Introduction

The role of the Asset Liability Management function (ALM) in the management of the banking book of a bank is constantly growing. A clear evolution can be seen as ALM managers realise that a reactive approach, which consists of the management of the banking book as a passive structure resulting from the commercial and funding strategy of a bank, should be replaced by a proactive approach where the banking book structure is decided in a conscious and active way in order to come up with the desired target structure of the banking book.

The intention of this book is to promote a change in the role of ALM and, in general, in the approach towards financial risk management practice in modern finance. It will show that the proactive role of ALM through an integrated approach for the management of two main financial risk categories, i.e. interest rate risk (IRR) and liquidity risk under one approach, and interrelation with the commercial strategy that a bank wants to adopt, brings significant benefits. Those benefits are mainly economical and can be quantified. The need for change seems to be driven by a number of challenges, such as a heavily regulated landscape, low or negative rates (in the eurozone), and margin compression, which the banking industry has been facing since 2008.

This is why the word 'optimisation' is commonly used in banks these days as an attempt to address the aforementioned challenges. However, I quite often wonder what this word means in practice. What in reality should be optimised, and how it should be optimised. I believe that often the word 'optimisation' just means to make better allocation of resources such as liquidity or capital in order to align a bank with the regulatory requirements. In my view, optimisation is a process which involves the application of optimisation techniques (described in this book) and definition of the optimisation criterion (which metric do we want to prioritise?), objectives (what do we want to optimise?), and constraints (conditions which need to be taken into account in the optimisation process). It also needs a practical implementation tool (method). One of the objectives of this book is to walk the reader through the optimisation process in detail, from a practical perspective, in order to quantify the economic benefits coming from this exercise. At the end, the reader is provided with two business cases on which the optimisation process is tested.

Additionally, the book sheds light on another aspect: the silo-based approach adopted for the management of financial risks still commonly used as a day-by-day practice in banks. The silo-based approach consists of separated management of financial risks, in particular interest rate risk in the banking book and liquidity risk. The consequence of this is taking suboptimal decisions regarding the funding strategy (and consequently liquidity and funding risk) and suboptimal hedging strategies (and consequently mitigation of the interest rate risk in the banking book). In my experience, I have always seen these two risk categories treated separately and not interrelated in the daily measurement and management process. For example, in the risk management department there was a person (or team) focused on the calculation of liquidity metrics and another person (team) responsible for analysis of the interest rate risk in the banking book (IRRBB) metrics. The treasury department, in each bank, had its own set-up and targets designed for this function. As such, in some banks you will see the ALM function operating within the treasury department, with the main objective being to focus on taking an active positioning on the interest rate curve and benefiting from the expected movements of the curve in line with the market forecast. Quite often the size and components of the liquidity buffer (also within the responsibilities of the treasury department) are decided separately and the impact on IRRBB metrics is assessed only after the whole process of building the liquidity buffer is already finalised. One of the most important tasks of a bank's treasurer is to come up with the funding strategy. This is the process where all available funding sources are assessed, and their composition is decided. Again, there is still quite often little interaction with IRRBB. Instead, my experience and academic research lead towards the conclusion that such an interaction should be imperative.

Let's analyse this aspect in detail.

The crucial task of the treasury department is to maintain a heathy balance between the profitability of the banking book and its exposure to financial risks altogether. There is a clear trade-off between the riskiness of the banking book and its profitability. In this book, I call it a target position. Finding such a target position (or target profile) is the real challenge of ALM analysis because it requires the analytical tools and framework to be put in place. Herein, the target profile means the definition of a composition of assets and liabilities so that the profitability of the banking book reaches its maximum, taking into account a number of regulatory and internal risk constraints. I will come back to this definition later. For now, my main objective is to show that there is a strong interrelation between those two risk categories, i.e. interest rate risk in the banking book and liquidity risk (the two main risk categories which the ALM department has to manage), which becomes very evident when looking at the projection of outstanding stocks according to interest commitment dates (interest rate risk view) and liquidity commitment dates (liquidity risk view).

In order to present this argument in detail, let's analyse a very simple case, in which the banking book of a bank is composed of the fixed rate loan funded by a floating rate note with a 3-month reset. Their financial characteristics are shown in Figure I.1.

In analysing the ALM profitability, we need to first define some terms. First of all, there is a positive margin resulting from the interest rate risk management which is attributed to ALM (the allocation of profits between business units and ALM is described in this book later on) if the spread of assets is higher than the spread of liabilities. If this margin is already crystallised and attributed, we call it margin locked in. If there is uncertainty about the future spread because the position, at some point of time, is exposed to the risk of changes in interest rates, we call it margin at risk. The same applies to the funding spread on the position as it fluctuates over time.

In the case of the analysed example, the banking book shows exposure to the IRR on 31 March 2019 due to the refixing of the floating rate liability. Starting from that date, the refixed asset will be funded by the refixing liability, causing the interest rate gap and the impact on net interest income known as NII sensitivity. As regards the profitability of this position, due to the interest rate risk component, the locked-in ALM margin is equal to 0.75%, while the ALM margin at risk is equal to 1% under the assumption of a decrease in EURIBOR 3 M by 25 bps (from 1.25% to 1%).

FIGURE I.1 IRR and liquidity profile in the banking book.

Source: own elaboration.

This situation is presented in Figure I.2.

The same situation analysed from the liquidity standpoint looks slightly different. The bank begins to be exposed to the liquidity risk on 30 September 2019 when the liability expires and needs to be rolled over. Starting from that date, the funding gap creates the NII sensitivity. It can be clearly seen in Figure I.3.

The ALM locked-in margin deriving from this position is equal to 0.25% (the difference between the liquidity spread of the asset and the liability). However, the ALM margin at risk depends on the new liquidity spread related to the liability which needs to be rolled over.

FIGURE I.2 Exposure to IRR in the banking book.

Source: own elaboration

Arriving at the total profitability of the bank, in this particular example, we need to sum the NII margin obtained by the positioning of the bank in terms of both interest rate risk and liquidity risk.

Consequently, the total net interest margin in the period until 31 March 2019 is equal to 1% (0.75% + 0.25%) and will be assigned to the ALM book within the treasury department. From 31 March 2019 to 30 September 2019 it gives 1.25%, but due to the fact that the component related to the IRR is uncertain, this result is unrealised. The same situation appears from 30 September 2019 onward. The unrealised ALM profit depends on the new liquidity spread of the liability in maturity and the movement of the EURIBOR 3 M pillar of the interest rate curve.

It is up to the treasurer to decide how to minimise the NII sensitivity derived from the interest rate risk and liquidity component of the banking book, and what profitability needs to be provided by the ALM unit to the bank. Therefore, the real challenge consists in understanding the trade-off between profitability and risk.

The realised profitability of the bank in terms of P&L impact is determined both by past hedging strategies concerning the interest rate management in the banking book and maturity transformation performed by the treasury with reference to its funding strategy. While the unrealised P&L results will be a function of the magnitude of the margin at risk due to both IRR and the funding strategy for the future accounting periods and the trade-off between expected P&L and its volatility...