IIF LATAM CHIEF RISK OFFICERS FORUM ENHANCING ALM AND BALANCE SHEET RISK MANAGEMENT IN LATIN AMERICAN BANKS 13 JUNE 2013 Miguel Yagüe ([email protected]) Rafael Niell ([email protected]) OLIVER WYMAN GROUP © Oliver Wyman | MAD-BNT01611-010 CONFIDENTIALITY Our clients’ industries are extremely competitive. The confidentiality of companies' plans and data is obviously critical. will protect the confidentiality of all such client information. Similarly, management consulting is a competitive business. We view our approaches and insights as proprietary and therefore look to our clients to protect 's interests in our presentations, methodologies and analytical techniques. Under no circumstances should this material be shared with any third party without the written consent of . Copyright © The main objective of this session is to illustrate our perspective on best practice approaches to manage ALM risk in Latin America • Many Latin American countries are facing a period of significant credit growth, margins decrease, and/or exchange rate volatility • This, together with new capital requirements, is putting pressure on return and adding new risks to their banks’ balance sheets • Optimizing ALM and balance sheet management in line with best practices has a strong upside • Risk usually plays a key role in ALM and balance sheet risk management along a number of dimensions – ALM governance and management (ALCO) – ALM risk measurement – Fund Transfer Prices (FTPs) – Liquidity risk measurement and management • This session is aimed at addressing a number of key ALM risk management challenges and related practices in this area, with focus on Latin American banks • We have also included some real client examples to better illustrate the topics • We encourage questions to be asked throughout the presentation 22 © Oliver Wyman | MAD-BNT01611-010 ALM risk has increased relative importance among Latam CROs in the last couple of years Oliver Wyman Risk Management Perspectives 2012-2013 Risk type priorities in 2012-2013 Priority order (with 1 being the highest priority) 5 Lower priority 4 3 2 1 Higher priority 0 Credit Risk Liquidity Risk Market Risk Interest rate Risk Operational Risk Business Risk Latam Europe 33 © Oliver Wyman | MAD-BNT01611-010 Section 1 Banking book risk basics 1. Banking Book risk basics ALM risk arises from the structural mismatch between assets and liabilities on the balance sheet 1 Repricing mismatch of assets and liabilities 2 Mismatch of FX positions Repricing profile of balance sheet items Currency denominations of balance sheet items As % of total assets in PEN As % of total assets at current FX rates 60% 60% 40% 40% 20% 20% 0% 0% -20% -20% -40% -40% 0-1 1-6 6-12 1-3 3-5 5-10 > 10 NA -60% month months months years years years years PEN USD Assets Liabilities Assets Liabilities Interest rate risk FX risk • Interest rate risk materialises in form of interest rate • FX risk arises from balance sheet items denominated volatility leading to changes in the IR curve (shifts, twists, in a different currency than the reporting currency etc.) • The foreign exchange risk is driven by the volatility of • Balance sheet assets and liabilities have different exchange rates of all currencies on the balance sheet sensitivities to interest rates in terms of economic value and generated margin • The risk increases depending on the difference in sensitivity to interest rates between assets and liabilities 55 © Oliver Wyman | MAD-BNT01611-010 1. Banking Book risk basics For assessing the IR risk from an ALM profile the sensitivities to single 11 interest rates need to be derived – in contrast to the liquidity approach Payment profile of a bullet loan Payment profile of a bullet loan Interest Economic Repricing Liquidity payment value1 maturity maturity (3y) (3y) Fixed rate Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 No impact on interest payments since loan is at fixed rate; variation of IR Assets Loan interest rate 3-year interest rate leads to changes in NPV of loan Interest Economic payment value1 Repricing Liquidity maturity maturity Variable rate (1y) (3y) Interest payments change according Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 to market rate movement; but Assets Loan interest rate 3-month interest rate variation of IR leads has no impact on NPV of loan When looking at interest rate risk, repricing maturity instead of liquidity maturity needs to be considered 1. Net present value of cash flows, discounting with IR curve 66 © Oliver Wyman | MAD-BNT01611-010 1. Banking Book risk basics The movement of interest rates impacts net interest margin and value 1 depending on the repricing gap between interest earning assets and interest bearing liabilities Impact of rising interest rates on value and net interest margin for prototype balance sheets Assets and liabilities by repricing maturity intervals Impact on economic value1and net interest margin 40 • Loans with longer repricing maturity funded by s g 20 deposits with shorter repricing maturity n Asset duration > di • When interest rates rise, interest paid on n 0 liability duration sta deposits has to be increased in order to keep ut -20 deposits whereas interest earned on loans O stays fixed -40 40 s • Repricing maturities of assets and liabilities are g 20 n matched, no repricing gap Asset duration = di liability duration stan 0 • Wdehpeons iitnst earneds ti nrtaetreess tr iesea,r ninetde roens tl opaanids oanre Out -20 increased simultaneously -40 40 • Loans with shorter repricing maturity funded by s deposits with longer repricing maturity (atypical g 20 Asset duration < din since unsustainable negative net interest an 0 margin in regular interest rate environment) liability duration Outst -20 • Wloahnesn cinatne rbees ti nrcarteeass reisde winhteerreeasst einatrenreeds to pna id on long-term deposits stays fixed -40 Assets Liabilities Yield curve Stressed yield curve 1. Net present value of cash flows, discounted with IR curve 77 © Oliver Wyman | MAD-BNT01611-010 1. Banking Book risk basics The US Savings & Loans crisis in the 1980s is a good example to 1 emphasize the need for and importance of managing the structural interest rate risk The contribution of interest rate volatility to the US Illustrative development of interest rates during the Savings & Loans crisis Savings & Loans crisis • S&L banks were local US banks involved in the core 18% banking business of a typical bank – Deposit-taking with short maturities 16% – Lending longer term, typically 30-year mortgages 14% • Until the crisis the Federal Reserve enforced stable Negative interest rates which allowed the S&Ls to NII make a good margin on the mismatch 12% – Banks paid about 4% to depositors – Received about 8% interest rate on mortgages, 10% Average typically fixed loan rate 8% • When the Federal Reserve let the interest rates float in the 1980s, the short term rates rose as high as 16% Positive 6% – Deposit-based funding cost rose to 16% as NII depositors demanded higher interest for not pulling their funds 4% Average – Mortgages fixed at 8% for a long duration led to deposit rate average loan rates rising at a slower pace than short 2% term deposit rates – This meant an unsustainable structure, leading to 0% many bankruptcies 1 2 3 4 5 6 Time 88 © Oliver Wyman | MAD-BNT01611-010 1. Banking Book risk basics Banking book FX risk has several sources and materializes in volatility 2 positions and cashflows denominated in a foreign currency Banking book FX risk Impact of USD devaluation on balance sheet reported in PEN • FX risk outside of the trading book arises from a A&L positions by currency mismatch in positions denominated in currency converted to PEN amounts different from the reporting currency A L • Such positions outside of the trading book include 50 PEN mainly: 100 PEN – Foreign currency loans (in the banking book) 50 PEN – Foreign currency assets in the investment portfolio – Wholesale and deposit funding in foreign currency to profit from lower interest rates – Structural FX positions arising from foreign USD devaluates by 20 % subsidiaries • FX derivatives typically appears in both trading and banking book – derivatives used for managing ALM A L position in the non-trading book investment securities Translates portfolio (Treasury’s AFS portfolio) is considered within into 10% 40 PEN the banking book market risk 100 PEN loss of value of assets 40 PEN USD denominated assets PEN denominated assets PEN denominated liabilities 99 © Oliver Wyman | MAD-BNT01611-010