ALM banking practices for a new era in liquidity risk

The dramatic collapse of Silicon Valley Bank on March 10 was the first of several failures in a cascading asset-liability management (ALM) crisis. There is nothing new about the dynamics behind these incidents: maturity transformation, liquidity risk and interest rate risk are at the heart of the traditional banking business model. But these old threats have been given new life by a shifting regulatory environment, a transatlantic gulf in how rules are applied, the changing behaviour of depositors and the historic speed of last year’s rate hikes.

Over the past decade, regulators have introduced stress tests, and liquidity and funding standards – and overhauled rules, specifically on interest rate risk in the banking book (IRRBB) – which all have some bearing on the current crisis. But they haven’t yet been implemented fully, or equally, from one jurisdiction to another. There are questions around whether the current framework is fit for purpose and whether there are limits to what certain regulatory tools – such as stress tests, liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs) – can do for banks in terms of liquidity risk management. The European Banking Authority has recently published a new version of secondary IRRBB legislation detailing supervisory outlier tests to measure interest rate risk and changed the templates in its stress tests. Further changes are expected to account for the shifting rates environment as well as the ALM crisis.

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Asset-liability management: Special report 2023

 

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The rate-hiking cycle has been seen as a boon for many banks, pushing up their net interest income (NII). But it has also made it harder to hold onto some depositors and has hit the value of banks’ bond portfolios. The crisis is likely to result in an overhaul of some ALM practices, including modelling deposits in a new digital age as well as reconsidering accounting classifications for bonds and new hedging strategies for banking book risks to cope with the high interest rate environment and heightened regulator and investor scrutiny. Prem Neupane’s article offers a timely road map to enhancing deposit modelling frameworks and opportunities for firms to integrate siloed data elements into these.

Liquidity modellers discuss these issues and how banks are achieving integrated approaches to ALM in an industry panel. Their views indicate that banks will need to review their deposit modelling assumptions and change them to reflect shifts in balance behaviour. They should also reconsider how to diversify their funding base to avoid concentration risk in their deposit base.

US regulators are expected to increase the reporting requirements around liquidity – particularly for regional and smaller banks. There is consensus that changes to the regulations are probably inevitable globally, but there are differing opinions on whether LCRs and NFSRs need significant recalibrations.

Experts agree that ALM strategies should be reviewed frequently and adjusted to the changing environment. Clearly, banks have been too focused on NII and should also consider economic value of equity and the market value of equity risk profile metrics.

Held-to-maturity is not the wrong approach in the accounting treatment of securities. There are times when this may be the best way for banks to classify their bonds on an economic basis. However, they should consider the liquidity management perspective and ensure they will not have to sell their bonds suddenly and unwind them in an unfavourable environment.

Banks are reconsidering their hedging strategies and using various dynamic products to protect themselves in the rising rate environment. Others are tackling uncertainty around deposit duration and customer behaviour by using swaptions or having the flexibility of using options.

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