Unit 4.5 – Case Study 3 Asset Liability Management

Unit 4.5 – Case Study 3

Asset Liability Management

For this case, we will use the CALMPRO global financial model that we first introduced in Unit 4.3. You will immediately recognize all of the risk schedules and analytics that we already used in Modules 4.3-4.5 on interest rate risk, forex risk and liquidity. This time, we will actually use the newer Release 4, called the ALMPRO. The ALMPRO adds more deposit and lending product slots, additional interest rate risk hedging opportunities using bond futures and now also models the mark-to-market replacement cost of derivative hedging instruments. However, this case is not about studying the formulas in the ALMPRO. Instead, we would like you to interpret the ALM analytics and review the financial performance and exposures of BankAfric in South Africa under various scenario assumptions.

In order to keep data entry to a minimum, the baseline scenario is already fully captured. You will also notice that most helper sheets and any other risk schedules and date ranges that will not be relevant for the case have been hidden, giving the ALMPRO a cleaner and more manageable look. All sheets are locked against accidental overwriting, leaving only the green shaded data fields open for changes. However, you can always unhide a cell range or worksheet, if you want to dig deeper. There is no password required to unlock or unhide a sheet (Review

-> Unprotect Sheet. Right-click on any sheet tab -> unhide).

The baseline data for December 2020 to December 2023 is in the file CERM19_Case3_Base.xlsx. The file is configured to reflect the operating history and financial forecast for the fictitious BankAfric that operates as a full-service Retail/SME/Corporate bank in South Africa. BankAfric has longstanding relationships with the international development finance community and regularly draws on special facilities supporting small business, agriculture and energy efficiency initiatives. Hence, the importance of USD and EUR as funding and operational currencies for BankAfric.

The baseline ALMPRO file contains all necessary information about BankAfric including the applicable prudential limits, policy constraints and the most binding covenants. What is captured in the baseline version of the tool is the operating history for December 2020 – June 2022 and the business plan for the remainder of 2022 and beyond.

Note also that BankAfric Bank is subject to an internal policy limit on interest rate risk as follows:

Net Interest Income at Risk ≤ 5%

This means that interest rate shock scenarios of:

+400 /-400 bps in the Reserve Bank of South Africa Repo Rate,

+200/-100 bps in the 3-month USD Libor and

+200/-100 bps in the 3-month EURIBOR

may separately and in combination not lead to a loss of more than 5% of budgeted Net Interest Income for the next 12 months,when using the co-movement weighted repricing gap analysis(sheet RepricingGap).

The purpose of this case study is to modelandmitigatethebalancesheetpositioningduringthebusinessreboundfollowingtheinitialCOVID-19recession and the Delta surge that had severely impacted the bank over the course of 2020 and in early 2021. WearenowattheendofJune2022.Management and Board at BankAfric Bank are reviewing the business plan for the remainder of 2022 as it is contained in the baseline model. The 2022 budget was established in December 2021, when business seemed to be roaring back and everyone assumed that the pandemic was finally over. The bank’s performance over the first half of 2022 has fallen behind the high expectations: the renewed COVID lockdowns in China have aggravated the persisting supply chain issues. The war in Ukraine and the spike in global food and energy prices are creating additional disruption in the regional economy. There are some narrow segments in the BankAfric portfolio that may see some windfall profits from high commodity prices, but for the majority of small businesses and for consumers, a new recession is looming.

Task 1 (40%): Analyze the Jan 2021 – Jun 2022 financial performance and the ALM positioning as of June 2022.

For this purpose, review the CERM19_Case3_Base.xlsxfile without making changes to the data. Consider expense and earnings trends over the course of 2021-2022 (materialized figures) and in the July-Dec 2022 budget as it is currently captured in the file. Consider the sources of income, changes in loan demand and deposit supply, the funding structure and currency composition of the balance sheet, as well as the overall size and adequacy of the loan loss provisions. What role does the trading book income play in supporting the cost base, and is this sustainable?

As you examine the ALM positioning, you should also comment on compliance with liquidity, capital adequacy and forex risk limits over the course of 2021 and 2022.

Check whether the standard liquidity stress test as configured in the sheet LiquidStresswould pass as of the March 2022 and June 2022 trigger dates. Comment on the liquidity trends that may explain the result.

Would BankAfric comply with the above Interest Rate Risk Limit as of June 2022using the co-movement weighted repricing gap analysis as configured in the sheet RepricingGap? Remember to consider rate shocks in all three currencies and combine the adverse outcomes per currency into a theoretical maximum loss scenario.

The best entry points for the analysis in Task 1 would be the following sheets: BalanceTotalHome (see also the Dashboard section beginning at line 92), IncomeTotalHome (note the annual summary to the right), Charts, LiquidStress, MaturityGapTotal and RepricingGap. You may also find it useful to take a look at the underlying per-currency balance sheets BalanceFx1, Balance Fx2 and BalanceHomeFx.

Task 2 (30%) : Basel III Liquidity Coverage Ratio

The BCBS guidance following the 2007-2010 global financial crisis places a strong emphasis on solid liquidity buffers. Basel 3 introduced a Liquidity Coverage Ratio in Pillar 1 that harmonizes the various liquid asset coverage ratios previously applied by national regulators. Compliance with the LCR limit has been adopted also in most emerging and developing markets.

At the bottom of the Sheet BalanceTotalHome as an extension to the Prudential Ratio and Covenant dashboard, we implemented a month-by-month LCR calculation covering the 2021-2023 operating history and budget. The LCR calculations are our attempt to implement the BCBS instructions as per the publication “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools” of January 2013, pages 12-43. The document is available for download alongside these case instructions.

Your task is to analyze and interpret the LCR values and calculation logic aspresentedintheALMPRO: Are the LCR values plausible for BankAfric against the required minimum of 100%? Do you agree with the assumptions made? Are deposit run-off rates below 10% realistic for an emerging market like South Africa?

Specifically, consider the treatment of required reserves, given that minimum reserve requirements are relatively high in South Africa at 12% for ZAR deposits and 15% for foreign currency deposits? Also comment on the treatment of interbank deposits held with commercial banks, the release of retail time deposits before maturity and the redeployment assumption of 50% on the loan portfolio.

What drives the high LCR values during all of 2021 and 2022? What is the reason for the sudden drop forecast for November 2022? How do you think a reversion into recession and slower loan demand in Q3/Q4 2022 might impact the LCR for the rest of 2022?

How does the LCR calculation differ from the internally-defined standard liquidity stress test in the sheet LiquidStress?

Task 3 (30%): Adjust the July – December 2022 Budget

Please save a separate copy of the baseline file that you may call YourName_Case3_ Adjustments.xlsx or similar. In this copy you should make the changes suggested below, which come out of the ALCO workshop that BankAfric held in late June 2022.

With the war in Ukraine, commodity shortages, supply chain disruptions and the global interest rate increases, the outlook for the rest of 2022 has obviously darkened. The disbursement targets and income expectations for the year 2022 are no longer realistic.

This creates a serious dilemma for BankAfric: Management was hoping to gain market share in 2022 and redeploy the excess liquidity accumulated during the deleveraging of the pandemic years. But BankAfric must also hedge against the prospect of accelerating inflation, higher funding costs and a new wave of loan defaults in the consumer and small business market. It is clear that unlike during the first year of the pandemic, Government will not be able to provide any further liquidity and credit support for the SME segment.

This leads the bank to the following urgent updates in the 2022 operating budget:

  1. The bank will need to implement an immediate hiring freeze and furlough some SME loan officers and call center agents from July 2022 onwards in order to bring operating expenses under control.
  1. Loan disbursement targets for the rest of the year 2022 and the first half of 2023 must be aligned with recent actual loan demand. Precious metals mining is one of the few bright spots in the loan portfolio, where the original disbursement forecast can be maintained unchanged. With the technical assistance of the DBSA and KfW, BankAfric will conduct a special marketing campaign for the recession- proof solar energy and energy efficiency themes.
  1. Excess liquidity is becoming a drag on earnings. The bank plans to lower the rates offered on corporate time deposits and allow the corporate deposit base to run off substantially.

Below are the necessary budget adjustments and analyses step by step.It would help us with the review of your case, if you mark in yellow all cells in which you made the following changes:

  1. The hiring freeze and staff furlough program will be reflected in the salary budget: In the sheet IncomeHistory line 92 maintain the monthly salary expenses at the June 2022 level from July 2022 through June 2023 before reverting to the currently captured budget.
  1. The necessary adjustments in loan disbursement targets are captured in the sheet DetailedAssumptions as follows:
  1. Line 36 Consumer Overdrafts: freeze the overdraft limits at the June 2022 level of ZAR 600,000,000 for July 2022 through June 2023.
  2. Line 40 SME Overdrafts: cap the monthly overdrafts at ZAR 1,500,000,000 for July 2022 through June 2023.
  3. Line 41 SME Working Capital: freeze monthly disbursements at ZAR 60,000,000 for July 2022 through June 2023.
  4. Line 42 SME Trade Finance USD: imports from Asia will continue to suffer from supply chain disruptions. Budget monthly disbursements of USD 1,500,000 for July 2022 through June 2023.
  5. Line 43 Tourism Seasonal EUR: European tourists are coming back, but the tourist arrivals from Asia are still far behind pre- pandemic levels: budget monthly disbursements of EUR 2,500,000 for July 2022 through June 2023.
  6. Line 47 Corporate Lines ZAR: cap the monthly overdrafts limits for corporates at ZAR 1,500,000,000 for July 2022 through June 2023.
  7. Line 49 SME Solar Promotion: increase monthly disbursements to USD 5,000,000 for July 2022 through June 2023.
  8. Line 53 SME Energy Efficiency: increase monthly disbursements to USD 3,000,000 for July 2022 through June 2023.
  9. Your IFRS 9 Point in Time models of default and collections point to an emerging recession that will require a proactive increase in provisioning rates. Raise all provisioning rates for performing loans by 25% (multiply by 1.25) in DetailedAssumptions!V140:AG162. For the Impaired Portfolio in IFRS 9 Stage 3 increase the provisioning rate (=LGD) from 70% to 75% in Line 163.
  1. In Detailed Assumptions adjust the strategic shift away from corporate term deposits as follows:
  1. In lines 199-201 set the monthly production of corporate time deposits to ZAR 50 million, USD 5 million and EUR 0 for July 2022 through June 2023.
  2. In line 218 set the ZAR time deposit rate as 2% below the money market reference for July 2022 through June 2023. In line 219 set the USD time deposit rate offered as 0.5% below the USD money market.

Comment on the projected full year results for 2022 after capturing the above adjustments, in terms of profitability, capital adequacy, forex risk, interest rate risk and liquidity. By year-end 2022, the balance sheet displays much lower liquidity as intended. Did BankAfric overshoot in its plan to manage liquidity down?

Task 4: Additional Bonus Question (25%): Forex Risk Hedging

  1. After having implemented the above budget adjustments, the ALCO decides to reduce the limits on a single currency and for the aggregate open position to 25% of regulatory capital from 30% in BalanceTotalHome lines 109 and 110. Review the open currency position in the sheet Charts and in the Dashboard Section in BalanceTotalHome. What is the problem and how might it be mitigated by adjusting the budget and/or the funding plan for 2022/2023?
  1. Consider a ZAR devaluation scenario and determine the effect on BankAfric’s financial position after implementing the budget adjustments as above:

In Detailed Assumptions Line 20 adjust the USD/ZAR exchange rate forecast for July 2022 to 17.00, for August 2022 to 18.00 and September 2022 to 19.00 at which level the exchange rate will remain until December 2023. The forecast for the EUR/USD exchange rate will remain unchanged at EUR/USD 1.05 throughout that period.

  1. Find the resulting net forex gains / losses from on balance sheet items and forex hedges combined for the second half of 2022 and for the full calendar year.
  1. Capture one or several forex hedging transactions in the sheet FxHedges that will bring the forecast aggregate open currency position into full compliance with the

+/- 25% position limits for July – Dec 2022.

CaseDeliverables

  1. Using plain text format, present your analysis and proposed actions in the answer sheet for Tasks 1 – 3, plus the Bonus Task 4, if worked. This should not exceed 5 pages and can rely mostly on concise bullet points.
  1. Submit the ALMPRO version with your properly captured changes and mitigations as per Tasks 3 and 4.

Good luck!

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