. 9
( 10)


rity of assets and liabilities. Typically longer-term interest rates are
higher than shorter-term rates; that is, it is common for the yield curve
in the short-term (say 0“3 year range) to be positively sloping. To take
advantage of this, banks usually raise a large proportion of their funds
from the short-dated end of the yield curve and lend out these funds for
longer maturities at higher rates. The spread between the borrowing and
lending rates is in principle the bank™s pro¬t. The obvious risk from
such a strategy is that the level of short-term rates rises during the term
of the loan, so that when the loan is re¬nanced the bank makes a lower
pro¬t or a net loss. Managing this risk exposure is the key function of
an ALM desk. As well as managing the interest rate risk itself, banks
also match assets with liabilities”thus locking in a pro¬t”and diversify
their loan book to reduce exposure to one sector of the economy.
Another risk factor is liquidity. From a banking and Treasury point
of view the term liquidity means funding liquidity, or the “nearness” of
money. The most liquid asset is cash. Banks bear several interrelated
liquidity risks, including the risk of being unable to pay depositors on
demand, an inability to raise funds in the market at reasonable rates,
and an insuf¬cient level of funds available with which to make loans.
Banks keep only a small portion of their assets in the form of cash
because cash earns no return for them. In fact, once they have met the
minimum cash level requirement, which is something set down by inter-
national regulation, they will hold assets in the form of other instru-
ments. Therefore, the ability to meet deposit withdrawals depends on a
bank™s ability to raise funds in the market. The market and the public™s
perception of a bank™s ¬nancial position heavily in¬‚uences liquidity. If
this view is very negative, the bank may be unable to raise funds and
consequently be unable to meet withdrawals or loan demand. Thus,
liquidity management is running a bank in a way that maintains con¬-
dence in its ¬nancial position. The assets of the banks that are held in
near-cash instruments, such as Treasury bills and clearing bank CDs,
must be managed with liquidity considerations in mind. The asset book
on which these instruments are held is sometimes called the liquidity
Asset and Liability Management

The general term asset and liability management entered common
usage from the mid-1970s onwards. In the changing interest rate environ-
ment, it became imperative for banks to manage both assets and liabilities
simultaneously, in order to minimize interest rate and liquidity risk and
maximize interest income. ALM is a key component of any ¬nancial insti-
tution™s overall operating strategy.
In the era of stable interest rates that preceded the breakdown of the
Bretton-Woods agreement, ALM was a more straightforward process,
constricted by regulatory restrictions and the saving and borrowing pat-
tern of bank customers.1 The introduction of the negotiable Certi¬cate of
Deposit by Citibank in the 1960s enabled banks to diversify both their
investment and funding sources. With this innovation there developed the
concept of the interest margin, which is the spread between the interest
earned on assets and interest paid on liabilities. This led to the concept of
the interest gap and the management of the gap, which is the cornerstone
of modern-day ALM. The increasing volatility of interest rates, and the
rise in absolute levels of rates themselves, made gap management a vital
part of running the banking book. This development meant that banks
could no longer rely on permanently on the traditional approach of bor-
rowing short (funding short) to lend long, as a rise in the level of short-
term rates would result in funding losses. The introduction of derivative
instruments such as FRAs and swaps in the early 1980s removed the pre-
vious uncertainty and allowed banks to continue the traditional approach
while hedging against medium-term uncertainty.

ALM Concept
ALM is based on four well-known concepts. The ¬rst is liquidity, which
in an ALM context does not refer to the ease with which an asset can be
bought or sold in the secondary market, but the ease with which assets
can be converted into cash.2 A banking book is required by the regulatory
authorities to hold a speci¬ed minimum share of its assets in the form of

For instance in the U.S. banking sector the terms on deposit accounts were fixed by
regulation, and there were restrictions on the geographic base of customers and the
interest rates that could be offered. Interest-rate volatility was also low. In this envi-
ronment, ALM consisted primarily of asset management, in which the bank would
use depositors™ funds to arrange the asset portfolio that was most appropriate for the
liability portfolio. This involved little more than setting aside some of the assets in
non-interest reserves at the central bank authority and investing the balance in short-
term securities, while any surplus outside of this would be lent out at very short-term
The marketability definition of liquidity is also important in ALM. Less liquid fi-
nancial instruments must offer a yield premium compared to liquid instruments.

very liquid instruments. Liquidity is very important to any institution that
accepts deposits because of the need to meet customer demand for instant
access funds. In terms of a banking book, the most liquid assets are over-
night funds, while the least liquid are medium-term bonds. Short-term
assets such as Treasury bills and CDs are also considered very liquid.
The second key concept is the money market term structure of interest
rates. The shape of the yield curve at any one time, and expectations as to
its shape in the short- and medium-term, impact to a signi¬cant extent on
the ALM strategy employed by a bank. Market risk in the form of interest-
rate sensitivity is signi¬cant, in the form of present-value sensitivity of spe-
ci¬c instruments to changes in the level of interest rates, as well as the sen-
sitivity of ¬‚oating-rate assets and liabilities to changes in rates.
The maturity pro¬le of the book is the third key concept. The maturi-
ties of assets and liabilities can be matched or unmatched; although the
latter is more common the former is also used routinely depending on the
speci¬c strategies that are being employed. Matched assets and liabilities
lock in return in the form of the spread between the funding rate and the
return on assets. The maturity pro¬le, the absence of a locked-in spread
and the yield curve combine to determine the total interest-rate risk of the
banking book.
The fourth key concept is default risk”the risk exposure that bor-
rowers will default on interest or principal payments that are due to the
banking institution.
To illustrate the basic ALM dilemma, let us consider a simple hypo-
thetical situation. Suppose a bank may access the markets for 3-month
and 6-month funding and investments. The rates available for these matu-
rities are presented in Exhibit 13.1. The ALM manager also expects that
3-month LIBOR in three months hence to be 5.10%.3 The bank can typi-
cally fund its portfolio at LIBOR while it is able to lend at LIBOR plus
100 basis points.

EXHIBIT 13.1 Hypothetical Money Market Rates

Term LIBOR Bank Rate

3-month 5.50% 6.50%
6-month 5.75% 6.75%
Expected 3-month rate 3-months hence 5.10% 6.10%
3—6 Forward Rate Agreement 6.60%

This forward rate could be obtained by observing the price of a Eurodollar CD fu-
tures contract or simply the ALM manager™s best guess based on his/her intuition and
Asset and Liability Management

The bank could adopt any of the following strategies, or a combina-
tion of them.

– Borrow 3-month funds at 5.50% and lend this out for three months at
6.50%. This locks-in a return of 1% for a 3-month period.
– Borrow 6-month funds at 5.75% and lend for six months at 6.75%;
again this earns a locked-in spread of 1%.
– Borrow 3-month funds at 5.50% and lend for six months at 6.75%.
This approach would require the bank to refund the loan in 3-month™s
time, which it expects to be able to do at 5.10%. This approach locks
in a return of 1.25% in the ¬rst 3-month period, and an expected
return of 1.65% in the second 3-month period. The risk of this tactic is
that the 3-month rate in three months time does not fall as expected by
the ALM manager, reducing pro¬ts and possibly leading to loss.
– Borrow in the 6-month at 5.75% and lend for a 3-month period at
6.50%. After this period, lend the funds for either three or six months.
This strategy is inconsistent with the ALM manager™s view however,
who expects a fall in rates and so should not wish to be long funds in
three months time.
– Borrow 3-month funds at 5.50% and again, lend six months at 6.75%.
To hedge the gap risk, the ALM manager simultaneously buys a 3—6
FRA to lock in the 3-month rate in three months time. The ¬rst period
spread of 1.25% is guaranteed, but the FRA guarantees only a spread
of 15 basis points in the second period. This is the cost of the hedge
(and also suggests that the market does not agree with the ALM man-
ager™s assessment of where rates will be three months from now!), the
price the bank must pay for reducing uncertainty, which is the lower
spread return. Alternatively, the bank could lend in the 6-month
period, funding initially for three months, and buying an interest-rate
cap with a ceiling rate of 6.60% and pegged to Libor, the rate at which
the bank can actually fund its book.

Although simplistic, these scenarios serve to illustrate what is possi-
ble, and indeed there are many other strategies that could be adopted.
The approaches described in the last option show how derivative instru-
ments can be actively used to manage the banking book, and the cost that
is associated with employing them.

The Balance Sheet
ALM and transactions required in managing the bank™s traditional activ-
ity may ¬rst be viewed in the context of the balance sheet. A banking bal-
ance sheet essentially is a grouping of the following activities:

– treasury and banking transactions
– collection of deposits and disbursing loans
– ¬nancial assets
– long-dated assets, and capital (equity and long-term debt)

A simpli¬ed balance sheet is shown in Exhibit 13.2.
The Financial Accounting Standards Board has de¬ned assets as
“probable future economic bene¬ts obtained or controlled” by the bank
that have arisen as a result of transactions entered into by the bank. Lia-
bilities are de¬ned as “probable future sacri¬ces of economic bene¬ts
arising from present obligations” of the bank to transfer assets to other
bodies as a result of transactions it has entered into. Assets are further
sub-divided into current assets which are cash or can be converted into
cash within one year, and long-term assets which are expected to provide
bene¬ts over periods longer than one year. A similar classi¬cation is
applied to current liabilities and long-term liabilities.
The relative shares of each constituent in a bank balance sheet will
depend on the type of activity carried out by the bank. Commercial
banks have a higher share of deposit-taking and loan activity, which are
held in the banking book. Integrated banking groups combining com-
mercial activity and investment activity, and investment banks, will have
a greater proportion of market transactions in the capital markets, such
as bond trading, equity trading, foreign-exchange, and derivatives mar-
ket making. These activities will be placed in the trading book. Risk
management in a bank is concerned (among other things) with the fund-
ing and hedging of the balance sheet. In terms of the activities under-
taken, there is therefore an obvious distinction between each of the four
types of transaction listed above.

EXHIBIT 13.2 Banking Balance Sheet

Assets Liabilities

Cash Short-term debt
Loans Deposits
Financial assets Financial assets
Fixed assets Long-term debt
Equity capital

Off-balance sheet Off-balance sheet
(contingencies received) (contingencies paid)
Asset and Liability Management

The Banking Book
Traditionally ALM has been concerned with the banking book. The con-
ventional techniques of ALM were developed for application to a bank™s
banking book”that is, the lending and deposit-taking transactions. The
core banking activity will generate either an excess of funds, when the
receipt of deposits outweighs the volume of lending the bank has under-
taken, or a shortage of funds, when the reverse occurs. This mismatch is
balanced via ¬nancial transactions in the wholesale market. The banking
book generates both interest-rate and liquidity risks, which are then mon-
itored and managed by the ALM desk. Interest-rate risk is the risk that
the bank suffers losses due to adverse movements in market interest rates.
Liquidity risk is the risk that the bank cannot generate suf¬cient funds
when required; the most extreme version of this is when there is a “run”
on the bank, and the bank cannot raise the funds required when deposi-
tors withdraw their cash.
Note that the asset side of the banking book, which is the loan port-
folio, also generates credit risk.
The ALM desk will be concerned with risk management that focuses
on the quantitative management of the liquidity and interest-rate risks
inherent in a banking book. The major areas of ALM include:

– measurement and monitoring of liquidity and interest-rate risk. This
includes setting up targets for earnings and volume of transactions, and
setting up and monitoring interest-rate risk limits;
– funding and control of any constraints on the balance sheet. This
includes liquidity constraints, debt policy and capital adequacy ratio
and solvency;
– hedging of liquidity and interest-rate risk. This involves taking posi-
tions whose value will offset an exposure to these two sources of risk.

The ALM desk or unit of a bank is a specialized business unit that ful¬lls
a range of functions. Its precise set of duties will be driven by the type of
activities in which the ¬nancial institution is engaged. Let us consider the
main types of activities that are carried out.
If an ALM unit has a pro¬t target of zero, it will act as a cost center
with a responsibility to minimize operating costs. This would be consis-
tent with a strategy that emphasizes commercial banking as the core busi-
ness of the ¬rm, and where ALM policy is concerned purely with hedging
interest-rate and liquidity risk.

The next level is where the ALM unit is responsible for minimizing
the cost of funding. That would allow the unit to maintain an element of
exposure to interest-rate risk, depending on the view that was held as to
the future level of interest rates. As we noted above, the core banking
activity generates either an excess or shortage of funds. To hedge away all
of the excess or shortage, while removing interest-rate exposure, has an
opportunity cost associated with it since it eliminates any potential gain
that might arise from movements in market rates. Of course, without a
complete hedge, there is an exposure to interest-rate risk. The ALM desk
is responsible for monitoring and managing this risk, and of course is
credited with any cost savings in the cost of funds that arise from the
exposure. The saving may be measured as the difference between the
funding costs of a full hedging policy and the actual policy that the ALM
desk adopts. Under this policy, interest-rate risk limits are set which the
ALM desk ensures the bank™s operations do not breach.
The ¬nal stage of development is to turn the ALM unit into a pro¬t
center, with responsibility for optimizing the funding policy within speci-
¬ed limits. The limits may be set as gap limits, value-at-risk limits or by
another measure, such as level of earnings volatility. Under this scenario,
the ALM desk is responsible for managing all ¬nancial risk.
This ultimate development of the ALM function has resulted in it tak-
ing on a more active role. The previous paragraphs described the three
stages of development that ALM has undergone, although all three ver-
sions are part of the “traditional” approach. Practitioners are now begin-
ning to think of ALM as extending beyond the risk management ¬eld,
and being responsible for adding value to the net worth of the bank,
through proactive positioning of the book and hence, the balance sheet.
That is, in addition to the traditional function of managing liquidity risk
and interest-rate risk, ALM should be concerned additionally with man-
aging the regulatory capital of the bank and with actively positioning the
balance sheet to maximize pro¬t. The latest developments indicate that
there are now ¬nancial institutions that run a much more sophisticated
ALM operation than that associated with a traditional banking book.
Let us review the traditional and developed elements of an ALM

Traditional ALM
We have noted that the simplest approach to ALM is to match assets with
liabilities. For a number of reasons, which include the need to meet client
demand and to maximize return on capital, this is not practical and banks
must adopt more active ALM strategies. One of the most important of
these is the role of the “gap” and “gap management.” This term describes
Asset and Liability Management

the practice of varying the asset and liability gap in response to expecta-
tions about the future course of interest rates and the shape of the yield
curve. The gap here is the difference between ¬‚oating-rate assets and lia-
bilities, but gap management must also be pursued when one of these ele-
ments is ¬xed rate. Simply put, this means increasing the gap when
interest rates are expected to rise, and decreasing it when rates are
expected to decline.
Such an approach is not without hazards. Gap management assumes
that the ALM manager is correct in his/her prediction of the future direc-
tion of interest rates and the yield curve. Expectations that turn out to be
incorrect can lead to unexpected widening or narrowing of the gap spread
and losses. The ALM manager must choose the level of trade-off between
risk and expected return.
Gap management also assumes that the pro¬le of the banking book
can be altered with relative ease. This was not always the case, and even
today may still present problems, although the availability of a liquid mar-
ket in off-balance sheet interest-rate derivatives has eased this problem
somewhat. However, historically it has always been dif¬cult to change the
structure of the book, as many loans cannot be liquidated instantly and
¬xed-rate assets and liabilities cannot be changed to ¬‚oating-rate ones.
Client relationships must also be observed and maintained, a key banking
issue. For this reason, it is much more common for ALM managers to use
off-balance sheet products when dynamically managing the book. For
example, FRAs can be used to hedge gap exposure, while interest-rate
swaps are used to alter an interest-basis from ¬xed to ¬‚oating, or vice-
versa. The widespread use of derivatives has enhanced the opportunities
available to ALM managers, as well as the ¬‚exibility with which the bank-
ing book can be managed, but it has also contributed to the increase in
competition and the reduction in margins and bid-offer spreads.

Basic Concepts in ALM
Generally a bank™s ALM function has in the past been concerned with
managing the risk associated with the banking book. In recent years, addi-
tional functions have been added to the ALM role. There are a large num-
ber of ¬nancial institutions that adopt the traditional approach, indeed the
nature of their operations would not lend themselves to anything more.
We can summarize the role of the traditional ALM desk as follows:

– Interest-rate risk management. This is the interest-rate risk arising from
the operation of the banking book. It includes net interest income sen-
sitivity analysis, typi¬ed by maturity gap and duration gap analysis,
and the sensitivity of the book to parallel changes in the yield curve.

The ALM desk will monitor the exposure and position the book in
accordance with the limits as well as its market view. Smaller banks, or
subsidiaries of banks that are based overseas, often run no interest-rate
risk, that is there is no short gap in their book. Otherwise the ALM
desk is responsible for hedging the interest-rate risk or positioning the
book in accordance with its view.
– Liquidity and funding management. There are regulatory requirements
that dictate the proportion of banking assets that must be held as
short-term instruments. The liquidity book in a bank is responsible for
running the portfolio of short-term instruments. The exact make-up of
the book is however the responsibility of the ALM desk, and will be a
function of the desk™s view of market interest rates, as well as its opin-
ion on the relative value of one asset over another. For example, it may
decide to move some assets into short-dated government bonds, above
what it normally holds, at the expense of other money market instru-
ments, or vice-versa.
– Reporting on hedging of risks. The ALM desk provides senior man-
agement with information by regularly reporting on the bank™s risk
– Setting up risk limits. The ALM unit will set limits, implement them
and enforce them, although it is common for an independent “middle
of¬ce” risk function to monitor compliance with limits.
– Capital requirement reporting. This function involves the compilation
of reports on capital usage and position limits as a percentage of capi-
tal allowed, and reporting to regulatory authorities.

All ¬nancial institutions will carry out the activities described above.

Developments in ALM
A greater number of ¬nancial institutions are enhancing their risk man-
agement function by adding to the responsibilities of the ALM function.
These have included enhancing the role of the head of Treasury and the
asset and liability committee (ALCO), using other risk exposure measures
such as option-adjusted spread and value-at-risk (VaR), and integrating
the traditional interest-rate risk management with credit risk and opera-
tional risk. The increasing use of credit derivatives has facilitated this
integrated approach to risk management.
The additional roles of the ALM desk may include:

– using the VaR tool to assess risk exposure;
– integrating market risk and credit risk;
– using new risk-adjusted measures of return;
Asset and Liability Management

– optimizing portfolio return;
– proactively managing the balance sheet; this includes giving direction
on securitization of assets (removing them from the balance sheet),
hedging credit exposure using credit derivatives, and actively enhanc-
ing returns from the liquidity book, such as entering into security lend-
ing and repo.

An expanded ALM function will by de¬nition expand the role of the
Treasury function and the ALCO. Speci¬cally, this may result in the Trea-
sury function becoming active “portfolio managers” of the bank™s book.
The ALCO, traditionally composed of risk managers from across the
bank as well as the senior member of the ALM desk or liquidity desk, is
responsible for assisting the head of Treasury and the Chief Financial
Of¬cer in the risk management process. In order to ful¬ll the new
enhanced function, the Treasurer will require a more strategic approach
to his or her function, as many of the decisions with running the bank™s
entire portfolio will be closely connected with the overall direction that
the bank wishes to take. These are board-level decisions.

Liquidity risk arises because a bank™s portfolio will consist of assets and
liabilities with different sizes and maturities. When assets are greater than
resources from operations, a funding gap will exist which needs to be
sourced in the wholesale market. When the opposite occurs, the excess
resources must be invested in the market. The differences between the
assets and liabilities is called the liquidity gap. For example if a bank has
long-term commitments that have arisen from its dealings and its
resources are exceeded by these commitments, and have a shorter matu-
rity, there is both an immediate and a future de¬cit. The liquidity risk for
the bank is that, at any time, there are not enough resources (or funds)
available in the market to balance the assets.
Liquidity management has several objectives; possibly the most
important is to ensure that de¬cits can be funded under all foreseen cir-
cumstances without incurring prohibitive costs. In addition, there are reg-
ulatory requirements that force a bank to operate within certain limits,
and state that short-term assets be in excess of short-run liabilities, in
order to provide a safety net of highly liquid assets. Liquidity manage-
ment is also concerned with funding de¬cits and investing surpluses, with
managing and growing the balance sheet, and with ensuring that the bank

operates within regulatory and in-house limits. In this section we review
the main issues concerned with liquidity and interest-rate risk.
The liquidity gap is the difference, at all future dates, between assets
and liabilities of the banking portfolio. Gaps generate liquidity risk.
When liabilities exceed assets, there is an excess of funds. An excess does
not of course generate liquidity risk, but it does generate interest-rate risk
because the present value of the book is sensitive to changes in market
rates. When assets exceed liabilities, there is a funding de¬cit and the
bank has long-term commitments that are not currently funded by exist-
ing operations. The liquidity risk is that the bank requires funds at a
future date to match the assets. The bank is able to remove any liquidity
risk by locking in maturities, but of course there is a cost involved as it
will be dealing at longer maturities.4

Gap Risk and Limits
Liquidity gaps are measured by taking the difference between outstanding
balances of assets and liabilities over time. At any point a positive gap
between assets and liabilities is equivalent to a de¬cit, and this is mea-
sured as a cash amount. The marginal gap is the difference between the
changes of assets and liabilities over a given period. A positive marginal
gap means that the variation of the value of assets exceeds the variation
of value of the liabilities. As new assets and liabilities are added over
time, as part of the ordinary course of business, the gap pro¬le changes.
The gap pro¬le is tabulated or charted (or both) during and at the
end of each day as a primary measure of risk. For illustration, a tabulated
gap report is shown in Exhibit 13.3 and is an actual example from a UK
banking institution. It shows the assets and liabilities grouped into matu-
rity buckets and the net position for each bucket. It is a snapshot today of
the exposure, and hence funding requirement, of the bank for future
maturity periods.
Exhibit 13.3 is very much a summary presentation, because the matu-
rity gaps are very wide. For risk management purposes, the buckets
would be much narrower; for instance, the period between zero and 12
months might be split into 12 different maturity buckets. An example of a
more detailed gap report is shown in Exhibit 13.4, which is from another
UK banking institution. Note that the overall net position is zero, because
this is a balance sheet and therefore, not surprisingly, it balances. How-
ever along the maturity buckets or grid points there are net positions
which are the gaps that need to be managed.

This assumes a conventional upward-sloping yield curve.
EXHIBIT 13.3 Example Gap Pro¬le

Time periods
Total 0“6 months 6-12 months 1-3 years 3-7 years 7+ years

Assets 40,533 6.17% 28,636 6.08% 3,801 6.12% 4,563 6.75% 2,879 6.58% 654 4.47%
Liabilities 40,533 4.31% 30,733 4.04% 3,234 4.61% 3,005 6.29% 2,048 6.54% 1,513 2.21%
Net Cumulative 0 1.86% (2,097) 567 1,558 831 (859)
Margin on total assets: 2.58%
Average margin on total assets: 2.53%

EXHIBIT 13.4 Detailed Gap Report

Total Up To 1“3 3“6 6 Months 1“2 2“3 3“4 4“5 5“6 6“7 7“8 8“9 9“10 10 Years
ASSETS £m 1 Month Months Months To 1 Year Years Years Years Years Years Years Years Years Years Plus

Cash & Interbank Loans 2,156.82 1,484.73 219.36 448.90 3.84 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Certificates of Deposit purchased 1,271.49 58.77 132.99 210.26 776.50 92.96 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Floating Rate Notes purchased 936.03 245.62 586.60 12.68 26.13 45.48 0.00 0.00 19.52 0.00 0.00 0.00 0.00 0.00 0.00
Bank Bills 314.35 104.09 178.36 31.90 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Other Loans 13.00 0.00 1.00 0.00 0.00 7.00 0.00 1.00 0.00 0.00 2.00 2.00 0.00 0.00 0.00
Debt Securities/Gilts 859.45 0.00 25.98 7.58 60.05 439.06 199.48 26.81 100.50 0.00 0.00 0.00 0.00 0.00 0.00
Fixed rate Mortgages 4,180.89 97.72 177.37 143.13 964.98 1,452.91 181.86 661.36 450.42 22.78 4.30 3.65 3.10 2.63 14.67
EXHIBIT 13.4 (Continued)

Total Up To 1“3 3“6 6 Months 1“2 2“3 3“4 4“5 5“6 6“7 7“8 8“9 9“10 10 Years
ASSETS £m 1 Month Months Months To 1 Year Years Years Years Years Years Years Years Years Years Plus

Variable & Capped Rate Mortgages 14,850.49 14,850.49 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Commercial Loans 271.77 96.62 96.22 56.52 0.86 2.16 1.12 3.64 8.85 1.06 0.16 0.17 0.16 4.23 0.00
Unsecured Lending and Leasing 3,720.13 272.13 1,105.20 360.03 507.69 694.86 400.84 195.19 79.98 25.45 14.06 10.03 10.44 10.82 33.42
Other Assets 665.53 357.72 0.00 18.77 5.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 284.03
TOTAL CASH ASSETS 29,239.95 17,567.91 2,523.06 1,289.77 2,345.05 2,734.43 783.31 888.00 659.26 49.28 20.53 15.85 13.71 17.68 332.12

Swaps 9,993.28 3,707.34 1,462.32 1,735.59 1,060.61 344.00 146.50 537.60 649.00 70.00 5.32 200.00 75.00 0.00 0.00
Forward Rate Agreements 425.00 0.00 50.00 0.00 220.00 5.00 150.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Futures 875.00 0.00 300.00 0.00 175.00 400.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
TOTAL 40,533.24 21,275.24 4,335.38 3,025.36 3,800.66 3,483.43 1,079.81 1,425.60 1,308.26 119.28 25.84 215.85 88.71 17.68 332.12
Bank Deposits 3,993.45 2,553.85 850.45 233.03 329.06 21.07 1.00 0.00 5.00 0.00 0.00 0.00 0.00 0.00 0.00

Certificates of Deposit issued 1,431.42 375.96 506.76 154.70 309.50 60.00 20.00 3.50 1.00 0.00 0.00 0.00 0.00 0.00 0.00
508.46 271.82 128.42 108.21 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Commercial Paper ’ CP & Euro
Subordinated Debt 275.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 200.00 75.00 0.00 0.00
Eurobonds + Other 2,582.24 768.75 1,231.29 121.94 53.86 9.77 13.16 150.43 150.53 0.00 7.51 0.00 0.00 0.00 75.00
Customer Deposits 17,267.55 15,493.65 953.60 311.70 340.50 129.10 6.60 24.90 0.00 7.50 0.00 0.00 0.00 0.00 0.00

Other Liabilities(incl capital/reserves) 3,181.83 1,336.83 0.00 0.00 741.72 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1,103.28
TOTAL CASH LIABILITIES 29,239.96 20,800.86 3,670.52 929.58 1,774.64 219.93 40.76 178.83 156.53 7.50 7.51 200.00 75.00 0.00 1,178.28

Swaps 9,993.28 1,754.70 1,657.59 1,399.75 1,254.24 1,887.97 281.44 905.06 770.52 15.76 6.48 7.27 8.13 13.06 31.30
FRA™s 425.00 0.00 150.00 70.00 55.00 150.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Futures 875.00 0.00 0.00 300.00 150.00 425.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
TOTAL 40,533.24 22,555.56 5,478.11 2,699.33 3,233.89 2,682.90 322.20 1,083.90 927.05 23.26 13.99 207.27 83.13 13.06 1,209.58
Net Positions 0.00 265.58 583.48 929.10 803.46 341.70 404.88 104.28 11.85 8.58 5.57
’1,351.09 ’1,234.54 4.62 ’877.45
Asset and Liability Management

EXHIBIT 13.5 Gap Maturity Profile in Graphical Form

EXHIBIT 13.6 Gap Maturity Profile, Bank with No Short Funding Allowed

The maturity gap can be charted to provide an illustration of net
exposure, and an example is shown in Exhibit 13.5, from yet another UK
banking institution. Some reports present both the assets and the liabili-
ties are shown for each maturity point, but in our example only the net
position is shown. This net position is the gap exposure for that maturity
point. A second example, used by the overseas subsidiary of a middle
eastern commercial bank, which has no funding lines in the interbank
market and so does not run short positions, is shown in Exhibit 13.6,
while the gap report for a UK high-street bank is shown in Exhibit 13.7.
Note the large short gap under the maturity labelled “non-int”; this
stands for non-interest bearing liabilities and represents the balance of
current accounts (cheque or “checking” accounts) which are funds that
attract no interest and are in theory very short-dated (because they are
demand deposits, so may be called at instant notice).

EXHIBIT 13.7 Gap Maturity Pro¬le, UK High-Street Bank

Gaps represent cumulative funding required at all dates. The cumula-
tive funding is not necessarily identical to the new funding required at each
period, because the debt issued in previous periods is not necessarily amor-
tized at subsequent periods. For example, the new funding between months
3 and 4 is not the accumulated de¬cit between months 2 and 4 because the
debt contracted at month 3 is not necessarily amortized at month 4. Mar-
ginal gaps may be identi¬ed as the new funding required or the new excess
funds of the period that should be invested in the market. Note that all the
reports are snapshots at a ¬xed point in time and the picture is of course a
continuously moving one. In practice the liquidity position of a bank can-
not be characterized by one gap at any given date, and the entire gap pro¬le
must be used to gauge the extent of the book™s pro¬le.
The liquidity book manager may decide to match its assets with its
liabilities. This is known as cash matching and occurs when the time pro-
¬les of both assets and liabilities are identical. By following such a course
the bank can lock in the spread between its funding rate and the rate at
which it lends cash, and generate a guaranteed pro¬t. Under cash match-
ing, the liquidity gaps will be zero. Matching the pro¬le of both legs of
the book is done at the overall level; that is, cash matching does not mean
that deposits should always match loans. This would be dif¬cult as both
result from customer demand, although an individual purchase of say, a
CD, can be matched with an identical loan. Nevertheless, the bank can
elect to match assets and liabilities once the net position is known, and
keep the book matched at all times. However, it is highly unusual for a
bank to adopt a cash matching strategy.

Liquidity Management
The continuous process of raising new funds or investing surplus funds is
known as liquidity management. If we consider that a gap today is funded,
Asset and Liability Management

by balancing assets and liabilities and thus squaring-off the book, the next
day a new de¬cit or surplus is generated which also has to be funded. The
liquidity management decision must cover the amount required to bridge
the gap that exists the following day, as well as position the book across
future dates in line with the bank™s view on interest rates.
Usually in order to de¬ne the maturity structure of debt a target pro-
¬le of resources is de¬ned. This may be done in several ways. If the objec-
tive of ALM is to replicate the asset pro¬le with resources, the new
funding should contribute to bringing the resources pro¬le closer to that
of the assets, that is, more of a matched book looking forward. This is the
lowest-risk option. Another target pro¬le may be imposed on the bank by
liquidity constraints. This circumstance may arise if for example the bank
has a limit on borrowing lines in the market so that it could not raise a
certain amount each week or month. For instance, if the maximum that
could be raised in one week by a bank is $10 million, the maximum
period liquidity gap is constrained by that limit. The ALM desk will man-
age the book in line with the target pro¬le that has been adopted, which
requires it to try to reach the required pro¬le over a given time horizon.
Managing the banking book™s liquidity is a dynamic process, as
loans and deposits are known at any given point, but new business will
be taking place continuously and the pro¬le of the book looking for-
ward must be continuously rebalanced to keep it within the target pro-
¬le. There are several factors that in¬‚uence this dynamic process, the
most important of which are reviewed below.

Demand Deposits
Deposits placed on demand at the bank, such as current accounts (cheque or
checking), have no stated maturity and are available on demand at the bank.
Technically they are referred to as “non-interest bearing liabilities” because
the bank pays no or very low rates of interest on them, so they are effectively
free funds. The balance of these funds can increase or decrease throughout
the day without any warning, although in practice the balance is quite stable.
There are a number of ways that a bank can choose to deal with these
balances, which are:

– to group all outstanding balances into one maturity bucket at a future
date that is the preferred time horizon of the bank, or a date beyond
this. This would then exclude them from the gap pro¬le. Although this
is considered unrealistic because it excludes the current account bal-
ances from the gap pro¬le, it is nevertheless a fairly common approach;
– to rely on an assumed rate of amortization for the balances, say 5% or
10% each year;

– to divide deposits into stable and unstable balances, of which the core
deposits are set as a permanent balance. The amount of the core bal-
ance is set by the bank based on a study of the total balance volatility
pattern over time. The excess over the core balance is then viewed as
very short-term debt. This method is reasonably close to reality as it is
based on historical observations;
– to make projections based on observable variables that are correlated
with the outstanding balances of deposits. For instance, such variables
could be based on the level of economic growth plus an error factor
based on the short-term ¬‚uctuations in the growth pattern.

Pre-Set Contingencies
A bank will have committed lines of credit, the utilization of which depends
on customer demand. Contingencies generate out¬‚ows of funds that are by
de¬nition uncertain, as they are contingent upon some event, for example
the willingness of the borrower to use a committed line of credit. The usual
way for a bank to deal with these unforeseen ¬‚uctuations is to use statisti-
cal data based on past observation to project a future level of activity.

Prepayment Options of Existing Assets
Where the maturity schedule is stated in the terms of a loan, it may still be
subject to uncertainty because of prepayment options. This is similar to
the prepayment risk associated with a mortgage-backed security. An ele-
ment of prepayment risk renders the actual maturity pro¬le of a loan
book to be uncertain; banks often calculate an “effective maturity sched-
ule” based on prepayment statistics instead of the theoretical schedule.
There are also a range of prepayment models that may be used, the sim-
plest of which use constant prepayment ratios to assess the average life of
the portfolio. The more sophisticated models incorporate more parame-
ters, such as one that bases the prepayment rate on the interest rate differ-
ential between the loan rate and the current market rate, or the time
elapsed since the loan was taken out.

Interest Cash Flows
Assets and liabilities generate interest cash in¬‚ows and out¬‚ows, as well
as the amortization of principal. The interest payments must be included
in the gap pro¬le as well.

Interest-Rate Gap
The interest-rate gap is the standard measure of the exposure of the bank-
ing book to interest-rate risk. The interest-rate gap for a given period is
Asset and Liability Management

de¬ned as the difference between ¬xed-rate assets and ¬xed-rate liabili-
ties. It can also be calculated as the difference between interest-rate sensi-
tive assets and interest-rate sensitive liabilities. Both differences are
identical in value when total assets are equal to total liabilities, but will
differ when the balance sheet is not balanced. This only occurs intra-day,
when, for example, a short position has not been funded yet. The general
market practice is to calculate the interest-rate gap as the difference
between assets and liabilities. The gap is de¬ned in terms of the maturity
period that has been speci¬ed for it.
The convention for calculating gaps is important for interpretation.
The “¬xed-rate” gap is the opposite of the “variable-rate” gap when
assets and liabilities are equal. They differ when assets and liabilities do
not match and there are many reference rates. When there is a de¬cit,
the “¬xed-rate gap” is consistent with the assumption that the gap will
be funded through liabilities for which the rate is unknown. This fund-
ing is then a variable-rate liability and is the bank™s risk, unless the rate
has been locked-in beforehand. The same assumption applies when the
banks run a cash surplus position, and the interest rate for any period in
the future is unknown. The gap position at a given time bucket is sensi-
tive to the interest rate that applies to that period.
The gap is calculated for each discrete time bucket, so there is a net
exposure for say, 0“1 month, 1“3 months, and so on. Loans and depos-
its do not, except at the time of being undertaken, have precise maturi-
ties like that, so they are “mapped” to a time bucket in terms of their
relative weighting. For example, a $100 million deposit that matures in
20 days™ time will have most of its balance mapped to the 3-week time
bucket, but a smaller amount will also be allocated to the 2-week
bucket. Interest-rate risk is measured as the change in present value of
the deposit, at each grid point, given a 1 basis point change in the inter-
est rate. So a $10 million 1-month CD that was bought at 6.50% will
have its present value move upwards if on the next day the 1-month rate
moves down by a basis point.
The net change in present value for a 1 basis point move is the key
measure of interest-rate risk for a banking book and this is what is usu-
ally referred to as a “gap report,” although strictly speaking it is not. The
correct term for such a report is a “PVBP” or “DV01” report, which
stand for “present value of a basis point” and “dollar value of an 01 [1
basis point]”, respectively. The calculation of interest-rate sensitivity
assumes a parallel shift in the yield curve; that is, it assumes that every
maturity point along the term structure moves by the same amount (here
one basis point) and in the same direction. An example of a PVBP report
is given in Exhibit 13.8, split by different currency books, but with all
values converted to British pounds sterling.
EXHIBIT 13.8 Banking Book PVBP Grid Report

1 day 1 week 1 month 2 months 3 months 6 months 12 months 2 years

GBP 8,395 6,431 9,927 8,856 (20,897) (115,303) (11,500) (237,658)
USD 1,796 (903) 10,502 12,941 16,784 17,308 (13,998) (18,768)
Euro 1,026 1,450 5,105 2,877 (24,433) (24,864) (17,980) (9,675)
Total 11,217 6,978 25,534 24,674 (28,546) (122,859) (43,478) (266,101)

3 years 4 years 5 years 7 years 10 years 15 years 20 years 30 years

GBP (349,876) (349,654) 5,398 (5,015) (25,334) (1,765) (31,243) (50,980)
USD (66,543) (9,876) (1,966) 237 2,320 (5,676) (1,121) 0
Euro (11,208) (3,076) 1,365 1,122 3,354 (545) (440) (52)
Total (427,627) (362,606) 4,797 (3,656) (19,660) (7,986) (32,804) (51,032)

GBP total: (1,160,218); USD total: (56,963); Euro total: (75,974); Grand total: (1,293,155)
All figures £
Asset and Liability Management

The basic concept in the gap report is the net present value (NPV) of
the banking book. The PVBP report measures the difference between the
market values of assets and liabilities in the banking book. To calculate
NPV we require a discount rate, and it represents a mark-to-market of the
book. The rates used are always the zero-coupon rates derived from the
benchmark government bond yield curve, although some adjustment
should be made to this to allow for individual instruments.
Gaps may be calculated as differences between outstanding balances
at one given date, or as differences of variations of those balances over a
time period. A gap number calculated from variations is known as a mar-
gin gap. The cumulative margin gaps over a period of time plus the initial
difference in assets and liabilities at the beginning of the period are identi-
cal to the gaps between assets and liabilities at the end of the period.
The interest-rate gap differs from the liquidity gap in a number of
detail ways, which include:

– whereas for liquidity gap all assets and liabilities must be accounted
for, only those that have a ¬xed rate are used for the interest-rate gap;
– the interest-rate gap cannot be calculated unless a period has been
de¬ned because of the ¬xed-rate/variable-rate distinction. The interest-
rate gap is dependent on a maturity period and an original date.

The primary purpose in compiling the gap report is to determine the
sensitivity of the interest margin to changes in interest rates. As we noted
earlier, the measurement of the gap is always “behind the curve” as it is
an historical snapshot; the actual gap is a dynamic value as the banking
book continually changes.

Traditionally, the main approach of ALM concentrated on interest sensi-
tivity and net present value sensitivity of a bank™s loan/deposit book. The
usual interest sensitivity report is the maturity gap report, which we
reviewed brie¬‚y earlier. The maturity gap report is not perfect however,
and can be said to have the following drawbacks:

– the re-pricing intervals chosen for gap analysis are ultimately arbi-
trary, and there may be signi¬cant mismatches within a re-pricing
interval. For instance, a common re-pricing interval chosen is the 1-
year gap and the 1“3 year gap; there are (albeit extreme) circum-
stances when mismatches would go undetected by the model. Con-

sider a banking book that is composed solely of liabilities that re-
price in one month™s time, and an equal cash value of assets that re-
price in 11 months™ time. The 1-year gap of the book (assuming no
other positions) would be zero, implying no risk to net interest
income. In fact, under our scenario the net interest income is signi¬-
cantly at risk from a rise in interest rates;
– maturity gap models assume that interest rates change by a uniform
magnitude and direction. For any given change in the general level of
interest rates however, it is more realistic for different maturity inter-
est rates to change by different amounts, what is known as a non-par-
allel shift;
– maturity gap models assume that principal cash ¬‚ows do not change
when interest rates change. Therefore it is not possible to effectively
incorporate the impact of options embedded in certain ¬nancial instru-
ments. Instruments such as mortgage-backed bonds and convertibles
do not fall accurately into a gap analysis, as only their ¬rst-order risk
exposure is captured.

Not withstanding these drawbacks, the gap model is widely used as it
is easily understood in the commercial banking and mortgage industry,
and its application does not require a knowledge of sophisticated ¬nan-
cial modelling techniques.

Bank Regulatory Capital

he primary players in the global money markets are banking and ¬nan-
T cial institutions which include investment banks, commercial banks,
thrifts and other deposit and loan institutions. Banking activity and the
return it generates re¬‚ects the bank™s asset allocation policies. Asset allo-
cation decisions are largely in¬‚uenced by the capital considerations that
such an allocation implies and the capital costs incurred. The cost of cap-
ital must, in turn, take into account the regulatory capital implications of
the positions taken by a trading desk. Therefore, money market partici-
pants must understand regulatory capital issues regardless of the products
they trade or they will not fully understand the cost of their own capital
or the return on its use.
The rules de¬ning what constitutes capital and how much of it to
allocate are laid out in the Bank for International Settlements (BIS) guide-
lines, known as the Basel rules. Although the BIS is not a regulatory body
per se and its pronouncements carry no legislative weight, to maintain
investors and public con¬dence national authorities endeavor to demon-
strate that they follow the Basel rules at a minimum. The purpose of this
chapter is to outline the main elements of the Basel rules, which are in the
process of being updated and modernized as Basel II.
Money market participants are cognizant of the basic tenets of the
rules, so as to optimize their asset allocation as well as their hedging
policy. Derivatives for instance require a signi¬cantly lower level of cap-
ital allocation than cash products, which (along with their liquidity) is a
primary reason for their use as hedging instruments. In addition, the
credit quality of a bank™s counterparty also affects signi¬cantly the level
of capital charge, and regulatory rules in¬‚uence a bank™s lending policy
and counterparty limit settings. All banks have internal rules dictating
the extent of lending, across all money market products, to their coun-


terparties. Capital allocation, targeted rates of return (which are a func-
tion of capital costs), and extent of counterparty risk aversion all dictate
the extent to which funds may be lent to counterparties of various credit
This chapter reviews the main aspects of the capital rules and also
introduces the Basel II proposals, and how credit risk exposure deter-
mines the extent of capital allocation. It also indicates the interplay
between the money market desk and longer-term traders whose capital
allocation requirements are greater. This will enable the money market
participant to place his/her operations in the context of banking speci¬-
cally and capital markets business generally.

Banks and ¬nancial institutions are subject to a range of regulations and
controls, a primary one of which is concerned with the level of capital
that a bank holds, and that this level is suf¬cient to provide a cushion for
the activities that the bank enters into. Typically an institution is subject
to regulatory requirements of its domestic regulator, but may also be sub-
ject to cross-border requirements such as the European Union™s Capital
Adequacy Directive.1 A capital requirements scheme proposed by a com-
mittee of central banks acting under the auspices of the Bank for Interna-
tional Settlements (BIS) in 1988 has been adopted universally by banks
around the world. These are known as the BIS regulatory requirements or
the Basel capital ratios, from the town in Switzerland where the BIS is
based.2 Under the Basel requirements all cash and off-balance sheet
instruments in a bank™s portfolio are assigned a risk weighting, based on
their perceived credit risk, that determines the minimum level of capital
that must be set against them.
A bank™s capital is, in its simplest form, the difference between assets
and liabilities on its balance sheet, and is the property of the bank™s own-
ers. It may be used to meet any operating losses incurred by the bank, and
if such losses exceeded the amount of available capital then the bank

In the United States banking supervision is conducted by the Federal Reserve; it is
common for the central bank to be a country™s domestic banking regulator. In the
United Kingdom banking regulation is now the responsibility of the Financial Servic-
es Authority, which took over responsibility for this area from the Bank of England
in 1998.
Bank for International Settlements, Basel Committee on Banking Regulations and
Supervisory Practice, International Convergence of Capital Measurement and Capi-
tal Standards, July 1988.
Bank Regulatory Capital

would have dif¬culty in repaying liabilities, which may lead to bank-
ruptcy. However for regulatory purposes capital is de¬ned differently;
again in its simplest form regulatory capital is comprised of those ele-
ments in a bank™s balance sheet that are eligible for inclusion in the calcu-
lation of capital ratios. The ratio required by a regulator will be that level
deemed suf¬cient to protect the bank™s depositors. Regulatory capital
includes equity, preference shares, and subordinated debt, as well as the
general reserves. The common element of these items is that they are all
loss-absorbing, whether this is on an ongoing basis or in the event of liq-
uidation. This is crucial to regulators, who are concerned that depositors
and senior creditors are repaid in full in the event of bankruptcy.
The Basel rules on regulatory capital originated in the 1980s, when
there were widespread concerns that a number of large banks with cross-
border business were operating with insuf¬cient capital. The regulatory
authorities of the G-10 group of countries established the Basel Commit-
tee on Banking Supervision. The Basel Committee on Banking Supervi-
sion™s 1988 paper, International Convergence of Capital Measurement
and Capital Standards, set proposals that were adopted by regulators
around the world as the Basel rules. The Basel Accord was a methodology
for calculating risk, weighting assets according to the type of borrower
and its domicile. The Basel ratio3 set a minimum capital requirement of
8% of risk-weighted assets.
The Basel rules came into effect in 1992. The BIS is currently inviting
comment on proposals for a new system of capital adequacy to replace
the current rules. The deadline for comment on its proposals is June
2002, with the BIS hoping to implement the agreed upon requirements
during 2005.

Capital Adequacy Requirements
The origin of the current capital adequacy rules was a desire by banking
regulators to strengthen the stability of the global banking system as well
as harmonize international regulations. The 1988 Basel accord was a sig-
ni¬cant advancement in banking regulation, setting a formal standard for
capitalization worldwide. It was subsequently adopted by the national
regulators in over 100 countries. The Basel rules have no regulatory force
as such; rather, individual country regulatory regimes adopt them as a
minimum required standard. This means that there are slight variations
on the basic Basel requirements around the world, of which the European
Union™s Capital Adequacy Directives are the best example.

Also known as the “Cooke ratio” after the Chairman of the Basel Committee at the
time, Peter Cooke.

The Basel I Rules
The BIS rules set a minimum ratio of capital to assets of 8% of the value
of the assets. Assets are de¬ned in terms of their risk, and it is the
weighted risk assets that are multiplied by the 8% ¬gure. Each asset is
assigned a risk weighting, which is 0% for risk-free assets such as certain
country government bonds, up to 100% for the highest-risk assets such as
certain corporate loans. So while a loan in the interbank market would be
assigned a 20% weighting, a loan of exactly the same size to a corpora-
tion would receive the highest weighting of 100%.
Formally, the BIS requirements are set in terms of the type of capital
that is being set aside against assets. International regulation de¬nes the
following types of capital for a bank:

– Tier 1: perpetual capital, capable of absorbing loss through the non-
payment of a dividend. This is shareholders™ equity and also non-
cumulative preference shares;
– Upper Tier 2: this is also perpetual capital, subordinated in repayment
to other creditors; this may include for example irredeemable subordi-
nated debt;
– Lower Tier 2: this is capital that is subordinated in repayment to other
creditors, such as long-dated subordinated bonds.

The level of capital requirement is as follows:

Tier 1 capital
----------------------------------------------------------- > 4%
Risk-adjusted exposure
Tier 1 + Tier 2 capital
----------------------------------------------------------- > 8%
Risk-adjusted exposure

These ratios therefore set minimum levels. A bank™s risk-adjusted
exposure is the cash risk-adjusted exposure together with the total risk-
adjusted off-balance sheet exposure. For cash products on the banking
book, the capital charge calculations (risk-adjusted exposure) is given by:

principal value — risk weighting — capital charge [8%]

calculated for each instrument.
The sum of the exposures is taken. Firms may use netting or portfolio
modelling to reduce the total principal value.
The capital requirements for off-balance sheet instruments are lower
because for these instruments the principal is rarely at risk. Interest-rate
derivatives such as forward rate agreements (FRAs) of less than one
Bank Regulatory Capital

year™s maturity have no capital requirement at all, while a long-term cur-
rency swap requires capital of between 0.08% and 0.2% of the nominal
The BIS makes a distinction between banking book transactions as
carried out by retail and commercial banks (primarily deposits and lend-
ing) and trading book transactions as carried out by investment banks
and securities houses. Capital treatment sometimes differs between bank-
ing and trading books. A repo transaction attracts a charge on the trading
book. The formula for calculating the capital allocation (CA) is:

CA = max { [ ( C mv “ S mv ) — 8% — RW ], 0 } (2)

Cmv = the value of cash proceeds
Smv = the market value of securities
RW = the counterparty risk weighting (as percentage)

As an illustration, the capital allocation for an unsecured loan of $50
million to an OECD (Organization for Economic Cooperation and Devel-
opment) bank that has a counterparty risk weighting of 20% is deter-
mined as follows:

CA = max { [ ( $50,000,000 “ 0 ) — 0.20 — 0.08 ], 0 }
= $800,000

Conversely, a repo transaction of the same size with the same coun-
terparty fully collateralized with U.S. Treasuries would have a capital
allocation determined as follows:

CA = max { [ ( $50,000,000 “ $50,000,000 ) — 0.20 — 0.08 ], 0 }
= $0

The detailed risk weights for market instruments are given in Exhibit 14.1.
Under the original Basel rules, assets are de¬ned as belonging to a
bank™s banking book or its trading book. The banking book essentially
comprises the traditional activities of deposit taking and lending, with
assets booked at cost and not revalued. Trading book assets (which
include derivatives) are marked-to-market on a daily basis, with a daily
unrealized pro¬t or loss recorded. Such assets are risk-weighted on a dif-
ferent basis to that shown in Exhibit 14.1, on a scale made up of market
risk and credit risk. Market risk is estimated using techniques such as

FRAs and swaps are discussed in Chapter 11.

value-at-risk, while credit risk is a function of the type of asset. The calcu-
lation of capital requirements for trading book assets is more complex
than that for banking book assets.
The process of determining the capital requirement of a banking insti-
tution involves calculating the quantitative risk exposure of its existing
operations and comparing this amount to the level of regulatory capital
of the bank. The different asset classes are assigned into the risk buckets
of 0%, 20%, 50%, and 100%. Not surprisingly, this somewhat rigid clas-
si¬cation has led to distortions in the pricing of assets, as any movement
between the risk buckets has a signi¬cant impact on the capital required
and the return on capital calculation. Over time the impact of the Basel
rules has led to the modi¬ed rules now proposed as Basel II, the ¬nal form
of which is expected to come into force in 2005.

EXHIBIT 14.1 Risk Weightings of Typical Banking Book Assets, Basel I

Weighting Asset Type Remarks
• Cash Zone A countries are members of the
• Claims on own sovereign and Zone OECD and countries that have con-
A sovereigns and central banks cluded special lending arrangements
• Claims on Zone B sovereign issuers with the IMF. Zone B consists of all
denominated in that country™s other countries.
domestic currency Under certain regulatory regimes,
holdings of other Zone A govern-
ment bonds are given 10% or 20%
weightings, and Zone B government
bonds must be funded in that coun-
try™s currency to qualify for 0%
weighting, otherwise 100% weight-
ing applies.
20% • Claims on multilateral development Under certain regulatory regimes,
banks claims on Zone B banking institu-
• Claims on regional governments or tions with residual maturity of less
local authorities in own or Zone A than one year also qualify for 20%
countries weighting.
• Senior claims on own country or
guaranteed by Zone A banking insti-
• Senior claims on Zone B banking
institutions with an original maturity
of under one year
50% • Claims secured on residential prop-
• Mortgage-backed securities
100% • All other claims

Source: BIS
Bank Regulatory Capital

Exhibit 14.2 summarizes the elements that comprise the different
types of capital that make up regulatory capital as set out in the EU™s
Capital Adequacy Directive. Tier 1 capital supplementary capital is usu-
ally issued in the form of non-cumulative preference shares, known in
the U.S. as preferred stock. Banks generally build Tier 1 reserves as a
means of boosting capital ratios, as well as to support a reduced pure
equity ratio. Tier 1 capital now includes certain securities that have sim-
ilar characteristics to debt, as they are structured to allow interest pay-
ments to be made on a pre-tax basis rather than after tax basis; this
means they behave like preference shares or equity, and improves the
¬nancial ef¬ciency of the bank™s regulatory capital. Such securities along
with those classi¬ed as Upper Tier 2 capital, contain interest deferral
clauses so that they may be classi¬ed similar to preference shares or

The existence of a regulatory capital system is designed to protect the
¬nancial system, and therefore by de¬nition the free market economy,
by attempting to ensure that credit institutions carry adequate reserves
to allow for counterparty risk. However domestic regulators are also
faced with a dilemma should a banking institution ¬nd itself in an insol-
vency situation, namely, to what extent should the bank be “rescued”
by the authorities. If the bank is suf¬ciently large, its failure could have
a signi¬cant negative impact on the national and global economy, as
other banks, businesses and ultimately individuals also suffered losses.
The large “money center” banks5 are obvious examples of the type of
¬rm that is considered too important to be allowed to fail. It is not
desirable though for regulators or national governments to present
explicit guarantees against failure however, since this introduces the risk
of moral hazard as risk of loss is reduced.6 There would also be an ele-
ment of subsidy as a bank that was perceived as bene¬ting from an
explicit or implicit guarantee would be able to raise ¬nance at below-
market cost. This introduces an anti-competitive element in one of the
most important sectors of the economy.

Known as “high street” banks in the United Kingdom.
This is the risk that, given that a guarantee against loss is available, a firm ceases to
act prudently and enters into high-risk transactions, in the expectation that it can al-
ways call on the authorities should its risk strategy land it in financial trouble.

EXHIBIT 14.2 European Union Regulatory Capital Rules

Limits Capital type Deductions

Tier 1 • No limit to Tier 1 • Equity share capital, • Bank holding™s of its
• “Esoteric” instruments including share pre- own Tier 1 instruments
such as trust-preferred mium account • Goodwill and other
securities are restricted • Retained pro¬ts intangible assets
to 15% of total Tier 1 • Non-cumulative prefer- • Current year unpub-
ence shares and other lished losses
hybrid capital securities
Tier 2 • Total Tier 2 may not
exceed 100% of Tier 1
Upper • Perpetual subordinated, • Holdings of other banks™
Tier 2 loss-absorbing debt own fund instruments in
• Cumulative preference excess of 10% of the
shares value of own capital
• General reserves • Holding of more than
• Revaluation reserves 10% of another credit
institution™s own funds
• Speci¬ed investments in
non-consolidated subsid-
• Quali¬ed investments,
de¬ned as a holding of
more 10% of a company
Lower • Cannot exceed 50% of • Fixed maturity subordi-
Tier 2 Tier 1 nated debt
• Amount qualifying as • Perpetual subordinated
capital amortizes on a non-loss absorbing debt
straight-line basis in the
last ¬ve years
Tier 3 • Minimum 28.5% of • Trading book pro¬ts • Trading book losses
capital covering market • Short-term subordinated
risk must be Tier 1 debt with a minimum
• Tier 3 capital can only maturity of two years,
cover market risk on plus a feature enabling
trading books. All regulator to block pay-
credit risk must be cov- ment of interest or prin-
ered by Tier 1 and Tier cipal in the event of
2 capital ¬nancial weakness
Other • Capital to only include fully paid-up amounts
• Issues of capital cannot include cross-default or negative pledge clauses
• Default of Lower Tier 2 capital is de¬ned as non-payment of interest or a wind-
ing-up of the bank
• No rights of set-off to be included in capital issues documentation
• Early repayment of debt must be approved by the bank™s regulator
• Interim pro¬ts must be audited accounts, and net of expected losses, tax and div-

Source: Bank of England
Bank Regulatory Capital

EXHIBIT 14.3 Add-On Risk Adjustment for Interest-Rate Swaps, Percentage of
Nominal Value

Maturity Plain vanilla Floating/Floating swaps Currency swaps

Up to 1 year 0.0 0.0 1.0
Over 1 year 0.5 0.0 5.0

Observation would appear to indicate that domestic regulators do not
treat all banks as equal however, notwithstanding the reluctance of regula-
tors to provide even implicit guarantees. The desire to avoid contagion
effects and safeguard the ¬nancial system means that large banks may be
rescued while smaller banks are allowed to fail. This has the effect of main-
taining an orderly market but also emphasizing the need for discipline and
effective risk management. For example, in the United Kingdom both
BCCI and Barings were allowed to fail, as their operations were deemed to
affect relatively few depositors and their failure did not threaten the bank-
ing system. In the United States, Continental Illinois was saved, as was Den
Norske Bank in Norway, while two smaller banks in that country were
allowed to fail, these being Norian Bank and Oslobanken. In Japan many
small banks have been allowed to fail, as was Yamaichi Securities, while
Long Term Credit Bank and Nippon Credit Bank both were rescued.
There is, of course, a cost associated with maintaining capital levels,
which is one of the main reasons for the growth in the use of derivative
(off-balance sheet) instruments, as well as the rise in securitization. Deriv-
ative instruments attract a lower capital charge than cash instruments,
because the principal in a derivative instrument does not change hands
and so is not at risk, while the process of securitization removes assets
from a bank™s balance sheet, thereby reducing its capital requirements.
The capital rules for off-balance sheet instruments are slightly more
involved. Certain instruments such as FRAs and swaps with a maturity of
less than one year have no capital requirement at all, while longer-dated
interest-rate swaps and currency swaps are assigned a risk weighting of
between 0.08% and 0.20% of the nominal value. This is a signi¬cantly
lower level than for cash instruments. For example, a $50 million 10-year
interest-rate swap conducted between two banking counterparties would
attract a capital charge of only $40,000, compared to the $800,000 capi-
tal an interbank loan of this value would require; a corporate loan of this
value would require a higher capital level still, of $4 million.
The capital calculations for derivatives have detail differences
between them, depending on the instrument that is being traded. For
example for interest-rate swaps the exposure includes an “add-on factor”
to what is termed the instrument™s “current exposure.” This add-on fac-
tor is a percentage of the nominal value, and is shown in Exhibit 14.3.

The perceived shortcomings of the 1988 Basel capital accord attracted
much comment from academics and practitioners alike, almost as soon as
they were adopted. The main criticism was that the requirements made no
allowance for the credit risk ratings of different corporate borrowers, and
was too rigid in its application of the risk weightings. That these were
valid issues was recognized when, on June 3, 1999 the BIS published pro-
posals to update the capital requirements rules. The new guidelines are
designed “to promote safety and soundness in the ¬nancial system, to
provide a more comprehensive approach for addressing risks, and to
enhance competitive equality.” The proposals also are intended to apply
to all banks worldwide, and not simply those that are active across inter-
national borders.
The 1988 accord was based on very broad counterparty credit require-
ments, and despite an amendment introduced in 1996 to cover trading
book requirements, remained open to the criticism of in¬‚exibility. The pro-
posed new Basel II rules have three pillars, and are designed to be more
closely related to the risk levels of particular credit exposures. These are:

– Pillar 1: A new capital requirement for credit risk, as well as a charge
for the new category of operational risk.
– Pillar 2: The requirement for supervisors to take action if a bank™s risk
pro¬le is high compared to the level of capital held.
– Pillar 3: The requirement for greater disclosure from banks than before
to enhance market discipline.

The markets have developed to a much greater level of sophistication
since the original rules were drafted, and the Committee has considered a
wide range of issues related to the determinants of credit risk.

In this section we consider the main points of the Basel II proposal and
also assess market reaction to it at the time of writing. As just noted, as
they currently stand the new Basel accord is split into three approaches or
Pillars, which we consider in more detail in this section.

Pillar 1”The Minimum Capital Requirements
The capital requirements are stated under two approaches”the stan-
dardized approach and the internal ratings based approach (IRB). Within
Bank Regulatory Capital

IRB there is a foundation approach and an advanced approach, the latter
of which gives banks more scope to set elements of the capital charges

Standardized Approach
In the standardized approach banks will risk-weight assets in accordance
with a set matrix, which splits assets according to their formal credit rat-
ings. The matrix is detailed in Exhibit 14.4, which shows the new pro-
posed risk weights as percentages of the standard 8% ratio.
The greatest change is to the four risk weight buckets of the current
regime. The revised ruling would redistribute the capital required for dif-
ferent types of lending and also add an additional category for very low-
rated assets. For sovereign lending there is a smooth scale from 0% to
8%, while the scale is more staggered for corporates. An unusual feature
is that low-rated companies attract a higher charge than non-rated bor-
rowers. For lending to other banks there are two options. In the ¬rst, the
sovereign risk of the home country of the bank is used, and the bank
placed in the next lower category. In the second option, the credit rating
of a bank itself is used. Whatever option is selected, the main effect will
be that the capital charge for interbank lending will increase signi¬cantly,
virtually doubling the current level.
National regulators will select which of the two approaches to use for
interbank exposures. Under option 1, loans will be categorized in accor-
dance with the rating of their sovereign domicile, while under option 2
loans would be slotted according to the bank™s own rating. If using the
latter approach, assets of shorter than three months will receive preferen-
tial treatment.

EXHIBIT 14.4 Basel Capital Requirement Proposals, Percentage Weightings

Credit Rating


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