Sample Asset Liability Management Policy - ALMP
Documentsplace.com presents on this page a free sample asset liability management policy (ALMP) that was formulated for a bank but can easily be adjusted to meet the needs of any financial institution.
This Asset Liability Management Policy encompasses the strategic management of the balance sheet aimed at achieving sustained growth, profitability and solvency. It involves a multiplicity of management activities and responsibilities, including the formulation of long-term strategic goals and objectives and the management of various risks including liquidity risk, interest rate risk and market risk.
The assets and liabilities of the Sample Bank Ltd shall be managed in order to maximize shareholder value, to enhance profitability and increase capital, to serve customer and community needs, and to protect the institution from any disastrous financial consequences arising from changes in interest rates. These objectives shall be pursued within the framework of written credit, capital, and investment policies. In a capsule, the Bank intends, through sound and dynamic funds management, to realize solid operating results produced against a background of a quality balance sheet.
By extension, therefore, the purpose of the Bank’s Asset Liability Management Policy is to:
Outline the Scope and Responsibilities of the Asset/Liability Committee (ALCO).
Define, Measure and Manage on a consistent basis the various Risks facing the Bank.
Establish guidelines to meet various applicable regulatory rules and statutes.
Form a consistent co-policy with other policies of the Bank (investments, lending, capital, etc.).
Coordinate the management of the Bank’s financial position.
The Asset Liability Management Policy of the Bank falls under the authority of the Board of Directors, who in turn assigns authority for its formulation, revision and administration to the Asset Liability Management Committee (ALCO). Ultimate responsibility for effective asset/liability management rests with the Board of Directors.
Board of Directors
The Board of Directors has the ultimate responsibility for the implementation of and ensuring adherence to this policy. The Board will, at least annually, formally review this policy with the Bank’s management. The Board of Directors will, at least monthly, review the funds management activities of the Bank. This review will include:
The minutes of the Asset/Liability Committee (ALCO) meetings held since the last board meeting.
A summary of the Bank’s most recent rate sensitivity analysis.
An analysis of the Bank’s liquidity position.
An analysis of the Bank’s financial result for the period just ended compared to the budget for the period, the previous period and the same period in the previous year.
Annually, the Board of Directors will also review and approve the Bank’s annual budget and the Bank’s strategic plan. The Board of Directors will also review and approve any other data, analyses, and transactions as may be appropriate in view of their overall responsibility for the funds management activities of the Bank.
Asset Liability Committee (ALCO)
Membership of the ALCO
The ALCO will consist of the following:
Fixed Members shall include the Chief Executive Officer (Chairperson of the Committee), Deputy Chief Executive Officer, Chief Financial Officer, Manager Retail Banking, Manager Information Systems & Technology, Deputy Manager Credit Administration, and the Recording Secretary, while the Ex-officio Members shall comprise the Deputy Manager Credit Risk Management, Senior Risk Officer, Senior Manager Treasury Management
For the purpose of separation of key functions, the Chairperson of the ALCO cannot be the main person performing the monthly update and measuring the Asset Liability Management (ALM) position using the Asset Liability Management system. The monthly update and measurement of the ALM position will be someone without authority to make investment or risk taking decisions. The Chairperson may designate that duty to another member of the ALCO or employee of the Bank.
Duties of the ALCO
The duties cited below do not necessarily represent an all-inclusive list of the duties of the ALCO, given the dynamic nature of its responsibilities. On a regular basis the ALCO should:
Also, the ALCO will ensure that it is aware of the overall financial performance of the Bank and, therefore, will keep abreast of significant changes/trends in its financial results. In this regard it will:
Review actual net interest income and asset liability distribution versus budget.
Measure performance against established standards and, if appropriate against peer group data. Review the level and makeup of non-earning assets.
Review the liquidity and contingency funding conditions of the Bank.
Given the importance of the ALCO in the management of the Bank’s balance sheet and related earnings stream, the ALCO will review the annual budget.
Meetings of the ALCO
ALCO Reporting Requirements
The ALCO shall provide the Board with the following reports:
All financial institutions assume some amount of risk as part of normal operations. It is the policy of the Sample Bank Ltd to manage and control the amount of risk it assumes. The primary objectives of the Bank’s asset/liability management process include:
Consistent earnings-to-growth plan and Net Worth to Assets within acceptable and controllable levels of the following four main risks:
Other Risks: Other risks may be measured from time to time. However, their importance is also key to the Bank’s continued successful operations. The ALCO will review these risks at least annually, and more often as conditions may warrant.
Provide for growth that is sound, profitable and balanced without sacrificing the quality of service.
Manage and maintain a policy and procedures that are consistent with the short and long-term strategic goals of the Board of Directors.
To this end, the assets and liabilities shall be managed to attempt to achieve the following major objectives:
These Guidelines and other guidelines forming part of this policy, as well as other financial management Information, are intended to be a guide for the ALCO on measuring different risks, their “tolerance ranges”, and other key financial management information. These guidelines are NOT meant to be absolute, but rather to help the ALCO and the Board of Directors in risk management and management of the bank’s financial position. There may be additional financial and risk measurements, as well as experience judgment, which will be used, yet not listed here. The guidelines may be amended from time to time.
Liquidity is measured in terms of having sufficient funds available at all times, to meet fully and promptly, the legitimate demands for money made on the bank arising from deposit withdrawal, presentation of cheques, maturing investments, draws under committed loan facilities, and other financial commitments. The Bank needs to assure depositors that they can withdraw their funds when desired, borrowers of the availability of funds to meet legitimate demands for credit expansion, and employees of the bank stability & longevity. It must be remembered however that too much liquidity will have a negative impact on profitability, while too little liquidity will increase the risk of insolvency. The Bank is deemed to have adequate liquidity when it can obtain sufficient cash promptly and at a reasonable rate (cost). The determination of the adequacy of the Bank’s liquidity position depends upon an analysis of the Bank’s position relative to the following factors:
Liquidity risk is the risk of having to fund some assets by the acquisition of additional funds under unfavourable market terms. This might occur when unexpected clearing drains occur in close proximity, when depositors are leaving the bank due to a perception of increased risk, or when loan growth is very strong. These demands are affected by changes in:
The Business cycle:
Measuring Liquidity Exposure
Liquidity exposure will be measured by calculating the Bank’s Net Liquidity Gap and by comparing current ratios with targets.
The Net Liquidity Gap will be calculated as follows:
Net Liquidity Gap as of June 30, 2003
Up to one year One to five years Over five years Total
Assets 180 46 284 509 Liabilities 471 4 4 479
Net Liquidity Gap -291 42 280 30
Ratios The ALCO will monitor the Bank's liquidity position by reviewing the following measures:
Cash reserve Minimum 6% 2. Liquid assets 20% - 26% 3. Loans/Deposits 70% - 80%
The cash reserve ratio is calculated by expressing cash reserves (comprising local cash and net balances with the Central Bank) as a percentage of total deposits. The Banking Act requires that commercial banks hold 6% of their deposits with the Central Bank. The liquid assets ratio is calculated as liquid assets expressed as a percentage of total deposits, and the Central Bank guidelines provide that this should be between 20% and 25%. Liquid assets comprise total cash reserves including foreign cash, treasury bills and other risk free investments, cheques held for collection and net balances with Central Bank and other banks. The loans to deposits ratio is calculated as net loans and advances expressed as a percentage of deposits. The Central Bank prudential guidelines require a ratio between 75% and 85%. A very high ratio suggests a less liquid position and presents the risk that some loans may have to be sold at a loss to meet depositors’ claims. A low ratio indicates excess liquidity and potentially low profits.
Forecasting future events is essential to adequate liquidity planning. Sound financial management can help buffer negative changes in the Bank’s economic climate and accentuate positive ones. Forecasting of future events is very subjective and fraught with potential error. Management must therefore develop contingency plans in case its projections are wrong. Effective contingency planning involves identifying minimum and maximum liability needs and weighing the alternative courses of action designed to meet the needs. Monthly cash flow projections will be sought from large customers.
The following are alternative ways the Bank can meet its liquidity needs:
The ALCO will review annually, as part of the annual budget preparation, or as often as necessary, the Bank’s deposit structure in relation to volume and trend of various types of deposits, maturity distribution of time deposits and rates paid compared to rates offered by competitors.
Investments purchased will be consistent with a separate written investment policy. The objectives of the investment policy are to (1) provide liquidity (2) provide for interest rate risk management, and (3) provide additional profit. The investments portfolio shall be diversified to minimize the risk of loss resulting from over concentration of assets in specific class, currency, Country, or economic sector.
The Bank shall adopt a flexible weightings approach (strategic asset allocation) involving the periodic adjustments of the weights for each category based either on the market analysis or on technical analysis (i.e., market timing). A new allocation therefore may be constructed to capture greater returns in a changing market. The initial allocation is as follows:
Class Initial Allocation New Allocation Short-term investments (Money Market) 55% Fixed Income (Bonds) 45% Equities 15%.
Interest rate risk arises when there is a mismatch between positions which are subject to interest rate adjustments within a specified period. The most important source of interest rate risk is the Bank’s lending, funding and investment activities, where fluctuations in interest rates are reflected in interest margins and earnings. Interest rate risk also arises in trading activities, where changes in interest rates may cause fluctuations in portfolio market values.
The interest rate gap is a common form of interest rate sensitivity measurement. GAP is equal to rate sensitive assets (RSA) minus rate sensitive liabilities (RSL). A rate sensitive asset/liability is one whose yield/cost varies with base rate fluctuations. With the GAP methodology the Bank’s assets and liabilities will be organized into re-pricing “buckets” using book values. The analysis will allow the Bank to determine the effect in the bank’s income due to a change in interest rates. A positive GAP exists when there is more RSA than RSL, and a negative GAP exists when there is more RSL than RSA.
The Bank will strive to achieve a balance between reducing risk to earnings from adverse movements in interest rates, and enhancing net interest income through correct anticipation of the direction and extent on interest rate changes. By running a positive GAP the Bank will benefit if interest rates rise, and by running a negative GAP it will benefit if interest rates fall. The Bank's GAP and interest rate exposure will be compiled and reviewed on a monthly basis. The GAP reports will be used to measure risk to net interest income arising from the re-pricing of assets and liabilities over time. The Bank will focus on net re-pricing imbalances (RSA - RSL) in the 30, 90, 180, and 365-day cumulative time frames, while measuring the risk based upon the size of the re-pricing balances, how long the re-pricing imbalances remain open, and potential movements in interest rates. While the GAP reports will be used to indicate the timing and sources of interest rate risk, it is understood that maintaining a balanced position for all time periods in a GAP report does not ensure immunity from interest rate risk.
The Bank will take into account the following limitations of GAP reporting:
To address the limitations of GAP reports, the bank will concentrate on simulation modeling.
The focus of simulation is to measure risk to net income by projecting the future composition of the bank’s assets and liabilities and applying different interest rate scenarios. Simulation modeling will be incorporated to run "what if" analyses to determine the effect of different strategies on the bank's risk profile and profitability.
By using simulation, the Bank will consider the varying interest rate spreads (Basis Risk) between deposits, CD rates, loans, investments, etc. The impact of prepayment rates on loans and securities will also be taken into account. Further, management will carefully assess and document the assumptions underlying the simulations including anticipated management reaction to a rise or decline in interest rates or changes in the yield curve.
While simulation can adequately assess short-term (1-2 years) interest rate risk, the Bank will not rely on this analysis to capture and isolate the risks associated with longer term re-pricing imbalances. Subjective analysis of the balance sheet will be utilized to evaluate long-term fixed-rate positions.
Market interest rates will be shocked using +/- 100, 200 and 300 basis point shifts. The rate risk limits are as follows:
Net Interest Change 1 Year Change As a Percent of in Market Rates Net Interest Income +300 basis points -30% +200 basis points - 20% +100 basis points -10% Base -100 basis points -10% -200 basis points -20% -300 basis points -30%
Asset Allocation Strategies
Interest rate risk will be managed through (1) investments (2) loan pricing, and (3) deposit pricing. Asset/Liability policies and strategies will be formulated upon the examination of how interest rate risk affects overall business risk, i.e., capital risk, and liquidity risk, credit risk, interest rate risk. After review of the current situation, the ALCO will devise various strategies to minimize risk while maximizing earnings and net worth. The following methods for managing the asset/liability mix will be reviewed:
The proper strategy will depend on the current level of risk, the time frame, and the current interest rate environment. If the Bank determines that there is a good chance that interest rates will increase, an attempt will be made to extend fixed-rate liabilities to longer maturities while purchasing variable rate assets in order to widen the net interest margin. If it is perceived that interest rates will decline, an attempt will be made to shorten fixed rate liabilities while securing longer-term fixed-rate assets in order to increase the net interest margin. Asset maturities will be managed as a result of the liability structure to maintain compliance within the ranges detailed.
Credit risk is the risk of loss resulting from the failure of a borrower or counterparty to honour its financial or contractual obligation. Credit risk arises both in the Bank’s direct lending operations or in its funding, investment and trading activities, where counterparties have repayment or other obligations to the Bank. The management of the Bank’s credit risk shall be consistent with separate written credit policies and procedures.
Credit Policy Objectives
The Bank’s credit policies will seek to achieve the following major objectives:
Sample Bank’s credit disciplines shall be based on a division of authority, a committee system for dealing with all major exposures, and periodic independent review by the Audit Department.
Banking officers, who have client contact, will develop and structure individual proposals, and will approve credits within their individual limits. Retail credits will be assessed and authorized in branches within the criteria established by the Bank. All proposals outside the officers’ limits will be adjudicated by the Credit Committee which will analyze the financial strength of the customers and the risks inherent in the proposals. All exceptions to the credit policy of the Bank, or credits outside of the authority of the Credit Committee, must be referred to the Executive Committee for its decision or recommendation to the Board of Directors. Higher risk exposures are subject to mandatory referral to the Board of Directors.
Credit lines for off-balance sheet instruments such as credit card limits, letters of credit and guarantee, shall be managed as an integral part of the same process.
At least annually, banking officers will meet formally with each commercial client to review their financial affairs and to assess the appropriateness of their credit requirements. The results will be formulated into a presentation which will be adjudicated in the same manner as a new credit. Where unusual risks exist, credits will be reviewed more frequently. In this way, the Bank will remain fully aware of customers’ risk profiles. Risk ratings will be reassessed with each credit presentation or review.
To minimize risk the Bank will only accept those credits where there is reasonable confidence that the asset will be redeemed at face value.
Limits and maximum maturity periods for various types of loans will be outlined in the Bank’s Credit Policy.
The Bank’s credit policies and limits are intended to ensure broad diversification across various types of credit risk. Limits will be set for individual borrowers, particular industries and certain types of lending. There various risks will be determined taking into account the relative risk of the borrower, economic activity or product type.
Pricing for Risk
The Bank will classify loans into risk categories by economic sector and by product and will price the loans to compensate for the risk involved.
Accounting for Problem Loans
The Board of Directors understand that in any portfolio there will be delinquent loans which require special accounting procedures. The Bank has therefore adopted the Central Bank Prudential Guidelines with respect to loan review, loan classification, loan provisioning, suspension of interest and loan write-offs. The guidelines require an annual review of at least 70% of the Bank’s credit portfolio taking into consideration; the terms of the loan, the business of the borrower, evaluation of the project being financed, security, and debt service. The loans are classified into five categories: pass, special mentioned, substandard, doubtful, and loss. Any loan classified as substandard, doubtful or loss requires a provision of 10%, 50% or 100% respectfully. A 1% provision is required for the percentage of the portfolio not reviewed. Interest should stop accruing on non-performing credits classified as substandard, doubtful or loss unless adequate security exists and full collection is expected within three months. Interest on Government guaranteed loans should continue to accrue up to the limit of the guarantee. Write-off is recommended for loans that have been classified as loss for over three months.
Market risk refers to the uncertainty of future earnings resulting from changes in interest rates, exchange rates, market prices and volatilities. The Bank assumes market risk from consumer and corporate loans, position taking, and trading and investment activities.
The strategy for controlling market risk shall involve:
The Bank conducts some trading activities on behalf of its customers, but also trades for its own account. Trading portfolios shall be managed with the intent to buy and sell financial instruments over a short period of time rather that hold positions for investments. Continued enhancement of the Bank’s trading risk management systems and processes will be kept up-to-date with market developments.
Trading on behalf of customers will be done only for securities listed on the Securities Exchange, including bonds, treasury bills and shares. Such trading will be done by the Bank’s Licensed Representative under the supervision of the Licensed Principal. There will be no limit for trades done on behalf of customers. Securities, whether listed on the Securities Exchange or not, traded on the Bank’s own account will be traded by the Bank’s Licensed Representative under the supervision of the Licensed Principal but will be authorized by the Bank’s officers in accordance with established investments limits. The current limits are as follows:
Daily reports of profit and loss, limit overruns and compliance will be circulated to all appropriate departments and management for evaluation. Rigorous analysis and testing programs will be applied to measure risk, and to verify accuracy of various controls and limits. These will include stress testing, and sensitivity analysis.
Foreign Exchange Risk
The operational currency of the Bank is the EC Dollar. However, in order to meet customer needs, the Bank buys and sells a number of foreign currencies, and also holds assets and liabilities denominated in several foreign currencies. Also, as a result of its investments in foreign currencies and its international trading activities, the Bank receives income and pays expenses in foreign currency. The Bank is therefore exposed to foreign exchange risk associated with the effect of fluctuations in the rates of exchange in various currencies. To mitigate the risk of loss due to rate changes the Bank will match its positions as closely as possible. However as it is not possible to match positions perfectly, the following exposure limits have been set for the various foreign currencies:
Where any currency holding is out of guidelines, trading will be conducted as soon as possible to bring the relative balance within the currency limit. Forward contracts may also be used where necessary to hedge credit commitments or to buy or sell cash to meet required limits. Positions will be analyzed on a daily basis, a currency risk report will be produced for the Board at the end of each month.
The ALCO will be responsible for reviewing the Annual Budget, which should have, as its foundation, a set of economic and interest rate assumptions. The Bank’s interest rate risk exposure, liquidity, and other limits must be incorporated into this planning process. Potential impacts of changes in rates on new product introduction, expansion, deposit and loan pricing, investment strategy and customer behaviour must be considered.
If during the period under review of the budget, the ALCO should determine that major budget goals are not being achieved, and that the potential effect of this variance will have a material adverse impact on the Bank’s financial performance objectives, then the ALCO shall consider altering budget expectations for the planning period.
The Bank will seek to achieve commercial growth targets while maintaining a tight rein on all cost. The following Cost Management Strategies will be applied as necessary and in the most effective way to achieve the desired results:
Productivity enhancements - Economies of scale - Economies of scope - Economies of experience - Computerization (electronic banking) - Process re-engineering Management Information - Budgetary control - Cost centre analysis - Product & business unit profitability analysis Appropriate pricing of Products & Services - Link charges to real costs - Establish pricing to encourage cost conscious behaviour from customers - Avoid cross-subsidies - Set up necessary systems measure customer and product profitability - Classify customer groups to ascertain profitability
Measuring Cost & Productivity
The Bank will seek to achieve market levels for the following measures of productivity:
The Bank will seek to achieve the following profitability ratios:
The rate of Income tax is 40%. However due to the expenses allowable against income tax, including capital allowances, tax-free securities and interest on residential mortgages under $150,000, the Bank pays an annual effective rate of between 20% and 30%. The Bank will seek to manage the tax position to the maximum benefit of shareholders.
Actual dividend payout, as a percentage of net income, will be determined by the capital position relative to loans, deposits, total assets, and projected growth trends. The dividend amount will be recommended by the Board for approval by the shareholders at the Annual General Meeting. For the next five years the dividend payout ratio will not exceed 5% of profits after tax, to a maximum of 5% of paid-up capital. When deciding on the dividend to be paid the Board should keep the following in mind:
Capital planning will be done in accordance with a separate written policy. The Bank shall measure capital using the capital solvency ratio and the risk-based capital adequacy ratio. The solvency ratio is calculated by expressing primary (Tier 1) capital as a percentage of total deposits. The Banking Act requires that the ratio must be greater than or equal to 5%. The risk-based capital adequacy is computed by expressing total capital (tier 1 capital plus tier 2 capital) as a percentage of on-balance sheet and off-balance sheet risk weighted assets. The ratio must be greater than or equal to 8%. See Appendix 1 to this policy for description of classes of capital for regulatory purposes.
Risk Weighting of Assets
On Balance Sheet Items Risk Weight
Current laws and regulations, as well as prudent and generally accepted banking practices, will be the foundation for and will act as the guiding hand in the development of policies, procedures, strategies and tactics relating to the management of the Bank’s assets and liabilities.
All funds management activities pre-dating the adoption of this policy and not in conformity with its various sections will be considered as exceptions to this policy. Management will make a concerted effort to bring the funds management activities of the Bank into compliance with the various guidelines and provisions of this policy as quickly as possible, subject to sound financial practices.
In those situations where it seems prudent to act in a manner that is contrary to this policy, and where it is impossible for the entire ALCO to meet, any two of the CEO, Deputy CEO, CFO or Manager Retail Banking may act for the entire ALCO; provided, however, that all actions taken in the absence of the entire ALCO shall be reported in full at the next regularly scheduled ALCO meeting.
The Chief Financial Officer shall review the policy annually and shall recommend all necessary changes to the Board for consideration and adoption.
This policy is intended to be flexible to deal with rapidly changing conditions; therefore, this policy can be amended by the unanimous vote of the members of the ALCO. Any and all modifications of this policy are to be reported to the Board of Directors at its next regularly scheduled meeting.
This asset liability management policy (ALMP) and any changes made during the annual reviews shall be adopted by resolution of the Board of Directors.
Adopted: By the Board of Directors Sample Bank Ltd.
More About this Sample ALMP
There is extensive coverage of liquidity risk and funding, investment, interest rate management and simulation, asset allocation strategies, credit risk management, and market risk, including trading risk and foreign exchange risk. Also included are details on profitability and productivity, income tax, dividends and capital, among other important areas. Effective asset management can only be achieved with the employment of a professionally formatted ALM policy.
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