Banks Split on Where to Locate ALM
The mixed response reflects the nature of the ALM function itself. “Because ALM straddles risk and finance, it’s not necessarily clear where the ALM department should be,” said Alexander Wolff, vice president, risk management at BancWare. “ALM is not a pure risk like market or credit risk because it has a strategy component, which is balance sheet management and forecasting,” he said.
The decision about where the ALM group belongs is not academic and could have an impact on a bank’s approach to ALM. “Some of our clients thought that treasury-based ALM groups, by being closer to the ‘execution’ side of hedging, the capital markets and market risk, will prefer the snapshot view of ALM with gap reporting and duration-type analysis over the dynamic forecast view of ALM favored by finance, which involves income and earnings forecasts and balance sheet modeling,” Wolff said.
Interestingly, since the survey was conducted, the Basel Committee for Bank Supervision has published new interest rate risk management guidelines that emphasize a risk measure known as economic value of equity. The measure is more closely related to market risk and the treasury function than to finance. Consequently, ALM groups that are based within banks’ treasury departments will likely have an easier time with the new guidelines than those located within finance.
The survey is based on responses from BancWare ALM software clients. BancWare received 91 answers from ALM team and asset/liability committee members from 71 institutions, with 31 per cent based in Europe and 69 per cent in North America. Respondents ranged from comptrollers and CFOs at smaller institutions to analysts and active users of the BancWare software. The results were presented at a client conference in Paris in July and are being made publicly available for this first time with the publication of this article.
Looking at the composition of banks’ asset/liability management committees (ALCOs), the survey found that all banks have their CFO on the committee and 77 per cent include treasurers. Less than two-thirds include line of business managers, and just 6 per cent have CROs on the committee.
“Since ALM contributes considerable insight to setting an institution’s strategy, you would expect that business and product management would work closely with the ALCO. The fact that just 61 per cent of ALCOs included line of business managers was somewhat surprising,” said Wolff. “At the same time, the low percentage of CROs on the ALCOs is related to the fact that ALM has a large accounting component, which CROs don’t necessarily concern themselves with.” Eighty per cent of banks surveyed said their ALCOs met monthly.
The BancWare survey also uncovered some differences between European and North American banks. The survey found that the most traditional and simple ways of measuring risk are more prevalent in Europe, while North Americans lean towards more complex types of reports. Yet, although US banks have better information as a result, European banks are more sophisticated when it comes to acting on that information and hedging. The survey found that while Europeans concentrate more on re-pricing and liquidity gap reports, North Americans focus more on market value and convexity measures. That puts North Americans further along in implementing the new Basel guidelines that emphasize economic value of equity.
In Europe, over 80 per cent of banks run monthly re-pricing gap reports and over 70 per cent do liquidity gap reporting on either a monthly or quarterly basis. Sixty per cent of North American banks do re-pricing gap reporting on a monthly basis, and 20 per cent do so monthly. Over 60 per cent of North American banks’ ALM groups do liquidity gap reporting either monthly or quarterly, but 30 per cent never run those reports at all.
Meanwhile, over 90 per cent of North American banks do market (or economic) value reporting either monthly or quarterly, while over 20 per cent of European banks never run those reports. One of the reasons for the greater emphasis in North America is due to the more developed secondary market for mortgage products there, which makes measuring market value more critical to determining risk and balance sheet management than in Europe. Convexity reporting is very uncommon in Europe, but used in North America by almost half of all banks. “This is most likely due to the fact that characteristics of US mortgage products produce quite substantial negative convexity that could lead to serious exposures if left unmanaged,” said Wolff.
Duration of equity reporting seems to be less widespread in Europe than North America, which is most likely due to the fact that Europeans have less experience calculating the market (or economic) value of their balance sheet than institutions following US GAAP accounting standards. Differences between European and North American banks regarding duration reporting are less clear. However, in Europe this type of reporting is more likely tied to re-pricing gap schedules, while in the US, duration reports are more likely to reflect effective duration. The survey also found little difference between Europeans and North Americans when it comes to income simulation, balance sheet and cash flows reporting. While European banks run somewhat less sophisticated ALM reports than American banks, they do run theirs more often and deal with a wider range of issues. American banks use more sophisticated duration analyses and valuation techniques, while Europeans use more complex income simulation.
Although almost all large banks hedge, more small and medium-sized European banks hedge their interest rate risk than their US counterparts. And at least in large institutions, European ALM teams seem to be involved in the interest rate risk hedging process more directly than their American colleagues.
At the same time, the use of more complex financial derivatives, such as swaptions and structured derivatives in addition to the more standard caps, floors and swaps seem to be more commonly used at European banks, especially smaller institutions, with up to 30 per cent more European banks using these products than their American counterparts.
These differences may be due to the fact that small banks in Europe have had to compete with well established European banking powerhouses, while the big US banks have had a relatively minor role in general retail banking up until the repeal of the Glass-Steagall Act in 1999. Or it could also be a cultural difference, with North American banks being more conservative when it comes to risk management, said Wolff.
When it comes to the size of banks’ ALM departments, the SunGard BancWare survey found that North American banks appear to employ more people in ALM than European banks. The average North American bank has a total of close to five ALM-team members, compared to about three for European banks.
The survey also found that US and European banks with less than 50bn in assets have an average of close to three ALM-group members, with one focused on data and two on ALM. Banks with over 50bn in assets have an average of close to seven ALM-team members with two focused on data and five on ALM. The jump in the size of the ALM department at larger banks is likely due to the added complexity of aggregating and consolidating data across multiple business units, geographic regions or legal entities, said 0Wolff.
In spite of other differences between them, North American and European banks have the same top concerns: regulatory compliance, correct modeling of bank products and communicating ALM results within their institutions. However, the Europeans placed a bigger emphasis on regulatory compliance, with 45 per cent of those respondents citing it as their top concern, compared to 16 per cent of North American respondents. Europeans’ biggest concern in this area is the International Financial Reporting Standards, while North Americans are focused on FAS 133 and SOX 404.