Bank Asset and Liability Management E-Book

Moorad Choudhry

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 1860

Veröffentlichungsjahr: 2011

Beschreibung

Banks are a vital part of the global economy, and the essence of banking is asset-liability management (ALM). This book is a comprehensive treatment of an important financial market discipline. A reference text for all those involved in banking and the debt capital markets, it describes the techniques, products and art of ALM. Subjects covered include bank capital, money market trading, risk management, regulatory capital and yield curve analysis. Highlights of the book include detailed coverage of: * Liquidity, gap and funding risk management * Hedging using interest-rate derivatives and credit derivatives * Impact of Basel II * Securitisation and balance sheet management * Structured finance products including asset-backed commercial paper, mortgage-backed securities, collateralised debt obligations and structured investment vehicles, and their role in ALM * Treasury operations and group transfer pricing. Concepts and techniques are illustrated with case studies and worked examples. Written in accessible style, this book is essential reading for market practitioners, bank regulators, and graduate students in banking and finance. Companion website features online access to software on applications described in the book, including a yield curve model, cubic spline spreadsheet calculator and CDO waterfall model.

Leseprobe

Contents

Foreword

Preface

About the Author

PART I: Banking Business, Bank Capital and Debt Market Instruments

CHAPTER 1: Bank Business and Bank Capital

Banking business

Capital

Financial statements and ratios

The money markets

Financial transactions

Characteristics of the money market

Money market conventions

CHAPTER 2: Financial Statements and Ratio Analysis

Firm financial structure and company accounts

Ratio analysis

CHAPTER 3: The Money Markets

Introduction

Securities quoted on a yield basis

Securities quoted on a discount basis

Extendable note commercial paper

Commercial paper dealing sheet

Money market screens on Bloomberg

BBVA money market rate screens on Bloomberg

Foreign exchange markets

Deposits and loans

Appendices

CHAPTER 4: The Bond Instrument

Bond-market basics

Capital market participants

Overview of the main bond markets

Bond pricing and yield: The traditional approach

Bond yield

Accrued interest, clean and dirty bond prices

Floating-rate notes

Bond instruments and interest-rate risk

Option-adjusted spread analysis

Appendices

PART II: Bank Treasury Asset–Liability Management

CHAPTER 5: Asset–Liability Management I

Basic concepts

Liquidity gap

Managing liquidity

The liquidity ratio

CHAPTER 6: Asset–Liability Management II

Introduction

Basic concepts

Interest-rate risk and source: Banking book

The ALM desk

Liquidity and interest-rate risk

Critique of the traditional approach

The cost of funding

Generic ALM policy for different banks

Securitisation

Appendix

CHAPTER 7: ALM Trading Principles

Trading approach

Repo market specials trading

An analysis of special repo rates

Matched book trading in repo

Hedging tools

Appendix

CHAPTER 8: Asset-Liability Management III: The ALCO

ALCO policy

ALCO reporting

CHAPTER 9: The Yield Curve

Importance of the yield curve

Part I: The money market yield curve

Using the yield curve

Yield-to-maturity (YTM) yield curve

The coupon yield curve

The par yield curve

The zero-coupon (or spot) yield curve

Using spot rates in bond analysis

The forward yield curve

The annuity yield curve

The Term Structure

Spot and forward rates in the market

Analysing and interpreting the yield curve

Yield curves as a function of the stochastic behaviour of interest rates

Further views on the yield curve

Interpreting the yield curve

Fitting the yield curve

Part II: A further look at spot and forward rates

Coupon bonds

Introduction to bond analysis using spot rates and forward rates in continuous time

Appendices

CHAPTER 10: The Determinants of the Swap Spread and Understanding the Term Premium

The determinants of the swap spread

The term premium

Impact of macro-level economic and political factors on swap spreads

CHAPTER 11: Introduction to Relative Spread Analysis

Relative value analysis: bond spreads

Swap spread and Treasury spread

Asset-swap spread

Z-spread

Cash-CDS basis

PART III: Financial Instruments, Applications and Hedging

CHAPTER 12: Repo Instruments

Introduction to repo

Repo fundamentals

The classic repo

The sell/buy-back

Comparing classic repo and sell/buy-back

Basket repo

Repo variations

Margin

Uses and economic functions of repo

Legal description of repo

The United Kingdom gilt repo market

CHAPTER 13: Money Market Derivatives

Forward rate agreements

Short-term interest-rate futures

Implied Eurodollar yield

Fixed basis point spread to Eurodollar rates

Using Microsoft Excel to check the market forward rate6

Options

Pricing inputs

Bounds in option pricing

Pricing methodology

Assumptions

The Black-Scholes model and pricing derivative instruments

The put-call parity relationship

B-S and the valuation of bond options

Interest-rate options and the Black model

Comment on the B-S model

Stochastic volatility

Implied volatility

Collars, caps and floors

Interest-rate risk exposure and option hedging

Appendices

CHAPTER 14: Interest-rate Swaps and Overnight-index Swaps

Basic characteristics of swaps

Non-vanilla interest-rate swaps

Overnight interest-rate swaps and Eonia/SONIA swaps

Basic interest-rate swap hedging applications

Swaptions

Bloomberg screens

Swap rates and the convexity bias

Appendices

CHAPTER 15: Hedging using Bond Futures Contracts

Introduction

Bond futures contracts

Futures pricing

Hedging using futures

The primary hedge measure: bond modified duration and PV01

Position after one month

Conclusions

CHAPTER 16: Credit Risk and Credit Derivatives

ALM and credit risk

Credit derivatives: An introduction

Asset swaps

Credit default swaps

Loan-only credit default swaps

Total return swaps

Credit-linked notes

Credit options

Index credit derivatives

Bank ALM applications of credit derivatives

Credit derivatives and ABS markets

Supply and demand: CDS of ABS

Risks in CDS positions

Credit default swap pricing27

CHAPTER 17: Value-at-Risk (VaR) and Credit VaR

Introducing Value-at-Risk

Correlation

Simple VaR calculation

Matrix calculation of variance–covariance VaR

Confidence intervals

Historical VaR methodology

Simulation methodology

VaR for fixed-income instruments

Derivative products and VaR

Option gamma

Stress testing

VaR methodology for credit risk

Appendix

PART IV: Funding and Balance Sheet Management using Securitisation and Structured Credit Vehicles

CHAPTER 18: Introduction to Securitisation1

The concept of securitisation

Market participants

Reasons for undertaking securitisation

The process of securitisation

Illustrating the process of securitisation: Airways No. 1 Limited

Credit rating considerations

CHAPTER 19: Structured, Synthetic and Repackaged Funding Vehicles

Asset-backed commercial paper

Evolution of ABCP programmes

Committed liquidity line funding

The synthetic ABCP conduit

Synthetic ABCP conduit: Example TRS term sheet

ABC Fund Limited Golden Claw Funding Limited Total Return Swap Term Sheet

The basket total return swap

Structured funding vehicles: Repo conduit

Synthetic repackaging structures

Synthetic funding structures

CHAPTER 20: Mortgage-backed Securities and Covered Bonds

Mortgage-backed securities

Mortgages

Mortgage risk

Securities

Covered bonds

Evaluation and analysis of mortgage-backed bonds

Commercial mortgage-backed securities

CHAPTER 21: Asset-backed Securities

Auto-loan-backed securities

Credit card-backed securities

Securitisation net interest margin (NIM) structures

CHAPTER 22: Collateralised Debt Obligations1

Motivation behind CDO issue

Market convergence: money and debt capital markets

CDO-squared

Analysis and evaluation

Investor analysis

CHAPTER 23: Synthetic Collateralised Debt Obligations

The synthetic CDO

Assessing the genesis of the synthetic CDO

Synthetic CDO deal structures

The managed synthetic CDO

The single-tranche synthetic CDO

Risk and return on CDOs

Pricing methodology for synthetic CDO notes17

Case studies

Scarab CSO Limited

CHAPTER 24: Synthetic Mortgage-backed Securities

Transaction description

CDS of ABS

CHAPTER 25: Structured Investment Vehicles

Overview and structure

Investor considerations

SIVs and credit arbitrage conduits

PART V: Bank Regulatory Capital

CHAPTER 26: Bank Regulatory Capital and the Basel Rules

Background

Banking regulatory capital requirements

Regulatory capital requirements

Action in the event of failure

The original Basel II proposals

CHAPTER 27: A Primer on Basel II

Introduction

Impact on specific sectors

Basel II and securitisation

Operational risk

Concluding remarks

PART VI: Treasury Middle Office Operations

CHAPTER 28: Funding and Treasury Procedures for Banking Corporations

Funding

Internal funding cost allocation

Transfer pricing

Capital structure

Bid-offer spread

Example ticket booking structure

Organisation of reporting line

PART VII: Applications software enclosed with the book

CHAPTER 29: Applications Software and Spreadsheet Models

YCF Cubic B-Spline yield curve application

RATE yield curve and swap/vanilla option pricing application

Structured finance securities: cash-flow waterfall models

Microsoft Excel applications

Appendix

Glossary

Index

Download CD/DVD Content

Advance Praise for Bank Asset and Liability Management

“Like the author’s book The Bond and Money Markets: Strategy, Trading, Analysis, this is again a superb example how a financial book should be written! Not only has Moorad managed to write another hit, but as with the previous book he has managed to show workable illustrations so that a novice or a full-blown professional can make good use of the examples – either for understanding the subject better or for simply brushing up on one’s memory. The book comes highly recommended!”

Tibor Szigeti

Fixed Income Analytics

Bloomberg L.P., London

“Again, Moorad Choudhry takes his readers beyond the older books in the market that simply list a string of facts, and into a world of highly practical and up-to-the-minute concepts and strategies. Bank asset–liability management is about knowing when and how to use all the tools available. The modern practitioner can’t be limited to just managing rate and liquidity risk, but must be highly versed in securitisation and other balance sheet techniques. This book tackles the whole spectrum.”

Peter Eisenhardt

Head of Short Term Fixed Income Origination

Debt Capital Markets

Bank of America N.A.

“Professor Choudhry has written a comprehensive guide providing invaluable insights into bank asset and liability management. The subject matter is delivered in an accessible and refreshingly clear manner. This latest publication is an essential read for anyone involved in the industry. Moorad delivers financial theories in a practical and entertaining package.”

Mark Williams (Director) and Wei Lieh Goh

Hedge Fund Derivatives

KBC Financial Products, London

“A complete representation of the asset–liability management challenge facing the bank risk manager, the best practice to deploy and the mitigating tools available. A thoroughly well-researched piece.”

Remi Bola

Chief Operating Officer

Asset Backed Solutions

The Law Debenture Corporation plc

“A highly readable text which serves as an essential primer for both market practitioners and academics alike to help understand the rapidly evolving risk management techniques used by Treasury and Money Market desks. The author uses real-world examples throughout, and includes extensive and up-to-date coverage of current financing products and the regulatory environment.”

Adam Sutton

Head of European Repo

Global Funding Desk

Bank of America, London

“A brilliant and comprehensive account of all the various disciplines that make up the art of bank asset–liability management. Professor Choudhry brings together the instruments, the procedures and the strategies that are vital knowledge for any successful risk manager or ALCO member. This book will be appreciated and respected by all bankers in all fields. A fantastic work! Every bank should have a copy of this book.”

Mohamoud Barre Dualeh

Private Banking Unit

Abu Dhabi Commercial Bank, UAE

“Bank Asset And Liability Management offers a clear, insightful perspective of the global banking and liquidity markets. It covers all the major products in just the right level of detail and is written in a practical, accessible style. This book is a great reference tool for all finance professionals. Really, really impressive.”

Bhavin Parmar

Securities Finance Trader

ABN Amro Bank N.V., London

“An informative account of banking ALM from the point of view of the market practitioner. The author brings together all the various strands that make up this important discipline in a technical yet accessible way”

Shahid Ikram

Head of UK Sovereign bonds and G7 hedge fund

Morley Fund Management IT, London

“Moorad Choudhry has managed to update and include the most relevant and practical knowledge required for ALM in a modern financial institution, especially with Basle II requirements and adoption looming ahead in 2008. Balance sheet management, financial markets and credit risk management, coupled with regulatory capital implications, are important considerations that are well addressed in this book that anybody looking to learn about or have a handy guide on ALM will find useful!”

Lee Ka Shao

Managing Director, Head of Investments

DBS Bank Limited, Singapore

Copyright © 2007 Moorad Choudhry

Published in 2007 by John Wiley & Sons (Asia) Pte Ltd

2 Clementi Loop, #02-01, Singapore 129809

All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop, #02-01, Singapore 129809, tel: [phone], fax: [phone], e-mail: [email protected].

The views, thoughts and opinions expressed in this book are those of the author in his individual capacity and should not in any way be attributed to KBC Financial Products or to KBC Bank N.V., or to Moorad Choudhry as a representative, officer, or employee of KBC Financial Products or KBC Bank N.V.

This book does not constitute investment advice and its contents should not be construed as such. Any opinion expressed does not constitute recommendation to any reader. The contents should not be considered as a recommendation to deal and the author does not accept liability for actions resulting from reading of any material in this book.

While every effort has been made to ensure accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this book can be accepted by the author, publisher or any named person or corporate entity.

The material in this book is based on information that is considered reliable, but neither the author nor the publishers warrant that it is accurate or complete, and it should not be relied on as such. Opinions expressed are current opinions only and are subject to change. The author and publishers are not soliciting any action based upon this material. Moorad Choudhry and any named person or entity may or may not have a position in any capital market instrument described in this book, at the time of writing or subsequently. Any such position is subject to change at any time and for any reason.

This disclaimer in its entirety applies to the CD-R accompanying this book.

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Library of Congress Cataloging-in-Publication Data

978-0-470-82135-0

For Angela...my dream girl.

I wish we’d met years ago.

Foreword

Asset and liability management (ALM) is a key aspect of risk management in the financial services industry. The business of financial services firms is risk and return, using their skills in the measurement of risks to make profits. In modern finance, this often involves using complex products. The types of risks taken by firms are often complex and hidden, reflecting the financial products on offer and the wider marketplace. As such, when analysing risks, it is important to think about the firm’s balance sheet holistically. A firm’s ALM Committee (ALCO) uses this modus operandi, managing its assets and liabilities, and supervising liquidity, credit, market and operational risks, in short prudential matters, at the most senior level.

Financial services firms, especially banks, are essential to the global economy. Therefore, ALM is a major aspect of their operations. Liquidity, the ability of a firm to generate money at often short notice and ideally low cost to meet a liability when it falls due, is important to the stability and smooth running of the global financial system. Poor planning has an impact beyond the individual financial institution. In similar vein, market risk, including yield curve and gap risks, requires thoughtful management, including monitoring and reporting.

There is no single metric that gives a full picture of these risks. The assessment of liquidity risk needs thinking about on- and off-balance sheet items. The management of market risk is complicated. These risks often overlap. ALM accepts this by monitoring them simultaneously. The process is as much qualitative as quantitative. Some observers even compare ALM to an art, not dissimilar to stress testing. ALCOs have to think about future market scenarios, the probability of these events occurring and their impact, and take action to mitigate these risks. In addition to making sure that the firm can withstand any event, including a stress, the Committee has to allocate assets and liabilities in order to meet certain objectives, profits and returns on equity (ROE) and the discipline of liquidity management.

ALM specialists have a wide variety of products and techniques to mitigate risk. Some tools, for example securitisation, have been around for years. Some techniques use fairly new products, for example credit derivatives. Moorad’s magisterial work brings all the issues into a single publication. The book is written in an easy to understand manner, ideal for both practitioners and regulators. The book is also practical for those who want to learn ALM. There is something for every stakeholder in this book.

Irving Henry

Director

British Bankers’ Association

Preface

As Sir Arthur Conan Doyle would have put it, so elementary a form of literature as the textbook on financial economics hardly deserves the dignity of a preface. It is possible, though, to bring some instant clarity to the purpose of such a book if we open with a few words here.

The traditional view of a bank is that of a financial institution that is in the business of taking deposits and advancing loans, and which makes its money from the difference in interest rate paid and received on these two products. While this quaint image would have been true a few hundred years ago, it is decidedly incomplete today. The modern banking institution is a complex beast, which in many cases operates in a wide range of products and services and across international markets. Banks are the cornerstone of the global economy, and at the highest level the banking sector influences, and is influenced by, macroeconomic trends such as GDP growth, central bank base interest rates, equity and debt capital markets activity, and the supply and demand for investments and credit.

However, notwithstanding our first statement that banks now engage in many complex activities outside traditional borrowing and lending, we must remember that at the core of all capital markets activity lies the need to bring together the suppliers of capital with the borrowers of capital. This was the original business logic behind the very first banks, so in that respect very little has changed! There is much other activity surrounding this basic function in the markets, but this need is paramount. Hence a key ingredient in bank strategy is the management of its assets and liabilities. It is this that is the subject of this book: Asset and Liability Management (ALM). These days there are a large number of instruments, in cash and derivative form, that make up a bank’s assets and liabilities. No matter. For the ALM desk in a bank, the cash assets and liabilities are king and must be managed prudently. That there is more to this than may meet the eye is apparent immediately from the thickness of this book!

Let us set the scene further with some discussion on banks.

Introduction

Banking operations encompass a wide range of activities, all of which contribute to the asset and liability profile of a bank. Table P.1 shows selected banking activities, and the type of risk exposure they represent. The terms used in the table, such as “market risk”, are explained elsewhere in this book. In Chapter 2 we discuss elementary aspects of financial analysis, using key financial ratios, that are used to examine the profitability and asset quality of a bank. We also discuss bank regulation and the concept of bank capital.

Table P.1 Selected banking activities and services

Service or functionRevenue generatedRiskLending– RetailInterest income, feesCredit, Market– CommercialInterest income, feesCredit, Market– MortgageInterest income, feesCredit, Market– SyndicatedTrading, interest income, feesCredit, MarketCredit cardsInterest income, feesCredit, OperationalProject financeInterest income, feesCreditTrade financeInterest income, feesCredit, OperationalCash management– ProcessingFeesOperational– PaymentsFeesCredit, OperationalCustodianFeesCredit, OperationalPrivate bankingCommission income, interest income, feesOperationalAsset managementFees, performance paymentsCredit, Market, OperationalCapital markets– Investment bankingFeesCredit, Market– Corporate financeFeesCredit, Market– EquitiesTrading income, feesCredit, Market– BondsTrading income, interest income, feesCredit, Market– Foreign exchangeTrading income, feesCredit, Market– DerivativesTrading income, interest income, feesCredit, Market

Before considering the concept of ALM, all readers should be familiar with the way a bank’s earnings and performance are reported in its financial statements. A bank’s income statement will break down the earnings by type, as we have defined in Table P.1. So we need to be familiar with interest income, trading income and so on. The other side of an income statement is the costs, such as operating expenses and bad loan provisions.

That the universe of banks encompasses many different varieties of beast is evident from the way they earn their money. Traditional banking institutions, perhaps typified by a regional bank in the United States or a building society in the United Kingdom, will generate a much greater share of their revenues through net interest income than trading income, and vice versa for an investment bank such as Lehman International or Merrill Lynch. The latter firms will earn a greater share of their revenues through fees and trading income.

During 2004 a regional European bank reported the following earnings breakdown, as shown in Table P.2.

Table P.2 European regional bank, earnings structure 2004

Source: Author’s notes.

Core operating income% shareNet interest income62Fees and commissions27Trading income11

However, this breakdown varies widely across regions and banks, and in fact would be reversed at an investment bank whose core operating activity was market-making and proprietary trading.

Let us consider now the different types of income stream and costs.

Interest income

Interest income, or net interest income (NII), is the main source of revenue for the majority of banks worldwide. As we saw from Table P.2, it can form upwards of 60% of operating income, and for smaller banks and building societies it reaches 80% or more.

NII is generated from lending activity and interest-bearing assets, the “net” return is this interest income minus the cost of funding the loans. Funding, which is a cost to the bank, is obtained from a wide variety of sources. For many banks, deposits are a key source of funding, as well as one of the cheapest. They are generally short-term, though, or available on demand, so they must be supplemented with longer term funding. Other sources of funds include senior debt, in the form of bonds, securitised bonds and money market paper.

NII is sensitive to both credit risk and market risk. Market risk, which we will look at later, is essentially interest-rate risk for loans and deposits. Interest-rate risk will be driven by the maturity structure of the loan book, as well as the match (or mismatch) between the maturity of the loans against the maturity of the funding. This is known as the interest-rate gap.

Fees and commissions

Banks generate fee income as a result of the provision of services to customers. Fee income is very popular with bank senior management because it is less volatile and not susceptible to market risk like trading income or even NII. There is also no credit risk because the fees are often paid up front. There are other benefits as well, such as the opportunity to build up a diversified customer base for this additional range of services, but these are of less concern to a bank ALM desk.

Fee income uses less capital and also carries no market risk, but does carry other risks such as operational risk.

Trading income

Banks generate trading income through trading activity in financial products such as equities (shares), bonds and derivative instruments. This includes acting as a dealer or market-maker in these products, as well as taking proprietary positions for speculative purposes. Running positions in securities (as opposed to derivatives) in some cases generates interest income, some banks strip this out of the capital gain made when the security is traded to profit, while others include it as part of overall trading income.

Trading income is the most volatile income source for a bank. It also carries relatively high market risk, as well as not inconsiderable credit risk. Many banks, although by no means all, use the Value-at-Risk (VaR) methodology to measure the risk arising from trading activity, which gives a statistical measure of expected losses to the trading portfolio under certain selected market scenarios.

Costs

Bank operating costs comprise staff costs, as well as other costs such as premises, information technology and equipment costs. Further significant elements of cost are provisions for loan losses, which are a charge against the loan revenues of the bank. The provision is based on a subjective measure by management of how much of the loan portfolio can be expected to be repaid by the borrower.

The capital markets

Capital markets is the term used to describe the market for raising and investing finance. The economies of developed countries and a large number of developing countries are based on financial systems that contain investors and borrowers, markets and trading arrangements. A market can be one in the traditional sense such as an exchange where financial instruments are bought and sold on a trading floor, or it may refer to one where participants deal with each other over the telephone or via electronic screens. The basic principles are the same in any type of market. There are two primary users of the capital markets: lenders and borrowers. The source of lenders’ funds is, to a large extent, the personal sector made up of household savings and those acting as their investment managers such as life assurance companies and pension funds. The borrowers are made up of the government, local governments and companies (called corporates). There is a basic conflict in the financial objectives of borrowers and lenders, in that those who are investing funds wish to remain liquid, which means they have easy access to their investments. They also wish to maximise the return on their investment. A borrower, on the other hand, will wish to generate maximum net profit on its activities, which will require continuous investment in plant, equipment, human resources and so on. Such investment will therefore need to be as long-term as possible. Government borrowing, as well, is often related to long-term projects such as the construction of schools, hospitals and roads. So while investors wish to have ready access to their cash and invest short, borrowers desire funding to be as long as possible. The economist John Hicks1 referred to this conflict as the “constitutional weakness” of financial markets, especially when there is no conduit through which to reconcile the needs of lenders and borrowers. To facilitate the efficient operation of financial markets and the price mechanism, intermediaries exist to bring together the needs of lenders and borrowers. A bank is the best example of this. Banks accept deposits from investors, which make up the liability side of their balance sheet, and lend funds to borrowers, which form the assets on their balance sheet. If a bank builds up a sufficiently large asset and liability base, it will be able to meet the needs of both investors and borrowers, as it can maintain liquidity to meet investors’ requirements, as well as create long-term assets to meet the needs of borrowers. The bank is exposed to two primary risks in carrying out its operations, one that a large number of investors decide to withdraw their funds at the same time (a “run” on the bank), or that large numbers of borrowers go bankrupt and default on their loans. In acting as a financial intermediary, the bank reduces the risks it is exposed to by spreading and pooling risk across a wide asset and liability base.

Corporate borrowers wishing to finance investment can raise capital in various ways. The main methods are:

continued reinvestment of the profits generated by a company’s current operations;selling shares in the company, known as equity capital, equity securities or equity, which confirm on buyers a share in ownership of the company. The shareholders as owners have the right to vote at general meetings of the company, as well as the right to share in the company’s profits by receiving dividends;borrowing money from a bank, via a bank loan. This can be a short-term loan such as an overdraft, or a longer term loan over two, three, five years or even longer. Bank loans can be at either a fixed or more usually, variable rate of interest;borrowing money by issuing debt securities, in the form of bills, commercial paper and bonds that subsequently trade in the debt capital market.

The first method may not generate sufficient funds, especially if a company is seeking to expand by growth or acquisition of other companies. In any case a proportion of annual after-tax profits will need to be paid out as dividends to shareholders. Selling further shares is not always popular among existing shareholders as it dilutes the extent of their ownership; there are also a host of other factors to consider, including if there is any appetite in the market for that company’s shares. A bank loan is often inflexible, and the interest rate charged by the bank may be comparatively high for all but the highest quality companies. However, it is often the first source of corporate finance. We say comparatively, because there is often a cheaper way for corporates to borrow money: by tapping the bond and money markets. And that is where banks come in.

Layout of the book

Bank Asset and Liability Management is written in seven parts, covering the various different but related aspects of bank ALM. These are:

Part I – Banking business, bank capital and debt market instruments

Part II – Bank treasury asset–liability management

Part III – Financial instruments, applications and hedging

Part IV – Funding and balance-sheet management using securitisation and structured credit vehicles

Part V – Regulatory capital and the Basel rules

Part VI – Treasury middle office operations

Part VII – Applications software enclosed with the book.

For newcomers to the market there is a primer on financial market arithmetic located in the Appendix, as well as a Glossary of market terms.

Highlights of the book include:

a detailed look at ALM activity and operation as undertaken by banks and securities houses, including risk management and management reporting;comprehensive coverage of the money markets;a look at the syndicated loan market;the use of securitisation in balance sheet management;applications of synthetic structured finance securities;yield curve analysis, the determinants of the swap spread and understanding the term premium;the role of the ALM committee (ALCO);coverage of market instruments including interest-rate derivatives (FRAs, futures, caps, floors and swaps) and credit derivatives, and their use and application for hedging purposes;calculating the credit risk exposure hedge notional amount;the latest developments in structured funding vehicles;description and analysis of structured credit products including collateralised debt obligations (CDOs) and structured investment vehicles (SIVs), and their application in ALM;the process of structuring a securitisation deal;synthetic CDO note pricing and tranche correlation; anda look at the Basel II regulatory capital rules and its implications.

The book also features a contribution from Andrew Oliver of KBC Financial Products in London, who wrote the chapter on Treasury middle office operations. This is an important element in overall ALM for banks and we are pleased to have Mr Oliver’s expert opinion on this subject. Parts of the chapters on credit derivatives and CDOs were co-authored with Abukar Ali of Bloomberg L.P., Richard Pereira of JPMorgan Chase and Jaffar Hussein of the Saudi National Commercial Bank, and my grateful thanks to them.

The accompanying CD-R features software co-written with Kevin Zhuoshi Liu, Rod Pienaar, Suleman Baig, Abukar Ali, Stuart Turner and Didier Joannas, and again my grateful thanks to them.

As ever, the intention is to remain accessible and practical throughout. We hope this aim has been achieved. Comments on the text are most welcome and should be sent to the author care of John Wiley & Sons (Asia) Ltd.

Acknowledgments and special thanks

With thanks to Luis Perez and Zhuoshi Liu for assistance with the Errata, much appreciated.

Big, big, emotional hug to the Raynes Park Footy Boys (Abubakar, Abukar, Anuk, Clax, Farooq, Harry, Kevin, Khurram, Mohamoud, Richard and Rod, plus honourary members Melvin Chan, Mike Brand, Brian Eales and Carol Alexander) – you are total legends and I love you like my own brother. A Solid Bond In Your Heart.

Salaam Aleikum to Adnan Jaffery at Citigroup, Bhavin Parmar at ABN Amro and Ali Mahdavi at Bloomberg. David Walters, I have high hopes for you, all the best. El Gunista get some desk sweets in mate... Thanks to Suraj Gohil and Bruno Pajusco at KBC FP for expert help on all matters CDS... Special thanks to Anne Carter as always for help with the proofing process, you are an absolute darling. Mr James Harrison, as you can see when I can’t remember the numbers in the calculations I just use x and y..!

Thanks to the Teesside 5-a-side boys including Jonno, Cooper, Dick, Walker and Pie – your attitude is spot on, and it’s my privilege and pleasure to know you.

Thanks to the publishing Dream Team that is Janis Soo, Paul Lim and Edward Caruso, you guys can make any book look good. Awesome – thank you.

Thanks to that other Dream Team which is any group of capital markets lawyers led by the legendary Jim Croke – the man is a demon!

EDG United thank you for the swansong... Also thanks to a company of youth on the football field for their first-class teamwork, the essence of success in any endeavour: Mark Burgess, Frank Spiteri, John Key, Russell Betteridge, Sam McArthur, Richard Silver, Hirak Chakravorty, Henrik Ljungstrom, Petch Pompili, Vladan Ognjenovic, Bilal Mannaa, Adam Hockley, Paul Muttett and Philip Cooper.

Finally, thank you to Terry Williams, Andrew Calvy, John Marshall, Ray Saunders, Anthony Goodin, Damon Carter, Rich Lynn, Neil Lewis, Stuart Medlen, Michael Nicoll, Jonathan Rossington, Alan Fulling, Sean Murphy and Michael Beddow for demonstrating consistently the unquantifiable, yet vital, characteristic that is the ability to inspire. Quintessential Best of British.

Or, as Justin Rockberger would say – “Be up for it!”

I beg that readers indulge me as I list my eight desert-island discs:

1. Lean On Me!, Redskins

2. My Sweet Lord, George Harrison

3. Rattlesnakes, Lloyd Cole and The Commotions

4. Still Ill, The Smiths

5. Don’t Let Me Down, The Beatles

6. I Can’t Help Myself, Orange Juice

7. A Lover Sings, Billy Bragg

8. Speak Like A Child, The Style Council

And, after nine years...that’s yer lot! Goodbye...

Moorad Choudhry

Surrey, England

30 January 2007

1 Hicks, J. 1939, Value and Capital, Oxford University Press, Oxford.

About the Author

Moorad Choudhry is Head of Treasury at KBC Financial Products in London. He is a Visiting Professor at the Department of Economics, London Metropolitan University; a Visiting Research Fellow at the ICMA Centre, University of Reading; a Senior Fellow at the Centre for Mathematical Trading and Finance, Cass Business School; a Fellow of the Global Association of Risk Professionals, a Fellow of the Institute of Sales and Marketing Management; a Fellow of the Securities and Investment Institute and a member of the Chartered Institute of Bankers. He is on the Editorial Board of the Journal of Structured Finance.

I must frankly admit that, if I had known beforehand the labour which this book entailed, I should never have been courageous enough to commence it.

– Isabella Beeton, Mrs Beeton’s Household Guide, Ward, Lock & Co., c.1861

PART I

Banking Business, Bank Capital and Debt Market Instruments

Part I is something of a primer on banking, and is designed to set the scene for beginners, be they students or practitioners. We need to be familiar with the nature of banking business, as well as the types of instruments used in money market trading. We also need to be familiar with banking capital and financial statements, the former preparatory to a discussion of regulatory capital and the Basel rules, the latter simply for general knowledge purposes. So the first part of this book covers all these areas.

We begin with a look at the fundamentals of banking business, and the different elements of bank capital. This is essentially an introduction into the nature of banking. We then look at financial statements, which comprise balance sheet and profit and loss account. The contents of this chapter may appear more at home in a textbook on accounting, but an understanding of ratio analysis is vital for the ALM practitioner, who is concerned with issues such as return on capital.

The remainder of Part I looks at financial market debt instruments, which are the main products issued and traded by banks. Chapter 3 discusses money market instruments and Chapter 4 is concerned with capital market instruments or bonds. For undergraduate students and junior practitioners we cover elements of financial arithmetic, which are essential to an understanding of ALM, in the Appendix at the back of the book.

“[Cassandra is] a bit like me – an achiever. I’ve always been an achiever ... ...I’ve never actually achieved anything, mind...but I’ve always been up there with a shout.”

— Derek ‘Del-Boy’ Trotter, “The Jolly Boys Outing”

Only Fools and Horses

BBC TV 1989

CHAPTER 1

Bank Business and Bank Capital

Banking has a long and honourable history. Today it encompasses a wide range of activities, of varying degrees of complexity. Whatever the precise business, the common denominators of all banking activities are those of risk, return and the bringing together of the providers of capital. Return on capital is the focus of banking activity. The coordination of all banking activity could be said to be the focus of asset and liability management (ALM), although some practitioners will give ALM a narrower focus. Either way, we need to be familiar with the wide-ranging nature of banking business, and the importance of bank capital. This then acts as a guide for what follows.

In this introductory chapter of the first part of the book, we place ALM in context by describing the financial markets and the concept of bank capital. Subsequent chapters look at money market instruments and the basics of bank financial statements. We begin with a look at the business of banking. We then consider the different types of revenue generated by a bank, the concept of the banking book and the trading book, and financial statements. The chapter concludes with an introduction to the money market, the key area of involvement for an ALM desk.

Banking business

We introduced the different aspects of banking business in the Preface. For the largest banks these aspects are widely varying in nature. For our purposes we may group them together in the form shown in . Put very simply, “retail” or “commercial” banking covers the more traditional lending and trust activities, while “investment” banking covers trading activity and fee-based income such as stock exchange listing and mergers and acquisition (M&A). The one common objective of all banking activity is return on capital. Depending on the degree of risk it represents, a particular activity will be required to achieve a specified return on the capital it uses. The issue of banking capital is vital to an appreciation of the banking business; entire new business lines (such as securitisation) have been originated in response to a need to generate more efficient use of capital.