ABSTRACT
The ALM Approach To The Management Of Interest and
Exchange Rate Risks
The Case Of The West African Development Bank
(WADB).
Interest of the topic
There are two types of risks: a positive one
and a negative one. The positive risk or upside risk can be defined as the risk
for a company to meet increasing profits while the negative risk or downside
risk is the opposite. The latest is the one that frightens a lot all companies'
managers because of its trickle down effects. Then they must manage carefully
that kind of risk.
As far as a company is concerned, the risk management should
be a priority. If not, the company loses a powerful tool in decision making.
The quality of its results, its solvency and consequently the future of the
company will also be compromised. This is very important as there is a large
range of risks interconnected one to the others. Therefore, a perfect
identification or taxonomy of risks and the choice of an accurate method of
measuring them are prior to their effective management.
There are many ways for managing risks like immunization,
forward hedge and diversification. But since a few years, banks are using Asset
and Liability Management (ALM) in order to manage their interest and exchange
rate risks and their liquidity risk. The ALM which aims at balancing risk and
profitability is based on a three-step approach: its attributions and links
with the other departments of the company, the identification and the measure
of the risks and finally the management of these risks. The latest should focus
on setting up the objectives, the constraints and also the managing action to
be undertaken. Meanwhile, the implementation of ALM requires a great
implication of the board of directors, an ALM committee or ALCO and a
sophisticated information system.
The West African Development Bank (WADB) has set up an ALM
system since 2001 and describing its experience should promote this approach.
If they use it, commercials banks will benefit from an ALM approach as well as
WADB which lends money to these banks. In fact according to some repricing
agreements, WADB lends money to primary banks and so expects a Return On
Investment (ROI). On the other hand, talking about the WADB's experience in ALM
leads us to compare the practice of that subject in that bank to what should be
done in theory. We'll then underline the inherent weaknesses and make a
contribution for a better risk management.
Problem to solve
We are aiming at a double goal:
- firstly, we'll make a complementary proposal to the WADB in
order to measure its interest rate risk. This method is called the value
measure. In fact, up till now the WADB is measuring its interest rate risk by
assessing the impact of interest rate fluctuation on the net interest rate
margin and on the Profit and Loss (P&L). This measure is unable to give a
bright analysis of interest rate risk as the risk manager can't forecast what
would be the value of assets and debts if the interest rate fluctuates. Neither
can he assess the impact on the value of equity. This is the purpose of the
value measure.
- secondly, we aim at making a contribution to ALM promotion
in the banking field of West African Economic and Monetary Union (WAEMU) just
because its practice is still not enough well known in our countries. This is
why the case of the WADB could be profitable for the banks of WAEMU zone.
Methodology adopted
In order to reach the above goals, we'll first of all set up
the theorical framework of the ALM approach to interest rate and exchange rate
risk management. Secondly, we'll describe the implementation of ALM at the
WADB. Comparing both of them, we'll be able to draw the strengths and
weaknesses of the ALM implementation at the WADB. Thus, the theorical analysis
will the be guideline that helps us to make our proposal of the interest rate
risk value measure since the WABD already uses the net interest margin measure
of interest rate risk.
Difficulties we faced
We were facing one major constraint in our survey. This
constraint is relative to information disclosure. We were therefore led to use
data of 2004 instead those of 2005 as we would prefer. That is the case of our
balance sheet which is not only a very simple one but also a balance sheet
drawn with accounting data instead of trading book data. The matter is that the
value measure of interest rate risk made on a trading book data is more
convenient as it reflects the market reality.
Diagnosis of the situation
The WADB has implemented its ALM system
since 2001 in its Risks Management Unit (RMU) which became the Risks Management
Division (RMD) in January 2005. This system was
computerized by Crédit Agricole Consultants a
French consulting company. It is focusing essentially on interest rate risk and
exchange rate risk management even if it is also in charge of liquidity risk
management. An ALM Committee has also been set up. It meets on a quarterly
basis and makes
proposals to the President of WADB after a relevant analysis
of interest rate and exchange rate risk. It's up to the President to take the
right decisions and to charge the operational departments to execute them.
However ALM is not an easy subject. It is recent among the
banking managing fields and indeed it is for WADB. That's why some strengths
and weaknesses can be underlined.
The strengths are relative mainly to:
- the ALM Committee which meets quarterly
- the fact that many employees are trained to ALM
- the implementation of a tool in order to make simulations
for interest rate and exchange rate risk management
- the fact of setting hurdle rates for risks hedging
Despite of these strengths, some weaknesses are still
bordering the ALM efficiency at WADB:
- the members of the ALCO team move very often. This can lead
to a misunderstanding of the last proposals and their bad implementation
- there are just two (2) employees in the Risks Management
Division (RMD). We do think that this number of employees is insufficient
- the information system is not performing well as it cannot
provide real time data
- the interest rate risk is just measured by its impact on the
net interest margin and the Profit and Loss (P&L)
- the hurdle rates for risks hedging seems to be irrelevant
- There's no notional division of the bank into responsibility
centre in order to perform pricing system and the allocation of equity.
Proposals
Taking into account the above weaknesses, our proposals will be
set in eight (8) points:
- increase the number of employees of the Risk Management
Division (RMD)
- perform the information system in order to provide real time
data
- perform the simulation tool in order to provide more features
for a better exchange rate risk management
- fasten the implementation of the managerial accounting and
control
- implement the value measure of interest rate risk
- re-think the idea of letting the borrowers support the exchange
rate risk because they are not as well equipped as the WADB to manage properly
that risk. Moreover this strategy can lead to a counterparty risk for the
Bank
- make a new assessment of the hurdle rates for risks hedging as
they were computed in the 80's
These proposals should be taken into account for a better
interest and exchange rates risks management. We would like to focus
particularly on the value measure of interest rate risk adoption in order to
make it part of the risks measuring tools of WADB.
Our own estimations give a proof that if that measure is well
conducted it remains consistent with the other ways of measuring interest rate
risk. In addition it gives a better sight of interest rate risk which measures
its impact not only on the net interest rate margin but also on the value of
assets, debts and equity. Therefore the value measure helps the risk manager to
make a better analysis and management of this risk. Moreover the risk manager
can take better commercial and strategic decisions.
Decisions
We suggest:
- firstly, a team should be set up in order to make a better
analysis of the implementation of the value measure because of the limits and
constraints that we faced in doing our own analysis. This team should be given
all necessary human, financial and material means to succeed in his task. The
team will also have to make some proposals to the President of the WADB.
- secondly, all the technical and material tools required for a
good implementation of that solution must be set up. In addition, conversant
employees must be trained or recruited for interest rate risk management
including the value measure.
- thirdly, this measure must be adopted and its results
controlled periodically.
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