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How can banks better address ALM in 2021?

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The Covid-19 pandemic continues to create many challenges for corporate governance teams. With ongoing lockdown restrictions meaning the vast majority of traders are currently working from home, it is very difficult for compliance teams to monitor what exactly the traders are doing and the potential risks of their market positions.

For more about how this specifically has affected the trading environment, this story from 2020 goes into more detail:

While traders are facing their own issues, Treasury departments in banks are also facing just as challenging a job in maintaining continuously effective Asset Liability Management (ALM) operations.

This is the mechanism through which Treasury teams address the mismatch between assets and liabilities, taking into account factors such as liquidity and interest rates, to ensure smooth cash-flow streams and better manage balance sheet risk.

A well-managed balance sheet is crucial both in increasing overall profitability and minimising the bank’s risk of not settling a contractual liability on time. But with traders physically separated in their respective homes, both from each other and their corporate governance bodies, many banks have found it increasingly difficult to ensure sound ALM processes.

The Regulator

This all comes at a time when the regulators are increasingly robust in enforcing stringent balance-sheet management standards.

Just this month the Bank of England’s Prudential Regulation Authority (PRA) published a consultation paper on the implementation of Basel III standards. The PRA are seeking to enhance bank’s regulatory obligations regarding minimum capital ratios and liquid asset holdings.

In many ways this is understandable. With the bleak economic environment the global economy is facing, it is perhaps more important than ever that major financial institutions have adequate capital buffers in place.

But how can banks best manage their balance sheets, especially when lockdown restrictions make communication and compliance oversight that bit more difficult?

Can banks do more?

To discuss all of this, we sat down with Professor Moorad Choudhry. Formerly a Divisional Treasurer at the Royal Bank of Scotland, Moorad now leads the Certificate of Bank Treasury Risk Management (BTRM) course with WBS Training. This is a technical course on managing a firm’s balance sheet and it’s capital, liquidity and market risk.

Moorad began by pointing to the pre-2008 conception of ALM and the need for a much more proactive approach to risk management than has traditionally been the case.

“Before the crash, ALM was the poor relation […] the Treasury Department took care of the funding and nobody really cared too much about it because liquidity was plentiful, capital was not overly constrained, and funding was cheap”.

This led to a culture of complacency in which risk was only properly considered after market positions had already been taken. “ALM was always a reactive function – the businesses would go out and generate business for a bank, lending money and taking deposits. What would traditionally happen was, customer relationship managers would go and do their business, and then the ALM function would manage the resulting balance sheet. And they would manage liquidity risk and interest rate risk post the fact”.

Since the crash, there has been a greater appreciation of the need for what Moorad calls “strategic ALM”. Instead of bankers operating almost entirely independently from their Treasury departments – with balance sheet risk settled in response to market positions – Moorad argues for “integrated balance sheet origination”.

This is a method of corporate governance in which Treasury risk managements concerns are taken into account as part of the bank’s overall trading strategy and limit setting. It is balance sheet management whereby Treasury teams are “involved in setting the limits, as part of the strategy setting for the bank or the trading house, as well as funding the balance sheet and then monitoring the limits”.

Moorad believes that this integrated approach is even more important when you consider the tunnel mentality that can arise from sales and volumes targets.

“If I say to you, ‘here’s your salary but you’ll get a 100% bonus if you go and reach that target,’ you’re going to go out and try to do that, and not care overmuch what other business lines do. In that kind of environment, it is difficult for the ALM function to work in a genuinely effective way.

“So, a proactive and integrated loans/deposits origination approach means that it doesn’t just do the monitoring. It’s also involved in the process of setting the limits in a way that is integrated, so both sides of the balance sheet know what the other is doing, and indeed what everyone else is doing. And then also monitoring and doing what it has traditionally always done, taking care of interest rate risk, liquidity risk and the FX hedging”.

Extreme Moderation and Restraint

In essence, Moorad’s “strategic ALM” is about taking risk away from individual business lines and absorbing it “centrally” into the bank.

It is about allowing traders to do their jobs – generating business and meeting their volume targets – within limits that have already been set with ALM considerations firmly in mind.

Especially at a time when risk oversight is even more difficult, Moorad believes that the benefits of having ALM deeply ingrained and integrated into the activities of trading desks are clear to see.

Whilst Moorad’s conception of ALM works as part of rather than in opposition to the pursuit of targets, the bonus culture itself is beginning to change.

The CEO of BlackRock, Larry Fink, started a debate on the subject as far back as 2018, and the Covid-19 pandemic has challenged it further. As Europe entered lockdowns in March last year, the ECB’s Andrea Enria called on banks to exercise “extreme moderation” on bonus payments:

In May, the Bank of England went one step further in expecting companies benefiting from government loans “to provide a letter to HM Treasury committing to showing restraint on the payment of dividends and other capital distributions and on senior pay”.

There are clear signs that increasing numbers of financial institutions are moderating their bonus cultures. The taming of this environment would undoubtedly have knock-on effects on ALM and help Moorad’s “integrated balance sheet management”.

Systemic Risk

In addition to the bonus culture which can create a “silo mentality”, Moorad also identifies the sheer size of many financial institutions as a potential ongoing problem.

 “Everyone talks about too big to fail, which is still with us, but I’ve also always talked about ‘too big to manage’. In essence, this is when a firm (any firm, not just banks) becomes so large that no one committee, let alone an individual, knows exactly what is happening in the whole firm and is aware what all the risk exposures at any one time are.

“You do get lots of large firms, and they have certain risk management weaknesses precisely because they are too big to manage. Once we get to a certain size, operating across lots of countries, it’s just the case that no one person or no one committee in the group actually can have a really good idea of what’s happening in the rest of the bank. In effect, one has now become too big to manage. I know that some people will disagree with me on this, not least Group CEOs and CFOs, and of course small firms also go bust, all the time. But this concept of “too big to manage” remains a risk management issue”.

The failure of the Royal Bank of Scotland in 2008 is arguably an example of this. As a report by the Financial Services Authority (FSA) determined in 2011, poor management decisions and a general lack of compliance oversight led to significant weaknesses in the bank’s capital position.

Poor ALM and a complacent approach to liquidity regulation led to an unhealthy dependence on much riskier short-term wholesale funding. Especially poor performance in particular areas of the bank – such as credit trading – eroded market confidence whilst the bank’s corporate governance teams, unable to oversee completely all departments in all countries, underestimated the extent of the issue.

Whilst for many the bank had become “too big to fail”, in many ways it had simply become “too big to manage”.

In all institutions of a similar scale, it is arguably impossible for corporate governance teams to maintain a strong control culture over all parts of the bank at all times. Much better, Moorad believes, to have ALM more firmly entrenched on the micro level, with traders conducting business within limits and strategies that have been established in close dialogue with Treasury departments.

ESG Metrics In ALM

We also discussed the relationship between ALM and the climate change movement. As we covered in a piece earlier this week, banks are increasingly considering climate risk in addition the traditional, technical issues of liquidity and interest rates.

Particularly with the change of administration in the U.S., this comes amidst growing pressure from governments and regulators for financial institutions to address the climate implications of their investments and activities:

Moorad believes that this ESG agenda is now a fact for banks to deal with, rather than a debate to be had. “Now the market has embraced ESG, I think the question should be, ‘how best should they incorporate that into their strategy?’ I think that’s the question to ask. It’s no longer should we have an agenda on it, because in effect we are required to”.

This is as a result of pressure from both regulators and external stakeholders.

Interestingly, however, Moorad suggests there is an economic soundness to this as well. “I think no company can get away today with saying, ‘we’re just concerned with return on capital. We’re just going to meet our P&L targets.’ No company would get away with it these days because the perception would  be that they are just mean and nasty and horrible”. Moorad quotes Milton Friedman to suggest that an ESG agenda and greater profitability may not be mutually exclusive.

“I was brought up on the free market ideals of the “Chicago School”, and Milton Friedman. People always quote the first part of what Professor Friedman said, that a company should only be concerned with return on capital and that shareholders can do all the good, nice, touchy-feely stuff as individuals.

“However, he then went on to say in the same article that a well-run company that has an eye on what we now call ESG issues will probably generate more return in the long run anyway”.

In any case, the regulators are certainly determined to enforce a climate agenda onto financial institutions. This will undoubtedly change balance-sheet considerations, which will increasingly need to take into account climate risk along with traditional concerns such as liquidity flows.

Moorad’s BTRM course is a “purely technical course on managing balance sheet risks” that “doesn’t include a section on ESG issues” – though “maybe it should”, Moorad adds. It is certainly an issue that will only increase in importance for banks and their Treasury departments in the years to come.

The BTRM solution

Moorad concluded by admitting that “corporate governance is not the most popular job”. Most aspiring bankers, particularly the majority which studies quantitative degrees at university, “have a preference for market risk. I think that’s because they’ve been brought up thinking that’s the cool area to work in”.

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Corporate governance demands a very specific kind of person who is prepared to challenge and tame the culture of risk-taking on which the industry has traditionally been based. They are instinctively cautious amidst the inherent risk of market conditions, yet also possess a huge amount of intellectual and business acumen.

“Managing asset-liability risk from a governance point of view” may “attract fewer people”, but it is undoubtedly an area of increasing importance for every major financial institution.

After all, regulators are more and more prepared to apply huge fines for non-compliance of ALM requirements.

In 2019, the PRA imposed a record fine of £44 million on Citigroup’s UK operations for misreporting their capital and liquidity positions.

Last year, regulators in the UK, US and Singapore fined Goldman Sachs a total of £2.9 billion for risk management failures.

With the implementation of Basel III standards in the pipeline, the cost of a lack of investment in Treasury space is sure to be more pointed. The significance of ALM mechanisms – and arguably the need for a more advanced, “strategic” approach to ALM – is only going to grow if banks wish to avoid the attention of regulators more than ready to dish out serious fines for compliance lapses.

Author: Harry Clynch

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