing.
■ independence of the unit that prepares the
reports from the position-taking function.
IFRS
Typically the liquidity and interest risk
The survey shows that the impact of IAS 39
reporting can be augmented to address the
on the hedging strategies is significant. 46%
key information that would enable the board
of the large banks and 63% of the medium
and senior management to understand
and small banks report that IAS 39 caused
fully the nature of the interest risk exposure
them to change their hedging strategies.
and how the ALM framework performs.
For instance, only 44% of the large banks The implementation of IAS 39 has proved to
and 27% of the smaller banks report their be challenging and resource consuming and
back-testing results, and no bank reports is still not satisfactorily completed at the level
key assumptions used in measurement of Information Technology.
methodologies.
Basel II
IT and control At the time of the survey, compliance with the
In the European market, one system, principles of the Basel Committee documents
Bancware from Sungard, is used by a has been assessed by all large banks and 69%
significant fraction of the banks participating of medium and small banks. A relatively low
in the survey (24% of the large banks and number of European banks expect significant
16% of the smaller banks). Other relatively impacts from the Basel II requirements on
popular systems are QRM and IPS-Sendero. interest rate risk management. This result is
The rest of the ALM systems landscape is somewhat contradictory with many of the
highly fragmented. Notably, 24% of large findings of the survey. It may be explained
banks and 20% of smaller banks have by the fact that interest risk in the banking
developed their own internal system to cover book is part of Pillar 2 of the Basel reform,
at least part of their needs. and that many banks have so far focused on
implementing Pillar 1 and have just started to
Basic modelling capabilities are supported
work on Pillar 2.
by the vast majority of systems used in
the industry. It is worth mentioning that the The survey shows that 94% of the large
challenges reported by medium and small banks calculate economic capital for interest
banks in their development of measurement rate risk while 51% of the medium and small
methodologies are mirrored in the capabilities banks are doing so. A negligible number of
of their systems (no treatment of embedded banks calculate economic capital on liquidity
options, no dynamic simulations, etc.). Many risks.
respondents report that they are aware of
the missing functionalities of their current
systems and plan to upgrade these in the
near future.
11
12
General information Figure 1.2. – Type of services provided by
the participating banks (the category ‘Other’
This survey was conducted in the summer includes, among others, custody services,
of 2006 in Europe, Asia and Australia. This public finance, leasing & factoring, acting as a
report presents the results for European central bank)
banks. Separate reports present the results of

the other regions. 2ETAILBANKING

#ORPORATEBANKING

60 European banks based in 14 countries 0RIVATEBANKING

participated in the survey1 (see Figure 1.1). !SSETMANAGEMENT

)NVESTMENTBANKING
Often, ALM organisation and practices

0RIVATEEQUITY
depend on the size of the banks. 3ECURITIESSERVICES

In order to facilitate comparison and the 2EALESTATE

)NSURANCE
analysis of the results we divided the

/THER
participating banks into two groups: a group

of medium and small banks (hereafter ‘m/s ,ARGEBANKS 3MALLMEDIUMBANKS
banks’) and a group of large banks. European
large banks are those that are included in
Europe’s TOP25 by capitalisation or Tier 1
Capital. The 60 European banks split into 18
large European banks and 42 m/s European
banks.
Figure 1.1 – Country of origin of the

participating banks

0O RG
S
!U D
ITZ NY
$E EN
TH ARK
3W M
ND
CE
4U N
&R Y
RIA
ND
XE LY
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U
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AI
U
LA
3 W MA
5
,U )TA
BO
ED
AN
RK
LA
ST
.E NM
LA
GI
3P
ER
ER
EL
M
ER
'
As expected, a majority of large banks

(89%) view themselves as being active in
international markets, while only 36% of the
m/s banks do so.
Most of the banks offer a variety of services,
Figure 1.2 giving an overview of the activities
of the participating banks. Large banks
are generally active in a large range of
services while m/s banks are generally more
specialised.
1 For reasons of confidentiality

we do not break down the
banks into large and m/s
banks by nation of origin.
13
14
ALM and ALCO Figure 2.2 shows that when the organisations
are decentralised, large banks are principally
structures organised by territory (56% with an

organisation by region) while m/s banks
This section describes the way ALM is tend to follow the legal units (67% with an
organised in the surveyed institutions: organisation by subsidiaries).
organisational structure, composition
of the ALM unit and the ALCO, level of Figure 2.2 –Types of ALM structure at banks
centralisation of ALM. ALM can potentially that opted for a decentralised organisation
have objectives and responsibilities that
could fit in finance functions, treasury
"YREGIONS

functions or the risk management function.
This hybrid nature can materialise in a variety "YGROUP
SUBSIDIARIES
of different organisations.
"YBUSINESS
General organisation of ALM LINES
All European large banks and nearly all "YLOCATION

(95%) m/s banks declare that they have a
‘structure’ that is in charge of Asset/Liability
Management. The majority of the banks ,ARGEBANKS 3MALLMEDIUMBANKS
see this structure as different from the risk

management structure (72% of large banks Asset/Liability Committee (ALCO)
and 73% of m/s banks).
All banks but one within each group reported
The level of centralisation of the ALM to have implemented an ALCO. A very large
structure is strongly dependent on the size of majority of banks consider that the missions,
the bank. objectives and responsibilities of the ALCO
At 50% of large banks these structures are well defined.
are decentralised while the proportion is When a decentralised ALM structure is
only 12% for m/s banks (Figure 2.1). The in place, the approach adopted on the
explanation of this result may be that m/s decentralisation at large banks shows a
banks tend to operate in local/regional clear difference compared to the m/s banks
markets and the need for decentralisation is (Figure 2.3). 92% of large banks have both a
less important than for large banks. The local global ALCO and decentralised ALCOs which
specificities of Asset/Liability Management led us to deduct that there is an appropriate
and the need to have a structure that is governance both at the local level and at the
adapted to the local market conditions may global level. The remaining 8% have only
also explain why the level of decentralisation decentralised ALCO.
is so important for large banks.
Figure 2.3 – Types of ALCO organisations at
Figure 2.1 – Distribution of centralised and banks with decentralised ALM structure
decentralised ALM structure among the
participating banks
,ARGEBANKS
3MALL

MEDIUMBANKS
3MALL

MEDIUMBANKS
,ARGEBANKS

/NLYGLOBAL 'LOBALDECENTRALISED /NLYDECENTRALISED
#ENTRALISED $ECENTRALISED
15
The situation is radically different at Figure 2.5 – Members of small & medium
m/s banks where only 44% have both banks’ global ALCOs
decentralised and global ALCOs and 44%
#&/
have only a unique global ALCO, presumably
#%/
because m/s banks have few operations
(EADOFTREASURY
outside their main local market. (EADOF!,-
The typical composition of the ALCO is (EADOFRISKMANAGEMENT
(EADOFCORPORATEBANKING

also dependent on the size of the bank (see
#//
Figures 2.4 & 2.5). While CFOs and CEOs are (EADOFCAPITALMARKET
actively participating in ALCOs in the majority (EADOFRETAILBANKING
of both large and m/s banks, we can see that (EADOFMANAGACCOUNTING
the head of risk management of large banks (EADOFSALESCOMDEVEL
seems to have a bigger influence than in the (EADOF3-%BANKING
(EADOFTAX
m/s banks.
/THER
Figure 2.4 – Members of large banks’ global
$ECIDINGMEMBER #ONSULTINGMEMBER
ALCOs
#&/ While the ALCO at m/s banks is still more

(EADOFRISKMANAGEMENT focused on an almost purely treasury view
#%/ of ALM, the ALCOs of large banks tend
(EADOFRETAILBANKING
to analyse all the business implications of
(EADOF!,-
ALM as well as all the perspectives on ALM
(EADOFCORPORATEBANKING
(EADOFTREASURY

(and the equally important risk management
(EADOFCAPITALMARKET perspective). Among the significant number
(EADOF3-%BANKING of ‘other participants’ to the ALCOs, we
#// found the heads of research or economists
(EADOFMANAGACCOUNTING
(18% of large banks and 5% of m/s
(EADOFSALESCOMDEVEL
banks), the heads of various other market
(EADOFTAX
departments (18% of large banks) and finally
/THER
board members (15% of m/s banks).

$ECIDINGMEMBER #ONSULTINGMEMBER The typical frequency of the global ALCO

meetings is monthly. The m/s banks tend to
Conversely the head of treasury of the large
have more frequent meetings (Figure 2.6),
banks is less often present than in the m/s
perhaps because ALCOs follow more closely
banks. Another significant observation is the
the trading-related issues (see Figure 2.7).
stronger participation of the heads of retail
The frequency of the decentralised meetings
banking and corporate banking at the large
is similar.
banks.
Figure 2.6 – Frequencies of the global ALCOs
meetings

%VERYWEEK

%VERYNDWEEK

%VERYMONTH

%VERYQUARTER

/THER

,ARGEBANKS 3MALLMEDIUMBANKS
16
The average duration of the global meeting enterprise-wide risk-management committee,
is around two hours at all banks. Not where all material risks are analysed in the
surprisingly the weekly and bi-monthly presence of senior management. More
meetings are shorter (around 1.5 hours), importantly, 59% of m/s banks’ ALCOs
whereas quarterly meetings are slightly longer analyse the traded market risk, while the
than two hours. proportion is only 18% for large banks. This
can have the same explanation as above but
The risks that are analysed by the vast
it can also be a consequence of organisations
majority of ALCOs in both large and m/s
where, operationally, market risk in the
banks are the liquidity and the interest
banking book and market risk in the trading
rate risks in the banking book (Figure 2.7).
book are not clearly separated because of the
However, ALCOs at large banks show a
small size of traded market books.
stronger specialisation on typical ALM risks,
while ALCOs in m/s banks also analyse other
ALM unit
types of risks and are less comprehensive
on ALM risks. Most ALCOs at large banks All of the large banks and 81% of the m/s
analyse FX risk (88%), while the proportion is banks have a specific unit dedicated to Asset
only 63% for m/s banks. & Liability Management.
35% of ALCOs in large banks analyse the The vast majority of banks (on average 95%)
ALM risk of the insurance businesses (to be think that that the mission, objectives and
compared with the 44% of the large banks activities of the ALM unit are well defined.
which report to have insurance businesses), There are, however, clear differences between
while the proportion of m/s banks which do m/s and large banks in terms of organisation.
so is only 7%, which is low considering that At large banks, the dominant business model
21% proportion of m/s banks do have an is to locate the ALM unit in the ‘finance’
insurance business. The ‘other’ ALM-related function (55% of respondents), while it is only
risks that are followed up by large banks’ the case for 14% of m/s banks (Figure 2.8).
ALCO are the risk of pension obligation (18%) Conversely, in m/s banks the ALM unit is
and capital management (12%). located within the market activities for 32%
of respondents, while the proportion is only
Figure 2.7 – Risks analysed by ALCOs
6% in large banks. Interestingly, a significant

proportion locates the ALM unit in the risk
,IQUIDITYRISK
)NTERESTRATERISKIN
management division: 17% for large banks
THEBANKINGBOOK
&8RISK
and 24% for m/s banks.
!,-RISKSOF

INSURANCEBUSINESSES
)NFLATIONRISK

Figure 2.8 shows, however, that there is a
4RADEDMARKETRISK

wide variety of organisational structures

#REDITRISK
#OUNTERPARTYRISKON

which can be found equally frequently, with

TRADINGACTIVITIES
/PERATIONAL2ISK
perhaps the exception of the localisation of

/THER
ALM within Finance at some large banks.
This choice of organisation in large banks
,ARGEBANKS 3MALLMEDIUMBANKS seems to show that ALM is viewed more like
a support function, with important financial
The ALCOs at m/s banks also analyse risks impacts (capital management, transfer pricing
that are outside the traditional ALM scope: a etc.) than a position-taking/keeping function,
significant proportion of m/s banks ALCOs which is still the organisation met in a number
analyse credit risk (29%) and counterparty of m/s banks.
risk on trading activities (20%) and even
operational risk (cited by 12% of the m/s
banks in the ‘other’ category). The ALCOs
of m/s banks tend to act more like an
17
Figure 2.8 – Reporting line of the ALM unit If ALM units don’t have a direct market
access they usually use the trading functions
3MALL
(e.g. by internal deals).
16% 32% 14%
MEDIUMBANKS
The median of the total staff number is 25
at large institutions and 5 at m/s banks. The
headcount reported by some large banks was
,ARGEBANKS 11% 6% 11%
much higher, probably because the definition
of the ALM unit in those banks extends to

support functions (middle office, back office)
3ENIORMANAGEMENT &INANCEFUNCTION -ARKETACTIVITIES
2ISKMANAGEMENTUNIT /THERLOCATIONS and market/treasury activities.
The previous analysis is corroborated by Figure 2.11 – Representation of the various

the results shown in Figure 2.9, which roles within ALM units
show a clear difference in the two groups’
-ANAGEMENT
perspective on ALM: the ALM unit is

!NALYST
considered as a profit centre for 28% of large

banks, while the proportion for m/s banks is -ETHODOLOGY
70%! &/OPERATORS

3YSTEMS
Figure 2.9 – Distribution of banks seeing their
/THER
ALM units as profit centres

,ARGEBANKS

The typical composition of the ALM unit in
m/s banks is one individual for each function
except the analyst function, where the typical
3MALL
MEDIUMBANKS
headcount is between two and three. Large
banks have much larger units, with twice

as many staff working on methodology
0ROFITCENTRE .OTAPROFITCENTRE and an absolute size of this function which
is much bigger (Figure 2.11). The size and
We can also see in Figure 2.10 that 33% of composition of the ALM units in large banks
large banks and 47% of m/s banks of the enables them to concentrate their efforts
ALM units have direct market access. and means on improving and refining their
capabilities.
Figure 2.10 – Proportion of ALM units having
a direct access to the markets
,ARGEBANKS
3MALL

MEDIUMBANKS

$IRECTACCESS .ODIRECTACCESS
TOMARKETS TOMARKETS
18
19
20
Policies and There are, however, some noteworthy
highlights and potential gaps with the Basel
responsibilities Committee requirements:

■ The organisational model is covered by
The previous section showed that many significantly fewer m/s banks than large
radically different organisations may be banks. This is perhaps caused by the
adopted for ALM. In this context and due simpler structures at some m/s banks which
to the hybrid nature of ALM which has do not need to be documented in detail.
already been mentioned, it is important that ■ Stress-testing requirements are only
clear policies and responsibilities are set covered by policies at 67% of large banks
up. The importance of clear policies and and 59% of m/s banks. The relatively low
responsibilities has been stressed by the numbers show potential gaps from the
Basel Committee. This section describes Basel Committee principles on interest rate
the policies and the responsibilities of the risks. Stress-testing is particularly relevant
different parties acting in ALM. in ALM, where the risk measurement relies
significantly on judgemental assumptions.
General
■ The number of new products approval
The Basel Committee considers that clearly policies is unexpectedly low as well.
defined interest rate risk2 and liquidity3 risk About one third of the banks don’t include
policies and procedures are essential. Nearly them in their policy, although it is explicitly
all the banks surveyed reported that they required by the Basel Committee principles
have defined policies for the management (principle 5). The increasing sophistication of
of balance sheet risks (around 90% for both commercial financial products and hedging
groups). instruments, and the potential significant
The ALM policies generally cover the main impact of new activities on the interest rate
expected points as shown in Figure 3.1. risk or the liquidity of the bank make such
policies an incontrovertible requirement.
Figure 3.1 – Topics covered by the ALM ■ Policies on systems and tools are present
policies (in the ‘Other’ category were quoted only at a small number of banks: 56% of
the manual for staff having a direct access to large banks and 32% of m/s banks. Most of
the markets and the FAS133 hedging policy). these policies include sections on system
selections and implementation. Sections on
/RGANISATIONALMODEL
system maintenance are even less frequent.

,IMITSETTINGANDCONTROLS
-ETHODOLOGYFORTHE
The main responsibilities in relation to the ALM
MEASUREMENTOFRISKS
-ANAGEMENTOFTHE

policies are mostly held by the ALCOs and the

!,-POLICIES board (Table 3.1 & Table 3.2). The involvement

2EPORTINGSTRUCTURE of the board can however be increased, as
)NVESTMENTAND
HEDGINGSTRATEGIES the Basel Committee expects the board of
.EWPRODUCTAPPROVAL

directors to approve strategies and policies
3YSTEMSANDTOOLS
regarding interest rate risk management as well
/THER as authorities and responsibilities4. As such,

one might expect a higher percentage on the

several ‘approval’ responsibilities. The board 2 Principles for the
,ARGEBANKS 3MALLMEDIUMBANKS Management and Supervision
should also ensure that senior management of Interest Rate Risk, Basel
Committee, 2004 (“BASEL
takes steps to enforce policies and strategies. IRR”), principle 4, .
The identification of ineffectiveness in policies 3 Sound Practices for
has quite a low percentage in general: only 6% Managing Liquidity in
Banking Organisations, Basel
for the board, and around 50% for the ALM unit Committee, 2000 (“BASEL
LR”), principle 3.
and the RM unit.
4 BASEL IRR, Cp. 27.
21
One would also expect senior management m/s banks it can be noted that the board
to have a greater role in that respect (28% delegated more of its tasks to the ALCO
in large banks and 14% in m/s banks) in line in large banks. Large banks’ financial units
with Basel Committee requirements that and the risk management function are also
senior management ensures that appropriate significantly more integrated in decisions
policies and procedures are established5. regarding ALM policies.
In the ‘control-orientated ‘responsibilities
there are quite similar results for the ALM
unit and the RM unit. In comparing large and
Table 3.1 – Distribution of responsibilities related to ALM at large banks
Senior ALM RM Other No

Large banks Board Finance ALCO
management unit unit unit one
Approval of ALM policies 67% 39% 22% 67% 33% 22% 0% 0%
Approval of the main proposed

50% 39% 22% 78% 33% 28% 0% 0%
changes in policies
Approval of exceptions to policies 39% 39% 17% 50% 22% 33% 0% 0%
Approval of responsabilities 50% 50% 22% 56% 11% 6% 0% 0%
Approval of delegation
39% 44% 6% 28% 11% 6% 0% 0%
of authorisations
Identification of ineffectiveness
6% 28% 17% 17% 39% 44% 11% 0%
in policies
Compliance with policies 0% 11% 22% 17% 56% 50% 22% 0%
Control of the implementation of

0% 17% 17% 11% 39% 61% 33% 0%
the policies
Table 3.2 – Distribution of responsibilities related to ALM at small & medium banks
Senior ALM RM Other No
Small & medium banks Board Finance ALCO
management unit unit unit one
Approval of ALM policies 71% 29% 2% 57% 10% 10% 0% 0%
Approval of the main proposed

69% 26% 2% 55% 10% 12% 0% 0%
changes in policies
Approval of exceptions to policies 48% 21% 5% 62% 10% 14% 0% 0%
Approval of responsabilities 52% 33% 5% 57% 12% 5% 0% 0%
Approval of delegation
40% 21% 2% 48% 12% 5% 0% 5%
of authorisations
Identification of ineffectiveness
7% 14% 5% 33% 48% 52% 7% 2%
in policies
Compliance with policies 12% 19% 7% 36% 31% 52% 19% 0%
Control of the implementation of

17% 21% 5% 33% 26% 64% 17% 0%
the policies
5 BASEL IRR, Cp. 31, 28.
22
As expected the main risks covered by the Figure 3.3 – Departments in charge of stating
ALM policy are liquidity and interest rate risk the strategies and general guidance for
in the banking book (Figure 3.2). The ALM investments
risks in insurance businesses are covered
!,#/

by only 17% of large banks, while the

4REASURY

percentage of ALCOs that follows these risks
"OARD

is much higher (29%) (see Figure 2.7). The
!,-UNIT

same observation holds for inflation risks in
3ENIORMANAGEMENT

m/s banks, which shows that ALM policies &INANCE

still need to be updated to include all types
2ISKMANAGEMENT

of ALM risk. In line with previous results,
/THER
the percentage of traded market risk in m/s

banks is high compared to large banks. And
finally, confirming the increased specialisation
and sophistication of ALM in large banks, a Checking the compliance of the effective
significant proportion of large banks include investments and the approved strategy is
capital measures as risk covered by the ALM principally done by a posteriori checks of risk
policies in the ‘Other’ category. of investments made (94% of large banks;
and 87% of m/s banks) and a posteriori
Figure 3.2 – Risks covered by the ALM
checks on volume invested (large 56%; m/s
policies
58%). An analysis of minutes of the treasury
,IQUIDITYRISK
committee by the entity in charge of defining

)NTERESTRATERISK
strategies and general decisions is done by

ONTHEBANKINGBOOK 31% of the large banks and only 5% of the

&8RISK
m/s banks.

)NFLATIONRISK The responsibility for hedging decisions is

#REDITRISK
allocated in quite a similar way to that for
!,-RISKOFINSURANCE

investments (Figure 3.4). The board and the
BUSINESSES
4RADEDMARKETRISK
senior management are, however, generally

less involved than in investment decisions
/PERATIONALRISK and the risk management department has
#OUNTERPARTYRISK
ONTRADINGACTIVITIES more influence. As for investment, often
/THER
several units are involved in the decision
process.

,ARGEBANKS 3MALLMEDIUMBANKS Figure 3.4 – Departments in charge of stating

the strategies and general guidance for
Responsibilities hedging

!,#/
The responsibility for definition of the

!,-UNIT
strategies and general guidance for

4REASURY
investments is generally held at a senior

2ISKMANAGEMENT
level in the organisation (Figure 3.3). All large

&INANCE
banks and 93% of the m/s banks allocate

3ENIORMANAGEMENT
this responsibility to one of the three senior

"OARD
authorities: the ALCO, the board of directors
/THER
or the senior management. The treasury and

the ALM unit are also active in establishing
this guidance (around 40%). ,ARGEBANKS 3MALLMEDIUMBANKS
23
We asked the banks whether the Figure 3.6 – Responsibilities of senior
responsibilities listed in Figure 3.5 management
were relevant to the board and to the
!SSESSMENTOFTHE
senior management (Figure 3.6). These ADEQUACYOF!,-LIMITS
responsibilities are required by the Basel 0ERIODICALEVALUATIONSUPERVISION

Committee, and we see that there are still ANDREVIEWOFTHE!,-POLICIESAND
PROCEDURES

some gaps that could be closed by redefining

!SSESSMENTOFRESOURCES
the role of the board of Directors and senior DEDICATEDTO!,-
management.
-AINTAININGANDEVALUATING
INTERNALCONTROLS
Figure 3.5 – Responsibilities of the board of -AINTAININGANDEVALUATING

Directors STANDARDSFORVALUINGPOSITIONS

ANDMEASURINGPERFORMANCES
!PPROVALANDRE EVALUATIONOFTHE
0ERIODICALANALYSISOFTHEIMPACT
STRATEGIESANDPOLICIESOFBALANCE
OFMARKETCHANGESONBALANCESHEET
SHEETRISKMANAGEMENT
RISKS
2ECOGNITIONANDRE EVALUATIONOF

3ETTINGOFINTERESTRATEANDLIQUIDITY
THEKEYASSUMPTIONSWITHINTHE
RISKAPPETITE
MEASUREMENTSYSTEM
!SSESSMENTOFTHEACTUAL
%NSURINGTHEPROVISIONOFCLEAR
PROCESSESFORREVIEWINGTHE!,-
GUIDANCEREGARDINGTHEACCEPTABLE
POLICIES
LEVELOFBALANCESHEETRISK

0ERIODICALANALYSISOFTHEINFORMATION /THER

TOEVALUATETHEMANAGEMENTPROCESS

OFTHEBALANCESHEETRISK

!PPROVALOFMAINCHANGESANDNEW

PROPOSALSREGARDINGBALANCESHEET ,ARGEBANKS 3MALLMEDIUMBANKS

RISKMANAGEMENT
%NCOURAGINGDISCUSSIONSINTHE

Senior management could also take a more
ORGANISATIONREGARDINGTHELEVELAND
MANAGEMENTOFBALANCESHEETRISK
active role: the recognition and assessment
of the ALM measurement key assumptions

/THER
is an area where the involvement of senior
management and ALCO is required (see Table

3.3). The balance sheet positions are often
,ARGEBANKS 3MALLMEDIUMBANKS heavily dependent on assumptions (maturity
Figure 3.5 shows that boards could take a more of non-maturating product, prepayment etc.).
active role in ALM, particularly in reviewing and These assumptions are often taken as facts
assessing the effectiveness of the ALM process by senior management and small changes
itself, by reviewing the process, approving the may radically modify the risk exposure of the
main changes and encouraging discussions on bank. Recognition and reassessment of these
ALM within the organisation. assumptions should be included in senior
management tasks.
24
Table 3.3 – Description of the responsibilities As for ALCOs, ALM units at large banks
attributed to the ALCOs have more responsibilities (Table 3.4). The
Large M/S
identification, measurement, monitoring
ALCO’s responsability
banks banks and reporting of interest risks and hedging
Supervision of the entity’s liquidity strategy execution is done by 50% of m/s
100% 85%
risk
banks while the percentage is much higher
Decision on the general strategies
for large banks.
on interest rate and liquidity risk 94% 83%
management
Definition of policies, limits and Table 3.4 – Description of the responsibilities
authorisation on liquidity risk 89% 73% attributed to the ALM units
management
Large M/S
Supervision of the entity’s interest risk 83% 93% ALM unit’s responsability
banks banks
Review and analysis of the legal and
regulatory changes that can have an 78% 68% General hedging strategy proposal 83% 86%
impact on ALM Identification, measurement,
Review of the diversity, the cost and monitoring, and reporting of medium/ 83% 67%
78% 61% long-term liquidity risk
the structure of financing sources
Review and evaluation of the results Transfer price setting 78% 75%
78% 63%
of stress testing
Identification measurement,
Decision on new financing and monitoring, and reporting of interest 78% 50%
72% 56%
securitisation structures rate risk
Design or approval of the financing Identification measurement,
72% 63%
strategy monitoring, and reporting of 78% 58%
shot-term liquidity risk
Decision on the investment strategy 72% 71%
Setting of Liquidity Contingency Plan 78% 67%
Definition of policies, limits and
authorisation on interest rate risk 72% 63% Hedging strategy execution 72% 50%
management
Identification measurement,
Review and monitoring of the needs
67% 39% monitoring, and reporting of foreign 72% 72%
of capital by each business unit
exchange risk
Review of the implementation and
the execution of the risk tranfer price 67% 63% Debt issuance 67% 42%
policies
Investment strategy execution 61% 33%
Validation of main modeling
67% 51% Capital issuance 61% 36%
assumptions
Decision on systems used for balance Defining optimal capital and debt
17% 37% 56% 61%
sheet risk management structure
General investment strategy proposal 50% 75%

On average the ALCOs at large banks have
Securitisation issuance 50% 31%
more responsibilities (on average 11.1 tasks)
Active portfolio management 33% 53%
than the m/s banks’ ALCOs (on average
9.8 tasks). The coverage of the above
responsibilities is also larger in large banks If policies and procedures are always defined
than in m/s banks (Table 3.3). Refinancing by the central ALM unit, the involvement
decisions and reviews of capital needs are of the central unit in the actual ALM
topics that are less present at ALCOs of management of the subsidiaries varies
m/s banks, whereas capital management and shows that there is some room for
is a topic that is addressed more and more improvement in the optimization of ALM at
frequently within the ALM framework of large a group-wide level. For instance, only half
banks. The validation of the main modelling of the central ALM units of m/s banks give
assumptions is still done by a relatively low instructions to subsidiaries to reduce liquidity
percentage of ALCOs, as well as decisions on risk if this risk is significant (Figure 3.7).
systems, despite the importance of systems
in the overall efficiency of ALM.
25
Figure 3.7 – Responsibilities of the holding/ Figure 3.9 – Units responsible for controlling
central entity towards subsidiaries’ ALM the risks generated by the ALM unit
function
2ISKMANAGEMENTUNIT

)NTERNALDEPARTMENT
$EFINETHEGROUPPOLICIESAND
WITHINTHE!,-UNIT
PROCEDURESINRELATIONWITH!,-

!GGREGATETHESUBSIDIARIESgEXPOSURES &INANCE

ANDREPORTTHEMTOSENIORMANAGEMENT

'IVEINSTRUCTIONTOTHESUBSIDIARYTO -ANAGEMENTACCOUNTING /THER

REDUCELIQUIDITYRISKIFTHISRISKIS )NTEXTAUDIT

SIGNIFICANT #ONTROLLINGUNIT
'IVEINSTRUCTIONTOTHESUBSIDIARYTO 4REASURY
"USINESSUNITCONTROLLINGMARKET
REDUCEINTERESTRATEEXPOSUREIFTHIS RISKCONTROLLING

EXPOSUREISSIGNIFICANT /THER
)MPLEMENTMAINTAINTHEGROUP!,-
SYSTEM

$ECIDEONTHESUBSIDIARIESgGENERAL

STRATEGYOFINTERESTRATEAND ,ARGEBANKS 3MALLMEDIUMBANKS
LIQUIDITYRISKMANAGEMENT

!UDITTHESUBSIDIARIESg!,-FUNCTION The location of the responsibility for the
$ECIDEONTHESUBSIDIARIESgGENERAL
INVESTMENTSTRATEGY

performance and risk reporting is, however,

less clear, with an equal involvement of ALM
/THER
units and risk management units at large

banks and a clear pre-eminence of the risk
management unit in m/s banks (Figure 3.10).
Looking ahead, we see that the risk
Banks should have risk measurement,
management unit is more and more involved
monitoring and control functions which are
in controlling the ALM risk, and one aspect
sufficiently independent from position-taking
of this control is certainly to develop an
functions. The ALM function can potentially
independent risk and performance reporting
combine these two types of functions;
on ALM risks.
however, banks generally state that the ALM
risk is controlled by an independent unit Figure 3.10 – Units responsible for measuring
even if this percentage is only at 66% for m/s and reporting the performance & risks of ALM
banks (Figure 3.8).

!,-UNIT
Figure 3.8 – Distribution of banks presenting
2ISKMANAGEMENT
a ALM risk-measuring & controlling unit
-ANAGEMENT
independent from the position taking ACCOUNTING
/THER

&INANCE -IDDLEOFFICEMULTIPLE

0RODUCTCONTROL
"USINESSUNITCONTROLLING
3MALL 4REASURY
MARKETRISKCONTROLLING
MEDIUMBANKS

/THER

,ARGEBANKS


)NDEPENDENT .OTINDEPENDENT
The two following results provide a more

complete picture on this issue. The
responsibility for risk controlling is located in
the risk management function for a majority
of banks. We can highlight, however, that
25% of large banks have this risk control
function as an internal unit of the ALM unit
(Figure 3.9).
26
Table 3.5 – Distribution of responsibilities amongst departments operationally active in ALM6:
Large banks/Small & medium banks ALM unit RM unit Treasury Others No one
Analysis on market tendencies and

50% 48% 17% 10% 28% 40% 28% 14% 0% 5%
evolutions
Back testing of measurement
44% 17% 56% 67% 6% 5% 11% 0% 11% 10%
methodologies
Control of the implementation of the
strategies of hedging and investment 44% 31% 44% 55% 17% 10% 28% 12% 11% 12%
of ALM
Control of the limits 44% 14% 72% 81% 11% 5% 11% 12% 0% 0%
Design of the techniques needed to

33% 24% 22% 33% 17% 10% 44% 24% 11% 14%
test the hedge effectiveness
Execution of hedging decisions 56% 52% 6% 2% 50% 36% 6% 7% 0% 2%
Funding of the group’s subsidiaries 50% 29% 0% 2% 61% 38% 0% 10% 6% 21%
Liquidity and interest risk measurement 50% 38% 67% 64% 11% 10% 11% 2% 0% 0%
Liquidity and interest risk stress testing 56% 43% 72% 71% 39% 5% 6% 5% 0% 2%
Regulatory reporting preparation 28% 21% 28% 62% 11% 5% 72% 29% 6% 5%
Reporting preparation to ALCO 61% 60% 33% 52% 22% 19% 0% 5% 0% 2%
Securitisation 22% 21% 0% 5% 17% 29% 39% 14% 22% 19%
Validation and control of the integrity of

28% 43% 44% 40% 6% 5% 61% 29% 0% 2%
the systems data
Validation of hedge effectiveness

28% 19% 11% 29% 11% 12% 61% 31% 17% 21%
testing developed for IAS 39
Validation of interest rate risk

39% 40% 67% 67% 6% 5% 22% 17% 0% 0%
management methodologies
Validation of liquidity risk management

50% 36% 61% 60% 28% 19% 11% 14% 0% 2%
methodologies
Validation of the methodologies and

44% 38% 67% 67% 17% 7% 11% 19% 0% 0%
assumptions used by the ALM unit
Validation of the methodologies

50% 29% 33% 36% 33% 24% 33% 33% 6% 2%
developed for transfer prices
Table 3.5 shows that the ALM units often have Liquidity contingency funding plan
similar responsibilities to another unit: the (LCFP)
control and measurement type of function can
Most banks have a formal LCFP which
be done by the risk management unit, while
covers policies and procedures to use as a
the position-taking function is shared with
blueprint in the event that the bank is unable
treasury. In this environment, it is important
to fund some or all of its activities in a timely
to state clearly the respective responsibilities
manner and at a reasonable cost. The Basel
of the different units to avoid duplication of
Committee recommends the definition of a
task and ensure both independence and
LCFP7. 28% of m/s banks have not, however,
completeness of the task and controls. The
defined such a plan (Figure 3.11).
category ‘others’ consists essentially of
the accounting department or the financial
controlling department. Securitisation is often 6 Multiple answers were
done by a specialised unit. possible so the sums of the
percentages exceed 100%.
7 BASEL LR, Principle 9.
27
Figure 3.11 – Degree of implementation of a Figure 3.13 – Components of the LCFP
liquidity contingency funding plan (LCFP)
#OMMITTEEWITH

DEFINEDROLE

ANDRESPONSIBILITIES
,ARGEBANKS
)NVOLVEMENTOFSENIOR
MANAGEMENT
-ECHANISMTO

3MALL IDENTIFYACRISIS

SPECIFICORSYSTEMIC
MEDIUMBANKS
0ROCESSOFCOORDINATION
INTIMEOFCRISIS

!LTERNATIVEWAYSOF
,#&0INPLACE .O,#&0INPLACE FINANCING
%XTERNAL
COMMUNICATIONPLAN
Banks can define different levels of severity to
describe a liquidity crisis. The typical number "ALANCESHEETACTIONS

of levels is three for both m/s banks and large )NTERNAL

banks – large banks tend, however, to use COMMUNICATION
PLAN
more levels than m/s banks8 (Figure 3.12). ,OGISTICALAND

ADMINISTRATIVE

SPECIFICPLAN
Figure 3.12 – The number of levels in LCFP.

/THER

LEVELS

LEVELS

LEVELS

LEVELS Most of the topics listed in Figure 3.13 are
LEVELS

detailed in ‘Sound Practices for Managing
LEVEL
Liquidity’ by the Basel Committee. While

large banks are in compliance with the

majority of the contents, m/s banks still need
to improve their procedures, in particular in
the definition of a committee9 with the power
to take decisions in time of crisis and the
definition of an external communication plan.
8 The number of severity levels

is not specified by the Basel
Committee.
9 BASEL LR, Cp. 61-8.
28
29
30
Methodologies Figure 4.2 – The frequency of the balance
sheet risk measure at large banks
This section explores the extent and the
sophistication of the modelling approaches !TA
CONSOLIDATED
used within Asset Liability frameworks. LEVEL
!TALEGAL
Size matters ENTITYLEVEL
The results of the present survey tend to "YBUSINESS

LINE

show that the size of the banking group has

a strong influence on the level at which the "YCOUNTRY
TERRITORY

risks of the balance sheet are measured.

Almost all large banks measure these risks
$AILY 7EEKLY -ONTHLY /THER
at the consolidated level, as well as at
decentralised level for a large proportion of
Figure 4.3 – Frequency of dynamic
them. For smaller banks, a decentralised
simulations
measure is more frequent, mainly at the legal
entity level. It is somewhat contradictory
to the results of question 2.1, which tend 3MALL
MEDIUM 7%
to show that the ALM structure is rather BANKS
centralised for m/s banks, and equally

distributed in large groups. ,ARGE

BANKS
Figure 4.1 – Levels at which the balance

sheet risk is measured
$AILY 7EEKLY -ONTHLY 1UARTERLY /THER .OSIMULATION
!TACONSOLIDATED
LEVEL
!TALEGALENTITY The factors modelled in dynamic simulations

LEVEL

are not uniform among the participating
"YBUSINESSLINE
banks, but do not depend on the bank’s

"YCOUNTRYTERRITORY size. If all institutions running simulations do
/THER
consider market interest rates as risk factors,

only two thirds of them account for the time
evolution of balance sheet volumes, and
less than a half account for FX scenarios.
Only a very small number of banks use
Most of the large banks measure their risk
the customers’ default probability in their
on a bi-weekly or monthly basis at the
calculations.
consolidated level. This frequency increases
strongly at the business level (Figure 4.2).
Liquidity risk measures
The focus of the business lines on their core
business facilitates a close follow-up of the The dominating methodology for the static
risks by the relevant management. A very measure of liquidity risk is the liquidity gap
similar tendency is visible with m/s banks. (Figure 4.4). The structural liquidity ratio and
the counterparty concentration analysis are
The degree of sophistication of the tools used
the two ratios that are the most commonly
depends strongly on the size of the entity
used at banks for the measurement of
as well. All banks analyse their liquidity and
liquidity risk (Figure 4.5).
interest rate risks with several methods, but a
significant portion of the participants do not
use dynamic simulations at all and rely solely
on standard static models (Figure 4.3).
31
Figure 4.4 – Static methods to measure seem to concentrate more effort only on
liquidity risk the assessment of the net interest income
than on the longer-term view given by the
,IQUIDITYGAP
economic value of capital (Figure 4.6).

.ETLIQUIDITY
POSITION Figure 4.6 – Indicators on which interest rate
)NTERBANK risk is calculated
CONCENTRATIO
ANALYSIS
)MPACT
OFHIGHER
REFINANCINGCOSTS .ETINTERESTINCOME

/THER

%CONOMICVALUEOF

CAPITAL
.ON INTERESTINCOME
INCLUDINGFEES
Figure 4.5 – Ratios used as indicators of

liquidity risk
3TRUCTURAL
LIQUIDITYRATIO
#ONCENTRATION Only a very small number of banks (less than
ANALYSIS
3URVIVALHORIZON
10%) try to analyse the impact of movements

,IQUIDITYGENERATION of interest rates on the non-interest rate
CAPACITYRATIO
$EPOSITVERSUS incomes, such as fees.
BORROWINGRATIOS
)LLIQUIDASSETVERSUS
DEPOSITRATIOS There exists a broad agreement on the

/THER methods used to measure the impact of interest
rates movements on the bank (Figure 4.7).
Figure 4.7 – Methods to measure interest rate
risk
90% of large banks and 75% of smaller
2EPRICINGGAPS
institutions try to capture their liquidity risk

3ENSITIVITYOF%6#
with dynamic simulations. These simulations
3CENARIOSANALYSIS
rely essentially on predefined scenarios 3TRESS TESTING

based on historical or specific events, and $YNAMICGAP

the majority of banks account for the impact 6A2OF%6#

of these events on the new production. Only 6ARIABLERATEGAPS

a limited number of banks (13% of small %ARNINGAT2ISK

banks and up to 31% of the largest ones) use /THER
probabilistic models.
Interest rate risk measures

Repricing gaps, the sensitivity of the
To manage the interest rate risk of the
economic value of capital, scenario analysis
balance sheet of a bank, the two measures
and stress tests are the most widespread
an asset liability manager traditionally looks
methods among all banks.
at are the net interest income (NII) and the
economic value of capital (EVC) and their The set of curve movements used in stress
respective sensitivities to movements of the tests is also quite standard. Almost all banks
yield curves. use parallel shifts in both directions, trying
to capture the effect of the non linearities
Interestingly, although both measures
embedded in the financial products in the
are used at almost all large institutions, a
balance sheet and off-balance sheet. 80% of
significant proportion of smaller entities
the large banks and only 50% of the smaller
32
institutions also use stress testing with Models of non-maturing
flattening or steepening scenarios. instruments
VaR of EVC, mainly based on historical With respect to the modelling of the non-
simulations or on parametric models, is also maturing deposits, the distribution of the
used by more than half of the participating methods in use is similar among large and
banks. smaller institutions (Figure 4.8). About two
It is quite interesting to note that there is thirds of the respondents use statistical
no unique choice of the confidence interval methods or estimations of the maturity, and
and the time horizon among both large and the remaining group uses the method of the
smaller banks: confidence intervals are replicating portfolio.
set between 95% and 99%, and holding
Figure 4.8 – Models for non-maturing
periods range from one day to two years
deposits
(see Table 4.1). Nevertheless about half of
the participating banks consider a 99%
confidence interval with short-term horizon ,ARGEBANKS
(up to 10 days) consistent with the estimated

time frame to implement corrective actions in
case of an adverse event. 3MALL

MEDIUMBANKS
More sophisticated methods such as

Earning-at-Risk (EaR) are less popular,
although quite powerful. The cost of the -AXMATURITY 3TATISTICALANALYSIS %STIMATEDMATURITY
2EPLICATINGPORTFOLIO /THER
implementation of the required technology
.OTE!TLARGEBANKSTHEESTIMATEDMATURITYISINMOSTCASESOFYEARS
and a delicate parametrisation of the models ANDRANGESFROMYEARTOYEARSFORTHEOTHERINSTITUTIONS
may prevent a wider use.

This clear division has probably both a
Table 4.1 – Choices of time horizon and
regulatory and a local business environment
confidence intervals for EVC-VaR calculations
explanation: in many countries deposits are
Large banks Small & medium banks not remunerated. A statistical analysis of
Confidence Confidence core and volatile volumes of deposits is then
interval/time % interval/time %
horizon horizon
meaningful. In other countries (for example,
95% / 1d 14% 97.5% / 1d 9%
Switzerland and Germany), deposits may
95% / 10d 4% 99% / 1d 27%
be remunerated and most of the effort has
95% / 1m 4% 99% / 10d 27%
been concentrated on the construction
95% / 0.5y 4% 99% / 2m 9%
of replication portfolios to model the time
99% / 1d 32% 99% / 2y 9%
evolution of the interest rate paid to the
99% / 10d 14% other 18%
customers. The latter approach is then
99% / 1m 11%
similar to the one adopted for products with
99% / 2m 4%
administered rates (see below).
99% / 1q 4%
Figure 4.9 – Models for equity
99% / 1y 4%
other 7%
,ARGEBANKS

A few large financial groups (23% of them)
also report having internal tools allowing the
integration of interest rate risks generated by 3MALL
MEDIUMBANKS

their banking and insurance businesses.

-AXMATURITY 3TATISTICALANALYSIS %STIMATEDMATURITY

2EPLICATINGPORTFOLIO /THER
33
Modelling the equity is a more judgemental estimation of the effective maturity.
question and there is an obvious lack
of agreement on the way to achieve it Products with administered rates
(Figure 4.9). Statistical methods are rather Similar to deposits, products with
seldom used and institutions seem to administered rates, be it by regulatory
rely on their own view or experience. The decision or purely internally to the banks,
maturities reported are in all cases longer play a central role in the management of
than a year, and many respondents tend the liquidity and interest rate risks of the
to consider equity as an almost permanent balance sheet. A lot of effort has then been
funding resource bearing no interest rate risk. concentrated on a realistic modelling of these
Another approach adopted by an increasing financial instruments.
number of banks is the benchmarking of the
Replication models are the most widely used
progression of the economic value of equity
tools. Originally based only on past market
against the performance of bond index of
rates, a number of banks have now improved
fixed maturity, typically 5 or 10 years.
these models by integrating the impact of
Products with prepayment options volume fluctuations (Figure 4.11).
Embedded prepayment options represent Figure 4.11 – Models for products with

a permanent challenge to asset liability administered rates
managers because customers do not adopt
2EPLICATIONMODELUSING
fully rational behaviour. One has then to MARKETRATESONLY
2EPLICATIONMODELUSINGMARKET
infer the driving forces that will influence RATESANDBALANCEVARIATIONS
2EPLICATIONMODELUSINGMARKET
the customers’ reactions and use them in a RATESANDECONOMICINDICATORS
consistent framework. The technical means 2EPLICATIONMODELUSINGMARKETRATES

BALANCEVARIATIONSANDECONOMICINDICATORS
and data available are key to this task and will 3TOCHASTICMODELFORTHERATE
INTEGRATINGIMPLICITCAPANDFLOOR

strongly influence the sophistication of the /THER

models the institutions will adopt.
Figure 4.10 – Elements of prepayment

modelling Interestingly enough, if more than 80% of
#ONTRACTUALMATURITY

banks using replication portfolios base their
3TATISTICAL
PREPAYMENTRATES
models on past market data, a significant
*UDGEMENTALESTIMATED

portion of institutions (30% of small banks,
PREPAYMENTRATES
#HARACTERISTICSOFTHEPRODUCT

50% of large banks) claim to determine their
DURATIONCONTRACTUALRATEx
)NTERESTRATELEVELS
optimal portfolios on simulated future values
2ATESINDEPENDENTFROM of market rates as well.
INTERESTRATELEVELS
STATISTICPREPAYMENT

/THER
Stress testing

,ARGEBANKS 3MALLMEDIUMBANKS Apart from being the new regulatory hot topic
in risk management10, stress scenarios are
Figure 4.10 shows that the approach adopted
a very efficient way of testing the limits of
at large banks differs strongly from the one
resistance of the balance sheet to adverse
at smaller banks which tend to adopt a
movements on the markets, and 90% of
pragmatic trade-off. At large institutions, the
the European banks stress test their interest
models are more developed and integrate
rate risk in order to measure the potential
essential variables such as the impact of
10 Basel Committee on losses if these extreme scenarios occur. But
Banking Supervision,
the level of market rates and the observed
surprisingly enough, 25% of large banks
International Convergence statistical prepayment frequencies. The
on Capital Measurement do not stress test their liquidity risk. This
and Capital Standards, contractual maturity of the contract is rarely
A revised Framework proportion goes up to 70% for small and
– Comprehensive Version,
considered as an important element in the
June 2006.
medium banks.
34
The common methodologies that most interest rate risk and only 20% of banks try to
European banks use to perform stress testing back test their liquidity risk.
are stress testing using specific scenarios,
One third of the banks doing back testing do
with worst-case scenario analysis and
a very close follow-up of their risk measure on
historical scenarios being the most popularly
a daily basis (see Figure 4.14). Then another
used (Figures 4.12 & 4.13).
third of the sample back test their interest rate
risk on a monthly basis, probably at the same
Figure 4.12 – Most commonly used stress
frequency as their internal reporting. The other
scenarios
banks undertake back testing on a wide range
3TRESSTESTINGONTHE
MAINASSUMPTIONS

of frequencies.
3TRESSTESTINGUSING

Figure 4.14 – Frequency of interest rate risk
SCENARIOSBASEDON
ECONOMICANALYSIS

back testing
3TRESSTESTINGUSING
$AILY
HISTORICALSCENARIOS

7EEKLY
3TRESSTESTINGUSING
-ONTHLY
SPECIFICSCENARIOS
1UARTERLY

3EMI ANNUALLY
!NNUALLY

Figure 4.13 – Specific scenario used /THER

7ORST CASE ,ARGEBANKS 3MALLMEDIUMBANKS

ANALYSIS
"USINESS
Liquidity risk back testing is more delicate,
EXPECTATIONS
ANALYSIS
and as one could expect, only a very limited

number of banks, be they large or small,
3TRESS TESTRISK
FACTORS undertake these kinds of tests: about 25% of
respondents report such a test, carried out
,ARGEBANKS 3MALLMEDIUMBANKS principally on a monthly basis.
Meaningful economic scenarios are The back testing of the assumptions made
very relevant for this kind of testing and in internal models for non-maturing deposits,
consequently are widely used: historical loan prepayment and administered rates-
extreme scenarios as well as scenarios based based products is also an important aspect of
on fundamental economic analysis are rather permanent validation of the risk management
popular among large banks (60% of them use tools. 60% of the large European banks claim
these scenarios). to review these assumptions, on an annual
basis for a majority of them. This number
Questioning the limits of the main drops to 35% at smaller institutions and it
assumptions of the models is also very clearly shows that this sophisticated and
relevant for the stress testing exercise, but time-consuming task needs levels of staffing
only half of the respondents report such tests. which might not be available for all banks.
Back testing and internal validation Banks’ view on their ALM models
Back testing the interest rate and liquidity risks Tables 4.2 & 4.3 below summarise the view
calculations for a balance sheet is far more that the banks participating in the survey
difficult in a trading environment than in market have on their internal liquidity and interest
risk management. But it is certainly a valuable rate risks measurement methodologies.
exercise in order to improve the quality of the All banks share the view that their ALM
asset liability management. Accordingly two models capture well enough the main risks in
thirds of the responding banks do back test their positions. Nevertheless topics such as
35
embedded optionalities, basis risk and clients’ Finally, another general concern is the
solvency (credit risk) remain at the top of the accounting impacts of some transactions
to-do list for a number of large and small applying the new IAS 39 accounting standard.
banks.
Having a robust enough tool allowing
modelling of the changes in business caused
by changing market conditions is also still to
be achieved by a proportion of the responding
institutions.
Table 4.2 – Large banks’ view on their internal ALM system capabilities
In banks’ view, their internal ALM model Totally Enough Partially No
Captures the main risks related to asset, liabilities and off balance sheet
71% 29% 0% 0%
positions
Is well documented, including the tests performed to confirm the main
53% 35% 12% 0%
assumptions
Is integrally part of the daily monitoring of risk management 53% 20% 20% 7%
Captures the optionality risk 6% 59% 35% 0%
Capture changes in the shape of the yield curve 38% 38% 19% 6%
Captures basis risk 19% 44% 19% 19%
Captures the clients’ solvency risk 0% 7% 7% 86%
Takes into account IAS39 31% 25% 6% 38%
Is regularly reviewed by internal or external audit or any independent

50% 38% 6% 6%
department
Does not constitute a black box 53% 40% 7% 0%
Captures the change of the bank’s business activity when interest rates change 19% 50% 25% 6%
Table 4.3 – Small & medium banks’ view on their internal ALM system capabilities
In banks’ view, their internal ALM model Totally Enough Partially No
Captures the main risks related to asset, liabilities and off balance sheet
50% 50% 0% 0%
positions
Is well documented, including the tests performed to confirm the main
21% 60% 19% 0%
assumptions
Is integrally part of the daily monitoring of risk management 30% 35% 16% 19%
Captures the optionality risk 12% 38% 29% 21%
Capture changes in the shape of the yield curve 30% 44% 21% 5%
Captures basis risk 19% 45% 26% 10%
Captures the clients’ solvency risk 7% 29% 17% 46%
Takes into account IAS39 20% 41% 12% 27%
Is regularly reviewed by internal or external audit or any independent

37% 35% 21% 7%
department
Does not constitute a black box 45% 43% 5% 7%
Captures the change of the bank’s business activity when interest rates change 14% 29% 31% 26%
36
37
38
Limits framework As seen in Chapter 4, liquidity gaps, net
liquid positions and structural liquidity ratio
In the present chapter are gathered the analysis are the most common methods used
results regarding the limits and frameworks to measure liquidity risk and quite often have
for liquidity and interest rate risk indicators limits attributed (Figure 5.3).
adopted by the participating banks.
Figure 5.3 – Liquidity risk indicators for which
Liquidity risk a limit exists
Only a very few banks do not have a liquidity /THER

risk limit framework in place (Figure 5.1). 94%

3URVIVALHORIZON
of large banks report that they have ensured

that this framework covers all entities within ,IQUIDITYRATIO

the group with material liquidity risk. This is .ETLIQUIDITY

POSITIONS
not yet the case for all the small banks: only

72% of them report that the limits framework ,IQUIDITYGAP

covers all material liquidity risks.
These frameworks constitute a real
management tool, and a large majority of
banks with such a framework monitor these
Interest rate risk
limits on a monthly basis as a minimum, and The general application of interest rate risk
two thirds monitor these limits every week at limits frameworks is clearly a consequence
least (Figure 5.2). of the spreading of risk management best
practice as well as the standardisation of
Figure 5.1 – Liquidity limits frameworks in the regulatory requirements across Europe.
place Interestingly enough, while all banks report
having a methodology in place to measure
3MALL
liquidity and interest rate risks, a couple of
MEDIUMBANKS
m/s-sized banks do not have internal limits
attributed to the risk measures (Figure 5.4).
All large banks report that their framework
,ARGEBANKS
covers all entities within the group with
material interest rate risk but only 82% of

medium and small banks.
,IQUIDITYLIMITSINPLACE .OLIQUIDITYLIMITSINPLACE
Figure 5.4 – Interest rate risk limits framework
in place
Figure 5.2 – Frequency of liquidity limit
monitoring
3MALL

MEDIUMBANKS
3MALL
40%
MEDIUMBANKS
,ARGEBANKS
,ARGEBANKS 63%

)22LIMITSINPLACE .O)22LIMITSINPLACE

$AILY 7EEKLY -ONTHLY .OPROC /THER
39
The frequency of interest rate risk limits Figure 5.7 – Proportion of limits on dynamic
monitoring is, in general, quite high. Almost interest rate risk measures.
all banks report doing it at least once a month
3MALL
(Figure 5.5). More than 50% monitor these
ON%6#
)MPACT
MEDIUMBANKS
limits every day, at least at the business unit ,ARGEBANKS
level, as seen in Figure 4.2. 3MALL

)MPACT
MEDIUMBANKS
ON.))
,ARGEBANKS
Figure 5.5 – Frequency of interest rate risk
3MALL
limit monitoring
)2GAPS
MEDIUMBANKS
,ARGEBANKS

3MALL
49% 3TATIC $YNAMIC
MEDIUMBANKS
The limit framework is seen as a real risk

management tool by the majority of the banks
,ARGEBANKS 63%
participating in the survey, as 78% of them
do review their limits annually (see Figure 5.8).

$AILY 7EEKLY -ONTHLY 1UARTERLY /THER

Furthermore, roughly 50% of the banks
may review their limits whenever deemed
In the previous chapter we could see that necessary by the management.
a number of methods to measure interest
rate risk are used by most of the banks Figure 5.8 – Frequency of limit framework
participating in this survey (Figure 4.7). But review
only a smaller number of indicators have

limits attributed at each bank and then are !NNUALLY

seen as risk management tools (Figure 5.6).
Each bank chooses a set of indicators of %VERY
interest rate risk and this set is not identical SIXMONTHS
across the banks interviewed. 7HEN

MANAGEMENT

REQUIRESIT
Figure 5.6 – Interest rate risk measures for
which a limit exists

3ENSITIVITYOF.))

3ENSITIVITYOF%6#

%CONOMICCAPITAL
)NTERESTRATEGAP

/THER
%ARNINGSAT2ISK 6A2
3TRESSTESTING
/THER

Figure 5.7 shows that limits on dynamic

measures of interest rate risk are not that
widespread, even at large banks. Limits in
place on the simulated net interest income
are based on dynamic measures for only
62% of large institutions and 46% of small &
medium banks. The impact of change in the
yield curves on the Economic Value of Capital
is considered by an important majority of
banks with a static methodology
40
41
42
Hedging decisions case by the responding banks are shown in
Figure 6.2:
Limits and controlling of these limits are
Figure 6.2 – Actions taken when a limit is
essential parts of a reliable balance sheet risk
breached
management. But these measures are useful
only when appropriate actions are taken as a -ACRO HEDGING

result of limit breach or when a ‘point of alert’
)NFORMATIONTOTHEBOARD
has been reached.
2ELEASEOFAgRESERVELIMITg
BYSENIORMANAGEMENT
Points of alert and limits breaches )MPACTONTYPES

OFINVESTMENTS

)MPACTONTYPESOF
Roughly 90% of the participating banks MARKETREFINANCINGS
have introduced ‘points of alert’ for their risk -ICRO HEDGING

/THER
6ARIOUSTYPESOF
measures, which are at lower levels than )MPACTONCOMMERCIAL
OFFERPOLICY
ESCALATIONTOBOARD
!,#/3-
,IMITREALLOCATIONS
the internal limit set by the board or the /THER !SSETSELL

senior management. These points of alert

are considered as early warning devices and ,ARGEBANKS 3MALLMEDIUMBANKS
allow the banks to take correcting action
before breaking the limit. The measures As in the case of alert points, the most
taken when the alert points are reached are popular approach to reduce the risk in the
summarised in Figure 6.1. case of a limit breach is macro-hedging.
Furthermore, as according to the Basel
Figure 6.1 – Actions taken when a point of
Committee11 limit, breaches should be
alert is reached
communicated to the senior management
-ACRO HEDGING
without delay, 61% of large banks and 70%

)NFORMATIONTO
of smaller institutions report such events

THEBOARD
to their board. In addition to the measures
)MPACTONTYPESOF
MARKETREFINANCINGS displayed in Figure 6.2, 69% of the large
)MPACTONTYPES
OFINVESTMENTS

banks and 93% of the small & medium banks
-ICRO HEDGING
have a specific and formalised process to

)MPACTON /THER explain why the breach occurred
COMMERCIALPOLICY )NFORMATIONTOVARIOUS
OTHERAUTHORITIES
Hedging instruments
BOARD!,#/3-
/THER

,ARGEBANKS 3MALLMEDIUMBANKS Figure 6.3 – Financial instruments used by

banks to reduce their exposure to interest
The respondents report using a mix of
rate risk
methods. Macro-hedging is the most

commonly adopted approach to reduce the )NTERESTRATESWAPS

exposure to the measured risk factor, as two #URRENCYSWAPS

thirds of the banks utilise that technique. &2!AND&UTURES

Interestingly, there is no real difference in
3WAPTIONS

the way large and smaller institutions react,
#APS&LOORS
except on the use of micro-hedging, where

)NFLATIONSWAPS
45% of small & medium banks but only 25%
)NFLATION INDEXED
of large banks adopt this strategy when BONDS
deemed appropriate. /THER

In the worse case of a limit breach, the
theoretic economic capital allocated to this
specific risk no longer covers the actual
risky position. The measures taken in this 11 BASEL IRR, Cp. 56.
43
Interest rate swaps are used by all banks Figure 6.4 – Ratio of notional volume of
without exception. Currency swaps are used derivative instruments and size of the balance
by half of the banks, presumably depending sheet
on the presence of net FX-positions in their

banking book. Non-linear products such

as swaptions or caps/floors are used more

frequently among large banks, as well as

the comparably new instruments to hedge
inflation risk.

Inflation swaps are used by 22% of the large

banks and only 5% of the m/s banks, inflation UPTO

indexed bonds are used by 11% of the ,ARGEBANKS 3MALLMEDIUMBANKS
large banks and 7% of the m/s banks while

inflation risk is analysed by 29% of large For small & medium banks, with many
banks’ ALCOs and 27% of smaller banks’ of them not listed on stock exchanges,
ALCOs (see Figure 2.7). the situation is quite different. More than
The resulting relative sizes of the derivatives two thirds of them hold notional volumes
portfolio differ widely across the sample of of derivatives larger than the size of their
banks (Figure 6.4). balance sheet. The largest volumes reported
surge to 12 times the bank’s size12.
Large banks, driven by the capital markets,
have reduced their derivative volumes and
two thirds of them hold a maximum of only
20% derivative notional volume compared to
the balance sheet size.
12 These figures have to be

taken cautiously: Some
banks accounted only for
the deals done with external
counterparties, which
caused some misleadingly
low volumes in ALM
derivatives portfolios.
44
45
46
Transfer prices To achieve the above-mentioned objectives
the components of the prices have to be
Market risks are priced – of course – by the chosen properly. Figure 7.1 below shows
market. But ALM units, as collectors and that the funding rate by maturity is, for
bearers of risk, often don’t have market nearly all banks, a major pricing component,
access by themselves. So internal risk together with adjustments for liquidity risk
transfer is used by many banks. In fact and prepayment risk. 47% of banks also use
only one of the European banks surveyed spreads to indices for some products.
does not use a transfer pricing system. We As we could see in Chapter 4 about
performed a detailed analysis of the use of methodologies, m/s banks are lagging slightly
this methodology in the present chapter. behind the larger institutions in measuring
liquidity risk and prepayment options,
Objectives and components of the and therefore fewer small banks consider
transfer pricing system adjustments for these risks in their pricing
Understanding the origin of their profitability framework.
is an objective shared by all banks, and
all respondents, except one, have a funds Figure 7.1 – Components of transfer prices
transfer pricing framework in place. In
&UNDINGRATE
separating the rate-sensitive and credit- BYMATURITY
sensitive parts of the revenue and allocating !DJUSTMENTFOR

LIQUIDITYRISK

them to the relevant business unit, each !DJUSTMENTFOR

PREPAYMENTRISK
bank aims to measure the profitability of

each individual business and facilitate the 3PREADTOANINDEX
management of interest rate risk. &ORFAITARYNEGOTIATED

/THER
#OUNTRYRISKS
ADJUSTMENT
%MBEDDEDOPTIONS
As shown in Table 7.1 below, another /THER
%QUITYREQUIREMENTS
important function of an FTP framework is

to help set better prices to every type of ,ARGEBANKS 3MALLMEDIUMBANKS
transaction by clarifying the contribution of
each risk factor to the overall revenue. Some products can be promoted without
harming the front office’s margin by setting up
Table 7.1 – Average ranking of the various special transfer prices often called ‘political
objectives of FTP frameworks in place transfer prices’ which may not be based on
Small & market rates. Figure 7.2 shows that among
Large
banks
medium the participating banks, this kind of product
banks
is more frequent in m/s banks than in large
Average Average
Object of transfer prices
ranking ranking
banks: only 12% of the large institutions,
but 41% of the smaller banks, have such
Measure the profitability of
1.9 1.9
each business unit products in place.
Facilitate the management of
2.3 2.9
interest rate risk Figure 7.2 – Use of political transfer rates to
Set better prices to assets
3.1 2.9 promote certain types of products
and liabilities
Reduce costs by minimising
number and size of external 4.2 3.8 3MALL
deals
MEDIUMBANKS
Provide a tool to promote

the competitiveness of
4.4 4.5
the products (commercial
strategy)
,ARGEBANKS
Establish the ALM unit results 4.6 4.5

9ES .O
47
The origin of this discrepancy is not obvious. Figure 7.4 – Various parties involved in the
Competition among banks may be an definition of the transfer prices
explanation. Small banks have higher funding

!,#/
costs and many of them do not measure the
risk due to options embedded in many retail 3ENIOR

MANAGEMENT

products. They may then need to resort to
!,-UNIT

political decisions in the pricing more often
&INANCE
than larger institutions. This seems to be DEPARTMENT
confirmed by Figure 7.3, which shows that !CCOUNTING /THER

DEPARTMENT "OARD
most often, when a political price is applied, 4REASURY
-ARKETDEPT
/THER
the aim is to reduce the price of the credit
product offered to customers.

Figure 7.3 – Goal of political transfer rates

when applied The type of transfer price chosen depends
strongly on the very nature of the financial
2EDUCEPRICE products in the balance sheet: the type of
OFPRODUCTS rate, (fixed, floating or administered) will most
often determine the type of assignments.
)NCREASEPRICE
OFPRODUCTS In Figure 7.5, one can see that the majority of
banks follow the matched funded approach
/THER
whenever possible. A significant percentage

of banks also use a pool approach for some

products in their balance sheet13.
Figure 7.5 – Types of assignments of transfer
Decisions, systems and handling prices
As transfer prices are highly strategic, usually

-ATCHEDFUNDED
more than one authority participates in the
pricing decision process.

3INGLEPOOL

Figure 7.4 shows that decisions are taken in
most institutions at a very senior level, with
-ULTIPLEPOOL

ALCOs and senior management being most
often involved. Interestingly enough, very few
/THER
banks involve their board of directors in the
decision process, and one large bank and
17% of the small & medium banks do not ,ARGEBANKS 3MALLMEDIUMBANKS
involve any senior authority in that process.

Depending on the products and the
maturities which are subject to the internal
trades, the single-pool method might lead
to artificial stimuli in selling some products.
13 Single-pool method: A Nevertheless, the rate of banks using the
standardised transfer
rate for all products and single-pool method is surprisingly high.
maturities is used. In the
multiple-pool method For very long-term fixed-rate products
several rates are assigned
to different spectrums of banks often use durations shorter than the
maturity. The matched-term
method assigns unique contractual period. 93% of the European
transfer rates to each source large banks and 82% of the medium and
and use of funds at the time
of origination, so the spread small banks use the expected duration
of each transaction can be
identified exactly. instead of the contractual period.
48
Ideally, all decisions regarding transfer prices
should be aligned with the general market
conditions and the businesses of the financial
institution. An update of the components of
the transfer prices can help achieve the goal
of being as close to the markets as expected.
Figure 7.6 – Distribution of transfer prices

update frequencies

1UARTERLY

3EMI ANNUALLY

!NNUALLY

.OFIXED

FREQUENCY /THER
MOREFREQUENTLY

/THER FREQUENCYACCORDINGTOPRODUCTS

Obviously the market tends to a yearly

review and update of the transfer prices. A
surprisingly high percentage in both groups
has no fixed update implemented.
49
50
Reporting structure Table 8.1 – Typical frequencies of the reported
information:
The Principles of the Basel Committee Reporting
frequencies Large Small &
regarding the Management and Supervision on liquidity risk banks medium banks
of Interest Rate Risk and Liquidity Risk indicators
require the banks to have adequate Daily (25%)
Daily (43%) Weekly (19%)
information systems for measuring, Liquidity gap
Monthly (30%) Monthly (38%)
monitoring, controlling and reporting the Quarterly (19%)
risk exposure. Reports must be provided on Net liquidity Daily (31%) Daily (31%)
position Monthly (50%) Monthly (54%)
a timely basis to the senior management,
board of directors and other appropriate Stress testing
Quarterly (21%) Yearly (20%)
personnel. An accurate, informative, and Ratios used to
Daily (40%) Daily (38%)
timely management information system measure liquidity
risk
is considered essential for managing risk
Tools used for Various: daily to
exposure14. N/S
dynamic monitoring yearly or ad-hoc
Monthly (75%)
All ALM units at large banks and 95% of Scenario analysis Monthly (67%)
Yearly (25%)
them at medium and small banks produce Weekly (25%) Weekly (33%)
Qualitative analysis
periodically standard reports for measuring, on liquidity risk
Quarterly (50%) Quarterly (33%)
monitoring and controlling the balance sheet
risks.
Overall, reports are prepared by the ALM
Liquidity risk units themselves for roughly half of the
surveyed banks or by an independent risk
Figure 8.1 – Information reported on controlling unit for the other half. They
liquidity risk are sent essentially to the ALCO, and to a
lesser extent to the board of directors or

,IQUIDITYGAP the senior management. Some m/s banks

.ETLIQUIDITYPOSITION
do not report to any of these institutions. A

3TRESSTESTING
significant number of banks in both groups
2ATIOSUSEDTOMEASURE
LIQUIDITYRISK do not comply with the Basel Committee
4OOLSUSEDFORTHEDYNAMIC
MONITORINGOFLIQUIDITYRISK principles that require the sending of the

3CENARIOANALYSIS
1UALITATIVEANALYSIS
report to the board of directors and the senior
ONLIQUIDITYRISK

management.
/THER

There is therefore significant room for
improvement in the liquidity reporting
framework to extend the type of measures
Many banks use more than one type of
reported (in particular scenario/qualitative
information to report the liquidity risk. Large
analysis and other key measures for m/s
banks use on average 3.5 of the above
banks), to extend the distribution of the
measures and m/s banks 2.8. Liquidity gaps
report, in particular to the board and senior
are reported in both large banks and m/s
management, and also for some banks
banks. Some key measures are, however,
to ensure that risk exposure reports are
reported more often in large banks than in
prepared by a unit that is independent from
m/s banks: net liquidity position, stress testing
the position-taking function.
and dynamic monitoring tools/measures.
The information used more operationally
to adjust the liquidity position is generally
reported more frequently – often on a daily
basis. Globally, most information is reported
14 BASEL LR, Cp. 21f ;
on a monthly basis. BASEL IRR, Cp. 61f.
51
Interest rate risk sensitivity of net interest income or qualitative
analysis.
Figure 8.2 – Information reported on interest
As for liquidity risk, reports are prepared by
rate risk
the ALM units or the risk controlling units, in
3ENSITIVITYOFNET an equal proportion. Reports are mainly sent
INTERESTINCOME
)NTERESTRATEGAP
to ALCO, and again not always to the board.

3ENSITIVITYOFECONOMIC
VALUEOFCAPITAL
Additional information to monitor

3CENARIOSANALYSIS balance sheet risk

3TRESSTESTING
1UALITATIVEANALYSIS
Besides the above-mentioned information
/THER
ONINTERESTRATERISK

3TRUCTUREEFFECT there is various other information that can
/THER /FF BALANCESHEETPOS

be useful to monitor balance sheet risks.

The following information is all explicitly or
implicitly required by the Basel Committee16.
The reporting on interest rate risk is more
Figure 8.3 – Additional information reported
homogenous between large banks and m/s
on balance sheet risks management
banks. The sensitivity of the net interest
income is, however, much less reported in ,IMITBREACHANALYSIS

m/s banks (55%) than in large banks (83%). "ACK TESTINGRESULTS

Globally, the reporting of key measures such )NVESTMENTANDHEDGING
PROPOSAL
as stress tests and scenario analysis is still
(EDGESSITUATION
low (around 55%). These measures can be
2ESULTSOFTHEINDEPENDENT
used to communicate the ALM risk effectively REVIEWOFTHE!,-FUNCTION

to senior management and the board. Results .EWPRODUCTSPROPOSALS

of stress-tests are also part of the minimum .EWPRODUCTSAPPROVAL

contents of reports required by the Basel /THER
/THER
!D HOCANALYSIS
Committee15. 3TABILITYOFDEPOTBASE
.EWBUSINESSREPORT
+EYASSUMPTIONS

Table 8.2 – Frequencies of the reported

information on interest rate
Reporting
frequencies on Large Small & The percentage of banks reporting this
interest rate risk banks medium banks information is quite low, and some key
indicators
information that would enable the board and
Sensitivity of net Monthly (67%)
Weekly (17%) senior management to understand fully the
Monthly (50%)
interest income Quarterly (22%)
Quarterly (17%) nature of the interest risk exposure and how
the ALM framework performs is missing.
Daily (30%)
Interest rate gap Monthly (65%)
Monthly (55%) Only 44% of the large banks and 27% of
Sensitivity of
Fortnightly the m/s banks report their back-testing
(18%),
economic value Monthly (71%)
Monthly (45%), results, 33% of large banks and 11% of
of capital
Quarterly (18%) m/s banks report the results of independent
Scenarios analysis
Monthly (46%)
Monthly (100%) review of the ALM function, new product
Quarterly (31%)
proposals are reported by 17% of large
Monthly (40%) Monthly (50%),
Stress testing
Quarterly (40%) 6monthly (33%)
banks and 18% of m/s banks and, finally,
no bank reports key assumptions, even
Qualitative analysis Monthly (75%)
none though usually these assumptions have a
on interest rate risk Quarterly (25%)
strong impact on the measured exposure.
All measures are mainly reported on a All the previous information is part of the
15 BASEL IRR, Cp. 62f monthly basis, for some measures the minimum information that should be reported,
16 BASEL IRR, Cp. 62f quarterly frequency is also used: stress-tests, according to the Basel Committee.
52
As for liquidity risk, the reporting framework The reporting framework of ALM is
for interest rate risk has significant room particularly important in an environment
for improvement in terms of contents, where:
distribution and preparation. ■ decisions are taken at a very senior level on
the basis of the reporting;
Table 8.3 – Frequency of reports on
■ the measurement of risk is very complex,
additional information on balance sheet risk
depending on assumptions; and
management
■ it is often difficult to build an organisation
Reporting
frequencies of Large Small & that enables clear independent risk control.
additional balance banks medium banks
sheet risk indicators
Limit breach Daily (28%)

Monthly (67%)
analysis Monthly (32%)
Monthly (28%) Daily (38%)

Back-testing results
Quarterly (28%) Monthly (38%)
Investment and Weekly (33%)

Monthly (69%)
hedging proposal Monthly (33%)
Hedges situation Monthly (63%) Monthly (58%)
Result of the
independent review Daily to 3 years Yearly (50%)
of the ALM function
New products
Ad hoc (100%) Ad hoc (71%)
proposal
New products
Ad hoc (100%) Ad hoc (63%)
approval
53
54
Systems and Figure 9.2 – Distribution of other systems
within large and small & medium banks
operational controls +ONDOR

3!0

3UNGARD&OCUS
In this section we explore the systems in

0ROMETEIA
place and the operational controls adopted to -UREX

ensure the quality of data and reporting. #OMIT

!,-3)3
2ISKTURK
The ALM systems in use 2ISK-ANAGER

&ERNBACH
There exist a number of Asset Liability /2-

Management systems (both vendors’
solutions and in-house developments) and ,ARGEBANKS 3MALLMEDIUMBANKS
the present survey tends to show that the

About 75% of respondents consider updating
systems landscape is quite fragmented
or changing their ALM software on a short
among European banks (Figure 9.1).
and mid term horizon. The distribution of the
Figure 9.1 – The ALM systems in use at large time frame is given in Figure 9.3.
and small & medium European banks. Banks
Figure 9.3 – Horizon for an update or a
may use several systems simultaneously.
change of the ALM software
3UNGARD"ANCWARE

12-

)03 3ENDERO 3MALL
37%
!LMONDE MEDIUMBANKS

&ERMAT

2ISK0RO
)NTERNALSOLUTION

/THER
,ARGEBANKS 31%
!LGORITHMICS

0ROFIT-ASTER

MONTHS YEAR YEAR /THERSPECIFY
Bancware or Sungard is used by a significant 55% of banks were not supported by external
portion of participating banks: 24% of large auditors or consultants for a review of their
banks and 16% of the smaller banks. Other ALM function.
popular systems are QRM and IPS-Sendero.
Interestingly, 24% of large banks and 20% Software functionalities
of smaller banks have developed their own
The link to accounting is central in ALM and
internal system to cover at least part of their
many pieces of software are able to organise
needs.
data to be compliant with analysis done
Quite a significant number of banks use by the controlling department. A grouping
systems that were not in the original list of the of data in various dimensions, such as
questionnaire (Figures 9.1 & 9.2). currencies, legal entities or account structure
is achieved by a majority of systems, both
The use of some products is strongly linked
at large and smaller banks (Figure 9.4). As
with the country or the linguistic area the
seen in Chapter 2, smaller banks tend to
vendor comes from: for example Promoteia
manage their balance sheet risks at the legal
in Italy, Fernbach and Sungard/Focus in
entity level (Figure 2.2), and consequently the
Switzerland and Germany, Riskturk in Turkey.
aggregation feature is less present in systems
in use.
55
Figure 9.4 – Basic functionalities of the ALM Figure 9.5 – Modelling functionalities of the
software in use ALM software currently available
4REATMENTOFTHEACCOUNT 0RECISEMODELISATIONOF

STRUCTUREBYLEVELOF PRODUCTSONBALANCESHEET

DETAILANDAGGREGATION
!UTOMATICLOADINGOF
MARKETCURVESANDRATES
4REATMENTOFDIFFERENT
CURRENCIES #ALCULATIONOFZEROCOUPONS
ANDFORWARDRATES
-ULTI COMPANYTREATMENT -ODELISATIONOFEMBEDDED

WITHHIERARCHICALLEVELSOF OPTIONSINRETAILPRODUCTS

ANALYSISANDCONSOLIDATION
-ODELISATIONOFLOANS
PREPAYMENT

,ARGEBANKS 3MALLMEDIUMBANKS $YNAMICPORTFOLIOMODELLING

All basic modelling capabilities are supplied -ARKET BASEDVALUATION

by the majority of software used in the 0ARAMETRISATIONOFDIFFERENT

SCENARIOSOFYIELDCURVES
industry (see Figure 9.5). An interesting
%ASINESSANDFLEXIBILITY
point is the fact that the modelling and TOGENERATEMODELS
implementation of embedded optionalities 6A2

and prepayments in retail products is
-ODELISATIONOFEMBEDDED
less developed at m/s banks. Dynamic OPTIONSINFINANCIALPRODUCTS
simulations seem to suffer from a lack of -ONTE#ARLOSIMULATION

development as well, as only 33% of small

institutions report having such a capability %A2

with their ALM system. -ODELISATIONOFLOAN

IMPAIRMENTS
The impact of credit risk through its
consequences on the impairment of loans is ,ARGEBANKS 3MALLMEDIUMBANKS
only rarely considered, even at large banks.

Integration with other risks is not an easy task
Along with their capabilities for modelling and very few systems propose a solution,
of the interest rate and liquidity risks of the which often follows the idea of calculating an
balance sheet, ALM systems are often able economic capital combining the main sources
to calculate transfer prices for the various of risks and their mutual correlations.
transaction types and are then accessed
by other users outside the ALM/Risk Figure 9.6 – Existing modules and required
management Department, such as the ones
Controlling or Accounting departments, as
)NTEGRATION

the available data make profitability analysis WITHOTHER

RISKS 15% 62%
easily possible (Figure 9.6). For those banks

0ROFITABILITY

reporting according to the IAS framework ANALYSIS
69% 15%
and having adopted the IAS 39 standard for
)!3
hedge accounting, several systems have
69% 31%
the capacity to measure the effectiveness of 4RANSFER

hedges and facilitate the documentation of PRICES 85% 15%
the hedge relationships.
,ARGEBANKS 0RESENT 2EQUIRED .ONE

3MMEDBANKS 0RESENT 2EQUIRED .ONE
Interestingly enough, there seem to be

different points of view regarding this
question: if 70% of small banks try to
integrate risks or at least require that the
system they use is able to do so, only
(roughly) 40% of large institutions consider it.
56
In order to leverage their modelling and can be distributed in various formats through
computing capabilities, almost all systems different channels. Figures 9.9 and 9.10
are able to generate analytical reports, as show that most software solutions used
well as scenarios comparison reports and in the industry have rather well-developed
multiple currencies reports (Figure 9.7), but capabilities for exchanging data with other
only a minority of these systems allow the applications. Data management is also
generation of the reports required by the widely available to super-users through the
local regulatory bodies. Consolidation reports possibility to add/modify/delete records or
seem also to be mostly generated by hand. parts of records.
Figure 9.7 – Reports generated by the ALM Figure 9.9 – Level of availability of various

application import & data transformation functionalities
)MPORTFILESOF
!NALYTICALREPORT DIFFERENTFORMATS
3CENARIOS
COMPARISONREPORT
#ALCULATIONIMPORT

2EGULATORYREPORT

2EPORTON 4OOLSTOMAP
MULTIPLECURRENCIES
EXTRACTFIELDS
#ONSOLIDATIONREPORT
0OSSIBILITYTOADD

MODIFYOR
/THERSPECIFY ELIMINATEFIELDS
0OSSIBILITYTOADD
!UDITTRAILREPORT
MODIFYOR
ELIMINATERECORDS

As the integration with spreadsheets is well
established among ALM systems (Figure 9.8), Figure 9.10 – Level of availability of various
graphical analysis and interaction with other export functionalities
reporting applications (such as Crystal Report %XPORTOFTABLES

or Business Objects) are not standardised FIELDSINTHEORDER
SPECIFIEDBYTHEUSER

features. Nevertheless vendors’ solutions are

0OSSIBILITYOFLINKS
rather flexible in the parametrisation of their WITHSPREADSHEETS
analytical reports which is not really the case

!PPLICATIONOFFILTERS
for in-house developments.
%XPORTOFINFORMATION
Figure 9.8 – Availabilities of reporting INMULTIPLEFORMATS
functionalities of ALM software
)NTEGRATIONWITH
SPREADSHEET
)NFORMATIONPERIODICITY The data management facilities available

SELECTIONBEFOREANALYSIS
are rated as rather good by the survey’s
&LEXIBLEPARAMETRISATION

respondents but there is some room for
)NTERACTIONWITHANOTHER
improvement on the frequency of update,
REPORTINGAPPLICATION
data integrity, data cleansing and monitoring
'RAPHICALANALYSIS

(Figure 9.11). M/s institutions seem to be
slightly more positive than the large ones

on their systems regarding data sources
integration and multi-user accessibility.
Technological capacity and
dedicated IT resources
Importing and exporting data in various
formats are key capabilities for risk
management software, as data are provided
by a number of source systems and reports
57
Figure 9.11 – Assessment of the data proportion of respondents (21% of large
management software quality. The results for banks and 31% of smaller banks) do not
the large financial institutions are shown in validate their data with the accounting
green, and the data for m/s banks in orange. figures. Controls of market data are less
widespread, especially at large institutions,

probably due to a better integration of risk
$ATAINTEGRITY 0%

management systems with front office and
$ATACLEANSING
MONITORING
trading systems. Control of customers’
behavioural data needs more investigation
$ATASOURCES
)NTEGRATION

and is done by about half of the participants.

-ULTI USER

ACCESSIBILITY Figure 9.13 – Operational controls of data

5PDATE #ONTROLOFASSET

FREQUENCY LIABILITY
CHARACTERISTICS
4IMELINESS #ONTROLOFINPUT

COMPLETENESS
!CCOUNTING
RECONCILIATION
'OOD -EDIUM 0OOR 'OOD -EDIUM 0OOR
#ONTRLOF
SYSTEMOUTPUT
Quite surprisingly, many respondents do #ONTROLOF

MARKETDATA
not have dedicated IT resources for the #ONTROLOF
BEHAVIOURALDATA
maintenance and the management of the

database(s) and the ALM application(s) (see ,ARGEBANKS 3MALLMEDIUMBANKS
Figure 9.12). The sharing of IT resources on

several projects or business systems seems
Figure 9.14 – Departments involved in
then to be quite frequent, even at large
operational controls
institutions.

)4DEPARTMENT
Figure 9.12 – Availability of dedicated IT

resources for ALM !,-DEPARTMENT

2ISKMANAGEMENT

3MALL /THERSPECIFY

MEDIUMBANKS

!CCOUNTING

/PERATIONS
,ARGEBANKS


Inaccurate or incomplete data can have
(AVE)4RESOURCES $ONOTHAVE)4RESOURCES
numerous causes and many banks have put
in place procedures to identify and resolve
Controls of data import data feeding problems: more than 80% of
As quality of data is a key point in risk large banks have documented processes
management, controls of data accuracy to fix issues like inaccurate file transfers,
and completeness are carried out by almost changes to core systems and the introduction
all banks (Figure 9.13) and involve several of new products (figure 9.15). This proportion
resources from the ALM/Risk management is lower at m/s banks. Procedures to identify
department and the IT department bottlenecks in the data transfer are much less
(Figure 9.14). The most common controls frequent, as only 60% of large institutions and
are controls of product characteristics, 50% of the m/s banks have such procedures
control of input completeness and account in place.
reconciliation. Note that a significant
58
Figure 9.15 – Existence of procedures to Figure 9.16 – Coverage of the review by
identify and resolve the following problems internal audit departments
!SSESSMENTOF
)NACCURATEFILE
DOCUMENTATION
TRANSFERS
APPROPRIATENESS
#HANGESTO
CORESYSTEMS #ONTROLOFTHE

.EWPRODUCTSNOT EXACTITUDE

PARAMETRISEDIN OFREPORTS

THESYSTEM
"OTTLENECKSIN %VALUATIONOFMEASUREMENT
THEPROCESSES
SYSTEMDATAAGGREGATION

PROCESSING

,ARGEBANKS 3MALLMEDIUMBANKS #OMPLIANCEOF

THEPROCESSES

WITHTHOSEDEFINED
Review of the ALM process by 2EVIEWOFTHE

internal audit IMPLEMENTATIONOF
THELIMITCONTROLFRAMEWORK

As interest rate risk of the non-trading activity #ONTROLOFTHE

is the main risk with credit for most of the IMPLEMENTATION

OFTHEPROCEDURES
responding banks, internal and external
reviews of the ALM function are key to 2EVIEWOFTHE

POLICIES
ensuring good and consistent management IMPLEMENTATION

of these risks. Nevertheless, the present !SSESSMENTOF

THEASSUMPTIONS
survey shows that 18% of the large banks PARAMETERSAND
and 25% of the m/s banks do not have METHODOLOGIESUSED
review procedures of the ALM activity by !SSESSMENTOF
internal audit. STAFFINGADEQUACY
Figure 9.16 shows the various checks of ALM

/THERSPECIFIY
operational processes done by the internal
audit departments at the participating banks.

All these controls are required by the Basel
Committee17, and the results of the survey
show that many banks need still to improve
significantly the scope of internal audit
review.
17 BASEL IRR, Cp. 68.
59
60
Impact of IFRS requirements’, as IAS 39 requires new
calculations (fair value, hedge effectiveness,
The implementation of IAS 39 had many hedging relationship) that need to be
ALM-related implications: predominantly implemented.
hedge accounting, but also the treatment of The implementation is generally not totally
internal derivatives, embedded derivatives, completed, as only 67% of large banks
fair value requirements etc. Asset liability and 77% of m/s banks consider their ALM
managers were therefore heavily involved in systems and procedures as meeting the IAS
IAS 39 implementation and IAS 39 also had 39 requirements.
important consequence for the ALM function
Some other aspects are more advanced:
in general. IFRS 7 is also requesting new
92% of large banks and 83% of m/s banks
disclosures on risk management.
have put in place internal procedures
IFRS implications for ALM and independent controls to prove the
effectiveness of the hedging relationship.
A key result of the present survey is the level
of the impact of IAS 39: 46% of the large Hedge accounting implementation
banks and 63% of the m/s banks said that
The major issue of IAS 39 – hedge accounting
IAS 39 made them change their hedging
– can be implemented in several different
strategies.
ways. The types of hedge accounting bases
The implementation of IAS 39 also proved to that were used by European banks are
be difficult and resource-consuming, and is summarised in Figure 10.1.
still not totally completed.
Figure 10.1 – Types of hedge relations in use
We asked the banks what were the
at European banks
main issues they faced in the IAS 39
implementation. The results are shown in the &AIRVALUE
MICROHEDGE
following table :
#ASHFLOWON
APORTFOLIOBASIS
Table 10.1 – Ranking of the main issues in the &AIRVALUEON
IAS 39 implementation at European banks APORTFOLIOBASIS%5
&AIRVALUEONA
PORTFOLIOBASIS)!3
Ranking of the main
Large Small &
issues in IAS39 #ASHFLOW
banks medium banks
implementation MICROHEDGE

Definition of a .ONE
methodology
1 1
compliant with

IAS39
System
2 2
requirements
Large banks have implemented different
Data collection 3 3
types of hedging relationships (on average
Changes of
2.5 per bank), while 13% of the m/s banks
procedures and 4 4
organisation have not implemented any and the remaining
Staffing 5 5
m/s banks implemented on average 1.7 types
of hedging relationship per bank.
The main issue for both large and m/s Fair value hedging is the most used solution,
institutions was the ‘definition of a but a significant proportion of banks also
methodology compliant with IAS 39’, implemented cash flow hedging on a portfolio
showing the difficulty of adapting hedge basis (64% of large banks and 26% of m/s
accounting rules to banking specificities. banks).
The second most important issue is ‘system
61
Finally, fair value hedging using the EU ‘carve Figure 10.4 – Capacity of systems to support
out’ is used by 57% of large banks and 26% functions on hedging strategies at small &
of m/s banks. medium banks
23% of the large banks and 10% of the m/s
(EDGEQUALIFICATION
banks felt constrained by the amount of core DESIGNATION
deposits to be hedged under IAS 39.

(EDGEEFFECTIVENESS

Several methods can be used to measure the !SSETLIABILITYMODELISATION
hedge effectiveness18. As expected, the ratio- PRE PAYMENTNEWPRODUCTIONETC
analysis ($-offset method) is the most popular (EDGEDOCUMENTATION

method, but the regression analysis is also
!CCOUNTINGENTRY
used by a significant proportion of banks.

Figure 10.2 – Measures of hedge relations PORTFOLIO MICRO HEDGING
effectiveness
Figures 10.3 and 10.4 show that systems

2ATIO !NALYSES
/FFSET
are, overall, rather weak in satisfying banks’
needs on IAS 39, which can be a source of
worry, considering the often very high number
2EGRESSION of hedge transactions in a banking book.
ANALYSES Furthermore, there is a significant difference
between large and m/s banks: many m/s
banks seem to rely on manual solutions. As
,ARGEBANKS 3MALLMEDIUMBANKS mentioned at the beginning of this chapter,
the ALM system implications of IAS 39 have
A sound management hedge accounting still not been totally addressed by European
framework requires adequate systems. The banks.
large majority of banks use only one system
for hedging strategies under IAS 39. The
systems used by the European banks support
the functionalities described in Figures 10.4
& 10.5.
Figure 10.3 – Capacity of systems to support

functions on hedging strategies at large
banks
(EDGEQUALIFICATION
DESIGNATION

(EDGEEFFECTIVENESS

!SSETLIABILITYMODELISATION
PRE PAYMENTNEWPRODUCTIONETC

(EDGEDOCUMENTATION

!CCOUNTINGENTRY

PORTFOLIO MICRO HEDGING
18 IAS39: AG 107.
62
63
64
Basel II Figure 11.1 – Areas impacted by the
implementation of the Basel Il requirements
The regulatory requirements of the on interest rate risk
Framework ‘International Convergence of
0OLICIES
Capital Measurement and Capital Standards’ #ONTROL

by the Basel Committee of Banking -EASUREMENTMETHODOLOGIES

Supervision (Basel II) have led to a significant 3YSTEMS

change in the risk management frameworks ,IMITS

(EDGINGSTRATEGIES
and in the way to measure operational and /RGANISATION

credit risks in the banking industries. Those #OMMERCIALANDPRODUCTPOLICY

risks are covered by the first pillar of the /THERSPECIFY
reform while Asset/Liability Management
risks are covered only by the second pillar. ,ARGEBANKS 3MALLMEDIUMBANKS
The Pillar 2 regulatory requirements are less

prescriptive than Pillar 1 requirements, even Capital requirements
though a specific paper released by the Basel
Committee in July 2004 details the ‘Principles Basel II requires banks to estimate the capital
for the Management and Supervision of required to support their ALM risks. The
Interest Rate Risk’. It can be expected that survey shows that 94% of the European large
now that most of the projects on operational banks calculate economic capital for interest
risk and credit risk are in their final stage, rate risk while 51% of the small & medium
regulators’ and bankers’ attention will shift to banks report doing so.
the remaining risks, and in particular the most The most common methodology for a
significant of these risks: the interest risk of calculation of the economic capital of interest
the banking book. The recently published rate risk is the so-called Economic VaR, as
consultation paper by the Committee of shown in Figure 11.2.
European Banking Supervisors (CEBS) on
stress testing under the supervisory review Figure 11.2 – Methodologies used to
process19 is a clear sign of the immediacy of calculate an economic capital for interest rate
this issue. risk

General requirements %CONOMIC6ALUEAT2ISK

3CENARIOANALYSISONECONOMICVALUE
At the time of our survey, the compliance with OFCAPITAL
the principles set by the Basel II papers has

been evaluated at all large banks and at 69% 3CENARIOANALYSISONEARNINGS

of the medium and small banks. About 80%

%ARNINGSAT2ISK
of these evaluations were done by the risk
controlling/risk management unit or with its
participation. The remaining evaluations were
mainly done by the ALM units themselves. ,ARGEBANKS 3MALLMEDIUMBANKS
In general, a relatively low number of

European banks reported expected impacts The calculation of economic capital for
of the implementation of Basel II requirements liquidity risk is an exception among the
on interest rate risk management. The areas responding banks, with only 11% of the
with the highest impact are policies, controls, large banks and 8% of the small & medium
measurement methodologies and systems as banks reporting such figures. This is certainly
described in Figure 11.1. linked to the early stage of development of
methodologies to calculate economic capital
on liquidity risk, as well as the controversy 19 Consultation Paper 12, June
9, 2006.
65
that rages through both industry and Table 11.2 – Confidence interval and time
supervisors as to whether capital should be horizon used for EC calculation on Economic
held against this risk at all. VaR – medium and small banks
The results of the present survey show that
the choice of values for the confidence Confidence interval
%
/ time horizon
interval and the time horizon in the calculation
of an economic capital depends strongly 90% / 1d 6%
on the size of the bank. (See Table 11.1 and
95% / 6 m 6%
11.2):
99% / 1d 13%
■ 50% of large banks use a rating-based
99% / 10d 31%
approach (one-year time horizon and
99.95% or 99.97% confidence interval) and 99% / 1m 13%
33% use a Basel II approach (one-year time 99% / 1y 13%

horizon and 99% confidence interval). The 99,9% / 1y 6%
remaining large banks use shorter or longer
99,97% / 1y 13%
time horizons.
■ Only 19% of m/s banks use a rating- The calculation of an economic capital on a
based approach (one-year time horizon dynamic income simulation is performed by
and 99,9% or 99,97% confidence interval) 31% of large banks and 12% of m/s banks.
and 13% a Basel II approach. 63% of m/s Therefore most of the banks calculate their
banks use a short-term time horizon (one economic capital on a static basis.
day to one month).
Basel II requires a standardised ‘shock’
Table 11.1 – Confidence interval and time of 200 basis points on the interest rate
horizon used for EC calculation on Economic position in the banking book. This shock is
VaR – large banks implemented by 65% of large banks and
68% of smaller institutions. All banks but
Confidence interval
one reported that this calculation passed the
%
/ time horizon outlyer test.
99% / 1y 33%
99,95% / 1d 8%
99,95% / 1y 17%
99,97% / 1y 33%
99,97% / up to 30y 8%
66
67

KUTAA
DZHIECHBUR

HALL
HEI

HALLO

AKSUNAI
ZDRAVSTVUYTE

HEJ
TERE

HELLO
GODDAG

SVEIKI
PRIVET

GUTENTAG
VITAYU

HELLO
GOEDEDAG

BONJOUR

HI

GAMARDZJOBAT

HI
NIHAO

BONJOUR
DZIENgDOBRY
KON NICHIWA

HOLA
CIAO

MERHABA

GIAgSOU

HI
OI
ASALAAMALEIKOM
AN NYONGHA SE YO

AHLEN
BONJOUR

JAMBO

SHALOM
ADAAB

HOLA
WHAgHAPIN

BONJOU

NAMESTE

AHALAN
HEGIDDIRA
LIHO

SA WAT DEE

BUENOSDIAS

ALOHA

SENGAYAI
XINCHO
MAQAYU

OI
OLA

COMOVAI

OBUSI

FOYENA

TEANASTELLEN
BAAGUNDARA

SUORSDEI

OI

WAYUMBE
AYUBOWAN

NILYERIA

HALO

MBOTE

BONJOUR

HOBO

MULIBWANJI

HOLA

BUENDIA

SAWUBONA

DUMELA

GUTENTAG

HELLO

HELLO

HOLA

KIAORA
68
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01 General information. .................................................................................................................................. 13

02 ALM and ALCO structures.................................................................................................................. 15

03 Policies and responsibilities.............................................................................................................. 21

06 Hedging decisions. ..................................................................................................................................... 43

08 Reporting structure. ................................................................................................................................... 51

09 Systems and operational controls. ............................................................................................. 55

11 Basel II. ................................................................................................................................................................... 65

An overview of ALM in Europe

60 European banks participated

or the contact person for your territory as listed on page 71.

Figure 1.1 – Country of origin of the

As expected, a majority of large banks

1 For reasons of confidentiality

structures organised by territory (56% with an

All European large banks and nearly all "YLOCATION

Management. The majority of the banks ,ARGEBANKS 3MALLMEDIUMBANKS

see this structure as different from the risk

,ARGEBANKS  

     

      /NLYGLOBAL 'LOBALDECENTRALISED /NLYDECENTRALISED

The typical composition of the ALCO is (EADOFRISKMANAGEMENT  

(EADOFCORPORATEBANKING  

the head of risk management of large banks (EADOFSALESCOMDEVEL  

seems to have a bigger influence than in the (EADOF3-%BANKING  

#&/   While the ALCO at m/s banks is still more

(EADOFTREASURY  

$ECIDINGMEMBER #ONSULTINGMEMBER The typical frequency of the global ALCO

        

The previous analysis is corroborated by Figure 2.11 – Representation of the various

70%! &/OPERATORS 

,ARGEBANKS  

,ARGEBANKS  

     

responsibilities Committee requirements:

Table 3.1 – Distribution of responsibilities related to ALM at large banks

Senior ALM RM Other No

Approval of ALM policies 67% 39% 22% 67% 33% 22% 0% 0%

Approval of the main proposed

Approval of exceptions to policies 39% 39% 17% 50% 22% 33% 0% 0%

Approval of responsabilities 50% 50% 22% 56% 11% 6% 0% 0%

Compliance with policies 0% 11% 22% 17% 56% 50% 22% 0%

Control of the implementation of

Approval of ALM policies 71% 29% 2% 57% 10% 10% 0% 0%

Approval of the main proposed

Approval of exceptions to policies 48% 21% 5% 62% 10% 14% 0% 0%

Approval of responsabilities 52% 33% 5% 57% 12% 5% 0% 0%

Compliance with policies 12% 19% 7% 36% 31% 52% 19% 0%

Control of the implementation of

5 BASEL IRR, Cp. 31, 28.

,ARGEBANKS 3MALLMEDIUMBANKS Figure 3.4 – Departments in charge of stating

     

responsibilities are required by the Basel 0ERIODICALEVALUATION SUPERVISION

some gaps that could be closed by redefining

 2ECOGNITIONANDRE EVALUATIONOF

General investment strategy proposal 50% 75%

     

,ARGEBANKS  

     

The two following results provide a more

Analysis on market tendencies and

Design of the techniques needed to

Execution of hedging decisions 56% 52% 6% 2% 50% 36% 6% 7% 0% 2%

1 For reasons of confidentiality

Management. The majority of the banks ,ARGEBANKS 3MALLMEDIUMBANKS

,ARGEBANKS

/NLYGLOBAL 'LOBALDECENTRALISED /NLYDECENTRALISED

The typical composition of the ALCO is (EADOFRISKMANAGEMENT

(EADOFCORPORATEBANKING

the head of risk management of large banks (EADOFSALESCOMDEVEL

seems to have a bigger influence than in the (EADOF3-%BANKING

#&/ While the ALCO at m/s banks is still more

(EADOFTREASURY

70%! &/OPERATORS

,ARGEBANKS

,ARGEBANKS

,ARGEBANKS 3MALLMEDIUMBANKS Figure 3.4 – Departments in charge of stating

responsibilities are required by the Basel 0ERIODICALEVALUATIONSUPERVISION

2ECOGNITIONANDRE EVALUATIONOF

,ARGEBANKS

7 BASEL LR, Principle 9.

8 The number of severity levels

9 BASEL LR, Cp. 61-8.

!TALEGAL

!TALEGALENTITY The factors modelled in dynamic simulations

of these events on the new production. Only 6ARIABLERATEGAPS

a limited number of banks (13% of small %ARNINGAT2ISK

probabilistic models.

although quite powerful. The cost of the -AXMATURITY 3TATISTICALANALYSIS %STIMATEDMATURITY

,ARGEBANKS

-AXMATURITY 3TATISTICALANALYSIS %STIMATEDMATURITY

consistent framework. The technical means 2EPLICATIONMODELUSINGMARKETRATES

7ORST CASE ,ARGEBANKS 3MALLMEDIUMBANKS

risk limit framework in place (Figure 5.1). 94%

the group with material liquidity risk. This is .ETLIQUIDITY

,ARGEBANKS 63%

level, as seen in Figure 4.2. 3MALL

,ARGEBANKS

interest rate risk and this set is not identical SIXMONTHS

,ARGEBANKS 3MALLMEDIUMBANKS Figure 6.3 – Financial instruments used by

exposure to the measured risk factor, as two #URRENCYSWAPS