CHAP 19- TREASURY AND ASSET
LIABILITY MANAGEMENT
·
If current interest rates
are higher than the contracted rates on mortgage advances, the mismatch in
interest rates leads to negative spread , or reduction in net interest income
(Nil).
·
If current interest rates
are higher than the contracted rates on mortgage advances, the mismatch in
interest rates leads to negative spread , or reduction in net interest income
(Nil).
·
The difference between
sources and uses of funds in specific time bands is
known as liquidity gap which may be positive or negative. The liquidity gap
arises out of mismatch of assets and liabilities of the bank.
·
Market risk comprises of
liquidity and interest rate risks
·
Liquidity risk is reflected
as maturity mismatch - which is the gap in cash inflow and outflow. The risk is
not being able to find enough cash, or cash at acceptable rate of interest, to
fund the gap.
·
Interest rate risk arises
when interest earnings are not adequate to set off interest payments due in a
given period, even if the book value of the asset equals that of the liability,
owing to a change in market rates of interest.
·
Liquidity and interest rate
sensitivity gaps arise out of mismatch of bank's assets and liabilities, and
are measured in specific time bands.
·
Net interest income (NII)
of the bank is the difference between interest earnings and interest payments
in a given accounting period. Hence interest rate risk may be defined as the
risk of erosion of NII, on account of interest rate movements in the market.
·
The risk of erosion of NII
is on account of deposit rates being floating (repriced every 6 months), while
the loan interest is fixed (repriced only after 5 years when the ftmds are
available for fresh lending, on repayment of the loan), or vice versa. The
interest rate mismatch is therefore also known as repricing risk.
·
ALM uses broad time bands,
hence even after using appropriate hedges, the market risk may not be
completely mitigated - the residual risk is called basis risk.
·
Treasury is mostly
concerned with market risk.
·
Derivatives, such as swaps
and options are extensively used in managing the mismatches in bank's balance
sheet.
·
Treasury is also
responsible for transfer pricing, whereby market risk is removed from the
banking assets and liabilities and cost of funds and return on assets is
arrived at on a rational basis.
·
The process is called
securitisation, whereby credit receivables of the bank can be converted into
units or bonds (often called pass-through certificates - PTCs) that can be
traded in the market. For instance, the mortgage loans of a bank can be
securitised and issued in the form of PTCs through a special purpose vehicle
(SPV) - which amounts to sale of bank's loan assets.
·
Transfer pricing refers to
fixing the cost of resources and return on assets of the bank in a rational
manner.
·
Run on the Bank is a
situation where depositors of a bank lose confidence in the bank and withdraw
their balances immediately.
·
Risk Appetite is the capacity
and willingness to absorb losses on account of market risk.
·
SPV: Special Purpose
Vehicle formed exclusively to handle securities paper, on behalf of the
sponsoring bank - also known as fire-proof company, as it exists independent of
parent company.
·
Credit default Spread (CDS)
is the annual fee the credit protection buyer must pay the protection seller
over the length of the contract, expressed as a percentage of the notional
amount.
·
Credit derivatives
segregate the credit risk from the assets through instruments known as credit
default swaps and transfer the risk from the owner to another person who is in
a position to absorb the credit risk for a fee.
A transaction where financial securities are issued against the cash
flow generated from a pool of assets is called “ SECURITIZATION”
