Liquidity risk management methodsLiquidity - the bank's obligations (off-balance sheet liabilities, loan agreements, credit lines, etc. is the ability to obtain sufficient cash or an equivalent amount of non-cash funds in correspondent accounts at a reasonable price for the purpose of timely payment.
In liquidity management, the effectiveness of liquidity planning is ensured as a result of the analysis of both sides of the Bank's balance sheet.
In addition to the sale of assets, the Bank provides loans from the Central Bank, commercial banks, the interbank market, and deposits of legal entities and individuals, in order to manage liquidity.
Important factors in determining the liquidity of the bank and its stability are the deposits (deposits) and current balances of current accounts of individuals and legal entities.
The Bank examines the potential of existing markets to meet the demand for each currency in which it operates, and carefully examines any discrepancies between the maturities of foreign currencies from the point of view of liquidity management.
Liquidity planning and management
Liquidity planning and management is carried out by the Bank's Assets and Liabilities Management Committee (hereinafter BALMC).
The Accounting and Reporting Department and the Treasury Department analyze the balance sheet and off-balance sheet liabilities to calculate the Bank's liquidity ratios. The analysis determines the percentage of funds to be directed to the average daily and monthly liquid assets and submits them to BALMC for consideration. BALMC approves the interest rates on funds to be directed to liquid assets.
The Accounting and Reporting Department calculates the liquidity ratios separately for the consolidated balance sheets and currencies (AZN; EUR; USD; RUR, etc.) according to the interest rates of the funds to be directed to liquid assets.
In order to carry out medium-term liquidity planning, if necessary, the Accounting and Reporting Department draws up a timetable for the distribution of payment periods on the consolidated balance sheet and foreign currencies. The table divides assets and liabilities into relevant categories by maturity, reflecting the excess (deficit) of liquidity, allowing APIC to take action before a problem arises.
APIC decides on policies and limits on the basis of submitted reports and proposals, and these decisions reflect the tactical and strategic tasks to be implemented by the Bank's structural units.
In order to manage liquidity, APIC reviews relevant liquidity proposals (deposit attraction, sources of funds, geography of borrowed funds, etc.) based on the analysis of reports.
APIC takes into account the following in liquidity planning:
- The current state of liquidity;
- Historically demand for funds;
- Expected demand for funds in the future;
- Sources of funds;
- The cost of resources involved in banking operations;
- Asset quality;
- From what sources to attract or concentrate resources for banking operations;
- General condition of the bank, including the level of capital and profit;
- Unforeseen liabilities such as unused credit lines, letters of credit, lending liabilities or off-balance sheet liabilities such as the purchase of securities or foreign currency;
- Measures to be taken by management in case of emergency (in case of emergencies, for example, unfavorable market conditions in terms of liquidity, temporary financial difficulties of the bank, banking projects that cause an unusual flow of deposits in the bank).
- Economic environment.
Information obtained for liquidity management
In order to properly analyze the current liquidity activity and demand for funds of the Bank in the future, the relevant structural units (branches, divisions) of the Bank should provide the following information to the Accounting and Reporting Department and the Treasury Department:
- Information on the largest providers of funds, their areas of activity and the amount of funds collected in which geographical area, the date of receipt of funds, payment terms, interest rates;
- Allocation of maturities of assets and liabilities to identify key discrepancies;
- Historical changes in liquid assets and deposits;
- Current liquidity ratios and other liquidity ratios and changes in these indicators in the interim;
- Pledged assets;
- Off-balance sheet liabilities;
- Issuance of intended loans and other obligations;
- Return on assets and cost of various resources for banking operations;
- Economic situation, including key economic indicators and interest rate forecasts.
The ratio of the average daily value of the bank's liquid assets to the average daily value of current liabilities (current liquidity ratio) thousand. Maintains at the level of 30%.
The following is taken into account when determining the minimum amount of the bank's current liquid assets:
- Historically demand for liquid assets;
- Daily demand for liquid assets;
- Current demand for liquid assets;
- Changes in the financing structure;
- Economic environment;
APIC also monitors compliance with capital adequacy standards in carrying out active operations while awaiting the Bank's liquidity.
Interest rate risk
Interest rate risk is the probable loss of financial instruments and the economic value of a bank as a result of interest rate fluctuations. The reason for interest rate risk is the mismatch of the bank's requirements and liabilities on interest rates and change periods. As a result, there is a risk of revaluation of planned net interest income (flow) due to the determination of new unfavorable interest rates in accordance with the new market conditions. As a result, there is a risk of a decrease in the bank's interest margin and net interest income. Assessing the degree of exposure of the bank to interest rate risk and defining measures for its immunization consists of a set of systematic measures of both organizational and technological nature, which include:
- Scenario modeling of interest rate risks;
- Development of a software and hardware complex to determine the volume and time structure of the bank's current assets and liabilities;
- Volume-time structure evaluation system;
- Development of criteria for classification of financial instruments according to sensitivity to changes in interest rates;
- Measures to classify existing and previously concluded contracts according to their sensitivity to changes in interest rates and redefinition;
- Measures to determine the basic indicators of interest rates and determine the dependence of actual weighted interest rates on changes in base rates;
- Compilation of the scenario of the structure of assets and liabilities for the next year;
- Preparation of quarterly (other periodic if required) reports to assess the Bank's exposure to interest rate risks;
- Development of measures for immunization of interest rate risk by changing the structure of assets and liabilities;
- A set of ongoing measures to classify current financial instruments by sensitivity group.
Foreign exchange risk
To assess currency risk, the currency structure of assets and liabilities in the bank's foreign exchange balance is compared. Each currency with a significant share (5% of assets) in the bank's balance sheet is considered separately.
The main method of current control over currency risk is the calculation of open currency positions (MTC) in foreign currencies. At the end of each working day, the calculation of the official mall is carried out by the Accounting and Reporting Department. During the day, the mall is supervised by the bank's Treasury Department and Risk Management Department. Thus, when conducting transactions in foreign currency, the Treasury Department carries out current control over the mall in terms of allowing the limits and standards set for transactions. The Risk Management Department oversees the mall to study the impact of large transactions and new financial instruments on the currency position in terms of risk management and the possibility of changing the limits.
The mall is calculated as the difference between assets and liabilities in a given currency. A long position when the exchange rate falls causes potential losses to the bank. As the exchange rate rises, a short position has a negative impact on performance
The methodology for calculating the mall is carried out in accordance with the "Rules for determining and regulating the open currency position limits of the authorized banks of the Republic of Azerbaijan" of the Central Bank of the Republic of Azerbaijan.
For the Bank, the aggregate size of long and short currency positions in currencies that can be freely converted at the end of each business day in all currencies shall not exceed 20% of the Bank's special funds (capital) in accordance with the Rules set out in paragraph 2.4.
Long and short currency positions for each freely convertible currency are set up to 10% of the bank's special funds (capital). Long and short currency positions for each closed currency should not exceed 5% of the bank's special funds. The aggregate size of long and short currency positions on closed currencies should not exceed 7% of the bank's special funds (capital).
In order to meet the above-mentioned Central Bank's regulatory indicators, the bank may set a "signal" currency position rate. This “signal” currency position indicator must be at least 0.5% less than the Central Bank's normative indicator for long or short currency positions for individual currencies. The aggregate long or short currency position indicator for all currencies must be at least 1% less than the Central Bank's normative indicator. At the initiative of setting or changing the “limit” limits, the Treasury Department submits a proposal to the Risk Management Department, which, after studying the risk criteria, submits the proposal to the Risk Management Committee for discussion if there is no serious objection to return.
STRESS-TESTING IN "AFB BANK" OJSC
Sharp decline in gross domestic product (GDP)
In order to measure the resilience of AFB BANK to possible shocks in the financial markets, a stress test was conducted in the 4th quarter of 2010. The stress test was conducted to determine how the sharp decline in GDP scenario would affect the bank's balance sheet, profit and loss statement.
It should be noted that all statistical data used in the stress test were obtained from the website of the State Statistics Committee of the Republic of Azerbaijan (www.azstat.org).
The model used in the stress test:
- The structure of GDP and its industrial sectors for 2000-2010 is shown.
- There is a relationship between changes in GDP and changes in industrial sectors. This dependence is measured by a correlation coefficient. Based on this correlation coefficient, the extent to which the change in GDP affects the total volume of output produced during the year for each industrial sector is determined.
- The Bank groups its customers by the industrial sectors in which they operate, which distributes loans to customers by maturity.
- Criteria for the impact of the industrial shock on customer loans, their current accounts and deposit portfolios are determined.
- A new balance sheet is prepared on the basis of these criteria, and the GAP is calculated for the periods.
The stress test was based on the Bank's reports dated 30/11/2010. On that date, the Bank's loan portfolio amounted to 27,427,425 manat. Of this amount, 14,238,826 manat are loans to legal entities. The volume of targeted reserves allocated for loans was 2560 manat, the ratio to the loan portfolio was 0.009%. The amount of funds in the current accounts of legal entities was 10,100,075 manat, time deposits were 9,200,000 manat. The distribution of these funds by sectors and by time is shown in Annex 1.
Annex 2 shows the structure of GDP for 2000-2010 and its industrial sectors. The relationship between industrial sectors and GDP is calculated. On the basis of this correlation coefficient (correlation coefficient), the reduction rate of each industrial sector was determined, assuming that GDP will decrease by 15% in 2011.
In Annex 3, the impact of the reduction rate on each sector on loans to enterprises operating in these sectors, the volume of deposits attracted from them, and current accounts is measured on the basis of defined criteria. Annex 4 shows how the balance sheet items change in percentage after the shock. Based on the results obtained, we can say that as a result of the shock of a 15% decline in GDP, the Bank's loans to legal entities amounted to AZN 14,238,826, a decrease of 29.69% to AZN 10,978,806. The amount of targeted reserves allocated for loans will increase from 2,560 manat to 504,346 manat and will be 4.6% of the loan portfolio. This indicates that the quality of the loan portfolio will deteriorate sharply.
The amount of funds in the current accounts of legal entities will decrease by 26% from 10.1 million manat to 8 million manat. Term deposits will decrease by 18.26% to 7,520,000 manat.
When analyzing the difference between the assets and liabilities (GAP) over the period after the shock, we see that the shock will have a more negative impact on the Bank's liquidity in the medium term. Thus, while the pre-shock GAP was 1.6 million between 181 and 365 days, this amount will more than halve after the shock to 738,000 manat. In general, the Bank's liquidity will remain manageable (Appendix 5).
The Bank's interest income is calculated at the average interest rate for each income-generating asset type. Interest income, which was 1.836 million manat before the shock, will decrease by 12.52% after the shock to 1.606 million manat. However, interest expenses will be reduced by only 0.4%. This is due to low interest rates on borrowed funds (average 6%). Interest expenses, which were 1.432 million before the shock, will be 1.423 million manat after the shock. As a result, net interest income will decrease by 55% to 182,250 manat after the shock. (Appendix 6)
With a 15% decline in GDP, the Bank's loan portfolio will fall sharply by 29.69% and net interest income by 55%. The impact of the shock on interest expenses was negligible due to low interest rates on attracted deposits and other liabilities. While interest income declines sharply, a slight decrease in interest expenses results in a sharp decline in net interest income. To reduce these losses, it is necessary to diversify the loan and deposit portfolio by industrial sectors.
Credit risk is the risk of loss as a result of the inability of a borrower, issuer or counterparty to fulfill its obligations under the terms of the contract.
In order to manage credit risks, AFB Bank OJSC has developed a credit policy and is guided by this policy in the lending process. The main purpose of the Credit Policy is to determine the main directions of the Bank's lending activities, the principles of formation and management of the loan portfolio. Credit policy expresses the structure of funds raised for the implementation of the bank's operating strategy, the direction of placement of credit resources, diversification of the loan portfolio, prevention of cooperation with borrowers engaged in illegal activities and the bank's position on other lending activities.
Each employee of the bank's sales structure is obliged to establish its activities within the framework of the Credit Policy.
In addition to the normative legal acts of the MBNP and the CBA, the internationally accepted principles and standards of credit risk management and the recommendations of the Basel Committee on Banking Supervision are the main criteria for the management of credit risk and quality placement of loans.
The Bank's credit risk management is based on the following principles:
- "4 eyes" principle in lending;
- 6 “C” principles;
- Individual approach to the borrower;
- Portfolio diversification;
- Distribution of loan decision-making powers;
- Loan portfolio monitoring;
- Establishment of reserves to cover possible losses (MBNP, IFRS).
The following risk management methods are used to monitor credit risks:
- Stress-test models;
- Scenario analysis;
- Migration matrices;
- Vintage analysis;
- Expected Loss (EL): Probability of Bankruptcy (PL), Immediate Loss in Bankruptcy (LGD)
- Risk portfolio
In order to effectively manage credit risks, a report on the credit risks to which the bank is exposed is prepared by the structural unit of the bank performing the risk management function. The report provides information on the risks to which the bank is exposed on the bank's loan and investment portfolio, the adequacy of these risks to the bank's risk management strategy and policy, as well as the impact of the risks on the bank's capital. The report is prepared on a monthly basis and submitted to the bank's Supervisory Board, RIEC and the Management Board.
Operational risk is the risk arising from inadequate or unsuccessful internal processes, people, systems and extra-bank events. Operational risk relates to the Bank's operating activities and includes risks resulting in financial losses due to incompetence, inadequate supervision and carelessness.
- Identify operational risks
The Bank determines operational risks by at least the following methods:
- “Risk and Control Self-Assessment Inquiries” sent to the Bank's structural units;
- Conducting interviews with heads and employees of the Bank's structural units;
- Determining and reviewing operational risk limits;
- Monitor and analyze business processes;
- To monitor the violations of the "4 eyes" principle in operations;
- Reports submitted by the relevant structures of the Bank on a monthly basis;
- Analysis of deleted and corrected transactions, etc.
The Bank also uses the Risk and Control Self-Assessment model to identify and manage operational risks. This process is carried out twice a year with the participation of all structures of the bank.
The Risk Management Structure conducts interviews with the structural units and discusses the risk events that occur and the operational risks that are likely to occur.
The Risk Management Structure also provides a risk-based opinion on all existing and new rules, procedures, products and services within the bank.
- Operational risk measurement
The bank uses the database to measure operational risks.
A Loss Database has been established to measure operational risks. The Risk Management Structure collects information from structures through “Risk and Control Self-Assessment”, interviews, Help Desk requests, Audit Reports, Monitoring Acts, Employee and Customer Surveys, and other reports and sources. This framework is used to reduce operational risks and identify weaknesses in the Bank's oversight.
There are two approaches to measuring operational risks:
- Top-down approach
- Bottom-up approach
The top-down approach is used to measure operational risks without breaking them down into parts.
Key indicators approach
This approach is the simplest and most generalized method of measuring operational risks. The main indicator is the bank's income for the last 3 years. Thus, the average income of the Bank for the last three years (the year in which it operates at a loss is not taken into account in the calculation of both income and numbers) is multiplied by the coefficient α (alpha) to find the amount of operational risks of the bank. According to the Basel Committee, the coefficient α is 15%. The mathematical description of the calculation is shown below:
Here, GI is gross income, α = 15%, and n is the number of years the Bank has been profitable in the last three years. The coefficient α can be selected outside the standard depending on the risk position of the bank. Thus, the Bank's operational exposure is measured using this method.
The bottom-up approach model is based on the search for operational risks at the micro level between different business units of the bank. In this method, each intra-bank business process is monitored and reviewed step by step. In this case, the work processes of the bank are observed separately.
- Stress tests
A stress test is an analysis performed to assess the potential impact of events that have been previously observed within or outside the bank or that may potentially affect the bank's operations on the bank's financial condition. Stress tests are carried out on a regular basis by the Bank.
- Reducing operational risks
The bank has identified measures to reduce operational risks. The implementation of established measures, limits and restrictions is constantly monitored.
- Key operational indicators on operational risks
One method used to manage and monitor operational risks is to identify and periodically monitor Key Risk Indicators (KRI). For this purpose, the bank has identified key risk indicators for processes and structures. Key Risk indicators are monitored regularly.
- Operational risk reporting
The structures must complete the “Risk and Control Self-Assessment” questionnaire once a quarter and submit it to the Risk Management Structure.
In addition, the structural units of the bank must submit reports to the Risk Management Structure at the specified frequency and in the prescribed form.
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