In this post I will look at the most common questions asked by those who prepare the Alco and liquidity reports. I will do this by introducing some general concepts in order to understand the Alco reports. I will then move on to the 3 main profiles within the Alco and Liquidity reports and look at the answer to each question under each profile.
What is the difference between Contractual Repayment (Liquidity) and Contractual Repricing (Interest Rate)?
Contractual Repayment is the liquidity risk of assets and liabilities, while Contractual repricing is the interest rate risk of assets and liabilities.For example: Bank A buys a 360 day Floating Rate Note, the issuer resets the asset’s interest rate every 3 months. The contractual repayment is therefore 1 year. However the contractual repricing is 3 months and not 1 year. Generally speaking although the interest repricing on assets and liabilities could be in the same time bucket (e.g. 1-year) as the contractual repayment, the contractual repricing could also be in an earlier time bucket than the contractual repayment (e.g. 3 months).
Note: The actual values of Contractual Repayment (Liquidity) and Contractual Repricing (Interest Rate) for the same balance sheet category are always identical, but may appear in different time buckets.
What is the difference between Zero, Variable and Fixed Contractual Repricing (Interest Rate)?
Only those assets and liabilities that receive or pay no interest should be placed under the Zero contractual repricing (interest rates) bucket. The most common assets and liabilities that come under this category are nostro balances, assets and liabilities like fixed assets, accrued interest and current accounts. Where capital is held locally (and interest is not payable on it to Head Office) please remember that for Interest rate repricing mismatch reports capital should be placed in the zero bucket. For VaR calculations capital should be placed in the repricing tenor that best reflects the next repricing date according to Funds Transfer Policy (FTP).
Those assets and liabilities whose rate of return or cost can be changed at any time during their life are placed under the Variable contractual repricing (interest rate) bucket. Note that the rate can change at any time and for as many times as the bank wishes. The most common assets and liabilities that come under this category are overdrafts and credit cards or savings accounts.
Those assets and liabilities whose rate of return or cost can change only at precise intervals during its life are considered to have a fixed contractual repricing (interest rate) risk.
Note that an asset or liability that has a 5 year contractual maturity and contractual repricing risk of 1 year is still considered fixed (interest rate may change every year, but is fixed for 1 year at a time). Just as an asset or liability that has a 5 year contractual maturity and 5 year contractual repricing risk (interest rate does not change) is considered a 5 year fixed rate contractual repricing risk.
What are the Three Balance Sheet Profiles?
The contractual profile places assets and liabilities in time buckets that best reflect the maturity stated on their legal contract. Often this profile is provided automatically by systems for finance.
The forecast profile places assets and liabilities in time buckets that best reflect the way they will behave in a practical and real world. This profile takes the contractual repayment (liquidity) profile as a starting point and, through the application of sensible assumptions change the profile to reflect the real world.This profile does not deal with contractual repricing (interest rate) risk.
The stress profile allows countries to monitor that they have sufficient funds available to survive a certain days liquidity crisis. This period represents the likely period needed to arrange both Group-wide and Central Bank support. This profile takes the contractual repayment (liquidity) profile as a starting point and uses the standard assumptions issued by market risk guideline for stress scenario.
How many assets should I disclose as Reserve Assets?
Under “Reserve Assets” you should only include those assets that are used to meet your regulatory reserve requirement plus any additional assets needed to meet the stress test.
For Example: Country A’s Central Bank has a reserve requirement of 20% of total deposits, and a need to keep a further 10 million of T-bills to meet the 3 day stress test. Assuming total deposits are 100 million, the bank will show 30 million under Reserve assets (20 million to meet regulatory requirements and 10 million for the stress test). The 20 million can be made up of cash, government securities or deposits at the Central Bank.
How do I forecast Reserve assets?
In the contractual profile reserve assets are placed according to time left to maturity. If the country is calculating the forecast and the stress test daily than the country is allowed to show any surplus reserve assets (those not required to meet the statutory reserve requirement and the stress test) at their earliest realisability or in the bucket that shows the bank’s business as usual profile.
Example A: Bank A calculates the forecast and the stress test every day. It has USD 200 million worth of 180 day Government T-Bills but needs only USD 180 million to meet the statutory reserve requirement. In the contractual profile Bank A places USD 200 million in the 6-12 month bucket of the reserve assets section. In the forecast USD 20 million will be shown in the call bucket and is allowable as a cash inflow to meet the business as usual needs.
However if the bank is not calculating the forecast and stress test daily, then the forecast profile should place reserve assets in the 1 to 5 year bucket. This is because of the assumption that the bank will always endeavor to keep those assets to meet the Statutory Reserve Requirement and to pass the stress test.
Example B: Bank A calculates the forecast and stress test once every two weeks. It has USD 100 million worth of 90 day Government T-Bills. In the contractual profile Bank A places USD 100 million in the 3-6 month bucket of the reserve assets section. In the forecast the USD 100 million under reserve assets will be shown in the 1-5 year bucket.Realisability should take account of when the cash is received from the sale of the asset. Therefore if the asset is sold today, but cash from the asset is received in 3 days, then the inflow should be placed in the 2-7 day bucket.
Central Bank dictates the level of reserve assets I keep, can I include them into my stress profile?
Yes, one reason why Central Banks force local banks to keep a percentage of their deposits in very liquid assets is so that the bank always has a minimum level of cash flow to meet an unexpected liquidity crisis. Although this should not be the only source of liquidity it is an important one and thus should be included in the stress profile. You should also include the securities that you have kept in the contractual profile to meet the stress test.
Also remember that as the level of deposits decline, so should the amount of assets required to meet the reserve requirement. Therefore when a stress test is carried out and an acceleration of deposit withdrawal is experienced, the surplus reserve requirement can be used as a cash inflow.
Only include those reserve assets from which cash is available in the specified stress days. Therefore if the bank has a 20-year bond that is not liquid then it should not be included in the specified days stress test.
Note: In some countries reserve assets held to meet the regulatory reserve requirement are not available to the bank even in stress situations.
What assets should be included in Marketable Assets?
Any surplus cash or marketable securities not being used to meet the regulatory reserve requirements or the stress test should be placed under “Marketable Assets”.
How do I forecast Marketable assets?
In the contractual profile marketable assets are placed according to time left to maturity. The forecast profile should place assets disclosed in “Marketable Assets” in the bucket that represents their earliest realisability or in the bucket that shows the banks business as usual profile. Make sure that the profile of inflows shown in the forecast is in line with treasury strategy and the Liquidity Contingency Plan.
Example: Bank A has USD 100 million worth of 2-Year Government Bonds. In the contractual profile Bank A places USD 100 million in the 1-5 year bucket of the marketable assets section. In the forecast the USD 100 million under marketable assets will be placed in the next day bucket (since the asset is very liquid).Realisability should take account of when the cash is received from the sale of the asset.
Note: There may be a cost to selling assets before their maturity and therefore the value shown in the forecast profile may be lower than that shown in the contractual profile.
Can I include all marketable securities into the stress profile?
If the bank does not calculate the forecast and stress test daily then the bank should only include those marketable securities that have not been used to meet the Maximum Cumulative Outflow (MCO) guideline and realistically realisable within the specified days of the stress test. Banks that calculate the forecast and stress test daily can include all “Marketable Securities” realistically realisable within the specified days of the stress test. Note that realisability should take account of when the cash is received from the sale of the asset.
Note: There may be a cost to realising the cash flow from securities before their maturity and therefore the value shown in the stress profile may be lower than that shown in the contractual profile.
What types of assets are included in Interbank, Intragroup and Custodial and Institutional Assets?
Interbank assets should include all assets held by another bank outside the group. This includes Nostro balances. Intragroup is the same except it only includes entities within the bank’s group. Custodial and Institutional should include all balance accounts or operating accounts held at 3rd party financial institutions.
Can I show early realisability of Interbank, Intragroup and Custodial and Institutional assets?
No, the forecast profile of fixed Interbank, Intragroup or Custodial and Institutional placings should place the asset in the same time bucket as the contractual profile does. This is based on the assumption that if a fixed loan is provided then the counter party will not pay it back early.
If I am in a liquidity crisis, can I call back loans made to local banks or banks with in group in other countries before their maturity?
Market Risks stress liquidity guidelines assumes that it is not possible to call in loans made to the Interbank market or Intragroup entities before their maturity. You are however allowed to include any Interbank or Intragroup loan that naturally matures during the specified days of the stress test.
Note: Intra-group deposits will also not be renewed at maturity unless a formal arrangement with the placing branch is in place.
In which time bucket should I place assets that have no precise contractual repayment maturity?
Assets that have no precise contractual repayment maturity or are “on demand” should be placed in the Call bucket. Examples of such assets include Overdrafts and Credit Cards.
In which time bucket should I place assets that have a fixed contractual repayment maturity?
Assets and Liabilities that have a fixed contractual repayment maturity should be placed in the time bucket that represents the time left to maturity(i.e. residual).
Example: Bank A provides a 6 month fixed loan to a customer. The asset should be placed in the 3m to 1 year time bucket when it is issued. In 4 months time, the same asset should be placed in the 1 to 3 month bucket because there are only two months left to the maturity of the asset.
Can I show early realisability of assets that have a contractual fixed maturity?
No, the forecast profile of a fixed loan should place the asset in the same time bucket as the contractual profile does. This is based on the assumption that if a fixed loan is provided to a corporate or personal customer then they will not pay it back early.
How do I forecast assets that have no contractual fixed maturity?
You can forecast assets that have no contractual fixed maturity (nostro, custodial and institutional balances, overdrafts and credit card outstanding) by calculating a Core balance and Volatile balance.
The following 5 steps are the suggested approach for estimating core balance for assets with no contractual fixed maturity. All the statistical measures can be calculated using Excel functions.
- Collect historical data: A minimum of 32 data points based on month end balances would be needed.
- Calculate the arithmetic mean
- Calculate the sample standard deviation
- Obtain the core balance: Core Balance = Mean of Observed Balance – 1 x Standard Deviation. The core balance is then positioned as a medium term cash flow with maturity greater than 1 year (In the 1-5 year bucket).
- Obtain the volatile component of the balance: Volatile Component = Last Observed Balance – Core Balance. The volatile balance is then divided by the number of working days in a month and positioned as a daily cash flow for each working day in the month (the volatile component can be placed in the earlier buckets and in amounts that best suit local patterns).
Note: In an ideal world a country would recalculate the core and volatile balance every month. However, if you cannot re-calculate the core balance each month therefore it is suggested that you calculate the balances for a particular month and turn that into a percent that can be used for the next 5 months.
Example: Bank A has a month end balance for Overdrafts of US $10 million. Their core balance is USD 6 million and their volatile balance is USD 4 million (using the method above). The next month the Bank assumes that 60% (6/10*100) of the month end balance will be core and 40% will be volatile and place the amounts accordingly. After 6 months the Bank recalculates the core balance in order to take account of changes in the behavior of their customers since the last time calculations were carried out. The above methodology is to be used where no alternative proxy is available.
What cash inflows am I allowed to include from Corporate and Personal assets?
As a general rule fixed loans maturing during the specified days of stress test should be included as a cash inflow. However if there are local circumstances that make this unrealistic (e.g. a significant number of the bank’s customers automatically roll over loans provided to them and therefore are not really capable of repaying the loans), the country should identify this and not include those loans into the stress test. No early recall of loans is assumed. At the same time inflows from assets that have no contractual repayment (Liquidity) like Overdrafts and Credit Card balances is prohibited because it is assumed that customers will not pay outstanding amounts back during a liquidity crisis.
What should go into the “other asset” category?
Essentially, no asset that has a customer as the counterparty should appear in the “other asset” column. Generally speaking “other assets” should account for less than 10% of your local balance sheet.
Note: Fixed assets e.g. Buildings etc have no maturity date should be placed in the long-term buckets as per banks accounting policy.
Is it OK for me to disclose bad and doubtful debts in other assets?
There are two types of bad and doubtful debts. Firstly, there are those that are recognized by the bank but no provisions have been made against them locally. In this situation one has to place the portion of the assets that are considered to be bad or doubtful in the longest tenor bucket on a separate line within the same balance sheet sub category.
Example: Bank A has 100 million of Personal overdrafts on their balance sheet. 20% of them are considered to be either bad or doubtful. The bank will show 80 million on one line titled “Overdrafts” in the call bucket and on an another line titled “Unrecognized Bad and Doubtful Debts” 20 million in their longest tenor.
Note: 20 million is not shown in other assets.
The second type of bad and doubtful debts is those that are recognized by the bank and provisions have been made against them locally. In this case (only this case) a separate line will show the amount of bad and doubtful debts in both the other asset side and the other liability side, as well as the interest in suspense in other liabilities.
Example: Bank A has 100 million of corporate overdrafts on their balance sheet. 20% of them are bad or doubtful that have been provided for locally. The bank will show 80 million in the call bucket and 20 million in the longest tenor and on a separate line under other assets. On the liability side two entries will be shown for the bad debt in the longest tenor. One will be the provision for bad and doubtful debts and the other will be interest in suspense shown in other liabilities.
Where banks Special Asset Management has forecasted a maturity profile for bad debts, they should be placed in the forecast and repricing profile according to the repayment and repricing schedule provided by them. They should remain in the 1-5 year bucket for contractual repayment.
How do I forecast Other Assets?
The forecast profile of other assets should place the asset in the same time bucket as the contractual profile does. This is based on the assumption that other assets (e.g. Buildings) are not liquid and therefore we will only see cash flow from the asset when it matures.
The bank has lots of fixed assets; can they be shown as a cash inflow during the stress test?
Usually other assets cannot be considered as cash inflow during the specified day stress test. Take fixed assets for example. The stress test is supposed to show positive cash flow during all specified days so that the bank can open for business on next day after the stress. However if the bank has had to sell it’s fixed assets (buildings, desks etc) to pass the stress test than there is no physical bank to open on day after the specified stress days because it’s buildings have been sold. Also as importantly most other assets are not liquid enough to be sold within specified stress days and therefore cannot be a source of cash inflow during the stress test.
How do I include Repo’s and Reverse Repo’s?
Due to different definitions of what constitutes a ‘Repurchase Agreement’ the treatment for Market Risk purposes is determined by the number of separate transactions involved. When a Repo or Reverse Repo is traded the purchase and sale of the instrument can be classed as one transaction or as two transactions.
- A ‘One-transaction’ trade will contain a simultaneous Purchase and Sale trade under one contract which covers all trade details,
- A ‘Two-Transaction’ Trade will involve completing a simultaneous Purchase and Sale trade, with separate documentation for each trade.
‘Repos’ are typically structured so that the asset title will only pass to the Buyer in the event of default of the seller, i.e. default on margin calls or final repayment. Therefore the Bond remains on the Balance Sheet of the ‘seller’ and only the cashflows arising due to the loan or deposit are shown.
Consider a 3 month Reverse Repo on a 5yr Bond (haircuts ignored, bond assumed to be trading at par)
|Advances under Reverse Repo||100|
|Impact on Net Mismatch||(100)||100||0|
Strictly speaking there is a Contingent Asset in the 5 yr. which would only occur in the event of default by the borrower on the principal due in 3m. However this is not noted in accounts, as a comparison this is similar to not showing the value of properties used as security for mortgages in Retail Balance Sheets
Consider a 3 month Repo on a 5yr Bond (haircuts ignored, bond assumed to be trading at par)
|Assets pledged as collateral under repo||100*|
|Liabilities arising under Repo||(100)|
|Impact on Net Mismatch||100||(100)||0|
*There is no impact of separately identifying the Assets pledged as collateral, however they should be listed separately so that they are not classed as ‘available’ for the purposes of market risks analysis such as Forecasts and Stress Liquidity.
Two Separate Transactions
This is the case where there are two separate transactions such as a buy/sell-back The Security is transferred to the purchaser’s balance sheet for the duration of the trade, with a contractual maturity reported as the residual maturity. This is consistent with an outright sale of the security.
The Cash Balance is reduced to finance the purchase of the security. The Net Mismatch would show a change in the profile relating to the increase or decrease in Marketable Assets.However, this does not reflect the true Balance Sheet profile in terms of Liquidity and ignores the expected tenor of the trade.
To provide a realistic picture, an entry on the Off Balance Sheet Forwards would show the reversal of the position in 3m, i.e. an adjustment to the cash position and an adjustment to the level of marketable assets. The adjusted mismatch of the Balance Sheet profile will then reflect the tenor of the trade.
Consider a 3m Buy/Sell-back on a 5 yr .Bond (haircuts ignored, bond assumed to be trading at par)
|Marketable Assets subject to Forward Sale||100|
|Impact on Net Mismatch||(100)||100|
|Off Balance Sheet|
|Forwards: Forward Sale of Assets under Repo||100||(100)|
|Impact on Adjusted Net Mismatch||(100)||100||0|
Placing the forward sale of the Bonds as an Off Balance Sheet Item is consistent with the current treatment of FX forwards.
|Number of Transactions||Typical Trade Type||Treatment|
|One||Classic Repo covered by an ISDA master agreement.||Only the resulting loan or deposits is shown|
|Two||Sell/Buy-Back||Impact on Cash Balance is recorded. Underlying Security is shown on the Buyers Balance Sheet, the Forward Sale of the Security and resulting flow of cash is shown as an Off Balance Sheet Item|
How do I include Repo’s and Reverse Repo’s in my Forecast and Stress?
The forecast of Repo’s and Reverse Repo’s should place the assets and liabilities in the same bucket as the contractual. You should also only show outflows or inflows from Repo’s and Reverse Repo’s if they naturally mature within the specified days of the stress test.
What liabilities should be considered as wholesale deposits?
All funds that meet one or more of the following conditions should be disclosed as wholesale deposits:
- The customer’s only Bank relationship is with Treasury.
- Pricing is at money market rates.
- The size is typical of money market transactions.
Note: The “typical size” of a money market instrument will differ from country to country.
What types of liabilities are included in Interbank, Intragroup and Custodial and Institutional Liabilities?
Interbank liabilities should include all liabilities placed by another bank outside the group. This includes Vostro balances placed by banks outside the group. Intragroup is the same except it only includes entities within the group. Custodial and Institutional should include all balance accounts or operating accounts from 3rd party financial institutions.
If I am in a liquidity crisis, can I delay repaying wholesale deposits and other deposits obtained from local banks or my banks in other countries?
market risks stress liquidity guidelines assumes there will be no delay in repayment of deposits obtained from either the wholesale market, the Interbank market or Intragroup entities. However you are allowed to exclude any wholesale deposits, Interbank or Intragroup deposits that naturally matures outside the specified days of the stress test.
In which time bucket do I place liabilities that have no precise contractual repayment maturity?
See explanation in Corporate and Personal Assets. Examples of such liabilities include Current Accounts and Savings Accounts.
In which time bucket do I place liabilities that have a fixed contractual repayment maturity?
See explanation provided in Corporate and Personal Assets. Examples of such liabilities include fixed loans or certificate of deposits.
Can I show early repayment of liabilities that have a contractual fixed maturity?
See explanation provided in Corporate and Personal Assets.
How do I forecast liabilities that have no contractual fixed maturity?
See explanation in Corporate and Personal Assets. Examples of such liabilities include Vostro, Custodial and Institutional balances, Current Accounts and Savings Accounts.
What cash outflows do I have to show from Corporate and Personal deposits?
A country should only include those fixed deposits that naturally mature during the specified days of the stress test. For those deposits that have no fixed contractual repayment like current accounts, savings account etc you are to use assumptions of Market Risk and spread the outflows between specified stress days.
Example: 25% of total corporate current accounts will flow out of the bank within specified days.
Assume Bank A has 100 million of corporate current accounts on its balance sheet. It will show an outflow of 25 million between specified days.
Note: Countries are allowed to determine the portion of the 25% outflow that will leave on each individual day with in specified days. This can be based on banking conditions, past experience etc.
What should go into my other liability category?
See explanation provided in Other Assets.
Is it OK for me to disclose bad and doubtful debts in other liabilities?
See explanation provided in Other Assets.
How do I forecast Other Liabilities?
See explanation in Other Assets.
Can other liabilities be shown as a cash outflow during the stress test?
See explanation in Other Assets.
How do I know when a liability is a commitment?
Generally according to bank’s Legal and Compliance department a liability should be considered a commitment when the bank has an “obligation to lend. That obligation can be conditional but if the conditions are capable of being fulfilled by a third party or we have to act reasonably (say the condition is that the borrower will provide us with a board resolution and all it has wrong with it, is a typographical error) we are Committed. On the other hand, if the documentation states that we have an absolute discretion as to whether or not to fund, then we do NOT have a Commitment.”
Therefore a commitment should be reported as such if the bank “has charged a fee or other wise has a legally binding contract”
Examples of liabilities that are commitments are undrawn Documentary Letters of Credit, unutilized overdraft and credit card limits.
Example: Bank A sets up a customer limit that allows the bank to issue LC’s up to the value of 100 million (essentially a credit limit). When a customer comes to the bank to ask for a LC, the bank still has an opportunity to deny the request for a LC. As a result establishing a limit does not create a commitment that will be shown on the off balance sheet section.
Once Bank A issues a LC on behalf of the customer is the bank committed to paying the exporter. Therefore only LC’s issued but not drawn upon are considered commitments.
Secondly when a LC is drawn and the bank pays funds to the exporter, the LC no longer exists and therefore is not a commitment. The only exposure Bank A has from the transaction is to the importer (especially if the importer has not paid funds to cover the LC amount). In that situation the exposure would be a corporate loan or Bills receivable.
My country deals only in Synthetic forwards, do I still need to show an off balance sheet position?
Yes, because in a synthetic forward the bank hedges the forward contract by taking local currency liabilities and converting them into foreign currency. The bank then deposits the foreign currency at another bank so that it can deliver the currency in the future. Although that creates an on balance sheet hedge you still have to show the position in the off balance sheet section because the bank has a contract to deliver another currency with the customer still outstanding.
I have tried to cover common questions on ALCO and Liquidity profiles in this post. Hope you found this post insightful. Please share your feedback and comments.