ALM in Today's Environment

24 Pages·2010·0.54 MB·English

Investment Symposium
March 2010

F4: ALM in Today's Environment

Pin Johnny Chung
Axel Andre

Moderator
Frank Zhang
ALM in Today’s Environment
Dr. Pin Chungg,, March 22nd,, 2010
Agenda
(cid:131) ALM and ERM in today’s environment
(cid:131) EERRMM ddeeffiinneedd,, ffrraammeewwoorrkk,, ddeeffiinniittiioonnss aanndd kkeeyy rriisskkss
(cid:131) More on ERM, modeling approaches, effective factors
(cid:131) ALM in ERM
(cid:131) ALM processes, workflow, tasks, analysis, and models
(cid:131) ALM enterprise partners and applications
(cid:131) CCoonncclluussiioonnss
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ALM and ERM in today’s environment
(cid:131) ERM is the strategy that aligns the firm’s business with the risk factors
of its environment in the pursuit of strategic objectives
(cid:131) Tillinghast-Towers Perrin survey reveals 80% of survey participants
consider ERM useful in pursuing earnings growth, revenue growth,
return on capital, and expense control
(cid:131) ALM is the core activity of ERM for financial institution
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ERM defined
(cid:131)Strategy
aalliiggnnmmeenntt ooff aa ffiirrmm wwiitthh iittss eennvviirroonnmmeenntt
(cid:131)ERM
aligns business with risk factors of its environment in pursuit of business goals
(cid:131)A firm’s goal: to create economic value
(cid:131)A framework links strategy, process, organizational forms, human
resources, IT, and other areas to improve performance
(cid:131)The general ERM goal:
to identify drivers of performance;
to plan a path for managerial actions to improve performance metrics
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ERM framework
Conceptual Organization •Market risk
framework approaches
•Credit risk
Firm’s
•Liquidity risk
Objectives
•Operational risk
•Business risk
•Other risks
Tools
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Some definitions
(cid:131)Financial risk
Unpredictable event results in a financial loss
AA ffiirm wiillll nott meett some speciiffiiedd ffiinanciiall goalls
(cid:131)Risk
Risk is more of a choice than a chance
(cid:131)Risk Management
Provides tools to measure risks and techniques to make rational decisions
(cid:131)Business
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financial products
(cid:131)Objective
Use cash flows generated from business activities, with leverage debt or equity capital
to enhance economic value through growth of earning, cash flow stability, and
reduced costs of financial distress
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Key risks
(cid:131) Liquidity risk
Fundingg risk: when an institution is unable to raise cash to fund its activities
Trading risk: unable to execute a transaction at the prevailing market prices
(cid:131) Market risk
Risk arising from changes in financial market prices and rates
(cid:131) Credit risk
Risk of an un-kept payment promise when an obligor defaults, or rating changes
(cid:131) Operational risk
Losses due to human error, fraud, management failure, systems, data or legal actions
(cid:131) Business risk
Due to volatility of volumes, margins, or costs when engaging in the firm’s business
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More on ERM
(cid:131) ERM takes a global view of the firm on the enterprise level
(cid:131) ERM takes a global view on the risks the firm is exposed to
(cid:131) ERM takes an integrated view of the business processes to achieve
the goal of alignment efficiency and adding value
(cid:131) FFoorr eexxaammppllee,, iinntteeggrraatteedd ffiinnaanncciiaall pprroodduucctt mmaannaaggeemmeenntt ooff iittss pprroodduucctt
design, pricing, capitalizing, funding and marketing
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Two approaches
(cid:131) To manage the risk adjusted return across: product design, pricing,
and funding by looking at the following 3Ps of ERM (Lo’90):
1. Probability of extreme events
2. Process of asset risk and return profile
3. Preference towards risk
1. Single line business:
Repackage financial risks, price them, transfer to other market participants
or hold them in a portfolio
2. Multiple financial products:
Manage the business portfolio problem
Find appropriate product mix and allocate the firm’s capital, taking an
integrated view of risks and returns of competing lines of business
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Single line business
Marketing
ALM Asset class 1
Pricing
Product Optimal SAA
Asset class 2
Design asset
allocation …
Asset class N
Liability Asset return
profile profile
ALM and Inforce
Management
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Multiple financial products
(cid:131)Design, Pricing, Funding, and Inforce Management
(cid:131)SSttrattegiic managementt off bbusiiness proffiille off mullttiiplle andd ddiiverse
products
(cid:131)Strategic Objective:
allocate capital among LoBs; consistent with risk-adjusted ROE (or other metrics)
satisfying risk based capital and all other regulatory requirements
(cid:131)Integration of design, pricing and funding of each product will result into
a process that maximizes risk-adjusted return for each product
(cid:131)Note that risk-adjusted return of a product is not independent from the
composition of the overall portfolio which leads to “portfolio choice
problem”
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Multiple line portfolio problem
Marketing
ALM
SAA
Pricing Asset class 1
N
Optimal
Product Asset class 2
asset N
Design
N allocationN …
Asset class N
N
EEnntteerrpprriissee lleevveell MMaarrkkoowwiittzz ssoolluuttiioonn
Liability Asset return
profiles profiles
ALM and Inforce
Management
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Effective ERM factors
(cid:131)Risk Measurement
Metrics include: VaR, CTE, Duration, Convexityy, Keyy Rate Duration
(cid:131)Risk Management
Supports diversification, hedging, risk transfer
Provides portfolio compression, risk decomposition, what if analysis, hedging and
optimization of complex portfolios
(cid:131)Performance Measure
Estimate contribution off each risk ffactor to the ffirm’’s overall risk proffile
(cid:131)Corporate Governance
Make sure components of ERM are in place; function properly; and are aligned with
each other and with the objective of the enterprise risk management strategy
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ALM in ERM
(cid:131)Management of firm’s balance sheet is at the core of ERM
(cid:131)TThhe bballance shheett reffllectts tthhe riiskks off tthhe enviironmentt ffrom tthhe assett
side and most of the business risks from the liability side
To align these risks is the goal of ALM
(cid:131)ALM provides tools for risk measurement and risk management
(cid:131)ALM takes a more focused view of risks than ERM
Asset side: market,, credit and liqquidityy risks
Liability side: volatility of margins and cost
(cid:131)ALM: Markowitz’52, Asset Allocation; Sharpe and Tint’90, Liabilities
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ALM processes and ALM charter
(cid:131) ALM processes:
11. EEsttabblliishh a comprehhensiive AALLMM polliicy
2. Define risk tolerances by integrating with the firm’s business strategies
3. Monitor risk metrics relative to defined tolerances
4. Initiate corrective actions when metrics break policy limits
55. PPeriioddiicalllly reviiew AALLMM polliicy andd makke addjjusttmentts whhen needdedd
(cid:131) ALM charter members:
CEO, CFO, CIO, Chief Actuary, CRO, Asset Manager, Hedging Head
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ALM workflow
contractual obligations, scenarios, risk
Data Storage assumptions, new business, marketing
assumptiions, bbehhaviior assumptiions
Risk Measurement: market valuation, option
adjusted analysis, Value-at-risk, Scenario
analysis
Analytic Tools
Risk Management: active dynamic analysis,
Hedging, Portfolio optimization
Results
Provide report to regulators, rating
Reporting agencies, and shareholders: earnings,
EaR, VaR, what if analysis
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ALM tasks
ALM Tasks
Align the asset and
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liability sides of
balance sheet through
asset allocation or
capital allocation
Sensitivity and scenario analysis
Earnings and balance sheet simulation When “neutralized”:
alignment of assets and
liabilities is achieved.
E.g., duration matching
to neutralize market risk
Dynamic balance sheet modeling
due to parallel shifts of
the term structure
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ALM analysis
(cid:131)Base economic environment:
Conduct cash flow analysis, duration and convexity calculations
(cid:131)Other Economic Environment:
Forecast or simulate of interest rates, exchange rates and credit spreads
(cid:131)Simulate the balance sheet by reporting the assets and liabilities under
assumed scenarios
(cid:131)Dynamic analysis:
Passive: time evolution of the current balance sheet
Active: focus on explicit ALM strategies
(cid:131)Simulation:
Future, dynamic across time
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