4 - The Principles of Banking MSC Module Course

THE PRINCIPLES OF BANKING:
STRATEGY, CAPITAL AND ASSET-LIABILITY MANAGEMENT
©Frankfurt–School.de
Agenda
0. Introduction
1. A primer on bank business and balance-sheet risk
2. Bank regulatory capital
3. Banking and credit risk
4. A primer on securitisation
5. The yield curve
6. Asset–liability management I
7. Asset–liability management II
8. Asset–liability management III: Trading and hedging principles
9. Asset–liability management III: The ALCO
10. The ALCO: Terms of reference and treasury operating model
11. Risk reporting, risk policy and stress testing
12. Principles of bank liquidity management
13. Liquidity risk metrics
14. Liquidity risk reporting and stress testing
15. Internal funds transfer pricing policy
16. Bank strategy I: Formulating strategy and direction
17. Bank strategy II: Capital and funding management
18. Principles of Corporate Governance
19. Repetition and exam logistics
20. Appendix
2
Schedule
No Day Schedule Hall
0. Introduction 2 pm
1. A primer on bank business and balance-sheet risk 1 4/2/2015 – U1
6 pm
3. Banking and credit risk 10 am
2 6/2/2015 M1
– 2 pm
5. The yield curve
10 am
6. Asset–liability management I 3 13/2/2015 – M1
2 pm
10 am
9. Asset–liability management III: The ALCO 4 20/2/2015 – M1
2 pm
11. Risk reporting, risk policy and stress testing 5 27/2/2015
10 am
M1
– 2 pm
10 am
14. Liquidity risk reporting and stress testing 6 6/3/2015 – M1
2 pm
17. Bank strategy II: Capital and funding management 10 am
7 13/3/2015 – M1
18. Principles of Corporate Governance 2 pm

20. Appendix
3
Agenda
0. Introduction
5. The yield curve
20. Appendix
4
1. Introduction
• Assistant professor
• Research focus: Banking and banking regulation
• CV:
- 2011 — ... : Assistant professor at AU
- 2008 — 2011 :
Risk management consultant for banks
- 2005 — 2008:
Ph.D. (‘Quantitative Liquidity Models for Banks’)
- 2004 — 2005:
Prof. Dr. Christian Schmaltz
Risk management consultant for banks
Aarhus School of Business, - 1997 — 2004:
True North Institute MSc (Business Engineering), MA (Economics)
How to contact me:
Email: chsch@asb.dk • Teaching at AU:
Office: C-wing, C105 - Masters level:
Meeting: request appointment
via email
Portfolio Theory and Investment Analysis (Autumn)
Bank Management (Spring)
Trading in Financial Markets (Summer)
- Bachelor level:
International Corporate Finance (Autumn)
5
1. Introduction: What the course will offer
After the course, you should be able to ...

• know what banks “produce”
• understand what is special about banks (compared to other firms)
• know which risks they are taking
• assess their risks
• assess the market environment in which they operate
• know how banks are regulated
• whether this was your first and last deep dive into banks ...
... or whether you would like to dive even deeper (master thesis, internship, job).
6
1. Introduction: Relation to other courses
Background and relation to other courses
• The course starts with a overview of banks and their business models. We
summarise what makes banks special, but theory and proof you will find in John‘s
course (5420) “The Economics of Banking“.
• Banks “produce“ derivatives and use them to (i) speculate, (ii) hedge risks or (iii)
arbitrate. We don’t price derivatives. This is done in Thomas’ and Elisa’s courses
“Credit risk derivatives”, and “Interest rate derivatives”. A deeper view on how to
use derivatives is also offered in my the course “Trading in Financial Markets”.
• We mention regressions, correlations and other econometric concepts.

A detailled dicsussion is provided in Stigh’s “Financial econometrics I & II”.
7
1. Introduction: Literature
The main reference is Moorad’s book:

• Moorad Choudhry: The Principles of Banking, 2012, Wiley, 912 pages
• I have chosen it for its practical approach,

the presentation style, and its comprehensiveness.
• It tells you how banks operate and prepares you
for job interviews.
This text may be supplemented by notes, articles, and alternative book chapters
to cover research-relevant aspects.
8
1. Introduction: Course material and exam
The course material consists of:

• Slides
• Exercises
• Workbook.xls.
Will be uploaded when needed.
Exam
• The exam will be mainly exercise-based (style PTIA), i.e. you should do it in XLS and
submit the PDF-print out of it.
• Exam is scheduled for Thursday, 19 March 2015, 2pm — 5pm.
9
Agenda
0. Introduction
5. The yield curve
11.Risk reporting, risk policy and stress testing
20. Appendix
10
Agenda
0. Introduction
5. The yield curve
20. Appendix
11
Agenda
0. ...
A. An introduction to Banking
B. The capital markets
C. Banking business and capital
D. Financial statements and ratios
E. The money markets
F. Bank cash flows and other basic concepts
G. Risk exposures in Banking
H. Drivers of credit risk
I. Macro-level risk management and strategy
J. Product line
2. ...
12
1.A An introduction to banking
Why do banks exist?1
Bank Corporate
Assets Liabilities Assets Liabilities
Debt
Illiquid (mainly
Illiquid Liquid Machines, from
Loans deposits Products, banks)
Real estate
Liquid Liquid Capital

Capital
assets assets
• The role of banking in the economy involves the transformation of assets:
- in the maturity dimension, i.e. short liquid deposits into illiquid long loans
- in the credit dimension — monitoring loans
- in the volume dimension, i.e. Many small deposits into a some large loans
- producing customised derivatives
- produce liquidity reserves for households (demand deposits)
- take on financial risks and manage them.
• This enhances economic efficiency and welfare
... but at the cost of inherently unstable banks (bank run).
1) Slide partially based on Anders Grosen, 2014, Bank Management slides
13
1.A An introduction to banking
Where do banks sit in the macro economy?
1) Slide like in PTIA-slides.

14
1.A An introduction to banking: Products and their B/S, P&L and risk implications
Service or function Balance sheet Revenue generated Risk
Lending
Retail, commercial, mortgage, Assets Interest income, fees Credit, Market
project finance
Trade finance, credit cards Assets Interest income, fees Credit, Market, Operat.
Lending, Syndicated Assets Trading, interest income, fees Credit, Market
Cash management
Processing Asset [balance <0], Fees Operational
Liabilities [balance >0]
Payments Fees Credit, Operational
Custodians --------- Fees Credit, Operational
Private banking --------- Commission income, interest income, Operational
fees
Asset management ---------- Fees, performance payments Credit, Market,
Operational
Capital markets
M&A ---------- Fees
Corporate finance Aseets (if banks lends), Fees, interest income (if bank lends)
Trading (Equities, Foreign Assets (long, MV > 0) Trading income, fees Credit, Market,
exchange, Derivatives) Liabilities (short, MV < 0) Operational
Trading (Bonds) Assets (long), Liabilities (short) Trading income, interest income, fees
Depositing (Retail, Corporate, Liabilities Interest income Liquidity risk
Public sector, Inter-bank)
1) Based on Choudhry (2012), Table 1.1, p. 4

15
B
From products to balance sheet: Example Commerzbank
1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions
Borrowing (client’s view) Payment Investment (client’s view) Services & Extras
Loans / Overdraft Facility Current account (—) Saving Deposits Government Securities
Loans / Consumption Current account (+) Term Deposits / Saving certif. Investment funds
Loans / Car Certificates Investment funds Saving Plan
Loans /Credit Card Wealth Management
Mortgages / Fixed-rate Custody
Mortgages / Variable-rate Assets Liabilities
Mortgages / Pre-payment Option Other Claims Unsecured

Deposits
Mortgages / Rate Locker Mortgages from
(property- customers
Mortgages / Securitis. Blocker secured Securitised
loans) liabilities
16
B
Financing Cash Management Asset Management International Business Risk Management
Bank financing (loans, leases) Corporate account (—) Money market deposits Capital market financing
Promissory note bonds Corporate account (+) Term Deposits Advisory services
Export and trade finance Currencies Certificates Payment services
Bank’s own debt issuances Cash pooling
Bank’s own equity issuances Treasury management
Assets Liabilities Information management
Other Claims Unsecured Portals and frontends

Deposits
Mortgages from Money market funds
secured Securitised Third party securities
loans) liabilities
Promissory Custody
Equity
note loans
Trading Trading Company Pension Scheme
assets liabilities
Working time accounts
Payment services
Documentary business
Derivatives 17
17
B
Asset Mgt & Leasing Real Estate Finance Ship Finance Public Finance
Finance leases (real estate) Pfandbrief Investment funds
Operating leases Ship Pfandbrief
Real estate loans Public sector Pfandbrief
Ship loans Lettres de Gage Publiques
Unsecured loans Repo (spot sale)
RE / infrastructure loans Assets Liabilities
Other Claims Unsecured

Repo (spot purchase)
Deposits
Mortgages from
secured Securitised
loans) liabilities
Promissory
Equity
note loans
Trading Trading
assets liabilities
Secured
deposits
Other assets
from
customers
18
B
5. Money market trading 6. Liquidity management
Trade loans Correspondent banks (—) Repo (spot sale) Advisory services
Repo (spot purchase) Correspondent banks (+) UD from other banks Payment services
Deposits to other banks Currencies Funding liquidity reserve Cash pooling
Liquidity reserve
Assets Liabilities
Other Claims Unsecured

deposits from
Mortgages customers
(property-
secured Securitised
loans) liabilities
Promissory
Equity
note loans
Trading Trading
assets liabilities
Secured
deposits
Other assets
from
customers
UD from
Claims on banks
banks
SD from
banks
Cash reserve 19
B
5. Money market trading
Instruments Products Products Instruments

Assets Liabilities
• Cash, • Repo for clients • Inter-bank deposits
• Central bank deposits 1% Cash reserve • Inter-bank
Liabilities to • CD / CP
18% deposits for • Repo
• Inter-bank loans banks
Claims on clients • Central MRO
• CD / CP 15%
• Reverse notes banks
• Saving / demand
• Loans Liabilities to deposits
Claims on 35%
• Roll-overs 43% customers • Call money
customers
• Mortgages • Term deposits
• Positive FV deriv.
• Assets held for trading • Senior unsecured
Trading Securitised
purposes (bonds, 22% 17% • Covered bonds
assets liabilities
notes, shares, FX, • ABS / Securitisation
precious metals) Trading
20% • Negative FV deriv.
• Bonds and notes liabilities
not held for trading Financial Remaining
15% 3%
• Equity investments investments liabilities
• Participations Subordinated
2% • Subordinated (unsec.)
Remaining capital
2% Hybrid
assets 1% • Hybrids
capital
1% Other assets • Common equity
Equity 4%
• Retained earnings
• Irrevocable credit lines, guarantees
• Back-up liquidity lines (SPV)
• Collat. for downgrade Contingent liabilities
• Margin calls / repo haircuts 20
B
5. Money market trading
Assets Liabilities
Cash flows are central for liquidity 1% Cash reserve Liabilities to
management: 18%
Claims on banks
 Assets: generate inflows 15%
 Liabilities: generate outflows banks
Liabilities to
 Liquidity risk: 35%
customers
Liabilities are (usually) of shorter term than Claims on
43%
assets customers Securitised
17%
=> Outflows are of shorter term than inflows liabilities
=> Risk that outflows cannot be paid Trading Trading
22% 20%
assets liabilities
Financial Remaining
15% 3%
investments liabilities
Remaining Subordinated
2% 2%
assets capital
Hybrid
1%
1% Other assets capital
Equity 4%
Inflows CF+t Outflows CF-t
Liquidity Maturity Ladder

=
Basis for any
liquidity modelling
21
1.A An introduction to banking: Bank income statement1
61%
16%
15%
8% 54,664 mio dkk (Core operating income)
-
-
35% (on profit), 0.17% on total assets
29% corporate tax rate
1) Danske Bank, Annual report 2014, p. 65

22
B
1.B The capital markets
23
Borrowers Lenders
• Wish long-term • Wish liquid investments

investment horizon 1. Capital (that can be reconverted to
(plants, equipment, market cash on demand)
real estate, 20 x • Wishes low interest rate risk
annual salary) • Maximise return
• Borrower faces • (Relatively) small amounts
substantial disclosure
Direct 1:1 relation • Need to assess credit risk of
cost borrower
If borrower’s amount is
large enough that
justifies to issue a bond
that will be liquidly
traded
But if borrower’s amount is too small and /
or lenders are not expert in credit analysis
24
Borrowers Lenders
• Information disclosure • Must diversify a lot

is limited (such that 2. Crowd
lender can only funding
perform basic credit
assessment)
=> lender requires
substantial premium
Direct 1:n relation
=> loan will be more
expensive than at a
bank!
=> often attracts
borrowers that
couldn’t get a loan at a
bank
=> make premium
even more expensive
25
Borrowers Lenders
• Amounts > 50 mio 1. Capital • Lender must manage

• Disclosure cost market interest rate risk
• Expensive funding 2. Crowd • Lender must diversify a lot

source funding • High credit risk
3. Bank
Assets Liabilities
• Get (relatively) • Available on demand
cheap, customised, • (Usually) lower yield than
long-term funding Illiquid Liquid capital market
Loans deposits • No credit risk
(if insured deposits)
Liquid
Capital
assets
26
3. Bank
Mismatches
Assets Liabilities
10Y DKK term loan, 1 mio 3M EUR term deposit, 0.01 mio
10 years 3 months 1) Interest rate
maturity mismatch
10 years 3 months 2) Liquidity

maturity mismatch
DKK EUR 3) FX mismatch
Defaultable 1 € paid in => 1 € paid back 4) Credit mismatch

(PD = 1%, LGD = 50%)
1 mio 0.01 mio Amount mismatch
Liquidity reserve Capital Bank1 manages

(to cover unexpected outflows from (to absorb losses from IR-, FX-,
sudden deposit withdrawals) credit mismatches)
mismatch risks 1—4
1) More precisely, the Treasury unit within the bank manages these asset—liability mismatches (= ALM risks)
27
1.C Banking business and capital
Example
Jyske bank
Brørup Sparekasse Denmark
Merkur Cooperative Bank
Nykredit Realkredit A/S
Goldman Sachs
Islamic Bank International of Denmark
Freddie Mac
Danish Central Bank
Varengold
Berenberg Bank
BMW Bank Ltd.

LCH.ClearNet
1) Based on Choudhry (2012), Table 1.1, p. 4

28
One large German bank...
Deutsche Bank Group
1. Corporate and Investment Bank (CIB)

(Capital Market Business) 3. Corporate
2. Private Clients and Asset Management (PCAM) Investments
[institutions / public and supranational, private (CI)
sector entities (from small to large multinationals)]
1.2. Global
2.2. Private
Transaction
Business Clients
1.1. Corporate Banking & Banking (GTB)
2.1. Asset & Wealth Management [private
Securities (CB&S) [Financial
individuals /
Institutions /
SME]
Corproate Clients]
2.1.2. Private
1.1.1. 1.1.2. Wealth Mgt
Global Corporate 2.1.1. Asset Mgt [High net worth
Markets Finance individuals /
families]
Traditional
Pf Mgt, tax
Origination / Sales / Trading banking products: Industrial
[Institutionals] advisory,
of securities Trade finance, [Private CA / Deposits / shareholdings /
AM, alternative inheritance
Corporate advisory cash mgt, Clients] Loans / bank-occupied
assets, absolute planning,
M&A trust & securities Mutual Investment real estate
return strategies, philanthropic
Other corporate finance services business Funds products / assets / other
real estate AM advisory (art /
activities Business banking holdings
foundation)
services
Global Banking Example:

Art as a Component in Investment Portfolios
29
B
Performance measure of DB is “Pre-tax return on average active equity” (= RoE).
N/M
Traditional
Pf Mgt, tax
Origination / Sales / Trading banking products: Industrial
[Institutionals] advisory,
of securities Trade finance, [Private CA/ Deposits / shareholdings /
AM, alternative inheritance
Corporate advisory cash mgt, trust & Clients] Loans / bank-occupied
assets, absolute planning,
M&A securities services Mutual Investment real estate
return strategies, philanthropic
Other corporate finance business Funds products / assets / other
real estate AM advisory (art /
activities Business banking holdings
foundation)
services
30
B
Controlling is based on management reporting.
1. 2. Management Reporting (mainly IFRS)
Consolidated Consolidation
Statements &
of Income Adjustments1 Corporate Global Asset & Private & Non-core
(IFRS) Σ Banking & Transaction Wealth Business operations
Securities Banking Mgt Clients units
Net Interest Activities:

15,891 - Origination / Sales / Trading of securities
Income
- Corporate advisory
Non-Interest - M&A
17,850 - Other corporate finance activities
Income
Total
33,741 (978) 34,719 15,648 4,006 4,466 9,541 1,058
Net Revenues
Sales & Trading (debt & other products) 9181

Sales & Trading (equity) 2288
Origination (debt) 1417
Origination (equity) 518
Advisory 590
Loan products 1107
Other products 547
Total net revenues 15648
31
B
Statements &

15,891 - Trade finance
Income
- Cash mgt
Non-Interest - Trust & securities services business
17,850
Income
Total
33,741 (978) 34,719 15,648 4,006 4,466 9,541 1,058
Net Revenues
Transaction services 4006

Other products 0
32
B
Statements &
(A) Asset Management (AM):
Net Interest [Private Clients]: Mutual Funds
15,891
Income [Institutionals] Asset Management (AM), alternative assets, absolute return
strategies, real estate AM
Non-Interest (B) Wealth Management: Portfolio Mgt, tax advisory, inheritance planning,
17,850 philanthropic advisory (art / foundation)
Income
Total
33,741 (978) 34,719 15,648 4,006 4,466 9,541 1,058
Net Revenues
Discretionary Pf/ fund mgt 2108

Advisory/ brokerage 807
Credit products 411
Deposits and payment services 236
Other products 904
33
B
Statements &

15,891 - Traditional banking products: Current Accounts, Deposits, Loans,
Income
investment products, business banking services
Non-Interest
17,850
Income
Total
33,741 (978) 34,719 15,648 4,006 4,466 9,541 1,058
Net Revenues
Discretionary Pf/ fund mgt 213

Advisory/ brokerage 860
Credit products 2149
Deposits and payment services 2064
Other products 4255
34
B
Statements &

15,891 - Industrial shareholdings
Income
- bank-occupied real estate assets
Non-Interest - other holdings
17,850 - Internal bad bank
Income
Total
33,741 (978) 34,719 15,648 4,006 4,466 9,541 1,058
Net Revenues
35
B
RoE is based on accounting capital, RORAC on risk capital.
Statements &
Income (loss)
before income 784 (1,529) 2,313 2,874 669 160 1,524 (2,914)
taxes
Average
49,191 18,236 3,012 5,888 11,865 10,189
active equity
Pre-tax return
on average 2012 5% 16% 22% 3% 13% (29%)
(2011) (12%) (25%) (34%) (17%) (16%) (18%)
active equity2
Economic 11,783 1,437 2012 6,610 5,461

27,304
capital (41%) (5%) (7%) (23%) (19%)
RORAC 9% 25% 47% 8% 23% -53%
Target capital
14%
return
1: Adjustments are mainly needed due to the following reasons: (i) Economically hedged short-term positions are marked-to-market in Mgt
Reporting but accrual in IFRS, (ii) Hedging of net investments, (iii) Trading results in own shares: considered in divisional figures, excluded
under IFRS, (iv) Intra-group rental income: incorporated in divisional figures, excluded under IFRS. See AR 2012, p. 294ff. for details. 36
B
Risk capital distribution in DB (as of 31/12/2012).
Non-interest income Sum CIB Transaction AWM PBC Non-core

Total Net revenues 34719 15648 4006 4466 9541 1058
Provision for credit losses 1722 121 168 18 781 634
Total Non-interest expenses 30620 12637 3169 4288 7221 3305
Income (loss) before income taxes 2313 2874 669 160 1524 -2914
Average active equity 49190 18236 3012 5888 11865 10189
Economic capital per business line Consolid. & Ad
CR 44% 17% 5% 1% 13% 8%
MR 46% 14% 1% 5% 11% 10% 5%
OR 17% 7% 0% 2% 1% 7%
Div -15% -5% -1% -1% -2% -6%
BR 8% 8% 0% 0% 0% 0%
100% 41% 5% 7% 23% 19%
27303.95 11783.81 1437.05 2011.87 6610.43 5460.79

RAROC 8.47% 24% 47% 8% 23% -53%
1: Adjustments are mainly needed due to the following reasons: (i) Economically hedged short-term positions are marked-to-market in Mgt
Reporting but accrual in IFRS, (ii) Hedging of net investments, (iii) Trading results in own shares: considered in divisional figures, excluded
under IFRS, (iv) Intra-group rental income: incorporated in divisional figures, excluded under IFRS. See AR 2012, p. 294ff. for details. 37
B
• The most important (pure) business models are: retail bank, wholesale bank,
investment bank.
• However, there are also hybrid models where a bank has a retail, a wholesale and
an investment banking arm (e.g., Danske, Deutsche, Unicredit) => universal banks
Retail
bank
Universal bank
Whole
sale bank
Invest-
ment
bank
Asset
manager/
fund
38
Bank
Assets Liabilities
• Commercial banking products (loans, deposits, bonds that are
held to maturity (hedges / strategic investment)
• Valued at (initial cost) plus accrued interest
Banking Banking
(not valued at market prices, even if instrument had market
book book
prices)
• IFRS: “Held to maturity”
• Main source of the asset—liability mismatch risks
• Items that banks want (have) to trade (buy and sell)
=> often “churn” rule: to be sold ≤ 180 days)
• Result from market making, proprietary trading, flow trading
(for customers)
Trading book Trading book
• Daily valued at market-(mark-to-market) or model prices
(mark-to-model) if market prices are unavailable or not
credible because very illiquid instrument
• Often derivative instruments
Liquid • Note: Banking book and trading book exist on both balance
Capital sheet sides!
assets
39
Bank
Assets Liabilities
Banking
Banking book
book
Trading book Trading book
• Repayable (e.g. term of 8 years, 7% coupon)

Tier 2 • If bank performs poorly, coupons can be
suspended
Capital
Liquid • Repayable (e.g. term of 8 years, 9% coupon)

assets Additional • If bank performs poorly, coupons can be
Tier 1 (aT1) suspended and if bank risks to default, it can be
Tier 1 converted into CET1
Core Equity • Paid in capital and retained earnings

Tier 1 (CET1)
40
Bank
Assets Liabilities Core Equity Total
Tier 1 -
Tier 1 - capital
Banking ratio
Banking book ratio ratio
book
Trading book Trading book ≥ 4.5% ≥ 6% ≥ 8%
Tier 2 Tier 2
Capital
Liquid
assets Additional Additional Additional
Tier 1 (aT1) Tier 1 (aT1) Tier 1 (aT1)
Tier 1
Core Equity Core Equity Core Equity Core Equity
Tier 1 (CET1) Tier 1 (CET1) Tier 1 (CET1) Tier 1 (CET1)
RWA RWA RWA
41
1.D Financial statements and ratios
Typical bank balance sheet

Assets Liabilities
Cash Short-term liabilities
Loans Deposits
Financial instruments (long) Financial instruments (short)
Fixed assets Long-date debt
Off-balance sheet Equity
(receivables) Off-balance sheet (liabilities)
42
Typical bank income statement Danske1 Jyske1 Deutsche1

+ Net interest income 61% 61% 48%
+ Net fee income 16% 21% 40%
+ Trading income 15% 7% 12%
+ Other income 8% 11% 1%
= Core operating income
- Personnel, Other depreciations 49%1 53% 40%
- Loan loss provisions2 10%1 14% 7%
= Net operating income
+ Other non-operating income
= Profit before tax
- Tax
= Net income
- Minority interest
= (to shareholders) Attributable income
1) Based on Annual Reports 2013, 2) Relative to core operating income
43
Key performance ratios (first pages in their on Annual Reports 2014)

Danske Deutsche Santander
• Profitability (RoE):
Santander (5.42%), Danske (5.0%),
Deutsche (2.6%)
• Efficiency / Cost—Income ratio:
Santander (49.9%), Danske (60.9%)
Deutsche (89%)
44
1.E The money markets
• System of markets (German, UK, US, Japanese, CHF, ... Money markets)
• Up to 12 months (beyond 12M: capital market)
• Lenders: commercial banks, central banks, money market funds, insurance
companies, local authorities, corporations
• Borrowers: government, banks (again), corporations
• Products:
Governments: short-term issues (T-Bills, Bu-Bills, UK Gilts, ...)
Corporates: commercial papers (ON, ..., 1 year)
Banks: commercial papers, deposits (ON, ..., 1 year)
Central banks: regular tenders (1W, 1M) + exceptional tenders (e.g. §Y)
• EURO Money Market survey 2014 (Oct 2014):
45
B
• Characteristics of money market:

- Serves short-term needs
- MM rates serve as benchmarks (e.g. Euribor, Libor, EONIA, CIBOR, ...) for
products (e.g. variable leg of swaps are indexed to 3M- or 6M-_ibors, 90% of
Spanish mortgages are indexed to 12M-Euribor)
- Very deep markets (large volumes are tradable without impacting the price)
- Over-the-counter (OTC), i.e. not on an exchange, but via telephone,
computers
- Day count convention: often actual / 360 or actual / 365
46
B
• EURIBOR:
Reference rate for EUR-Forward Rate Agreements (FRAs), short-term interest
rate futures, and interest rate swaps
Each of the 25 panel banks (as of 4/2/2016) delivers a quote of the rate that
the bank believes is the one that a prime bank quotes to another prime bank
for inter-bank depositing for 1W, ..., 1Y.
(44) (25)
• Many banks have left the EURIBOR-panel
as they are afraid of legal issues / being
sued
• European commission on Libor rigging:
Deutsche: 633 m USD
Société Générale: 606 m USD
JPMorgan: 107 m USD
Citigroup: 95 m USD
...
47
Outstanding % EURIBOR
Asset class volume ($ BN) related % Callable % roll-of after x years
Level 1 Level 2 1 2 3 5 7 10 20 30
Loans Syndicated loans 535 90% 18% 45% 69% 89% 92% 93% 97% 100%
Corporate loans (bilateral) 4,322 60% 25% 42%
SME loans 1,518 60%
CRE/Commercial mortgages2 - 60%
Retail mortgages 5,073 28%
Consumer loans 800 Low
Other Loans to Households 1082 Low
Bonds Floating/Variable Rate Notes 2,645 70% 10% 23% 44% 59% 76% 81% 84% 87% 89%
Covered Bonds 2,557 23%
Securitisation1 RMBS 952 100% 63% 0% 0% 1% 1% 2% 2% 5% 32%
CMBS 107 100% 55% 4% 10% 16% 37% 53% 66% 76% 86%
ABS 197 91% 49% 3% 7% 13% 19% 27% 42% 63% 82%
CDO 165 78%
OTC derivatives IR Swaps 137,553 High 18% 33% 44% 62% 72% 81% 93% 98%
FRAs 25,559 High 90% 99% 100% 100% 100% 100% 100% 100%
IR Options 24,249 High 24% 38% 48% 62% 69% 75% 84% 85%
X-currency swaps 9,731 High 27% 44% 56% 72% 80% 86% 95% 99%
ETD IR Options 12,439 100% 95%
IR Futures 4,905 100% 95%
Deposits Retail deposits 8,102 Low 38% 88%
Corporate deposits Medium 65% 94%
2,336
SME deposits Medium
Mutual funds Money market funds TBC Indirect
Bank loan funds TBC Indirect

Non-financial Late payment terms
TBC TBC
contracts Discount rates
Global Domestic Only High >$1 TN Medium $100 BN>x>$1 TN Low <$100 BN
1. Roll-off rates in this draft represent contractual maturity, actual roll-off is expected to be significantly faster due to prepayment.
48
B
1.E The money markets (Bloomberg ticker: EUMM)
• Current challenge: (1) Excess liquidity

(2) Negative/ low interest rates (where to invest the liquidity?)
• Example:
German
Money
Market
49
1.F Bank cash flows and other basic concepts
• Capital and leverage:

- equity to absorb potential losses, i.e. most junior claim
- between 4% (leverage = 25) — 12.5% (leverage = 8) of total assets
(new regulatory requirement: leverage < 33.3, i.e. capital/ total assets ≥ 3%)
• Gap (or mismatch):
- interest rate gap:
difference in contractual interest maturity between assets and liabilities
- liquidity gap:
difference in contractual liquidity maturity between assets and liabilities
Example: 100 DKK mortgage, 10Y, with 12M Euribor interest rate:
interest maturity: 12M
liquidity maturity: 10Y
If funded with 100 DKK 12M fixed-rate term deposit
=> Interest rate gap: [0—12M]: 0 DKK, [1Y—10Y]: 0 DKK
=> Liquidity gap: [0—12M]: 0 DKK, [1Y—10Y]: 100 DKK
• Yield curve:
- Curve of yields across time: {maturity, yield}
- Shape of yield curve determines profit
- Movements of curve determine associated risk
50
• Liquidity:
- Liquidity risk results from liquidity gap [+ long-term loans, — short-term funding]
when (i) non-maturing deposits are unexpectedly withdrawn early
or (ii) term funding is not rolled over at maturity.
- The liquidity transformation naturally implies a liquidity risk.
• Risk management:
- Credit risk is a natural banking risk as banks promise depositors to repay each EUR
that has been deposited although these EURs are used to lend to borrowers that do
not always pay back the borrowed amount
- Understanding of credit risk of (i) individual customers and (ii) of all customers
together is essential.
- Equally important: loan origination standards
(i.e. rule who is accepted / declined a loan)
51
B
• Non-risk-adjusted performance measures:1
1) Choudhry (2012), p. 34
52
• Risk-adjusted performance measures:
1. RORAC: Return on risk-adjusted capital

Net revenues[€ ]
RORAC  [%]
Risk capital[€]
2. RAROC: Risk-adjusted return on capital

Net revenues - COE
RAROC 
Risk capital
target Risk-
Business Net RORAC Net RORAC adjusted RAROC
Unit Volume Risk Capital Revenues [%] Margin [%] Min Revenues return [%]
1 10000 250 200 2.00% 80.00% 100 100 40.00%
2 10000 400 200 2.00% 50.00% 160 40 10.00%
40%
3 4000 250 100 2.50% 40.00% 100 0 0.00%
4 20000 100 -50 -0.25% -50.00% 40 -90 -90.00%
Net rev Net rev Net rev Risk - adj. return
- Risk Cap  RORAC target Risk Capital
Volume Risk Cap
53
• Risk-adjusted performance measures:

• What exactly is “risk capital”? It is the amount of risk measures with regulatory
models (“regulatory capital”) or internal models (“economic capital”).
Net revenues
RORAC  [%]
Risk capital
Amount of Capital
Risk [p.a.]
to absorb potential risks
Risk Measure
• Same unit (e.g. in €),

Most Risk Capital  RORAC 
common
independent of instrument / risk measures
type / business line / etc. Net revenues [€]
• Same horizon as revenues 1.) Regulatory Models [%]
(e.g. p.a.) Regulatory capital [€]
• Same parameters:
(e.g. Confidence for VaR) Net revenues [€]
2.) Internal Risk Model [%]
• VaR is most common, but not Economic capital [€]
necessarily (see Exp. Shortfall)!!
Net revenues
Not used:
%
54
• Loan valuation
• Example:
Assets = 100 = Loan [1 year, x% loan rate]
Liabilities = 10 Equity + 90 Deposits [5% deposit rate]
RoEtarget= 10%
т = 20%
• Determine break-even loan rate x%:
10 
X  100  5%  90 (1  0.2)
1  10%

95%  1  X  (1  0.2)  5%  40%  0.2  60%  100  (1  5%  (1  0.2))  90
(1  10%) 2
 x %  7.35% p.a.
2
E CFt 
Equity0  
t 1 (1  RoE )t
• Remark: If the loan officer sets a rate > x%, (s)he generates shareholder value. If
the loan officer receives a bonus linked to the shareholder value that s/he has
generated, the bonus function would be bonus : = max(loan rate — x%, 0%).
55
B
• Loan loss provisions1
Net loan value :

100  0.95  (1  7.35%  (1 - 0.2))  0.05  (0.4  0.6  0.2) 
1.1
90  (1  5%  (1  0.2))

1.1
 8.72
Loan Loss Provision s (LLP)  10  8.72  1.28
Interest margin after tax :
(1 - 0.2)  7.35%  100 - 5%  90
 2.28
Attributab le income :
 2.28 - 1.28
 1.00
1) Choudhry (2012), p. 38
56
• Capital requirements1
• Banks are free to choose their capital level as long as it is above the regulatory
minimum
• Regulators require banks to hold a minimum of capital
Additional Tier 1 (aT1)
Additional Tier 1 (aT1)
Core Equity Tier 1 (CET1)
≥ 4.5% ≥ 6.0% ≥ 8.0%

RWACredit Risk
+ RWAMarket Risk CET1- T1- TC-
+ RWAOperational Risk ratio ratio ratio
1) Choudhry (2012), p. 38
57
1.G Risk exposures in banking
• Credit risk
- Default risk (borrower defaults) and migration risk (borrower’s credit worthiness
deteriorates, but borrower still does not default)
- Parameters:
PD: probability of default, LGD: loss given default, EaD: exposure at default
- Credit portfolio models:
Describes portfolio loss distribution, i.e. taking into account diversification
• Market risk:
- Potential losses resulting from movements of market prices like interest rates,
credit spreads, FX-rates, stock prices, and commodity prices
- Reinvestment risk: payments before investor’s horizon such that proceeds need to
be (re-)invested => rate unknown => risk
- Pre-payment risk: unexpected early (partial or full) repayments of mortgages
- Model risk: arises if (i) instruments are priced with a model (if non-observable
market prices) or (ii) risk is measured
Model risk increases with complexity, number of assumptions, shortage of data
• Liquidity risk
- Funding / Roll-over risk: risk of not being able to roll-over funding
- Market liquidity risk: unable to sell an instrument quickly without large discount
58
1.G Risk exposures in banking
• Credit risk: ...

• Market risk: ...
• Liquidity risk: ...
• Operational risk
Potential losses arising from ‘running the bank’, i.e. from internal or external fraud,
system failure, breaking law, selling wrong product to customers, accidents, ethics,
discrimination
Not specific to banks: any firm is exposed to operational risk
• Country risk:
Any risk of the host country (crisis, political turmoil, ...)
• Risk management function:

- independent from front office (i.e. units that make profit out of risk taking)
- reporting to CRO (business independent board member)
- monitoring separation between front, middle and back office
- reporting of limit usage
- communicating risks and risk strategy to shareholders
59
B
1.H Drivers of credit risk
1. Credit risk exposure Cash instruments: (Face) value, market

notional (face) value value: observable
Derivative instruments: Potential future
current mark-to-market + exposure: model-based
potential future exposure
2. Credit risk drivers Probability of default Internal estimates
(PD) From external ratings
From CDS spreads or
corporate bond yields
Credit rating migration (Historical) migration
matrices
Recovery rate Regression models for
(= 1 – LGD) different collateral types
3. Default correlation Do defaults occur Historical estimates
together? Expert judgement
1) Choudhry (2012), p. 47
60
B
1.I Macro-level risk management and strategy
• Board of directors approves risk strategy and sets risk appetite

Risk appetite statement = document with upper limits on risk exposures per country,
per sector (more granular limits: set by operating business units),
concentration limits
Board sets:
(lower) limits for capital ratios, leverage ratios
upper limits for funding gaps and wholesale funding volumes
• Limit system ensures that the ability to take on risks is limited
• Target return rates:
Board sets target rates per business line (should be sustainable across the cycle)
Can set different RoE across business lines (because funding costs are different)
Risk-adjusted return limits (e.g. RAROC-limits)
• Dynamic risk management:
continuous re-assessment for transactions whether still profitable even under
changed environmental factors
61
B
• Centralised risk management1

• ALM-desk within
Treasury
• Banks global
interest risk and
liquidity risk
• Business lines
originate risks,
but do not keep
them, but
transfer / sell them
to ALM-desk
=> risk-free margin
in business unit
• Maximal netting in
globalised setup
1) Choudhry (2012), p. 56
62
• ALM and ALCO1

• ALM-desk manages
IR, FX and L’y risk
• Strategic oversight:
in ALCO
• ALM tasks:
- Defines current
A&M-mix
- Hedging policy for
all asset classes
- Definition of risk
measures
- Reporting and limits
of risk measures
• ALM desk can be cost
entre centre (small
banks) or profit
centres (large banks)
• Group ALCO in
large banks
1) Choudhry (2012), p. 57
63
B
1.J Product line
• Non-interest bearing accounts

• Demand deposits
• Term deposits
• Certificates of Deposits
• Commercial papers
• Asset-backed Commercial Paper
• Foreign exchange
• Government bonds
• Floating rate notes
• Repos
• Letters of credit
• Structured deposits
• Liquidity facilities
• Syndicated loans
64
Agenda
0. Introduction
5. The yield curve
20. Appendix
65
Agenda
0. ...
A. Definition of ‘regulatory’ capital and timeline
B. Basel I
C. Basel II
D. Basel III (Europe: CRR)
3. ...
66
2.A Definition of ‘regulatory’ capital
• ‘Regulatory’ capital is the minimum amount of capital that a bank must hold (for an
individual deal or for the whole bank) according to the regulator
• Example (Basel I, 1988—2007):
Risk Amount Bank
weights EUR Assets Liabilities
Residential
50% 100
mortgages Liquid
Corporate deposits
100% 100
loan
Liquid Capital
0% 100 assets (CET1 +
(T-Bill) aT1 + T2)
• 8% * (50%*8%*100 + 100%*8%*100+0%*8%*100)*12.5 ≤ Capital  8% ≤ Capital/ RWA
Risk-weighted assets (RWA)
Regulatory capital
67
2.A Timeline: From Basel I to Basel II to Basel III
Past Present
National Implementation European Implem.
Basel I Basel II Basel 2.5 Basel III
(1988 — 2007) (2007 — currently) (2012— currently) ([2013, 2018] — …)
International Market Risk International Convergence Revisions to the Strengthening

convergence of Amendment of Capital Measurement market risk resilience of the
capital (bcbs 24) and Capital Standards framework banking sector
measurement (bcbs 128) (bcbs 157) (bcbs 164)
and capital
standards 3 Pillar concept
(bcbsc 111) 1. 2. 3. 1 1
Market
Market Market
risk1
Supervisory review
risk risk
Market discipline
Minimum capital
Regulatory risk
measurement
requirements
Credit Credit
risk, Credit risk1
risk
IRBA
Op.
risk
Leverage Ratio
Liquidity risk1
…
1) Regulatory risk model can be either regulatory models (“standardised approaches”) or internal models with specific
regulatory (minimum) requirements (confidence levels, data history, etc.).
68
Agenda
0. ...
B. Basel I
C. Basel II
3. ...
69
2.B Basel I
• Basel I assigns risk weights to asset classes.

• Basel I only covers credit risk (from 1988 onwards) and market risk (from 1996
onwards).
• Within an asset class, all obligors receive the same risk weight, no matter how risky
an obligor is. Therefore, Basel I is almost a flat capital requirement, i.e. hardly risk-
sensitive.
• Example:1
1) Choudhry (2012), p. 84
70
Agenda
0. ...
B. Basel I
C. Basel II
3. ...
71
Hier weiter B
2.C Basel II: Model overview (1/2)
Net revenues Net revenues - COE Regulatory capital

RORAC  [%] RAROC  [%] Risk capital  
Risk capital Risk capital  Economic capital
2 Risk Capital
Market Risk Credit Risk
Comm-
Approaches IR EQ FX Others1 Approaches PD LGD EaD
odities
Standardised IR-risk EQ-risk FX-risk CO-risk Spec.

Approach model model model model models Standard. External
External
1. Regulatory Foundation
Capital Internal
Internal VaR [99%,10d]
IRBA Advanced Internal
Model2,3 ΔP&L = sensitivities * Δ risk factors
Aggregation RWA = LossVasicek[99.9%,1Y]
Simulation of risk factors

(credit, market, ...)
2. Economic Internal VaR [pbank-specific,1y] Credit Risk

Capital Model ΔP&L = sensitivities * Δ risk factors Models PD LGD EaD
CVaR= Loss distrib. [1y,pbanksp.]

1: Others: weather / electricity derivatives
2: “Internal model” in regulatory section is the internal model with regulatory-defined {horizon, confidence level}. Step can be left out by
3: DB, AR 2008, p. 95 : “We calculate value-at-risk for both internal and regulatory reporting using a 99% confidence directly simulating the
level. For internal reporting, we use a holding period of one day. For regulatory reporting, the holding period is ten days. loss.
„
only positions in regulatory trading book
72
B
2.C Basel II: Model overview (2/2)
Net revenues Net revenues - COE Regulatory capital

RORAC  [%] RAROC  [%] Risk capital  
Risk capital Risk capital  Economic capital
2 Risk Capital
Market Credit
Operational Risk Business Risk Risk Diversification
Risk Risk
Basic Indicator
... ... Basic
Approach
1. Regulatory Gross-Income
Capital Standardised
Approach
... ...
Advanced VaR[99.9%, 1y]
2. Economic Regulatory Model Aggregation

... ... VaR[pbankspec., 1y]
Capital (if VaR: scaled if not 99.9%) Model
73
2.C Basel II: Only IR risk and equity market risk in the trading book are
considered. Therefore, a distinction in trading and banking book is necessary.
3 Pillar concept
1 2 3
Assets Liabilities
(i) Banking book
(ii) Trading book

(i) Banking book
(i) Banking book
(ii) Trading book
(ii) Trading book
Equity
Other assets
74
2.C Basel II: Tier 3 capital is still eligible under Basel II (under Basel III not anymore).
3 Pillar concept
1 2 3
Assets Liabilities
(i) Banking book
Deposits (ii) Trading book
Loans
Securitised
liabilities
Tradeable
liabilities
Tradeable assets Others
Tier 3
Ly Reserve Equity Tier 2
add Tier 1
Other assets
CE
1: Have more equity than debt character (e.g. Preferred stocks), 2: Germany: only TCR has to be reported. 3: Basel III figures as of 1/1/2019.
75
2.C Basel II: There are only two capital ratios (Tier 1 and total capital ratio).
3 Pillar concept
1 2 3
Assets Liabilities
(i) Banking book
1. Credit Risk (CR)
Loans
Securitised
liabilities
2. MR
Tradeable
liabilities
2. MR
Tier 3
Ly Reserve Equity Tier 2
addTier 1
Other assets
CE
1. Credit Risk St’ed Appr. RW1 (regul. segment, ext. rating) x 8%

RWACR x EaDEx-/ Internal
(CR) IRBA K (PDInternal, R, ...)* LGDEx-/Internal
2. Market Risk St’ed Appr. RW1 (regul. segment, instrument characteristics)

RWAMR mc 60 x 12.5
(MR) Internal %, 10 d  max{VaR10,1%, t 1 ;
VaR99Internal   VaR10,1%, t i },3  mc  4
60 i 1
3. Operational Basic / St’ed Risk weight (regulatory segment) x Gross income

RWAOpR
Risk (OpR) Internal .9%,1Y  VaR( severity, frequency)
VaR99AMA
1: RW: risk weight
76
2.C Basel II: There are only two capital ratios (Tier 1 and total capital ratio).
3 Pillar concept
1 2 3
Assets Liabilities
(i) Banking book
1. Credit Risk (CR)
Loans
Securitised
liabilities
To be reported quarterly to regulator
2. MR
Tradeable
liabilities (e.g. FSA)
2. MR
Tier 3 Tier 3
Ly Reserve Equity Tier 2 Tier 2
addTier 1 Tier 1 - Tier 1 -
Other assets
CE CE ! Capital ! Capital !
1. Credit Risk
RWACR
≥ 2% 1 ≥ 4%1 ≥ 8%1
(CR) (4.5% ) (6% ) (8% )
RWAbank RWAbank RWAbank
+
2. Market Risk Total
RWAMR CE-capital Tier 1
(MR) Capital
ratio ratio
+ Ratio
3. Operational Analysts / Rating
RWAOpR Regulatory Capital Adequacy
Risk (OpR) agencies
1) In parentheses: Basel III / CRR – minimum thresholds

77
2.C Basel II: Model overview
2 Risk Capital
Comm-
odities

External
Capital Internal


CVaR = Loss distrib. [1y,pbanksp.]
1: Others: weather / electricity derivatives Step can be left out by

2: “Internal model” in regulatory section is the internal model with regulatory-defined {horizon, confidence level}. directly simulating the
3: DB, AR 2008, p. 95 : “We calculate value-at-risk for both internal and regulatory reporting using a 99% confidence
loss.
level. For internal reporting, we use a holding period of one day. For regulatory reporting, the holding period is ten days.”
78
2.C Basel II: Credit Risk / Standardised Approach
IRBA:
CRSA:
- Based on internal ratings
- Based on external ratings (except: securitisations)
- Supervisory risk weights
- Individually calculated risk
- No specific minimal weights
requirements
- Minimal requirements
- No permission needed
- Permission /approval required
79
2.C Basel II: Credit Risk / Standardised Approach / Risk weights
Risk-weighted assets: RW * 8% * EaD * 12.5

(For comparison: RW=100%  Basel I) Capital charge
1. Risk-sensitive (different to Basel I):

Class
External Unrated
Borrower segment AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- B+ to B- Less than B-
Rating
Central governments
Financials
Covered bonds
short-term
Corporates long-term
Multi-lateral development banks
Mutual funds shares
Analog to I
Regional governments / Analog to I Other public entities Other positions
and II,
local administrations and II
else 100%
2. Not risk-sensitive (same as in Basel I):

International organisations Residential mortgage Cash
Retail Past due items

Commercial mortgage
Participations Loans to property savers Tangible assets
80
2.C Basel II: Credit Risk / Standardised Approach / Examples

Capital charge
Class
External Unrated
Rating
short-term
Retail
Retail 75% Capital charge
12.00€
Residential mortgage
Retail 35%
8.00€ 8.00€
MB Bank AG
4.00€
Corporate 1.60€
100 Loan,
External Lia- 20% * 8% * 100 = 1.60 EUR
Rating: AA bilities
Capital charge AAA
to
A+
to
BBB+
to
BB+
to
B+
to <B-
Other NR
AA- A- BBB- BB- B-
assets
MB Bank AG
Capital charge
Retail
100 Loan
Lia- 75% * 8% * 100 = 6.00 EUR
6.00€
Any score bilities

Capital charge
Other
assets score
81
2.C Basel II: Credit Risk / Standardised Approach / Examples

Capital charge
Class
External Unrated
Rating
short-term
Retail
Retail 75% Capital charge
12.00€
Residential mortgage
Retail 35%
8.00€ 8.00€
MB Bank AG
4.00€
Corporate 1.60€
100 Loan,
External Lia- 100% * 8% * 100 = 8.00 EUR
Rating: BB+ bilities
Capital charge AAA
to
A+
to
BBB+
to
BB+
to
B+
to <B-
Other NR
AA- A- BBB- BB- B-
assets
MB Bank AG
Capital charge
Retail
100 Mortgage
Lia- 35% * 8% * 100 = 2.80 EUR
6.00€
Any score bilities 2.80€

Capital charge
Other
assets score
82
B
Basel II
Required credit risk capital
Credit quality weight (CRW) of the Amount of credit equivalence depends on:
borrower Structure of the contract,
x 8% x
CRW depends on: borrower (Remaining) term, Collateral
segment, score, etc. Netting agreements
Basel I 100% x 8% TA1
Basel II / Standardised Appr. CRW (regul. segment, ext. rating) x 8% * EaD * 12.5
Solv-D IRBA K (PD, R, ...)* LGD
Unexpected loss (Capital)

Risk-weighted assets
1) TA : Total assets
83
Basel II
Basel I 100% x 8%
Basel II / Standardised Appr. CRW (regul. segment, ext. rating) x 8% * EaD * 12.5
• Solv-D
…
IRBA K (PD, R, ...)* LGD
Basel I
Loan
x 100% x 8% = 80.0 million
(e.g. 1,000 Solvency
million) 0%
Basel II / Credit Risk Standardised Approach (CRSA)

120.0 million
100% 80.0 million
Loan x x 8% = 40.0 million
(e.g. 1,000
million) 0% 16.0 million
Solvency
Rating
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Internal Ratings-based
Approach (IRBA)
200%
202.0 million
Loan x 100% x 8% =
(e.g. 1,000
million) 0% Solvency 12.0 million
PD
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
84
2 Risk Capital
Comm-
odities

External
Capital Internal


CVaR = Loss distrib. [1y,pbanksp.]

loss.
85
2.C Basel II: Credit risk / Internal rating based approaches
1. Risk drivers 2. Risk weighting formula 3. Minimum requirements
• PD = Probability of
Default • Defines, how the risk • Minimum standards,
• EaD = Exposure at components are which have to be
Default converted into risk- complied with
• LGD = Loss Given weighted assets appliance of the IRB
Default • Based upon credit risk Approach by a bank
• M = Maturity model • Dependant on the
• AS = Annual Sales (the so-called “Gordy- exposure class and the
• In part, compute its Model”) selected approach
own estimates, in part,
given by supervision; • Dependant on the (Foundation Approach
which components have exposure class and the vs. Advanced Approach)
to be estimated, selected approach
depends on the
exposure class and the (Foundation Approach
selected approach vs. Advanced Approach)
(Foundation Approach
vs. Advanced Approach)
86
Loss probability
Loan
100
LGD = 45%
100
0
45% Loss 55% Recovery (“No Loss”)
(= LGD ) (= 1-LGD )
Expected Unexpected
Loss Loss
Loan rate Capital Uncovered
Maximum loss in 99.9%
of cases
87
Loss probability
Assets Liabilities
Retail loan Deposits

100 PD = 1%
LGD = 45% Other liabilities
Others Other Equity

Ly Reserve assets
100
0
45% Loss 55% Recovery
(= LGD ) (= 1-LGD )
Expected Unexpected EL  PD * LGD  1% * 45%  0.45%

Loss Loss  1 (PD)  R  1 (99.9%) [ x] : NormsDist ( x)
q99.9%, Re tail  [ ]  LGD
0.45% 1- R  1 (x) : NormsInv(x )
44.55% 1 1
 (1%)  15% (99.9%)
LGD*PD  [ ]  45%
4.96% 1 - 15%
q99.9%  4.96%
Loan rate Capital Uncovered Capital  q99.9%, retail  EL  4.51%
88
Loss probability
0 Expected q99% Loss given default Recovery 100

loss (LGD)
Margin Capital Uncovered
 1 (PD)  R 1 (99.9%)

PD LGD Capital  [ [ ] - PD]  LGD
1- R
 1 (PD)  R  1 (99.9%)
[ ]  LGD
1- R
89
1  e 35PD 1  (1  e 35PD )
R  3%   16%  , 3%  R  16%
Retail, 1  e 35 1  e 35
Non-mortgage  1 ( PD)  R  1 (99.9%)
K  [[ ]  PD]
1 R
TAS  5
1  e 50PD 1  (1  e 50PD ) 4%  (1  ) SME1 8%...12%  R  20%...24% ,
R  12%  50
 24%  50
 45
1 e 1 e  0 Non-SME ATS  5m€ ...50m€
b  (11.852%  5.478%  ln( PD)) 2
Corporates Maturity
M  min( 5Y , max( 1Y , Duration )) Adjustment
1  ( M  2.5)b 
8%
1 ( PD)  R 1 (99.9%) , SME CRR-SME-multiplier
K  [[ ]  PD]  [ ]  10.5%
1 R 1  1.5b  1, Non  SME CRR, Article 501(1)
1 LGDRe gulatory IRBA-Foundation [45%: first, 75%: subordinated, 12.5%: lien)]

Risk weight RW int ernal
 K  Internal
8%  LGD IRBA-Advanced
Required capital Required capital  EaD  RW internal  8% (Note : Standardis ed Approach : RW external (segment, external rating ))
Risk-weighted
RWA Credit risk  12.5  Required capital
assets
Capital Tier 1  Tier 2  Tier 3
Total Capital Ratio TCR 
RWA Credit risk  RWA Market risk  RWA Operational risk
1)SME  Firms with group total annual sales (TAS) of ≤ 50 Mio. EUR are entitled to a capital relief.
Firms with TAS < 5 Mio. EUR are set to 5 Mio. EUR. 90
TAS  5
1  e 50PD 1  (1  e 50PD ) 4%  (1  ) SME1 8%...12%  R  20%...24% ,
R  12%  50
 24%  50
 45
1 e 1 e  0 Non-SME ATS  5m€ ...50m€
b  (11.852%  5.478%  ln( PD)) 2
Maturity
M  min( 5Y , max( 1Y , Duration )) Adjustment
1  ( M  2.5)b 
8%
1 ( PD)  R 1 (99.9%) , SME CRR-SME-multiplier
K  [[ ]  PD]  [ ]  10.5%
1 R 1  1.5b  1, Non  SME CRR, Article 501(1)
Without CRR-SME-multiplier Without CRR-SME-multiplier

Corporates
1)SME  Firms with group total annual sales (TAS) of ≤ 50 Mio. EUR are entitled to a capital relief.
Firms with TAS < 5 Mio. EUR are set to 5 Mio. EUR. 91
Market Credit
Operational Risk Business Risk Risk Diversification
Risk Risk
Basic Indicator
... ... 1.a. Basic
Approach
1. Regulatory 1.b1, 1.b2 Gross-Income

Capital Standardised Approach
... ...
1.c Advanced VaR[99.9%, 1y]
2. Economic Proprietory Model Aggregation

... ... VaR[99.9%, 1y]
Capital (if VaR: scaled if not 99.9%) Model
92
2.C Basel II: Credit risk / Operational risk
1. Internal risk measurement can also use regulatory models.

2. The majority of regulatory models has qualitative minimum requirements.
3. AMA has minimum requirements from (TSA, ASA) plus some more.
2. Internal (Economic capital)

Characteristics 1. Regulatory (RWA)
Use the regulatory model Use something else
(1.a) Basic Indicator Approach (BAI)
(1.b1) Traditional Standardised Approach (TSA) (2.a) Use different

Use accounting figures
accounting figures
(1.b2) Alternative Standardised Approach (ASA)
(2.b) AMA, Bank-quantile

Use actual operational losses and (e.g. DB: 99.98%)
(1.c) Advanced Measurement Approach (AMA), 99.9%
statistical methods
(2.c) Use something
completely different
93
94
Net interest Income
+ Net Non-interest Income
+ Net profit / loss on financial operations (incl. trading book reval.)
Business line Gross income1 OpRisk Factor Capital
(1.a) BAI Bank GI 15% CapBank
B1: Corporate Finance GI1 18% Cap1
B2: Trading & Sales GI2 18% Cap2
B3: Retail Banking GI3 12% Cap3
B4: Commercial Banking GI4 15% Cap4
(1.b1) TSA B5: Payment and Settlement GI5 18% Cap5
B6: Agency Services GI6 15% Cap6
B7: Asset Management GI7 12% Cap7
B8: Retail Brokerage GI8 12% Cap8
CapBank
Business line Vol Margin OpRisk Factor Capital

B3: Retail Banking Vol3 3.50% 12% CapASA3
B4: Commercial Banking Vol4 3.50% 15% CapASA4

(1.b2) ASA
Rest: like TSA CapRest
CapASA,Bank
1) Average of positive gross income of last 3 years

95
Example: capital charge under 1.a Basic Indicator Approach:

1. Calculate the OpRisk VaR given the following information:
Operational Risk
OpRisk factor 15%
Retail Exposure 50,000,000,000
Retail Margin 0.80%
Wholesale Exposure 10,000,000
Wholesale Margin 0.50%
OpVaR  OpRisk Fa ctor  Gross Income

 15%  [0.80%  50,000,00,000  0.50%  10,000,000]
 60,007,500 EUR
96
Agenda
0. ...
B. Basel I
C. Basel II
3. ...
97
2. Bank regulatory capital, 2.D Basel III (Europe CRR): Regulation at a glance
Pillar 1 (CRR) Pillar 2 (National law) Pillar 3 (CRR)
• Finance department: regulatory reporting • Sound risk mgt processes, methods, • Disclosure
• Treasury: ensure compliance systems, governance => www....
• Regulatory capital and liquidity adequacy: • Internal capital and liquidity adequacy:
• RWA: only credit, market and operational risk • Risk-bearing capacity /
• External models (std’ed approach) or approved internal models Internal capital adequacy
Core Equity Core Equity Tier 1 All available financial resources

≥ 4.5% + 2.5% + x%1 + y%2 ≥ 100%
Tier 1 - ratio RWACR + RWAMR + RWAOpR VaRGroup
+ additional Tier 1 Aggregation

Tier 1 Core Equity Tier 1
ratio ≥ 6% + 2.5% + x%1 + y%2 VaRCR + VaRMR + VaROpR + VaRBusiness + ...
RWACR + RWAMR + RWAOpR
• Own capital definition
• Internal models (models do not need
+ Tier 2 capital Wording: Regulatory approval from regulator)
Total capital + additional Tier 1 capital, 99% - 99.9% • Diversification effects possible
ratio Core Equity Tier 1 (aggregation)
≥ 8% + 2.5% + x%1 + y%2
RWACR + RWAMR + RWAOpR • Wording: Economic capital, 99.9x%
+ additional Tier 1
Leverage Core Equity Tier 1
1.1. 2018
ratio ≥ 3%
Total assets + z%*OBS4
Liquidity Liquidity buffer • Internal models for cash flows
Coverage ≥ 100%3 • For risk management and planning
ratio Outflows — Inflows • Internal stress tests
Net Stable Long-term funding
Funding 1.1. 2018 ≥ 100%
ratio Long-term investments
Quarterly reporting (except of LCR: monthly): ratios + components Reporting of addit. data, no fixed thresholds
1) x% : buffer for systemically important financial institutions (SIFI), 1% ̶ 3.5% 4) OBS: Off-Balance sheet items
2) y% : countercyclical buffer for slowing down lending, 0% ̶ 2.5% 98
3) Gradual compliance: 2015: ≥60%, 2016: ≥70%, 2017: ≥80%, 2018: ≥90%, 2019: ≥100%
2.D Basel III (Europe: CRR)
Although tightly regulated by Basel II, global regulators identified 7 major vulnerabilities (2 ̶ 7).
2 Event risks (Defaults, Migration) of credit Micro level:

derivatives and securitisations in trading book strengthening
3
Level and quality of capital basis diminished individual
4
institutions in
Systemic counterparty risks materialised:
• Large (interbank loans / deposits AND OTC periods of stress
derivatives) and opaque (OTC)
interconnectedness of institutions
Crisis’s • Migration risk in counterparty credit risk for OTC
Actions
main transactions ignored so far in capital ratio
on two
drivers levels
5
Excessive leverage and procyclical deleveraging
6a Transmission of shocks through the cycle

Macro level:
(procyclicality)
6b Failure of large banks (e.g. Lehman) threatened
addressing system
the global banking system wide risks and
(global systemically important banks)
amplification
7
Insufficient liquidity buffers effects
99
2.D Basel III (Europe: CRR): Overview
Basel III and CRR ( Basel II )

Pillar 1 (Minimum standards)
Basel 2.5
2
Market risk
3 CapitalCore Tier1
(bcbs 193)
1. Core Equity Tier1 Ratio ≥ 4.5%
12.5*( KCR + VaROpR + VaRMR + sVaRMR + IRM + VaRΔCVA ) + [2.5%-8.5%]
B
3 4 2 2 4 6
Capital
3 CapitalCore Tier1 + Capitaladdit. Tier1
definition 2. Tier 1 Capital Ratio ≥ 6.0%
RWA 2 4 + [2.5%-8.5%]
C
4 6
Risk 3 CapitalCore Tier1 + Capitaladdit. Tier1+ CapitalTier2
bcbs 189
coverage 3. Total Capital Ratio ≥ 8.0%

RWA 2 4 + [2.5%-8.5%]
D
5 6
Basel III
Leverage 3 CapitalCore Tier1 + Capitaladdit. Tier1

ratio 4. Leverage Ratio 5 ≥ 3%
Total Assets + {0/5/25/50/100}% Off-Balance
6a Counter-
cyclicality Highly quality liquid assets
Systemic 5. Liquidity Coverage Ratio 7 ≥ 100%1
207 6b Outflows ̶ min(75% Outflows; Inflows)
Risk
7 Liquidity
risk Available stable funding
(bcbs 188, 238, 6. Net Stable Funding Ratio 7 ≥ 100%
271) Required stable funding
1) 1.1. 2015/2016/2017/2018/2019: 60%/ 70%/ 80%/ 90%/ 100%
100
2.D Basel III (Europe: CRR): Implementation timeline
Reporting ≠ Compliance ≠ Disclosure
Application of CAD IV and CRR
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Start CAD IV and CRR trilogue (EU Com / council / parl.)

Reporting (quarterly)
Enter into force CRR (28/6/13) and CAD IV (17/7/13)

1. Capital ratios
Pillar I - constraint
(CET1, T1, TC)
Disclosure
BCBS 164
BCBS 189
2. Leverage
Pill I - constraint
ratio
Disclosure
Reporting (monthly)
3. Liquidity
Pillar I - constraint
Coverage Ratio
Disclosure
4. Net Stable
Pill. II Pill I - constraint
Funding Ratio
Disclosure: tba
Reporting (monthly/quarterly2)
BCBS 188
BCBS 165
5. EBA Liquidity
Pillar II - requirement
Monitoring tools1
Disclosure: not envisaged
101
31/21/2013
28/6/2013
17/7/2013
1/1/2014
Mar 2013
Feb 2012
Basel III vs. CRR
• CRR is a framework. Many details are outsourced to RTS / ITS and are fixed in 2014.
BIII Non-Basel III
• Access to taking up / • Access to taking up /
EBA R/ITS [Impact/ Calibr./ L2-Cap, Retail, Buffer use, HQLA)]

pursuit of business pursuit of business
• Free movements of
• EU Banking Pass
services (EU Banking Pass)
Adoption CAD IV
• Prudential Supervision • Enhanced
CAD IV
(Pillar II) transparency

• Conservation buffer • Systemic risk buffer
• Capital buffers
• Anticyclical buffer • Other SIFI-buffers
• Remuneration, Div’y
• Corporate Governance
• Enhanced governance
Start Trilogue1
• Sanctions • Sanctions
Final Draft
Applicable
• Capital Re-Definition
• Capital
• Capital disclosure
• LCR, NSFR
• Liquidity
• Monitoring tools
Adoption CRR
• Leverage • Leverage ratio
• CVA
CRR
• Counterparty Credit Risk

• Capital requirements
• Large exposures • Large exposures
• Disclosure
• Disclosure Requirements
Requirements
• Single Rule Book • Single Rule Book
1) EU Commission, European council, European parliament
102
Basel III vs. CRR
BIII Non-Basel III

• Access to taking up / • Access to taking up /
pursuit of business pursuit of business • Due to national particularities
• Free movements of (structure of banking sector,
• EU Banking Pass
services (EU Banking Pass) legal and administrative system,
• Prudential Supervision • Enhanced economic cycle) better national
CAD IV
(Pillar II) transparency discretion (supervisory license,

• Conservation buffer • Systemic risk buffer cross-border cooperation of
• Capital buffers
• Anticyclical buffer • Other SIFI-buffers regulators, capital buffer,
• Remuneration, Div’y Internal Governance
• Corporate Governance
• Enhanced governance (remuneration), ICAAP-process,
• Sanctions • Sanctions regulatory sanctions)
• Capital Re-Definition
• Capital
• Capital disclosure
• LCR, NSFR
• Liquidity
• Monitoring tools
• Leverage • Leverage ratio • Single Rule Book: harmonisation
of banking regulation /
• CVA
CRR
• Counterparty Credit Risk Level-playing field in European

• Capital requirements
baking market
• Large exposures • Large exposures
• Disclosure
• Disclosure Requirements
Requirements
• Single Rule Book • Single Rule Book
1) EU Commission, European council, European parliament
103
Example
CRR – weight (given) Bank A CRR – weights
NSFR LCR Leverage RWA EUR Assets Liabilities EUR LCR NSFR
Retail loans, Retail, stable,
50% 0% 100% 75%*8% 100 Maturity: between 31 days Maturity: ≤ 30d & on 100 5% 95%
and 1Y demand
0% 100% 100% 0% 5 Cash reserve Core Equity Tier 1 5 0% 100%
105 Σ Σ 105
(here) CET1-ratio = Tier 1 – ratio = Total Capital ratio
Core Equity Tier 1

5 5
Capital R’s = = = = 6.67% (> 4.5%/6%/8%)
Risk-weighted Assets 12.5*(75%*8%*100 + 0%*5) 75
Leverage ratio
T1
5 5
LR= = = = 4.76% (> 3%)
Total Assets 100%*100 + 100%*5 105
LCR
Liquidity reserve 100% * 5 5
LCR = = = = 100% (> 60%)
CFt- - 5% * 100 + 0%*5 – 0%*100 5-0
CFt+
NSFR
Available stable funding 95% * 100 + 100%*5 100

NSFR= = = = 200% (>100%)
Required stable funding 50% * 100 + 0%*5 50
104
How the different products are weighted in the ratios, you find in these references.
Weights Basel Europe

Capital Basel II CRR
ratio (BCBS 128) (EU No. 575/2013)
Leverage CRR
BCBS 270
ratio (EU No. 575/2013)
Delegated act
LCR BCBS 272
(C(2014) 7232 final)
NSFR BCBS 295 Not finalised yet
105
Higher regulatory requirements imply ... reduced cost from future crises (less probable, less severe) at
the cost of more expensive bank products (higher loan rates, lower deposit rates) and less profitable
banks (making banks less attractive for shareholders).
• Bank capital has the following function:
1.To maintain the business:
Capital is what is used as a base to lever up the balance sheet through liabilities raising, which then
enables undertaking of operations (assets) and then expansion via capital expenditure, acquisition
2. To absorb losses:
Any loan / trading / operating losses will be covered by capital base,
which therefore must be sufficiently large to absorb all expected and unexpected losses.
3. Maintain public, customer and market confidence:
A strong capital base assures stakeholders that the bank is a safe store for their funds, particularly
during times of crisis.
4. Reduce moral hazard risk:
On the retail side, customers’ deposits are protected by deposit insurance schemes. This reduces
incentives for customers to monitor the health of their bank, and for the bank owner’s agents to
maintain a safe and sound balance sheet. In theory, the more capital a bank has (as a percentage of
its balance sheet) the more equity shareholders have at risk, hence this better aligns the interests
ofcustomers and owners (and regulators).
• Together with the profit motive, the above can be conflicting from time to time, thereby creating a
“push and pull” effect between shareholders and regulators:
Higher capital requirements will reduce RoE and may generate extension of risk-reward profile to
maintain returns. It also could mean “less lending”.
Higher capital reduces risk of insolvency but may also act as a constraint on lending and/or push up
costs to customers, neither of which helps the economy.
106
2 Risk Capital
Comm-
odities

External
Capital Internal


CVaR= Loss distrib. [1y,pbanksp.]

loss.
107
2.C Basel II: Market risk
2. Regulatory Definition for capital requirements: Core Equity Total

Tier 1
Tier 1 capital
ratio
ratio ratio
• Market risk: any FX and any commodity position. Equity, Interest rate and Credit
only in regulatory trading book, i.e. FV’ed-positions outside trading book change
value, but this is not acknowledged. Only banks with regulatory trading books
(“Trading book institutes”) are exposed to market IR risk and EQ risk. ≥ 4.5% ≥ 6% ≥ 8%
Assets Liabilities
Tier 2
Banking Banking
BookRegulatory BookRegulatory
Commodity Commodity
Additional Additional
FX (positions in FX) FX (positions in FX)
Tier 1 (aT1) Tier 1 (aT1)
Commodity Commodity
FX FX
Trading Trading Core Equity Core Equity Core Equity
Credit (spreads) Credit (spreads)
BookRegulatory BookRegulatory Tier 1 Tier 1 Tier 1
IR IR (CET1) (CET1) (CET1)
EQ EQ
RWAMR
+
RWACR
+
RWAOpR
108
2. Bank regulatory capital Market Risk
2.C Basel II: Market risk IR-risk

EQ-risk model
model
Standardised FX-risk CO-risk Spec.
Approach model model models
General Specific General Specific
Two methodologies: 1. Maturity ladder approach (CRR, §339: ) vs. 2. Duration method (CRR, §340).
1. Maturity Ladder Approach
capital charge on matched positions
Time Bands for two Coupons 1. 2. 3. 4. Final open
>= 3% < 3% Risk Weight Long Short Intrabucket Intrazone Interzone position
<= 1m <= 1m 0,00% 10%
1–3m 1–3m 0,20% 10%

Zone I 40%
3–6m 3–6m 0,40% 50.000 10%
40%
6–12m 6–12m 0,70% 100.000 250.000 10%
1–2y 1,0–1,9y 1,25% 200.000 10%
10% 30%
2–3y 1,9–2,8y Zone II 1,75% 150.000
3–4y 2,8–3,6y 2,25% 50.000 10% 150% 100%
4–5y 3,6–4,3y 2,75% 10%
5–7y 4,3–5,7y 3,25% 200.000 10%

40%
7–10y 5,7–7,3y 3,75% 10%
10–15y 7,3–9,3y Zone III 4,50% 10% 30%

15–20y 9,3–10,6y 5,25% 10%
>20y 10,6–12y 6,00% 10%
12–20y 8,00% 10%
>20y 12,50% 10%
109

EQ-risk model
model
Steps: i – ix General Specific General Specific
1. Maturity Ladder Approach (§339 CRR)
Sum of longs and shorts Vertical disallowance

Band Net Position Risk Weight Weighted Position Open Position Matched
Long
(Market Short
value) (Market values) Long Short Long Short
I,1 0,00% 0 0 0 0 0
I,2 0,20% 0 0 0 0 0
I,3 50.000 0,40% 0 200 0 200 0
I,4 100.000 250.000 0,70% 700 1750 0 1050 700
II,1 200.000 1,25% 2500 0 2500 0 0
II,2 150.000 1,75% 0 2625 0 2625 0
II,3 50.000 2,25% 1125 ii
0 1125 0 0
i
III,1 2,75% 0 0 0 0 0
III,2 200.000 3,25% 6500 0 6500 0 0
III,3 3,75% 0 0 0 0 0
III,4 4,50% 0 0 0 0 0
III,5 5,25% 0 0 0 0 0
III,6 6,00% 0 0 0 0 0
III,7 Σ 550.000 450.000
8,00% 0 0 0 0 0
III,8 12,50% 0 0 0 0 0
Partial CCs 10%*(Sum of matched)=70

110
iii

EQ-risk model
model
Steps: i – ix General Specific General Specific
1. Maturity Ladder Approach (§339 CRR)
Horizontal disallowance
Between I and
within Zones Between I and II Between II and III III
Open Position Matched Open Position Matched Open Position Matched Open Position Matched Open
Long Short Long Short Long Short Long Short
Zone I 0 1250 0 0 250 0 0 250 0 0 0 0
Zone II 1.000 0 2.625 0 0 1.000 0 0 0 0 0 0 6250
Zone II 6.500 0 0 6.500 0 0 6.500 0 0 6.250 0 250
iv v vi vii viii
Partial 40%*0+30%*(2625+0) 100%*

CCs =787,5 40%*1000=400 40%*0=0 150%*250=375 6.250
Vertical disallowance 700 10% 70

Horizontal disallowance in I 0 40% 0
Remark: Horizontal disallowance in II 2.625 30% 787,5
For portfolios with (i) only long or (ii) only
Horizontal disallowance in III 0 30% 0
short positions:
cc = 100% * Σ RW(i) * MV(i), Horizontal disallowance in I/II 1.000 40% 400
i.e. It is the simple sum Horizontal disallowance in II/III 0 40% 0
Simple sum  perfect correlation, i.e.
No diversification at all in the st’ed Horizontal disallowance in I/III 250 150% 375
model!!! Open end position 6.250 100% 6250
Total general risk charge 7882,5 ix
(7.9% of net PF-volume)
111

EQ-risk model
model
2. Duration Approach (§340 CRR)
2. Duration Approach Time Band Assumed PV x modD1 PV x modD1

Yield xΔy(D
Change
Approach is identical to maturity ladder but
Δy(D)
positions are slotted in terms of duration and risk
weights for time bands are given by modified <= 1m 1,00% …
duration times assumed yield change: 1-3m 1,00% …
3-6m 1,00% …
Further Difference: Vertical disallowance at a rate of
2% not 10% 6-12m 1,00% …
1,0-1,9y 0,90% …
Modified Duration 1,9-2,8y 0,80% …
modD = D/(1+r) 2,8-3,6y 0,75% …
3,6-4,3y 0,75% …
modD: modified Duration 4,3-5,7y 0,70% …
D: Duration
r: Yield 5,7-7,3y 0,65% …
7,3-9,3y 0,60% …
Note: As yield might be different, the 9,3-10,6y 0,60% …
implied risk weights within each band 10,6-12y 0,60% …
might differ! 12-20y 0,60% …
>20y 0,60% …
112

EQ-risk model
model
Table 1 (in CRR §336)
Further Net Positions
1 Qualifying 2 Low Quality Else

Debt with CRSA=0%
Maturity
< 6M <= 2Y > 2Y
0% 3,125% 12,5% 20% 150% 100%
Capital Charge = 8% * ...

1 Qualifying (CRR, §336 (4)): 2 Low Quality:
• Investment grade (Table 1) • Debt that would receive a 150% risk
• Unrated but listed at recognised stock exchanges, banks considers weight in CRSA:
them equivalent to “qualifying items”, sufficiently liquid See next slide:
• Issuer is deemed investmet grade equivalent. • Sovereign, etc. < B-
• Liquid corporate bonds of CRR-institutions • Others: < BB-
• Covered bonds in this category would receive half of the risk weight.
113

EQ-risk model
model
Steps: i - iii General Specific General Specific
Standardised approach / equity risk model (CRR, §341 ̶ 344):
Equity A General Risk

portfolio
Net Position in market 1
Long and 8%(Sum over
short in … ABS(net market
same issue positions))
i Net Position in market N iii + cc
and same
nat. market
on a net B Specific Risk
basis
8%(Sum over ABS(net positions))

Institute’s
own stocks
do not have Specific Risk Capital Charge is 2% if stock is highly liquid and
to be taken investment grade, for derivatives on indices, or if pfo is diversified and
into account. individual stock has fraction < 5%.
For linear derivatives:

• Futures and Forwards at current market price
• Futures on indices at marked-to-market value of notional underlying
portfolio
• Equity swaps as two notional positions
• Matched positions in identical equity or stock are fully offset
114

EQ-risk model
model
Standardised approach / equity risk model (CRR, §341 ̶ 344):
Net Position
Equity Long Short per issuer Net | Net | %
Deutsche Bank 1400
Forward Sell, DB 500
Short Call DB,
B Specific risk:
delta=0.5 500 DB 400 400 8%

Commerzbank 800 300 CoBa 500 500 8%
UniCredit 70 570 UniCredit -500 500 8%
Dax-Future 300 800 Dax-Future -500 500 0%
Bank of America 100 BoA 100 100 8%
Own shares 100 Own shares 100 100 0%
cc, specific risk 120 = 8%*
Overall Gross
Net Position per position
Equity Market Long Short market Net | Net | % (0%: for diversified
Deutsche Bank Dax 1400 Dax 400 400 8% indices)
Forward Sell, DB Dax 500 FTSE MIB -500 500 8%
Short Call DB,
A General risk:
delta=0.5 Dax 500 Dow 100 100 8%

Commerzbank Dax 800 300 cc, general risk 80 = 8%*
UniCredit FTSE MIB 70 570 Σ|Nettopositioneni
Dax-Future Dax 300 800 in each market|
Bank of America Dow 100
Own shares ---- 100
cc, specific risk 120
cc, general risk 80
Total capital charge: 200
115

EQ-risk model
model
Steps: 1 - 4 General Specific General Specific
Standardised approach / FX risk model (CRR, §351 ̶ 354):

1
Net Position in Currency 1 FX-capital charge only if FX-position is material , i.e. if ...
A 2%  Equity  Max[A, B]  ABS(C)  Overall FX - position
Net Cash Position [CCY] and/ or
+ Net Forward Position [CCY]   ccy
+ Net Δ-equivalent [CCY] for options B Equity    
max[ pos[i, cy]  1{pos[i,cy]0},- pos[i, cy]  1{pos[i,cy]0} ]  fx [€/ccy]
 
to buy / sell CCY c in ccy i i
+ MV for non-CCY-options [e.g. " FX  business"
equity options], but denom. in CCY
+ Guarantees3 [CCY]
+ Net Future Incomes / Expenses Open net A) Internal Model
[CCY] positions per (The Standardised Approach to Market Risk for FX allows for an Internal FX-Model)
currency
+ accrued interest, expenses and (long + short2) B) Regulatory model:
income (if certain)
For higly correlated currencies1, matched positions might
Excllude: structural positions be accounted at 50% (instead of 100%) of their volume.
protecting CAR and positions netCurr1 [CCY]
deducted from capital 2 Capital charge
netCurr2 [CCY] netCurr1
in reporting
…
Net Position in Currency 2 currency
netGold 3
… [ounce] netCurr2 A:= - Σ nCurr(i)
in reporting
Spot rates
Curr(i) <0
Net Position in Currency N currency MAX(A,B) 8%
Nominal or … B:= Σ nCurr(i)

Net Position in Gold [ounce] Curr(i) ≥ 0
NPV
netCurrN
1:
in reporting
Closely correlated currencies: based on daily FX-rates of last 3 years or last
5 years, the probability to have a loss within the next 10 trading days that
currency
exceeds 4% of matched volume is less than 99% (3Y) or 95% (5Y) (cf. CRR, §
354). It is likely to be fulfilled by pegged currencies only. netGold 4
2) Short positions are <0. in reporting Net Gold ABS(C) 8% 116
3) Only guarantees that will be drawn for sure, e.g. for defaulted counterparties.
currency Position = C

EQ-risk model
model
Standardised approach / FX risk model (CRR, §351 ̶ 354):
Delta [for Open Individual Position FX-rates Open Individual

"Currency" Cash Forward Options options] ["Currency"] [x EUR/ CCY] Position ["EUR"]
GBP 3000 5000 -14000 0.5 1000 1.17 1166.67
USD 4000 -24000 38000 0.5 -1000 0.70 -700.00
Open Net FX- capital
HKD 1200 -600 -2000 0.5 -400 0.10 -39.29 position Risk weight charge
JPY 10000 -3000 -8000 0.5 3000 0.01 23.38 1190.05 8% 95.20
Gold [Ounce] 500 -398 -200 0.5 2 985.21 1970.42 1970.42 8% 157.63
Capital charge 252.84
117

EQ-risk model
model CO-
Standardised FX-risk Spec.
risk
Approach model models
model
Steps: i – iii General Specific General Specific
Standardised approach / Commodity risk model (CRR, §359 ̶ 360):
Risk Types for Commodities Positions: Standardised Approaches:

• Risk of Spot Price Changes (Directional Risk) 1. Simple Approach
• Basis Risk (Relative Price Changes)
• Interest Rate Risk 2. Maturity Ladder
• Forward Gap Risk
(Risk of changes in forward rates)
1. Simple Approach for each commodity (CRR §360):

a) Directional Risk: 15%*(ABS(net position = long + short)) for each commodity’s net position
b) Basis / Interest / Forward Gap risk: 3%*gross position (= ABSlong + ABSshort)
c) cc = sum of both
2. Maturity Ladder Approach (CRR §359): ... => next slide
118

EQ-risk model
model CO-
Standardised FX-risk Spec.
risk
Approach model models
model
Steps: i - iv General Specific General Specific
Standardised approach / Commodity risk model (CRR, §359 ̶ 360):
2. Maturity Ladder Approach (CRR §359): Example of Capital Charge for a specific commodity
Net position time bands spread rates long short matched open to carry forward matched eventually open
of 0 - 1 month 1.5% 300 -100 100 200 200 0
commodity iii
(long or 1 - 3 months 1.5% -250 0 -250 -50 200
short) in 3 - 6 months 1.5% 100 i 0 100 50 50
standard unit 6 - 12 months 1.5% 0 0 50 0
and
converted in 1 - 2 yrs 1.5% 150 -150 150 0 50 0
reporting 2 - 3 yrs 1.5% 250 0 250 300 0
currency at > 3 yrs 1.5% -400 0 -400 0 300 -100
spot price.
SUM 250 ii 700 550 100
Physical partial CCs 3.75 4,2 15
stock in first overall CC 22.95
time band.
1.5%*Sum of Sum of absolute 0,6%*|carried 15%*remaining Capital iv
matched carry forward forward| open charge of
pos. commodity
119
If PD increases, the capital ratio decreases.
PD increases to 3%
Deposits Deposits
Loans, Loans
100 Retail 100 Retail
PD = 1% PD = 3%
Capital 10 Capital
Origination +6 months
1 - e -351% 1 - (1 - e -351% )
-353% -353%
1- e 1 - (1 - e )
R  3%   d   12.16% R  3%  - 35
d - 35
 7.55%
1- e -35
1- e -35 1 - e 1 - e
1
 (1%)  12.16% 1 (99.9%)  1 (3%)  7.55% 1 (99.9%)
Capital  [ [ ] - 3%]  45% 100  5.02
Capital  [ [ ] - 1%]  45% 100  3.66 1 - 7.55%
1 - 12.16%
 1.37  3.66
10 10
TCR   21.85% TCR   15.93%
12.5  3.66% 100 12.5  5.02% 100
120
If PDs increase, more capital is required.
Plot: for a loan with PD = 1% at origination, capital change by factor x if the PD changes to y%.
Capital new = 1.37 * capital (at PD=1%)
+2%
121
For loans where PD deteriorates, more capital is required.
21.85%
Total Capital Ratio [%]
15.93%
122
If loans default, TCR’s nominator and denominator decrease.
Plot: For a loan with PD = 1% at origination, capital change by factor x if the PD changes to y%.
PD constant
1% Default
Deposits
Loans, Loans Deposits
100 Retail 99
Retail
PD = 1% PD = 1%
Capital 10 Capital 9
Origination +6 months
PD1%, per 1 EUR

R  3% 
1 - e -351%
d
1 - (1 - e -351% )
 12.16%
Capital  Capital  3.66%  (100  1)  3.63
-35 -35
1- e 1- e
1
 (1%)  12.16% 1 (99.9%)
Capital  [ [ ] - 1%]  45% 100  3.66 9
1 - 12.16% Taken out in nominator (Risk)
10  1
and denominator (Capital)
10
TCR   21.85% TCR   19.86%
12.5  3.66 12.5  3.66%  (100  1)
0.4513 < 1 99
123
If loans default, TCR’s nominator and denominator decrease.
1% Defaults => TCR = 19.86% (example from previous slide) -10
90
Loans
Retail Deposits
PD = 1%
-10
0
124
Recession: Loans default AND PDs increase.
Which effect dominates? Why?
(DR=0%, PD=1%)
(DR=1%, PD=1%)
(DR=2%, PD=1%)
Impact of defaults
(DR=2%, PD=2%) Impact of increased PDs
125
Agenda
0. Introduction
5. The yield curve
20. Appendix
126
Agenda
2. ...
A. Definition of credit risk
B. Credit rating
C. Understanding credit risk
D. External ratings
E. Internal ratings
F. Credit Value-at-Risk
G. Credit limit setting and rationale
H. Loan origination process standards
4. ...
127
3.A Definition of credit risk
• Credit risk exposure:

Any claim against someone (loan, derivative with positive market value, guarantee, ...)
Credit risk against derivative counterparty is called “Counterparty Credit risk”
Migration risk Credit default risk
• Increased PD, i.e. higher probability that obligor • Risk that an obligor defaults1
might default Default : = if payments are 90 days due or there are
• Increased LGDs, i.e. smaller recoverable amounts objective reasons to believe that the obligor has
(especially in a recession if there is a low demand defaulted (e.g. legal liquidation process has been
(and excess supply) of the collateral) triggered [by other lender])
(who has money to buy a house / car in a recession
when everybody struggles, loses their job, etc.?) • Measures of default risk:
- Exposure at Default (EaD): loan amount or
modelled value for derivatives / credit lines
- Likelihood of default: Probability of Default (PD)
- Severity of default
LGD = (EaD – liquidation salet1/(1+r)t1
+ legal feest2/(1+r)t2)/ EaD
At cost Increasing loan loss provisions Booking impairments
At Fair Credit spread increase (just not as much as in Credit spread jumps to expected LGD [%] – level
value default) => Mark-to-market loss / P&L-loss => Mark-to-market loss / P&L-loss
1) Note that also “technical default” exists: if an obligor thinks (s)he does not have the obligation to pay (e.g. someone that has leased a car and has
paid maintenance cost). (S)he thinks that the leasing company should pay this. The leasing company thinks that the lessee should pay it. They
128
dispute. The lessee stops the monthly leasing rate ... although financially (s)he would be able to pay it. That’s a technical default. Someone not
paying although financially (s)he would be able to do so.
• Loan loss provisions are “expected” losses. It is priced 1:1 into the loan rate.
• Capital serves to protect the bank against unexpected losses.
It is priced as RoE [%] * Unexpected loss into the loan rate.
Unexpected
losses
(beyond the
average)
Expected loss
(= the long-term
average)
129
• Models to determine credit risk Detailed in this class
Individual obligor Portfolios of obligors
Ratings KMV Portfolio manager
Scorecards CreditRisk+
Option models (Merton model)

CreditMetrics
Equity is call option on assets with strike
= face value debt
Needs asset volatility and market value
of assets
(both estimated from stock market data)
CreditMetrics
(Mark-to-market models)
130
Probability of Loss Given Exposure at

Default X Default X Default Expected
=
% % Euro Loss $
• Obligor level • Given a default • What is the

- Moody’s and what are the expected
S&P Grades expectations of exposure when
• Internal ratings loss as a percent the obligor
- Financial and of EAD actually defaults
qualitative - Differentiated Unexpected
factors by seniority Loss $
and collateral
Portfolio
effects
Exposure at
Default
• Correlations Euro
• Credit VaR
• Economic capital
131
3.B Credit ratings
• Both risk types are contained in a rating migration matrix:

Migration risk Credit default risk
Transition
AAA AA A BBB BB B CCC/C (P)D NR Σ
Matrix
AAA 87.19% 8.69% 0.54% 0.05% 0.08% 0.03% 0.05% 0.0% 3.37% 100%
AA 0.56% 86.32% 8.30% 0.54% 0.06% 0.08% 0.02% 0.02% 4.09% 100%
A 0.04% 1.91% 87.27% 5.44% 0.38% 0.16% 0.02% 0.08% 4.72% 100%
BBB 0.01% 0.12% 3.64% 84.87% 3.91% 0.64% 0.15% 0.24% 6.42% 100%
BB 0.02% 0.04% 0.16% 5.24% 75.87% 7.19% 0.75% 0.90% 9.84% 100%
B 0% 0.04% 0.13% 0.22% 5.57% 73.42% 4.42% 4.48% 11.72% 100%
CCC/C 0% 0% 0.17% 0.26% 0.78% 13.67% 43.93% 26.82% 14.37% 100%
Standard & Poor’s: Global Corporate Average Transition rates (1981—2011) (%)
(http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245330814766)
• External ratings (Moody’s, Standard & Poor’s, Fitch) signal the credit risk opinion of a
“specialist”
• Are based on inhouse information (that rating teams) have gathered when they visited
the firm that is to be rated
• Solicited ratings: rated company asks and pays for the rating
• Unsolicited ratings (especially sovereign): rating agency acts alone, not on request
132
3.B Credit ratings
Systematic downgrades (like in structured finance) are due to a (systematic)
model error or a (systematic) moral hazard
• Before the crisis, rating agencies

used the same models to determine
the rating of corporate debt and
structured finance (securitisation
deals) ... although structured finance
deals are different (it is a portfolio
of claims, instead of one single
claim, someone has originated the
claims, someone has selected the
claims for this transaction,...)
=> many possibilities “to fool” the
investor ... and the rating agency.
Source: The Credit Rating Crisis, Efraim Benmelech, Jennifer Dlugosz
133
3.B Credit ratings
Not only default rates vary across time, but also recovery rates.
Source: Moody´Investor Service: Corporate Default and Recovery Rates 1920–2010
134
3.C Understanding credit risk
• Credit risk applies in the first instance to loan portfolio but also counterparty
exposure on securities and derivatives contracts (Basel III recognises with large
increase in counterparty credit risk charge for IB exposures)
• A first-cut look at credit risk would be to observe size of

Loan loss provision as a percentage of the loan book
Loan loss provision as percentage of pre-provision profit
• But these are not totally transparent as loan assets are themselves growing heading
into a recession; higher leverage must also be considered
• The real risks lie almost invariably in asset classes / sectors / regions experiencing
the fastest growth
Concentration risk
Growth into areas outside the bank’s area of genuine expertise
• Most common time to default: after 45–55 months => substantial delay
=> default statistics (as of today) do not provide the latent danger of the new
business => today’s default rates might look “too good” and would trigger
excessive risk taking if they are used to set limits
135
• Typically analysts use the following as measures of credit risk:

- Loan-loss provisions as % of loans
- Non-performing loans (NPL) as % of loans
- Loan-loss provisions relative to NPL (“coverage ratio”)
• Provision is taken at a point where bank feels interest and full principal of the
loan is not collectible. This is subjective management action – so conservative
approach recommended
• On provision bank reduces P&L and reduces the value of the loan
• Provision value as % of loan takes into account any collateral provided
and expected loss-given-default (LGD)
• Loan loss provisions reported are the net provision
after provisions “written back”, e.g., through recoveries on a previous bad loan
• NPL defined as when loan is 90-days past due
136
• The act of banking produces credit risk, just like it produces liquidity risk
• In theory credit risk hedging means elimination of credit risk, but in practice it is
really about hedging credit concentration risk
• For practical purposes, it is too expensive and unwieldy to completely transfer all
your credit risk
• The hedge transaction carries Basel III counterparty credit risk charge
• The CDS-Cash basis may be positive, meaning the asset runs at a loss
• An accurate hedge is difficult for many bank loan customer names
• Securitisation (ABS) is only partially feasible.
• In practice then the credit risk hedge where it does use CDS will be to move
concentration risk (concentrated by customer, sector, geography, etc.)
• Ultimately the best credit risk mitigation is sound origination policy …
137
3.D External ratings
Rating process
Information meeting
Rating Recommendation
Rating contract
Preparation of Rating Committee

Analyst Team
Documents
Rating Decision
Presentation Documents Market and Sector
Information
Preliminary Analysis
Objection Refusal Acceptance
Analysis
Internal
Internal Use
Use Publication
Company visit
Management Discussions Main differences to internal rating
138
B
Rating process
(I) Financial Profile (1/2)

• Quality of Accounting information:
- Quality of external auditor, goodwill, inventory assessment, write-off policy
• Financial Policy
- Volume of short-term debt, high debt service, financial planning
• Profitability
- EBITDA margin = EBITDA / turnover; ROCE = EBIT / capital employed
- Return on Equity, coverage of pension expenses, inflation adjustment
• Capital Structure and Leverage
- Balance-sheet debt level {debt/(debt+equity)} and debt level at market value
{debt/(debt+MV)}
- Binding long-term delivery contracts, operating leasing, sold / secured
receivables
- Off-balance sheet items
139
B
Rating process
(I) Financial Profile (2/2)

• Debt servicing capacity (Cash Flow)
- Capacity for meeting obligations from debt repayment
=> interest expense / EBIT or (interest expense + rental expense) / EBITR
- EBITDA / total indebtedness,
- Free cash flow / (interest expense + repayment obligations) (=DSCR)
• Financial Flexibility
- Relationship of parent company to subsidiaries
- Funding alternatives
- Possibility of regrouping assets, investment flexibility
• Besides the absolute amount, the trend across time is analysed for all ratios.
Because of their objectivity, cash flow ratios are weighted higher in ratings than
profit-oriented ratios.
140
B
Rating process
(II) Business Profile

• II.1 Sector Risk / Threats
- Growth prospects
- Economic cycles
- Vulnerability to technological change
- Vulnerability to state regulation
- Risks due to loss of know-how
Sector risk serves as upper rating limit, i.e. no company can be better than the
sector. Apart from this, sector analysis identifies the success factors of a sector
which will later be included in company-specific analyses.
• II.2 Company-Specific Risk / Threats
- Degree of diversification of the distribution side (customers / regions)
- Implicitly company size => small companies cannot diversify
- Qualification and risk appetite of management
- Strategy and operative planning
- Dependence on key persons
- Restrictions through partners
- Competitive position (market share, price enforcement capability)
=> SME’s are disadvantaged in the examination of specific risk
141
B
S&P’s rating methodology for the segment “banks”
See Appendix (slide 11) for notching thresholds for Bank specific factors
BICRA SACP for an average bank in developed

methodology economies placed in the ‘bbb’ and ‘a’
range. Only banks with stronger business
positions, and capitalisation sufficient to
withstand a scenario of extreme stress
Bank specific without reliance on external support, are Indicative ICR is the same as
generally assigned higher SACPs the SACP unless the bank is
factors
likely to receive additional
External capital, liquidity, or risk relief
Business
The BICRA support from the government or the
position
methodology(3) is Macro factors parent group in a crisis
considerations
used to assess the
strengths and Economic risk Capital and Group
The final ICR is set at the
weaknesses of the score earnings Support same level as the indicative
broader operating ICR, or maximum of one
environment that Anchor SACP(1) ICR(2) notch higher or lower
situate, or anchor, The view of a bank's final
Industry Risk Governmental creditworthiness is refined by
the SACP considering its relative credit
risk score position Support standing among all banks
with a similar SACP (the
same or one notch higher or
Funding and lower)
liquidity A bank that is a subsidiary
receives the higher indicative
ICR resulting from
BICRA application of either the
Banking group support framework or
Industry the government support
framework
Country Hybrid debt and Senior unsecured
Risk preferred stock ratings issue ratings
Assessment
Score
Source: S&P, Banks: Rating Methodology and Assumptions, 09.11.2011
(1) SACP: Stand Alone Credit Profile
(2) ICR: Issuer Credit Rating
(3) “Banking Industry Country Risk Assessment Methodology And Assumptions”, published 9 Nov. 2011 142
3.E Internal ratings
1. Classification and Regression Trees
• The sample is to be divided into homogenous sub-groups using a binomial tree.

• The nodes of the tree represent alternative decisions and the “leaves” classification
groups.
• “leaves” => rating classes => rating model
• Given a portfolio of clients with their characteristics, the method determines both
the most discriminatory characteristics and the most discriminatory threshold values
(= nodes).
Leverage ratio ≤ 10%

Y N
Return on Equity > 8% Return on Equity > 6%

Y N Y N
DSCR1 > 300% DSCR1 > 150%

Y N Y N
R1 R2 R3 R4 R5 R6
1) Debt Service Coverage Ratio (DSCR) : = Free cash flow / (interest expense + repayment obligations)
143
2. Logit model (estimation in 3 steps)
1. Decide which factors could be good (discriminatory) predictors of future defaults (1., ..., 5.):
Firm 1. 2. 3. 4. 5.
No WC/ TAt RE/ TAt EBIT/ TAt EQMV/ TAt Sales/ TAt Defaultt+1
1. 0.15 0.05 0.1 0.04 2.1 0
2. 0.04 0.02 0.03 0.03 0.8 1
3. 0.12 0.04 0.08 0.03 1.4 0
4. 0.15 0.01 0.02 0.03 1.1 1
... ... ... ... ... ... ...
900. 0.15 0.01 0.02 0.03 1.1 1
2. Estimate logit model/ regression:

Original Altman' s z - score :
Working Capital t Retained Earnings t EBIT t
z - score t = 1.2  1.4  3.3
Total Assets t Total Assets t Total Assets t
Market Value of Equity t Sales t
 0.6  0.999
Total Liabiliti es t Total Assets t
e scoret  t
Default t 1  1  Minimises the error to predict the inidividual default
1  e scoret  t / survival [0,1].
3. Calibration: definition of zones (with thresholds) such that predicted defaults

(score > distressed threshold) = historical default rate (Σ Defaultt+1 / 900):
 > 2.99, Safe zone DRt+1 = 0 => PD[score>2.99] = 0

z  scoret  (1.81 , 2.99], Grey zone DRt+1 = 0.5 => PD[1.81 <score≤2.99] = 0.5
  1.81, Distress zone
 DRt+1 = 1 => PD[score < 1.81] = 1
144
Model accuracy (1/2)
• The probability of default is the expected future default rate.

PDt+1 = E[DRt+1 I Ωt]
• Accuracy of PD-model:
(out-of-sample: on a validation portfolio, i.e. different portfolio
than the one that has been used to estimate the model)
1. Calibration: (that model correctly predicts the default rates)

test metric = (PDt – DRt)
2. Discriminative power:
(that model correctly discriminates between defaulters
and survivors)
=> next slide
145
Model accuracy (2/2) / Discriminatory power1
Jahr 0 Jahr 1 The CAP-curve2 provides a graphical intuition of the discriminatory

Score Gesamt Solvent Insolvent power (also called “Gini test”).
1 20 10 10 x-axis: cumulative distribution of all obligors, low ... good rating
y-axis: cumulative distribution of insolvent obligors.
2 50 44 6
Accuracy ratio: area of rating / area of perfect model.
3 110 105 5
4 50 47 3
5 20 19 1
Gesamt 250 225 25
AR – Accuracy Ratio/ Gini-

coeff.
= 0.44
0 ≤ Gini ≤ 1
1) See XLS-Worksheet “Ch3 Discriminatory Power”.
2) CAP : Cumulative Accuracy Profile
146
LGD – model (1/2)
1. Determine the LGD for every single default:
Loss Given Default (LGD) : = percentage of EaD leading to economic loss, incl. in the case of default, incl. costs and discounting effects
Loss
Book value Loss Given
Default
Loss of
(LGD)
Exposure interest
value Work-Out
Proceeds Costs1
(EAD)
from Net
utilisation proceeds
in case of
insolvency
Components of Loss Given Default

Information layer:
1) Based on work-out plan Client Business Collateral
2. Estimate (e.g. linear) regession model (OLS) with contract, customer, and collateral information that potential < drive liquidation
value, e.g.:
LGD Loan i  β0  βcar type  Cartyp i  βRezession  1iRezession  βCar use  Car use i ...  εi
Contract type: full payment lease, partial amortisation, hire-purchase
Customer information: industry (car used to generate turnover (e.g. taxi, logistic company) vs. car is not required (e.g. dentist)), ...
Object information: car type, ...
147
LGD – model (2/2)
Direct cost Indirect cost
Received instalment Liquidation value of collateral
Default triggered Write-off cost of contract
Economic loss
148
3.F Credit Value-at-Risk
• The portfolio risk is not the sum of the individual risks for each obligor (except, if
all obligors are perfectly correlated (if belonging to the same group)).
• Credit portfolio models model the loss distribution of a portfolio of obligors, based
on their individual risk parameters (PD, LGD, EaD) plus the correlation.
• The shape of the distribution and thus the unexpected loss (quantil / VaR) depend
on the correlation.
• Vasicek density:
 2
 
1 1
1  1 2  1   ( x )   ( PD ) 
  ( x )   
1  2    
f ( x)  e  

• By contrast, the expected loss (EL) is additive from the individual expected losses.
In particular, the EL is independent of the correlation. The correlation does not
enter the formula of EL: EL = PD*LGD*EaD
149
• The most relevant credit portfolio models are:
Credit Risk+ Credit Metrics
• Insurance idea • Based on migration

• Loss distribution in a matrices, it
closed form computes future
• Independent market prices for all
segments potential ratings.
• Poisson distribution • Based on the
of defaults transition matrix,
• Exposure = LGD one obtaines a
• Credit portfolio is (marginal)
aggregated in distribution of future
exposure buckets prices.
• Joint distributions
for multiple assets
are derivable.
• Risk = CVaRx%
150
Credit Risk+1 Credit Metrics
m = Sum PD
Number Proba- Cumm

m n  e m Loan PD Defaults
Number bility
Proba- Prob
P[n defaults]  Loan
A PD
2,00% Defaults
0 bility
52,20% 100,00
n! AB 4,00%
2,00% 1
0 33,93%
52,20% 47,80
0.650  e 0.65 C
B 5,00%
4,00% 2
1 11,03%
33,93% 13,86
P[0 defaults]   52.2% D
C 7,00%
5,00% 3
2 2,39%
11,03% 2,83%
0! DE 9,00%
7,00% 4
3 0,39%
2,39% 0,44%
0.651  e 0.65 EF 11,00%
9,00% 5
4 0,05%
0,39% 0,06%
P[1 default]   33.9% G
F 13,00%
11,00% 6
5 0,01%
0,05% 0,01%
1! H 2,00% 7 0,00% 0,00%
G 13,00% 6 0,01%
0.652  e 0.65 HI 3,00%
2,00% 8
7 0,00% 0,00%
P[2 defaults]   11.0% JI 9,00%
3,00% 9
8 0,00% 0,00%
2!
K
J 9,00% 10
9 0,00% 0,00%
... KL 10 0,00%
Sum 65,00% Exposure 100
1) See XLS-Worksheet “8. Ch3 Credit Risk+”.

151
Credit Risk+1 Credit Metrics

VAR: With 99,56% a maximum of 3 loans default with exposure 100
The VAR is 300.
n  PD.  LGD
Number Proba- Cumm. Expected LGD
Loan PD Defaults bility Prob. Loss
A 2,00% 0 52,20% 100,00% 0,00 0,00
B 4,00% 1 33,93% 47,80% 33,93 100,00
C 5,00% 2 11,03% 13,86% 55,99 200,00
D 7,00% 3 2,39% 2,83% 63,16 300,00
E 9,00% 4 0,39% 0,44% 64,71 400,00
F 11,00% 5 0,05% 0,06% 64,96 500,00
G 13,00% 6 0,01% 0,01% 65,00 600,00
H 2,00% 7 0,00% 0,00% 65,00 700,00
I 3,00% 8 0,00% 0,00% 65,00 800,00
J 9,00% 9 0,00% 0,00% 65,00 900,00
K 10 0,00% 0,00% 65,00 1000,00
L
Sum 65,00% Exposure 100
Expected loss 65
Economic capital 300 – 65 = 235
1) See XLS-Worksheet “8. Ch3 Credit Risk+”.
152
Credit Risk+ Credit Metrics1
1. Individual value distributions in 1 year:

1Y transition
matrix AAA AA A BBB BB B CCC Default
AAA 90.81% 8.33% 0.68% 0.06% 0.12% 0 0 0
AA 0.70% 90.65% 7.79% 0.64% 0.06% 0.14% 0.02% 0
A 0.09% 2.27% 91.05% 5.52% 0.74% 0.26% 0.01% 0.06%
BBB 0.02% 0.33% 5.95% 86.93% 5.30% 1.17% 0.12% 0.18%
BB 0.03% 0.14% 0.67% 7.73% 80.53% 8.84% 1% 1.06%
B 0 0.11% 0.24% 0.43% 6.48% 83.46% 4.07% 5.20%
CCC 0.22% 0 0.22% 1.30% 2.38% 11.24% 64.86% 19.79%
1Y-forward risk-adjusted zero rates

Y1 Y2 Y3 Y4
AAA 3.60% 4.17% 4.73% 5.12%
AA 3.65% 4.22% 4.78% 5.17%
A 3.72% 4.32% 4.93% 5.32%
BBB 4.10% 4.67% 5.25% 5.63%
BB 5.55% 6.02% 6.78% 7.27%
B 6.05% 7.02% 8.03% 8.52%
CCC 15.05% 15.02% 14.03% 13.52%
1) See XLS-Worksheet “10. Ch3 CreditMetrics”.

153
1. Individual value distributions in 1 year:

Potential values in 1 year of a today's [BBB-bond, 6%-coupon, 5 years]: Potential values in 1 year of a today's [A-bond, 6%-coupon, 3 years]:
Coupon 6% Coupon 5%
Notional 100 Notional 100
Probabilit
Values Probability Values y
AAA 109.35 0% AAA 106.59 0%
AA 109.17 0% AA 106.49 2%
A 108.64 6% A 106.30 91%
BBB 107.53 87% BBB 105.64 6%
BB 102.01 5% BB 103.15 1%
B 98.09 1% B 101.39 0%
CCC 83.63 0% CCC 88.71 0%
Default 51.13 0% Default 51.13 0%
6 6 6 106
107.53  6    
(1  4.10%) (1  4.67%)
1 2
(1  5.25%) (1  5.63%) 4
3

154
2. Joint value distribution in 1 year:

0.09% 2.27% 91.05% 5.52% 0.74% 0.26% 0.01% 0.06% Ρ=0
1Y joint
transition (independent defaults)
0% AAA 0.00% 0.00% 0.02% 0.00% 0.00% 0.00% 0.00% 0.00%
0% AA 0.00% 0.01% 0.30% 0.02% 0.00% 0.00% 0.00% 0.00%
6% A 0.01% 0.14% 5.42% 0.33% 0.04% 0.02% 0.00% 0.00%
87% BBB 0.08% 1.97% 79.15% 4.80% 0.64% 0.23% 0.01% 0.05%
5% BB 0.00% 0.12% 4.83% 0.29% 0.04% 0.01% 0.00% 0.00%
1% B 0.00% 0.03% 1.07% 0.06% 0.01% 0.00% 0.00% 0.00%
0% CCC 0.00% 0.00% 0.11% 0.01% 0.00% 0.00% 0.00% 0.00%
0% Default 0.00% 0.00% 0.16% 0.01% 0.00% 0.00% 0.00% 0.00%
106.59 106.49 106.30 105.64 103.15 101.39 88.71 51.13

1Y joint
transition
109.35 AAA 215.94 215.85 215.66 215.00 212.50 210.74 198.07 160.48
109.17 AA 215.76 215.67 215.48 214.82 212.32 210.56 197.89 160.30
108.64 A 215.23 215.14 214.95 214.29 211.79 210.03 197.36 159.77
107.53 BBB 214.12 214.02 213.84 213.17 210.68 208.92 196.24 158.66
102.01 BB 208.59 208.50 208.31 207.65 205.16 203.40 190.72 153.14
98.09 B 204.67 204.58 204.39 203.73 201.24 199.48 186.80 149.22
83.63 CCC 190.21 190.12 189.93 189.27 186.78 185.02 172.34 134.76
51.13 Default 157.72 157.62 157.43 156.77 154.28 152.52 139.84 102.26

155
3. Ordered PF values = Joint distribution in 1 year:

Determine 99%-quantil
Cum Prob
102.26 0.00% 0.00%
134.76 0.00% 0.00%
... ... ...
139.84 0.00% 0.00%
203.40 0.01% 0.40%
203.73 0.06% 0.46%
99%-quantil 204.39 1.07% 1.53% => VaR, 99% = 204.39
204.58 0.03% 1.55% With 99% certainty, the PF value will be >= 204.39.
204.67 0.00% 1.55%
205.16 0.04% 1.59%
207.65 0.29% 1.88%
208.31 4.83% 6.71%
... ... ...
215.67 0.01% 100.00%
215.76 0.00% 100.00%
215.85 0.00% 100.00%
215.94 0.00% 100.00%
Prob( ) = 99.54%
156
3.G Credit limit setting and rationale
• Determine strategy and business model (which type of customers to serve, which
countries, which capital market funding)
• Set up budgets of risk exposures to serve these customers
• Translate budgeted risk exposures into required capital
• Allocate capital to the business lines and products
• Limits = allocated capital
• Limit setting:
- The default of a single borrower (group) should be absorbable, i.e. should not
breach any regulatory limit
- Concentration limits (per industrial sector, geography, product line) to ensure
diversification
- Establish cut-off score / cut-off rating: no lending to customers with a worse
score / rating than the cut-off’s
- No lending beyond customers’ debt servicing capacity (e.g. no lending at LTV 125
to customers with low income)
• Limits per individual obligors, regions, industrial sectors

• Limit types: volume, risk measure (e.g. VaR, expected loss)
157
3.H Loan origination process standards
• Credit risk applies in first instance to loan portfolio but also counterparty exposure
on securities and derivatives contracts (Basel III recognises with large increase in
counterparty credit risk charge for IB exposures)
• A first-cut look at credit risk would be to observe size of

Loan loss provision as a percentage of the loan book
Loan loss provision as percentage of pre-provision profit
• But these are not totally transparent as loan assets are themselves growing heading
into a recession; higher leverage also be considered
• The real risks lie almost invariably in asset classes / sectors / regions experiencing
the fastest growth
Concentration risk
Growth into areas outside the bank’s area of genuine expertise
double
158
• A sound loan origination process consists of:

- Approval framework: who can approve what type of loan
(the larger/ riskier/ less profitable the loan, the more (senior) people must agree)
- Cut-off ratings and scores
- Collect information from customer (“Know your customer”)
- Preferably liquid collateral
- Capital request form for large transactions (detailing profitability of transaction /
customer)
- Collateral enablement template: to document usability of collateral
jurisdiction, transferability, minimum disclosure (to obligor upon transfer / third
parties)
159
Example of lending approval matrix (German bank):

(II) Credit approval matrix based on internal
(I) PD- & Rating Mapping ratings [in mio EUR]
Germany Other countries
Maximum Internal
S&P Fitch Moody's PD Rating NRC RRC GRC NRC RRC GRC
AAA AAA Aaa
AA+ AA+ Aa1 0.03% 1
AA AA Aa2
AA- AA- Aa3
Investment A+ A+ A1 0.07% 2
grade A A A2
≤ 45 ≤ 75 > 75 ≤ 20 ≤ 75 > 75
A- A- A3
BBB+ BBB+ Baa1
BBB+ BBB+ Baa2
1.17% 3
BBB- BBB- Baa3
BB+ BB+ Ba1
BB BB Ba2
BB- BB- Ba3
3.51% 4 ≤ 10
B+ B+ B1 ≤ 37.5 ≤ 62.5 > 62.5 ≤ 62.5 > 62.5
B B B2 6.10% 5 ≤ 7.5
Speculative
B- B- B3 10.54% 6 ≤ 2
grade
CCC CCC Caa
CC CC Ca 35% 7
≤ 30 ≤ 50 > 50 ≤ 50 > 50
C C C 0
8
D D D 100%
9
NRC National Risk Committee

RRC Regional Risk Committee
GRC Global Risk Committee
160
Agenda
0. Introduction
5. The yield curve
20. Appendix
161
Agenda
...
A. Market characteristics
B. Reasons for undertaking securitisation
C. The process of securitisation
D. Credit rating considerations
E. The securitisation market post-2008
F. Securitisation as an inhouse deal to create collateral
G. Impact on rating agencies
5. The yield curve
6. ...
162
4.A Market characteristics: Securities Securities
Secured securities Unsecured securities

Corporate bonds
Sovereign bonds
Untranched securities Tranched securities
ABCP Asset-backed securities

Mortgage Backed
Covered bonds Asset Backed MBS
Asset Backed Credit Linked Collateralised

Sec. (ABS) Notes (CLN) Debt Obl. (CDO) Residential
RMBS
Credit Card
Receivables Collateralised
Loan Obl. (CLO)
Commercial
CMBS
Lease / Trade
Receivables
Collateralised
Bond Obl. (CBO)
Consumer
Loans 163
4.B Reasons for undertaking securitisation
• Funding:
- Support rapid asset growth / lending capacity (as securitisation collects quicker
large amounts of funding than e.g. deposits)
- Diversify funding (adds wholesale funds)
- Reduces funding cost (ABS has better rating than originator => funding cost via ABS
are lower)
- Reduces maturity mismatch because ABS-maturity often matches asset pool
maturity
• Balance sheet management:
- Regulatory capital relief (before Basel III: SPV is not a bank => no (substantial)
regulatory capital requirements, with Basel III: SPVs to be consolidated / taken
on-balance => lower capital relief)
- Economic capital relief
=> increases RoE
• Risk management:
- Credit risk has been transferred to SPV and investors
• Customer relationship:
- Preserving customer relationships with obligor clients whose assets are securitised
164
4.C The process of securitisation
- Represents investors
Asset Report - Monitoring of transaction
Trustee - Enforcing rights of

noteholder
Manager
Assets ABS
Bank sells asset Equity Tranche
pool to SPV SPV (issuer) Non-rated
(originator) Cash Cash
ABS Cash ABS
Senior Mezzanine
Lawyers Tranche Tranche
(drafting all legal documents) AAA/Aaa AA/Aa2
Rating agencies
165
4.C The process of securitisation: Credit enhancement
Probability
Loss distribution
ELSenior
ELMezzanie
Tranche start Tranche end
ELSenior
Loss
Sold credit risk if equity tranche retained

166
4.C The process of securitisation: Credit enhancement
Average rating of BBB => tranches with better rating (AAA) ...
... and tranches with worse rating
Assets Liabilities
Class A Notes
AAA
Collateral 70% – 92%
Pool
100%
Ø rating: BBB Class B Notes
BBB, 7% – 30%
Subordinated
Equity, CCC 1% – 5%
167
0 Bank would like to sell credit risk. 2 SPV tranches portfolio. 4 Equity tranche
back to bank.
1 Bank sells loans to SPV receiving cash. 3 A and B tranches sold to investors.
SPV 0 Bank
Temporary
Cash short-term Loans Deposits
debt funding
Cash Capital Cash Equity

1
Tranching
Loans Cash Deposits

Class A note
Cash 2 Class B note

Equity/ 1st Loss
4
Equity/ 1st Loss
Cash Capital 3 Cash Equity
Investors
• Bank (originator) often retains first loss piece, i.e. the equity tranche.
168
Relief of regulatory capital
Loan originator
Loans
(150% RW)
100 => requires 12 EUR Deposits
RW = 150%(=on 100 EUR Notional
full portfolio)
capital
(= 150%*8%*100)
Cash Equity 12
Cash Deposits
RW = 1250% on 1.50 EUR Notional

(= size of equity tranche) Equity/ 1st Loss1
Cash Equity 1.5
• Please note: Improvement of risk-weighted capital ratios (CET1, T1, Total capital ratios), but
not of leverage ratio! Only if balance sheet shrinks (and liabilities are reduced)
[cash, deposits], LR would improve!
1) Requires only 1.5 EUR capital (= 8%*1250%*1.5).
169
4.D Credit rating considerations
• Financial modelling:
- Arranger sets up cash flow model for asset pool (here: Airline tickets receivables)
- Potential variables to simulate: historical sales values, seasonal sales factors,
credit card cash flows
- Output:
- Minimum asset coverage levels to service the tranches
- Debt service coverage ratio
(= Free cash flow / (interest expense + repayment obligations) (=DSCR))
- how much bigger could debt payments be (interest + principal) and they would
still be covered by the free cash flow?)
- the higher the better
- Likelihood that obligations can be serviced (principal and interest payments, fees)
- CDO model:
- cash flows less important, objective is to determine the final form of underlying
portfolio
- Simulations on subsets of pool of assets to achieve target diversity score
(for target rating) and note spread (for lowest funding cost)
- ABS-model: arranger concerned with cash flows and legal obstacles on cash flows
- Loan-to-value: preferably < 1
- Payment-to-income ratio:= loan interest payments / income of borrower per month
170
 INPUTS Cash Flow Model:

1. Repayment seniority
(sequentiel / pro-rata /
Trigger)
2. Loss allocation
3. Static / revolving
4. Repayment of the notes
(bullet / soft-bullet /pass-
through)
5. Repayment speed
3rd party runs coverage test
6. Losses / Defaults / Timing
7. Trigger and Trigger Levels
3rd party runs coverage test
171
Collateral
Wgt Avg
Rating Desired Tranche
Default Rating
Probability
Collateral
Diversity Determine
Score Credit Enhancement
Level
Collateral Cash Flow

Recovery Model Expected Loss
Rate
Stress Test Level
172
4.1 Given a portfolio of 100 corporate loans with even volumes, design a securitisation
that consists of an AAA, an Aa2, a Baa1 and an equity tranche.
0. Asset pool given 1. Compute diversity score: • Diversity score:
Industry code Min
Max
1
26 translate number of
Notional
Collateral No [EUR] Industry Rating Industry
Number of
collateral
Diversity
score
actual (correlated)
1 1 12 Aa2 1 1 1 assets (here: 100) into
2 1 17 Aa2 2 1 1
3 1 1 equivalent number of
3 1 19 Aa2
4
5
1
1
1
1 independent assets
4 1 6 Baa1
99 1 ... 14 Aa2
6
7
1
1
1
1
(here: 54)
100 1 15 Aa2 8 1 1
9 1 1 N2 • Bilateral
Σ 100
10 1 1 D N N
11
12
3
10
2
4   ij
correlation
13 10 4 i 1 j 1 (like: Markovitz)
14 10 4
N
15 10 4
D • (Average) single
16 10 4
1  ( N  1)  
17 10 4 correlation
18 3 2
19 3 2 • PDi = PDj = PD
20
21
3
3
2
2 • All assets have
22
23
3
3
2
2
same size
24 3 2
8  N industry  1  1 12% < ρ < 28%
25 3 2 D
26 3 2 2
Number of
collateral 100 54
173
Given:
Cumulative Rating factors
PD(Ratingi)/ PD(AAA)
PDs (T)
2. Compute average PD: Idealized expected defaults Rating factors
Maturity 5 Rating\ Rating\
Weighted Maturity 5 Maturity 5
Number of average rating | RF(PF) - For lookup Aaa 0.0029%
Rating Rating factor collaterals factor RF(Rationg | function Aaa 1
Aa1 0.0310%
Aaa 1 0 0 86 Aaa Aa1 11
Aa2 0.0680%
Aa1 11 0 0 76 Aa1 Aa2 23
Aa3 0.1420%
Aa2 23 82 19 64 Aa2 Aa3 49
Aa3 49 0 0 38 Aa3 A1 0.2610%
A2 0.4670% A1 90
A1 90 0 0 2 A1
A2 161 0 0 73 A2 A3 0.7300% A2 161
A3 252 0 0 164 A3 Baa1 1.1000% A3 252
Baa1 379 18 68 291 Baa1 Baa2 1.5800%
Baa2 545 0 0 457 Baa2 Baa3 3.0500% Baa1 379
Baa3 1052 0 0 964 Baa3 Ba1 5.2800% Baa2 545
Ba2 8.4100% Baa3 1052
Ba1 1821 0 0 1733 Ba1
Ba2 2900 0 0 2812 Ba2 Ba1 1821
Ba3 11.8600%
Ba3 4090 0 0 4002 Ba3
B1 5559 0 0 5471 B1 Ba2 2900
B2 7141 0 0 7053 B2
B1 16.1200%
Ba3 4090
B3 9328 0 0 9240 B3 B2 20.7100%
B3 27.0500% B1 5559
Caa 12522 0 0 12434 Caa
Σ 100 87.503 Caa1 36.3137% B2 7141
Rating A1 Caa2 48.7500% B3 9328
PD 0.2610% Caa3 69.8212% Caa 12522
174
3. Compute distribution of number of defaults:
Diversity
score 54 PD 0.2610%
P[Number of
x defaults = x] Pcum 1-Pcum
0 86.8381% 86.8381% 13.1619%
ProbNumber of defaults  0   0.261%0  1  0.261%   86.8381%
54! D 0
1 12.2710% 99.1091% 0.8909% 0!54  0!

2 0.8509% 99.9601% 0.0399%
3 0.0386% 99.9987% 0.0013%
4 0.0013% 100.0000% 0.0000%
5 0.0000% 100.0000% 0.0000%
6 0.0000% 100.0000% 0.0000%
7 0.0000% 100.0000% 0.0000%
8 0.0000% 100.0000% 0.0000%

9 0.0000% 100.0000% 0.0000%
10 0.0000% 100.0000% 0.0000%
11 0.0000% 100.0000% 0.0000%
 D
ProbNumber of defaults  x      PDi  1  PD 
D i
 
x
 PDi  1  PD 
D! D i

x!D  x !
175
3. Compute distribution of number of defaults: Given:
Diversity Cumulative
score 54 PD 0.2610% PDs (T)
P[Number of Idealized expected defaults
x defaults = x] Pcum 1-Pcum Rating\
0 86.8381% 86.8381% 13.1619% Maturity 5
1 12.2710% 99.1091% 0.8909% Aaa 0.0029%
2 0.8509% 99.9601% 0.0399% Aa1 0.0310%
3 0.0386% 99.9987% 0.0013% Aa2 0.0680%
4 0.0013% 100.0000% 0.0000% Aa3 0.1420%
5 0.0000% 100.0000% 0.0000% A1 0.2610%
6 0.0000% 100.0000% 0.0000% A2 0.4670%
7 0.0000% 100.0000% 0.0000% A3 0.7300%
Baa1 1.1000%
8 0.0000% 100.0000% 0.0000% Baa2 1.5800%
Baa3 3.0500%
9 0.0000% 100.0000% 0.0000%
Ba1 5.2800%
10 0.0000% 100.0000% 0.0000%
Ba2 8.4100%
11 0.0000% 100.0000% 0.0000%
4. Compute tranches: Ba3 11.8600%
Max number of B1 16.1200%

Rating PD defaults % of Notional Rounded In EUR B2 20.7100%
AAA 0.0029% 3 94.44% 94.00% 94.00 B3 27.0500%
Investors Caa1 36.3137%
Aa2 0.0680% 2 1.85% 2.00% 2.00
want: Caa2 48.7500%
Baa1 1.1000% 1 1.85% 2.00% 2.00
Caa3 69.8212%
(Remaining)
Equity 0 1.85% 2.00% 2.00
Σ 100
176
4.2 Compute the Return on Equity (RoE) (i) before securitisation and (ii) after
securitisation (when equity tranche is retained and all other tranches are sold).
Interest rate level 4.00%
Collateral pool income

Number of Interest Required
Rating Spread collaterals Volume Income Risk weight regulatory capital
Aaa 0.08% 0 0 0 0.2 0

Aa1 0.15% 0 0 0 0.2 0
Aa2 0.30% 82 82 3.526 0.2 1.312
Aa3 0.60% 0 0 0 0.2 0
A1 1.00% 0 0 0 0.5 0
A2 1.50% 0 0 0 0.5 0
A3 2.25% 0 0 0 0.5 0
Baa1 3.00% 18 18 1.26 1 1.44
Baa2 4.00% 0 0 0 1 0
Baa3 4.50% 0 0 0 1 0
Ba1 5.00% 0 0 0 1 0
Ba2 6.00% 0 0 0 1 0
Ba3 8.00% 0 0 0 1 0
B1 10.00% 0 0 0 1.5 0
B2 11.00% 0 0 0 1.5 0
B3 13.00% 0 0 0 1.5 0
Caa 20.00% 0 0 0 1.5 0
Σ 100.00 4.79 2.75
177
4.2 Compute the Return on Equity (RoE) (i) before securitisation and (ii) after
securitisation (when equity tranche is retained and all other tranches are sold).
RoE of securitised collateral portfolio
Item Size [%] Spread Volume Income/ Cost
Collateral Pool 100% 4.786
AAA 94% 0.30% 94 -4.042
Aa2 2% 0.50% 2 -0.09
Baa1 2% 3.40% 2 -0.148
ABS Cost -0.100
Retained equity Income on retained
Assets 2% 2 0.406
Balance tranche equity tranche
sheet
Bond A2 0% 0.35% 0 Debt funding cost
Funding
Equity 100% 2 0.406 Profit
ROE 20.30%
RoE of Non-securitised collateral portfolio

Item Size [%] Spread Volume Income/ Cost
Income of asset
Assets
Balance Collateral Pool 100.00% 100 4.79 pool
sheet Bond A2 97.25% 0.35% 97.248 -4.23 Debt funding cost
Funding
Equity 2.75% 2.752 0.56 Profit
ROE 20.19%
178
4.E The securitisation market post-2008
• 500 bn volume before the crisis (around 0.25 * Total Assets of Deutsche Bank)
• With crisis: double decrease: (1) in securitisation activity, (2) in selling to investors
1) Source: AFME, http://www.afme.eu/WorkArea//DownloadAsset.aspx?id=12351

179
Jan-Jun/2007 Increasing Deliquency Rates in US Subprime
Source: Global Financial Stability Report, April 2008, IMF, p. 6.
Why are loans from 2000 better than loans from 2007?:
- Securitisation provided incentive for moral hazard: sell credit risks
=> lower credit assessment / attract weak clients by interest rate
teaser 180
• Same market drop in US as in Europe

• Still, US market is much larger (has longer tradition) than the European
securitisation market
1) Source: AFME, http://www.afme.eu/WorkArea//DownloadAsset.aspx?id=12351
181
• AFME board members: AFME is not a public data provider but a lobby group.
• Here you can see who has an interest in the reactivation of the European
securitisation market.
1) Source: AFME, Annual report 2014, p. 15.

182
4.F Securitisation as an inhouse deal to create collateral
Bank
GovBond Equity
Loans
Loans Other
Other assets
Loans Deposits liabilities
Loans
...
• Bank would like to raise funds with ECB (maybe because bank does not get funds in
inter-bank market anymore)
183
Bank
GovBond Equity
Loans
Loans Other
Other assets
Loans Deposits liabilities
Loans
...
Reverse repo /
Cash ECB-repo Other liab.
Tender to bank
GovBond
• Secured borrowing from ECB, pledging the GovBond as collateral

• The loans (e.g. residential mortgages, SME loans) are not accepted as collateral
(loans of large corporates with a minimum rating are allowed)
184
Bank
GovBond Equity 1 SPV

AAA Other
Other assets
Deposits A liabilities
C
Reverse repo /
Cash ECB-repo Other liab.
2 Tender to bank
• (1)
1 Securitise loans
• 2 Enter ECB-repo pledging AAA and A tranche as collateral because securitisations
are eligible as collateral
=> although the loan are not allowed, in their securitised form they are allowed
=> ECB-securitisations (securitisation to create ECB-collateral)
• No credit risk transfer because bank still owns all loans !!!, pure funding transaction 185
• Requirements for a securitisation to be ECB-eligible:
186
4.G Impact on rating agencies
• Credibility of ratings has been

undermined (too many downgrades)
• Rating agencies are now regulated (if
they want their ratings to be used by
banks for banking regulation (credit
risk standardised approach)
• Rating model revised: liquidity and
funding of originator and SPVs are
taken into account
• Agencies have seen their revenues
affected by drop in ABS issuances
(and less need for ratings)
Source: The Credit Rating Crisis, Efraim Benmelech, Jennifer Dlugosz.
187
Agenda
0. Introduction
5. The yield curve
20. Appendix
188
Agenda
3. ...
5. The yield curve
A. Money market yield curve
B. Types of yield curves
C. Analysing and interpreting the yield curves
D. Further views on the yield curve
E. A further look at spot and forward rates
F. Swap curve
G. Fitting the yield curve
H. A secured funding curve
7. ...
189
5. The yield curve
5.A Money market yield curve
• Yield [Issuer, instrument, maturity]: main measure of return,

e.g. 5% [Germany, bond, 18 months]
• Yield curve: yields for different maturities for the same type of issuer / credit risk
• Yield curves are plotted for any debt instrument (class)
• Important yield curves:
- Government bond yield curve: primary yield curve for domestic capital market
(US: US Treasuries, Euro: German Bund, UK: Gilts)
Is this the risk-free rate? => only for some sovereigns
Is this a liquid rate? => only for some sovereigns (Italy, Germany, US, UK)
- Libor curve: up to 12M, bullet structures
- Swap curves: short-term overnight-index swaps (OIS),
long-term interest rate swaps
- Eurodollar yield curve (= exchange-traded futures curve for short-term
USD deposits in LDN, good indicator of expected money market rates)
190
5. The yield curve
5.A Money market yield curve
• Benchmark curves:
yield curve (of instruments) where yield results from supply and demand
In particular, their prices are not derived from a model!
(These instruments are like ‘commodities’: the price of 1 ounce sugar today is $5.45
because supply and demand set it there. The yield of a government bond / swap is
4.50% because supply and demand set it there.)
Benchmark instruments / yields are: government bond yields, swap rates,
exchange-traded futures, FRA (forward rate agreements), Libor, Eurodollar yields
• Use of yield curves:
- Quants:
Derive discount factors to price (other) instruments,
e.g.: price = cash flow(T) * df(T)
- Traders / issuers:
Forecast future direction of market rates based on today’s curve shape
- Central bank / government:
Extract expected inflation levels
- Portfolio / fund managers:
relative value between different maturities, same instrument (slope opinion)
relative value between different instruments, similar maturity (spread opinion)
191
5. The yield curve
5.B Types of yield curves
• Yield-to-maturity yield curve: per issuer, any coupon

• Coupon yield curve: per issuer, same coupon
(because: same issuer, same maturity might have different yields because of
different coupons (e.g. UK gilt, 5Y, 5% coupon vs. 0% coupon)
Different coupons imply (i) different reinvestment risk (the higher the coupon, the
higher the reinvestment risk) and (ii) different tax treatment (tax rate (capital
gains) ≠ tax rate (coupon income))
• Par yield curve:
Important for primary / issuance market, because bonds are issued at par (= 100)
(and not at 102 or 99.5). Par also means: par yield = coupon !!
If there are no bonds traded at par, par curve is derived from non-par bonds:
non-par bonds => zero-coupon yield curve => coupon par curve
• Zero-coupon yield curve:
This is the true interest rate level as no coupon is paid, i.e. there is no reinvestment
risk and no tax bias. The curve can be derived by bootstrapping from coupon yield
curves (e.g. swap curves)
192
5. The yield curve
• Zero-coupon yield curve:

This is the true interest rate level as no coupon is paid, i.e. there is no reinvestment
risk and no tax bias. The curve can be derived by bootstrapping from coupon yield
curves (e.g. swap curves).
N 1
1  rm N   DFn
Discount factors : DFN  n 1
, (5.4), page 235
1  rm N
1/ N
 1 
Zero  spot rates : rs N    1
 N
DF
1/ k
 DFn 1 
Zero  forward rates :n  k rf n     1, (5.8), page 242
 DF n 
193
5. The yield curve
Zero-coupon discount factors
cf. sheet “14. Ch5 Bootstrapping”
Spot zero rates Forward
1. Given swap rates: Maturity [Y] Rate [p.a.] rsT rates
1
(1 / 2 )
1 6% = 6.00% 4  107 
2 7% 7.04%   1 (1 / 3)
 93.40  6  108 
3 8% 8.11%   1
 85.47 
1 1 coupon
rs1 = swaprate
2 What is 7 EUR 0 1 2 3
worth today? 7
2
6.60 (1  6%)1 7.00
3 Fixed leg must be
worth today: 100.
93.40 3 107.00
4 Back-out zero rate Σ 100.00
from resulting
zero bond.
5 6 What are coupons 0 1 2 3

worth today? 8
5
7 (1  6%)1
Fixed leg must be 7.55 8.00
worth today: 100. 8
6
(1  7.04%) 2
Back-out zero rate 6.98 8.00
8
from resulting 7
zero bond. Σ 85.47 108.00
100.00
194
5. The yield curve
Zero-coupon discount factors
Spot zero rates
Maturity [Y] Rate [p.a.] rsT
1 6% 6.00%
2 7% 7.04%
3 8% 8.11%
10
(1  7.04%) 2
2.1. Price coupon bond: Maturity [Y] Cash flow PV Price

Coupon: 10% 1 10 9.43 105.22
2 10 8.73
3 110 87.05
2.2. Price floater: Maturity [Y] Cash flow PV Price

Coupon: 1Y-Euribor 1 6
2 ?
3 100 + ?
• The coupon bond has fixed cash flows => straight forward pricing by discounting.
• The floater has cash flows that are unknown as of today.
=> Need expected rates
=> Forward rates implied by current term structure.
• Note: We need interest rates twice:

1. To discount
2. To approximate future cash flows that are based on interest rates that are unknown as of today.
195
5. The yield curve
Forward yield curve
1  r s (T 1)   1  r   1  r 
T 1
fT sT
T
 rfT 
1  rsT  T
1
1  r s (T 1) 
T 1
rfT = Forward from T-1 till T
196
5. The yield curve
Forward yield curve

Spot zero rates Forward
Maturity [Y] Rate [p.a.] rsT rates
1 6% 6.00% -----
(1  7.04%) 2
2 7% 7.04% 8.08%  1
(1  6%)1
3 8% 8.11% 10.30%
(1  8.11%) 3
 1
(1  7.03%) 2
2.2. Price floater: Maturity [Y] Cash flow PV Price

Coupon: 1Y-Euribor 1 6.00 5.66 100.00
2 8.08 7.05
3 110.30 87.29
• Floater always has a price of 100 at fixing date and close to 100 all other dates.
• Now we can use the derived spot and forward rates to price any future payoffs.
197
5. The yield curve
Forward yield curve
today 1 year 2 years 3 years
for one year
spot one year 6% in one year 8.08%
for one year
Spot two years 7% in two years 10.30%
Spot three years 8%
198
5. The yield curve
Forward yield curve
Swap-, zero spot- and zero-forward curves

11%
10%
9%
8%
7%
6%
5%
1 2 3
Maturity
Swap (coupon) rates (zero) Spot rates Zero forward rates
199
B
5. The yield curve
Forward rates are not predictors of future spot rates
• Forward rates do not forecast future spot rates under the historical measure.
• Forward rates forecast future spot rates under an artificial probability distribution,
the terminal value distribution, not the historical / statistical distribution.
• Forward rates can be locked in for future periods (via futures or forward rate
agreements (FRA) ) to ensure a certain interest level.
Both futures and FRAs can be understood as tradable future interest rates.
200
To continue, 27/2/2015
5. The yield curve
Deriving a discount curve based on several financial instruments
• Deriving a discount curve: See exercise 2 of Chapter 5 in XLS.
• A discount curve is preferably derived from one instrument class.
• However, many instruments do not span the whole maturity spectrum:
Cash money market rates: ON, ..., 1Y
Interest rate futures: 3M,..., 12M
Interest rate swaps: 1Y, ..., 30Y
• Thus, a discount curve is derived from several different instruments. As each
instrument carries its own cash flow element and default risk element, they cannot
be combined without adjustments.
• 1. Credit risk adjustment:
- Uncollateralised interbank deals have (low) credit rate risk:
cash money market rates, swaps
- Collateralised exchange-traded deals have no credit risk: futures
- However, almost all inter-bank deals are nowadays collateralised
(like at an exchange) => no need for credit risk adjustment
• 2. Payoff adjustments:
- Futures’ pay off is linear in fixing rate: payoff = volume * (rfixing – rcontract)
- FRAs payoff is non-linear in fixing rate: payoff = PV01(rfixing, tenor)* (rfixing – rcontract)
- Non-linearity can be adjusted with non-linear instruments (e.g. options):
Caplets are options (payoff: max(Libor – strike, 0),
If they are out-of-the money they are especially non-linear.
201
5. The yield curve
5.C Analysing and interpreting the yield curve
XLS: “15. Ch5 YieldCurveDynamics” (Germany, 09/1972 – 12/2014, 508 months )

• Yield curve shapes:
Descripton Example Shape

Normal Level: average 1975–05 (33)
Slope: slightly
positive
Upward- Level: low 2009–05 (441)

sloping Slope: steep
positive
Downward- Level: high 1981–06 (106)

sloping Slope: steep
negative
Humped Increasing and

decreasing
202
5. The yield curve
• Shape of the yield curve:

Convey information on future direction of interest rates
Important for maturity / slope trades (e.g. 10Y against 1Y)
Level not so important
• Yield curve modelling (e.g. in course “Interest rate derivatives”)
Important to price derivatives where payoff depends on
level (e.g. Caplet: payoff = max(r – strike,0)) or
slope (e.g. Curve steepener: payoff = max(r(10y) – r(1Y), 0) )
• In what follows: fundamental explanations of shape,
not of dynamic (volatility, distribution of rates)
- Expectations hypothesis (explaining any shape of yield curve):
- Liquidity preference hypothesis (explaining upward-sloping yield curve):
- Money substitute hypothesis:
- Segmentation hypothesis:
- Humped yield curve:
- Combined theory:
- Flat yield curve:
203
B
5. The yield curve

not of dynamic (volatility, distribution of rates)
- Expectations hypothesis (explaining any shape of yield curve):
Ø return of rolled-short term instruments = return from long-dated instrument
increasing curve => investors expect short-term rates to rise
But: empirics show that forward rates often overestimate future spot rates, i.e.
Ø return of rolled-short term instruments < return from long-dated instrument
=> There must be another reason for investors to hold short-term instruments
- Liquidity preference hypothesis (explaining upward-sloping yield curve):
- investors prefer to invest short-term (lower credit risk, remain flexible to react
to liquidity shock) => to ‘convince’ investors for long-term maturities => pay premium
- Money substitute hypothesis (explaining upward-sloping yield curve):
- short-term bonds: increased demand (increasing price, reducing yield)
because is money substitute
- long-term bonds: increased supply (depressing price, increasing yield) for investors
to minimise cost
- Segmentation hypothesis (explaining any shape):...
- Humped yield curve:...
- Combined theory:...
- Flat yield curve:...
204
B
5. The yield curve

- Liquidity preference hypothesis (explaining upward-sloping yield curve): ...
- Segmentation hypothesis (explaining any shape):
- every investor / issuer prefer certain maturity => supply and demand in each maturity
determine the price for that maturity
- if there is less demand / more supply for a certain maturity => prices are lower/
yields are higher than for segments with high demand / low supply
- does not provide any information content (because no explanation on the ‘why’
certain maturities are preferred!)
- Combined theory (explaining any shape):
- Combination of ‘Expectation’ and ‘Liquidity preference’ theory:
0rfi = E[i-1rs1) + Li
Period n 0 1 2 3 4 5
E[rs] 4.50% 4.50% 4.50% 4.50% 4.50%
Ly premium 0.50% 1.00% 1.50% 2.00% 3.00%
Forward rate 0rfn 5.00% 5.50% 6.00% 6.50% 7.50%
Spot rate rsn 5.00% 5.30% 5.80% 6.20% 8.80% 7.00%
- Flat yield curve: unstable, likely to break out to upward- or downward-sloping

- flat, low level: long maturities likely to increase
- flat, high level: long maturities likely to decrease
205
B
5. The yield curve
• Shape of yield curve also driven by macroeconomic factors:

- short-term rates: driven by availability of cash in the markets (see EUR-area, 2015)
- positive, but modest slope: cheap money, loose monetary policy
- negative slope: often preceding recessions
- also: swap spread (= swap rate – government yield) yields information
content (see next slide)
• Information content/ predictability is important for leaving banks’ interest rate risk
positions open / unhedged (=> see chapters on ALM)
206
5. The yield curve
5.D Determinants of the swap spread
• Swap spread:= swap rate – government yield

- without market frictions: swap spread = average default risk premium of inter-
bank market
- value indicator, i.e. whether it is recommendable for ALM-team to leave interest
rate risk position open or whether to hedge / close it
- Is swap spread = (inter-bank) default risk premium?
Take another risk-free rate: 3M-GC-repo rate
Plot: swap spread 1 = swap rate – government yield (= risk-free)
Plot: Libor spread 2 = 3M-Libor – 3M-GC-rate (= risk-free)
Both: swap rate and 3M-Libor represent inter-bank default risk
=> taking the difference to a risk-free rate should only leave us with the same (!)
inter-bank default risk premium
• Curves are not identical

• Obviously, swap spread contains more
than just inter-bank default premium
207
5. The yield curve
5.D Determinants of the swap spread
• Swap spread
- Level: larger if government yields are higher
- Slope: positive slope => swap spread narrows
- High demand for swaps to hedge (e.g. large trading in bonds, active issuance
market) => swap spread widens (swaps become relatively even more expensive
compared to government bonds)
- Market volatility:
interest rate uncertainty increases wish to hedge => higher swap spread
default uncertainty (e.g. shocks like 9/11): investors seek risk-free (government)
assets => higher swap spread
- Government borrowing:
high government borrowing => increases government yields => narrows swap spread
208
5. The yield curve
5.E Fitting the yield curve
• Small errors in discount curves are magnified in forward curve

=> unsmooth forward curve
=> techniques to smooth discount curves
(trade-off between accuracy and smoothness:
if all observed points are matched => curve is not smooth
if curve is smooth => not every observed point might be matched)
• Reasons for errors in discount curves:
- irregular coupons in bonds (e.g. bank holidays, Sundays)
- need discount factors for non-standard periods (e.g. 2.3 years)
- market liquidity bias in bond prices (some bonds are demanded more (‘on the run’)
than other (‘off the run’))
- prices of bonds not from same time point
- different tax rate of bonds with different coupons
- different bid-ask-spreads in bonds
• Techniques
- Interpolation: linear, cubic (x1,x2,x3), ...
- Parametric: interest-rate models (Vasicek, Longstaff & Schwartz, ...)
- Non-parametric: Nelson & Siegel (1974), ...
209
B
5. The yield curve
5.F Implementing curves in practice
• Internal unsecured funding curve

- Important as this curve determines break-even rate for transactions
- Decides which transactions (loans, deposits, ...) are profitable and which ones are not
- Decides upon profit split between treasury and business units
- Affects many people, products / departments in a bank => is important
• Formal policy to set Internal Funding Curve (IFC) to ensure that curve is derived every day
using the same methodology, data source, etc., thus to avoid manipulations
• Input:
- Prices (yields) of outstanding bonds of the bank
- Extract risky yield curve (= coupon that bank would have to pay if
it issued a new bond today)
- Derive discount function (from risky yield curve)
- Derive spread for floating rate note (FRN)
• Internal secured cost of fund curve (sCOF): ...
210
B
5. The yield curve
5.F Implementing curves in practice
• Internal unsecured funding curve: …
• Internal secured cost of fund curve (sCOF):

- Used to derive funding curve of a secured transaction
(e.g. covered bond, securitisation, etc.)
- Take OIS-curve as lower bound for sCOF (because ENONIA = rate paid for cash collateral)
as banks’ collateral would never be better than cash
- Unsecured curve is upper bound for sCOF
- A second lower bound: Pfandbrief curve: liquid and secure
- Thus: secured curve lies between the two curves (OIS and unsecured)
- where between: depends on collateral asset class, liquidity of collateral
=> case-specific
211
Agenda
0. Introduction
5. The yield curve
20. Appendix
212
Agenda
...
5. The yield curve
A. ALM gap(s)
B. Liquidity gap
C. Managing liquidity
8. ...
213
6.A ALM gap(s)
1. Maturities 3Y, 1Y-Floater

3Y-Fixed-rate
Bond
Capital
3Y 3Y 2 dimensions
Maturity
=> 4 possible mismatch
cases between Assets
Interest Rate
1Y 3Y and Liabilities
Maturity
2. Risk: = Maturity mismatches / gaps

2.1. Liquidity-risk (gap): 2.1 Liquidity Risk
Mismatch in
Yes No
capital-maturity
1 2
2.2. Interest rate-risk (gap): Yes 3Y-Loan, 1Y-deposit, 3Y-Loan, 3Y-deposit,
Mismatch in fixed-rate fixed-rate rate fixed-rate 1Y-floating
rate (3Y IR) (1Y IR) rate (3Y IR) (1Y IR)
interest rate maturity 2.2 Interest
Rate Risk
3 4
No 3Y-Loan, 1Y-deposit, 3Y-Loan, 3Y-deposit,
1Y-floating fixed-rate fixed-rate fixed-rate
(1Y IR) rate (1Y IR) rate (3Y IR) rate (3Y IR)
214
6.A ALM gap(s)
• How are the returns for the different cases?
New wholesale,
unsecured for our bank
1Y ... 3Y
0.75% ... 2.25%
Swap
(against 6M-Euribor)
1Y ... 3Y
0.50% ... 1.50%
215
6.A ALM gap(s)
• How are the returns for the different cases?

Liquidity risk / mismatch
No Yes
Loan capital maturity 3Y 3Y
Funding capital mat’y 3Y 1Y
Loan, Ly premium 0.75% 0.75%
Funding, Ly premium 0.75% 0.25%
Liquidity return 0 0.50%
Interest rate risk / mismatch Interest rate risk / mismatch
No Yes No Yes
Loan IR maturity 3Y 3Y 1Y 3Y
Funding IR mat’y 3Y 1Y 1Y 1Y
Loan, risk-free IR 1.50% 1.50% 0.50% 1.50%
Funding, risk-free IR 1.50% 0.50% 0.50% 0.50%
IR return 0 1.00% 0 1.00%
Liquidity risk / mismatch

Conclusion:
Interest rate risk / mismatch Interest rate risk / mismatch
Risk <=> Return
No No Yes Yes
No Yes No Yes
Liquidity return 0 0 0.50% 0.50%
IR return 0 1.00% 0 1.00%
216
6.A ALM gap(s)
• All cash flows are “routed” through / pooled in treasury.
• Fixed interest rate cash flows are transferred by internal swaps ( , ) to separate IR-book.
• Liquidity maturities (and gaps) are in liquidity management, interest maturities (and gaps) are in IR-mgt.
Lending Unit Treasury Depositing Unit
ALM
Notional Notional
+ 1.50% Swap [3Y] Liquidity – 1.50% Swap [3Y]

+ 0.75% Funding spread4 [3Y] Management – 0.75% Funding spread4 [3Y]
Loan -1.50% - 6M Deposit

[3Y] Euribor
3Y, + 6M +1.50%
3Y,
6% Euribor
Interest Rate
[3Y]
1%
Management
Bullet Bullet
PD = 0.79% Credit Risk
LGD = 100% 2.50% Credit Risk
Segment: Retail (= 0.79% (EL) + 20%*8.55% (UL3) Management
Credit risk: IRBA
Operations Operations
Operations
0.25%: Operating cost (e.g. HR, Facilities) 0.25%: Operating cost
1.00% 5.00%1 2.00%2 1.00%

Break-even- Break-even-
Net margin Net margin
( Minimum) rate ( Maximum) rate
1) 5.00% = 1.50% + 0.75% + 2.50% + 0.25% 2) 2.00% = 1.50% + 0.75% - 0.25%
3) 8.55% = Φ[ (Φ-1[0.79%] + √0.15*Φ-1[99.9%]) / √(1-0.15) – 0.79% ] * 100%, 4) 0.75% = 2.25% (Wholesale, 3Y) – 1.50% (Swap, 3Y)
217
6.A ALM gap(s)
– 1.50% – 6M
[3Y] Euribor
+ 6M +1.50%
Euribor [3Y]
Interest Rate
Management
• Driver of interest rate risk:

- different currency (risk-free) interest rate curves
• Main sources of interest rate risk exposure:
- mismatch in IR-maturities between assets and liabilities (e.g. 3Y ≠ 5Y ≠ 3M-Euribor ≠ 6M-Euribor)
- prepayment risk (borrowers unexpectedly pay back their mortgage early,
if interest rates have decreased since they entered the mortgage,
What they really do: they go to another bank, take a cheaper mortgage and pay back the old one)
• Main hedges of interest rate risk: IR-swaps
218
6.A ALM gap(s)
Notional Notional

• Ly book: is a portfolio of floaters (e.g. 6M-Euribor) of different liquidity maturities

Because: all positions have the same IR-rate (e.g. 6M-Euribor) there is no interest rate risk
left in the liquidity book (this was the objective when transferring all fixed-rate interest
cash flows to the interest rate book and receiving / paying 6M-Euribor cash flows): PV01 ~ 0 EUR !!
• Main sources of liquidity risk:
- Roll-over risk (funding matures, not rolled-over and bank cannot find new funding for remaining
assets) if there are mismatches in liquidity maturities between assets and liabilities
- Unexpected withdrawals (deposits, credit lines, liquidity facilities)
• Main hedges of liquidity risk:
- Liquidity buffer
- (Liquidity lines at other banks that can be drawn in case of emergency – works like your overdraft
facility at your bank. Only, that these liquidity lines are not reliable: there have been cases where
counterparties have just cancelled these lines exactly when the bank wanted to draw on them.
Yes, the bank has a right to draw of them, because these lines are in theory “irrevocable” lines.
Yes, the bank can go to court and sue the counterparty – but at this stage, the bank might
have been illiquid. And even if not: the counterparty prefers to pay a penalty than to borrow
funds to a bank that is close to collapse. Thus, in the LCR, liquidity lines are not allowed
as part of the liquidity reserve.) 219
6.A ALM gap(s)
• Where exactly is the risk? => See below!
Δspread ΔIR
• Note: Interest rates and spreads might behave independently (2 different risks!).
E.g. Northern Rock: maybe interest rates have not changed a lot, but ... spreads : no new funding!
t0 t1 (1 year later) t2 t3
2Y
New 2Y
3Y 1Y loan
deposit at
loan deposit (initially:
new rates
3Y)
1.00% p.a. – 1.50% p.a. – 1.50% p.a.

IR income
P (= 1.50% – 0.50%) (= 1.50% – 3.00%) (= 1.50% – 3.00%)
&
L 0.25% p.a. – 2.75% p.a. – 2.75% p.a.
Liquidity income
(=0.75% – 0.25%) (=0.75% – 3.50%) (=0.75% – 3.50%)
t1
t1
t0 t0
t0 t0
220
Assets Liabilities
Loan, 6.00%
Funding, 6.00%
6.A ALM gap(s) 300 3Y, 0.5Y
0.5Y, 0.5Y 400
Loan, 7.00%
300 Funding, 6.50%
10Y, 10Y 200
4Y, 4Y
Interest rate risk Liquidity risk
• Plot volumes • Plot volumes

with their with their
interest-rate liquidity
maturity maturity
• Plot net • Plots cash

position IR-gaps Liquidity gaps flows
(= uncovered (= Δ-view of
position) volume
ladder /
previous plot)
• Plots IR- • Plots funding

Cumulative gap
sensitivity in needs
each bucket (= uncovered /
unfunded
assets)
221
Assets Liabilities
Bond, 6.00%
Funding, 6.00%
6.A ALM gap(s) 300 3Y, 0.5Y
0.5Y, 0.5Y 400
• Replacing the loan by a bond that can be sold Loan, 7.00%
Funding, 6.50%
300
within 6M => Ly maturity: 6M. 10Y, 10Y
4Y, 4Y 200
• IR-profile: unchanged, Ly risk: reduced.
• Plot volumes • Bond enters

with their with its
interest rate “liquidation
maturity horizon”, not
with its legal
maturity
• Plot net • Partially

position IR-gaps Liquidity gaps counter-
(= uncovered balances /
position) nets outflow
of 6M-funding
(– 400, 6M)
• Plots IR- • Open /

Cumulative gap
sensitivity in uncovered
each bucket funding
position is
reduced
222
Assets Liabilities
Bond, 6.00%
Funding, 6.00%
6.B Liquidity gap 300 3Y, 0.5Y
0.5Y, 0.5Y 400
Loan, 7.00%
300 Funding, 6.50%
10Y, 10Y 200
4Y, 4Y
• Plot volumes • Bond enters

with their with its
interest rate “liquidation
maturity horizon”, not
with its legal
maturity
• Gross cash flows (not netted)
• Plot net • Tradeable
Undated Assets &

products are not
Liabilities, p. 361)
position the only ones
(= uncovered where the LEGAL
position) MATURITY IS NOT
taken:
- demand deposits
- credit lines
- new business
• Plots IR-
• Open /
sensitivity in
uncovered
each bucket
funding
position is
reduced
223
6.B Liquidity gap
How many cash flow ladders does a bank have?
Purpose Assumptions Cash flow profile
1. Contractual
 Contractual maturities Nothing to model: contractual maturities
Regulatory
 Termination of liabilities are written in the product contracts
Let’s take this reporting
 No new business
balance sheet: (LCR, MT)
2. Expected /  Complete drawdowns
To identify  Use of E[]-parameters Use historical CF distribution of

Accounting
planned
funding gaps  Deposits stable products: deposits, CL, bond holdings

representation and derive  Bonds held mid-term and determine E[] and q95%:
funding plan  CL partially drawn E[] q95%
10y Bonds
Deposits
Be prepared for
10y Loans daily  Use 95%-quantiles of
3. Risk
3M-floating fluctuations
Equity parameters
(operational
liquidity [roll-over, new bus., ...]]
Credit Lines (CL)
requirement) Credit line drawings
4. – 7.: Stress
scenario (s)
To determine Scenario-specific, e.g.: Expert judgement as event is usually so

required - Deposits withdrawn rare that no statistical observations are
liquidity stress - Bonds limited liquifiable available
buffer - CL: larger drawdowns
224
6.B Liquidity gap
• Hedging liquidity risk:

1.Matching asset and liability maturities: only possible for banks that are funded
at capital or interbank markets (e.g. mortgage banks, investment banks, all banks
without retail & corporate deposits). It is possible, but almost no bank does it,
because it is too cumbersome.
Banks that are funded by retail or corporate deposits: it is the client and not the
bank who decides upon the funding maturity. For these types of (commercial / retail)
banks, matching liquidity asset and liability maturities are impossible.
2.Liquidity buffer: All1 banks hold liquidity buffers, i.e. very liquid instruments like
risk-free deposits at central bank (– 0.20% at ECB, 14/2/2015), T-bills, Covered Bonds
3.Allocate funding evenly across maturities and not 100% in one bucket:
4.Monitor which day how much funding matures and avoid maturing in holiday periods.
1) Note, that even if all cash flows are matched, this would mean: Outflows – Inflows = 0. You know from the LCR, that inflows are capped, i.e.:
100% >= Ly Reserve/(Outflows – min[75%*outflows, Inflows]). Thus, even banks that go for “cash flow matching” have to hold a Ly-reserve because of
225
LCR!
6.B Liquidity gap
• How much of undated / non-maturing assets and liabilities is stable,

i.e. still available within the next 12 months?
• Example:1
Bank has time series of deposit volumes of the last 10 years.
Bank computes annual changes of deposits volumes and takes 1%-quantile (here: – 15.80).
Using the model: bank invests the 1%-quantile of deposit balance in liquid assets
and the rest long-term. Thus, in 99% of the years, the Ly-reserve is sufficient to cover
deposit outflows and the long-term assets do not have to be “touched”/ sold
(with a presumably large loss).
unstable
core
1) XLS-worksheet: “22. Ch6 Deposit modelling(froz)”. More on this subject: http://www.boj.or.jp/en/research/brp/ron_2014/data/ron140331a.pdf

226
B
6.C Managing liquidity
• Usually, there is a funding gap in the short-maturities that is

neutralised in the longer maturities by maturing assets.
• Banks plan their new business, the prolongations of existing business
(loans and term deposits) to estimate the expected funding needs.
• These funding needs can be closed with spot funding or forward funding:
Bank 1 Bank 2
227
6.C Managing liquidity
• Case study 6.1 (page 366ff)

• Important rows (here): gap, gap as % of total funding, Gap limit
Important, because “gap as % of total funding” is the limited quantity
• Most banks have limits on the quantity “Net gap”, because it is the
cumulative liquidity need that is not covered by inflows and thus might be
covered by liquidity reserve (if one assumes a worst case scenario that no external
funding can be raised!).
228
Agenda
0. Introduction
5. The yield curve
20. Appendix
229
Agenda
...
A. Basic concepts
B. Interest rate risk and source
C. The ALM desk
D. Liquidity and interest rate risk
E. The cost of funding
F. Generic ALM policy for different banks
G. Securitisation
H. Middle-Office Treasury Procedures and ALM practice
9. ...
230
7.A Basic concepts
Liquidity is a term with distinct but related meanings depending on the
context.
1. Asset / Market Liquidity (Trader):
Asset = liquid, if can be quickly converted into cash without material liquidation
cost (asset liquidity is also called “market liquidity”)
2. Institutional Liquidity (Treasurer):
Institution = liquid, if it is able to meet all payment obligations ( CFt ) on time
Inflows  Outflows
CFt  CFt
Liabilities are of shorter term than assets => Outflows are of shorter term than inflows
If CFt  CFt : Need Liquidity Management

L t : Asset Sale, Ft : new Funding
CFt  L t  Ft  CFt
3. National Liquidity (Central Banker):
Liquidity : = Means of payment or legal substitutes1
= Money Basis (Bank notes + Central Bank Deposits)
+ Book money (Money created by commercial banks)
*) All Assets that have legal payment character.
231
7.A Basic concepts
• Foundations of ALM
- simultaneously manage assets and liabilities
- manage balance sheet, i.e. have an aggregate / macro view
=> aggregate cash flows, aggregate fixed / floating interest rate volumes, aggregate
interest income / expenses, aggregate interest rate sensitivity ... and not per product.
• 4 key concepts:
1 Liquidity
2 Money market term structure
3 (Liquidity and interest) maturity profile of the book
4 Default risk
• Interest rate gap management:

- Manageable with derivatives (FRA: locks in future spot rates, swaps: fix  floating)
- Note: To speculate in IR, bank does not need loans and deposits, a portfolio of swaps
could perfectly replicate the IR-position of a large bank. Thus, without doing loans /
deposits, one could take the same IR-risk / chance as a large bank.
• Liquidity rate gap management:
- managed with cash instruments (bonds, commercial papers, securitisations) as no
liquidity derivatives (except Ly lines) exist!
232
7.A Basic concepts
0
3M 3M 3M 3M 3M
loan fund fund loan fund
6.50% 5.50% 5.50% 6.50% 5.50%
6M 6M 6M 6M 6M
3M loan fund loan fund loan
6.75% 5.75% 6.75% 5.75% 6.75%
3M 3M 3M
fund loan fund
E[5.10%] E[6.10%] 6.60%FRA
6M
0–3M 1.00% 1.00% 1.25% 0.75% 1.25%
3M–6M 1.00% E[1.65%] E[0.35%] 0.15%
For sure Uncertain/ risky
233
B
7.B Interest rate risk and source
• Banking book:
- Loans and deposits, held to maturity, valued “at cost”, i.e. not at market prices
- Shortage / excess of customer funds are funded / invested in wholesale / inter-bank
market
• ALM:
- Measurement and monitoring of interest rate and liquidity risk
- Managing any balance sheet constraints: liquidity gap limits, debt policy,
any Basel III / CRR – ratio (CET1-R, T1-R, TC-R, LR, LCR, NSFR)
- Hedging of interest rate and liquidity risk
• Open interest rate positions always affect a result metric:
- Open fixed rate positions: constant in earnings, but volatile in value
- Open fixed floating rate positions: constant in value, but have volatile earnings
234
• Sources of interest rate risk (in the banking book)

- Gap risk: difference in interest rate maturity, sensitive to parallel shifts (change of level)
- Yield curve risk: sensitive to rotation (change of slope)
- Basis risk: assets and liabilities are priced off
different yield curves
Example: Assets linked to “US prime rate”
Liabilities linked to Eurodollar Libor
(Eurodollar Libor = interest rate for US deposits
in LDN)
- Run-off risk: risk that depositors withdraw deposits because deposit interest rates are
low (compared to non-deposit investment alternatives like stocks, funds, etc.)
Note: I disagree with the text book. Interest rates are rarely the reason for large
withdrawals, but rather a loss of confidence. The EUR-area has currently extremely low
interest rates and customers do not massively withdraw deposits.
- Option risk: customers can terminate ahead of contractual arrangements
(e.g. for mortgages, for callable bonds, etc.) 235
7. Asset–liability management II Assets Liabilities
Loan, 6.00%
7.B Interest rate risk and source 300 3Y, 0.5Y
Funding, 6.00%
0.5Y, 0.5Y 400
Interest rate gap analysis 300

Loan, 7.00%
Funding, 6.50%
10Y, 10Y 200
4Y, 4Y
• The IR-gap directly translates into a change in Net Interest Income:
Gap = Air – Lir (Volume of interest rate-sensitive assets and liabilities)

ΔNII = Gapcum * Δr = (Air – Lir ) * Δr(Δr : interest rate relevant for valuation)
Question: why Δr does not
have a maturity index, like Δrt?
• Positively gapped
• NII increase in rising interest rates because new
funding at roll-over dates (100 at t=0.5, 300 at
t=4) becomes more expensive.
• NII grows in decreasing rate environment
• Popular maturity buckets: [0,0.25y), [0.25y,0.5y), [0.5y,1y), [1y,2y), [2y,5y), [0.5y,∞)
236
Example:1 1) Compute the rate sensitivity of Net Interest Income (NII) for the
following bank assuming constant position volumes.
0.5 0.5 1 3 ∞
Total [ON, 6M] (6M, 12M] (1Y, 2Y] (2Y, 5] (5Y, ∞]
Assets Mortgages, fixed rate 125.00 10.00 10.00 25.00 40.00 40.00
Mortgages, floating rate 100.00 50.00 50.00
Interbank demand deposits 75.00 75.00
Sovereign bonds 60.00 30.00 0.00 30.00
Cash 20.00 20.00
Non-earnings assets 20.00 20.00
Total assets 400.00 135.00 60.00 55.00 40.00 110.00
Liabilities Term deposits -200.00 -50.00 -100.00 -50.00

Retail Demand deposits -125.00 -125.00
Interbank demand deposits -25.00 -25.00
Non-interest bearing liabilities -10.00 -10.00
Capital -40.00 -40.00
Total Liabilities -400.00 -200.00 -100.00 -50.00 0.00 -50.00
Swap Receive [fix] 200.00 100.00 100.00

Pay [floating] -200.00 -200.00
Periodic gap -265.00 -40.00 105.00 140.00 60.00
Cumulative gap -265.00 -305.00 -200.00 -60.00 0.00

Δr 1.00%
Δ NII per bucket -1.33 -1.53 -2.00 -1.80
Δ NII per bucket p.a. -2.65 -3.05 -2.00 -0.60
*(– 1)
(1) Fixed rate volumes, Receive 465.00 405.00 250.00 110.00 0.00
(2) Fixed rate volumes, Pay -200.00 -100.00 -50.00 -50.00 0.00
(1) + (2) = CumGap 265.00 305.00 200.00 60.00 0.00
Δ NII per bucket -1.33 -1.53 -2.00 -1.80
*) See XLS-worksheet “24. Ch7 NII-Slides” =(400 – 135)+(200 – 0) =465 – 60 – 0 =250 – 40 – 100
237
Interbank demand deposits -25.00 -25.00
Non-interest bearing liabilities -10.00 -10.00
7. Asset–liability management II -200.00
Capital
Total Liabilities
-40.00
-400.00
-100.00 -50.00 0.00
-40.00
-50.00
7.BSwap
InterestReceive
rate [fix]
risk and200.00
source 100.00 100.00
Example:1 2) Compute the
Pay [floating] change-200.00
-200.00 in NII for the next year [0,1).
Periodic gap -265.00 -40.00 105.00 140.00 60.00
Cumulative gap 0.5

-265.00 0.5
-305.00 1
-200.00 3
-60.00 ∞
0.00
Δr Total
1.00% [ON, 6M] (6M, 12M] (1Y, 2Y] (2Y, 5] (5Y, ∞]
Assets Mortgages, fixed rate
Δ NII per bucket 1%
125.00 10.00
-1.33 10.00
-1.53 25.00
-2.00 40.00
-1.80 40.00
Mortgages, floating
Δ NII per bucket p.a.rate 100.00 -2.65
50.00 -3.05
50.00 -2.00 -0.60
Interbank demand deposits 75.00 75.00
(1) FixedSovereign
rate volumes,
bondsReceive 60.00 465.00 405.00 250.00
30.00 110.00
0.00 0.00
30.00
Change
(2) Fixed rate
Cash in Income
volumes, Pay in 20.00 -200.00 -100.00 -50.00 -50.00 0.00
20.00
(1) + (2) = [0,1Y]
Non-earnings CumGap
assets 20.00 265.00 305.00 200.00 60.00 0.00
20.00
ΔTotal
NII perassets
bucket 400.00 -1.33
135.00 -1.53
60.00 -2.00
55.00 -1.80
40.00 110.00
-3.00% 8.55
-2.00% 5.70
Liabilities Term deposits -200.00 -50.00 -100.00 -50.00
-1.00% 2.85
0.00% Interbank demand 0.00deposits -25.00 -25.00
1.00% Non-interest bearing
-2.85liabilities -10.00 -10.00
2.00% -5.70
Capital -40.00 -40.00
3.00% -8.55
Total Liabilities -400.00 -200.00 -100.00 -50.00 0.00 -50.00
Swap Receive [fix] 200.00 100.00 100.00

Pay [floating] -200.00 -200.00
Periodic gap -265.00 -40.00 105.00 140.00 60.00
Cumulative gap -265.00 -305.00 -200.00 -60.00 0.00

Δr 1.00%
Δ NII per bucket -1.33 -1.53 -2.00 -1.80
(1) Fixed rate volumes, Receive 465.00 405.00 250.00 110.00 0.00
(2) Fixed rate volumes, Pay -200.00 -100.00 -50.00 -50.00 0.00
(1) + (2) = CumGap 265.00 305.00 200.00 60.00 0.00
Δ NII per bucket -1.33 -1.53 -2.00 -1.80
*) See XLS-worksheet “24. Ch7 NII-Slides”
238
Example:1 3) Compute the change in NII for the next year [0,1) if positions
also change.
• Assume that positions change with the following volume – rate relation:
(increasing interest rates => assets decrease, liabilities increase)
1
Vt 1  Vt  (1  (  r ) ) 3
Elasticity parameter Position

-10.00% Mortgages, fixed rate
-5.00% Interbank demand deposits
15.00% Retail Demand deposits
• Obviously, the asymmetric growth of assets and liabilities implies an imbalance

between them. This imbalance needs to be funded or invested. Assume that this
funding / investment is done in the capital market with position
“Interbank demand deposits”.
239
oday's volume:
also change. Elasticity parameter
125 -10% Mortgages, fixed rate
75 -5% Interbank demand deposits
Assets Δr Position Total [ON, 6M] (6M, 12M] (1Y, 2Y] (2Y, 5] (5Y, ∞]
-2.00% Mortgages, fixed rate 140.75 11.26 11.26 28.15 45.04 45.04
-2.00% Interbank demand deposits 82.50 82.50 0.00 0.00 0.00 0.00
-1.00% Mortgages, fixed rate 137.50 11.00 11.00 27.50 44.00 44.00
-1.00% Interbank demand deposits 80.95 80.95 0.00 0.00 0.00 0.00
1.00% Mortgages, fixed rate 112.50 9.00 9.00 22.50 36.00 36.00
1.00% Interbank demand deposits 69.05 69.05 0.00 0.00 0.00 0.00
2.00% Mortgages, fixed rate 109.25 8.74 8.74 21.85 34.96 34.96
All other assets 225.00 10.00 10.00 55.00 40.00 110.00
-25 Interbank demand deposits

-125 15% Retail Demand deposits
Liabilities Δr Position Total [ON, 6M] (6M, 12M] (1Y, 2Y] (2Y, 5] (5Y, ∞]
-2.00% Retail Demand deposits -106.97 -106.97 0.00 0.00 0.00 0.00
-2.00% Interbank demand deposits -66.28 -66.28 0.00 0.00 0.00 0.00
-1.00% Retail Demand deposits -110.69 -110.69 0.00 0.00 0.00 0.00
-1.00% Interbank demand deposits -57.76 -57.76 0.00 0.00 0.00 0.00
1.00% Retail Demand deposits -139.31 -139.31 0.00 0.00 0.00 0.00
2.00% Retail Demand deposits -143.03 -143.03 0.00 0.00 0.00 0.00
All other liabilities -250.00 -50.00 -100.00 -50.00 0.00 -50.00
Swap Receive [fix] 200.00 0.00 0.00 100.00 100.00 0.00
Pay [floating] -200.00 -200.00 0.00 0.00 0.00 0.00
0.5 0.5 1 3 ∞
Δr Position [ON, 6M] (6M, 12M] (1Y, 2Y] (2Y, 5] (5Y, ∞]
-2.00% Periodic gap -319.49 -78.74 133.15 185.04
-2.00% Cumulative gap -319.49 -398.23 -265.08 -80.04
-2.00% Δ NII per bucket 3.19 3.98 5.30 4.80
-1.00% Periodic gap -316.50 -79.00 132.50 184.00
-1.00% Cumulative gap -316.50 -79.00 132.50 184.00
-1.00% Δ NII per bucket 1.58 0.40 -1.33 -5.52
1.00% Periodic gap -293.50 -81.00 127.50 176.00
1.00% Cumulative gap -293.50 -81.00 127.50 176.00
1.00% Δ NII per bucket -1.47 -0.41 1.28 5.28
2.00% Periodic gap -290.51 -81.26 126.85 174.96
2.00% Cumulative gap -290.51 -81.26 126.85 174.96
2.00% Δ NII per bucket -2.91 -0.81 2.54 10.50
240
also change.
Δ Income in next year
Without position
With position changes changes
-2.00% 7.18 5.7
-1.00% 1.98 2.85
1.00% - 1.87 -2.85
2.00% - 3.72 -5.7
241
To continue Fri, 6/3
Interest rate gap analysis
• Assumptions underlying gap analysis (that ΔNII ~ gap):

- only measures NII-changes due to changes of level (not change of slope)
- re-pricing in bucket take place at mid-point, e.g. repricing in [1y,2y) at 1.5y
• Weaknesses:
- Static: today’s asset & liability mix are taken as constant, new business
not incorporated
- No consideration of time value of money, i.e. measures the change in NII
(e.g. ΔNII in [1y,2y) = 10 mEUR and ΔNII in [2y,5y) = 10 mEUR).
Total change = 10 mEUR + 10 mEUR, but one should somehow present-value the
changes to make them comparable.
- Arbitrary (and no objective procedure) setting of time periods
([1y,2y) and why not [1.1y,2.1y)?)
242
7.C The ALM desk
• ALM desk can be:

- Cost centre: hedge all risks (profit target = 0) and minimise operating cost
- Minimise cost of funding: keep funding risk positions open to benefit from decreasing
rates and close them (to hedge against rising rates)
ALM-profit = actual NII – fully hedged NII
(Gaps) are monitored and limited
- Profit centre:
ALM-(periodic) profit = actual NII – fully hedged NII
or ALM-(value) profit = ΔPV (Assets) – ΔPV (Liabilities)
Exposure measured as gap or ΔNII99%, ΔPVEQ99%
• Traditional tasks of ALM desk:
1.Interest-rate risk management: measure IR-exposure,
take opinion, i.e. that there will be a profit for the (subjectively) expected rate
change: ΔrOpinion
ΔNII = Gap * Δr = (Air – Lir ) * ΔrOpinion >> 0
(and if the opposite (–) happens: ΔNII = Gap * Δr = (Air – Lir ) * (– ΔrOpinion) << 0 )
2.Liquidity funding management: set up Ly reserve and keep it >= (regulatory) limits
3.Report on: exposure (= limit usage) and compare them to limits
4.Compute regulatory ratios and ensure that they are beyond regulatory minima
243
7.D Liquidity and interest rate risk
• Note that if this table was a liquidity gap table,

“variable mortgages”
(~50% of balance sheet) have a maturity of
“<1M”, i.e. they are linked to 1M-Libor and seem
to be repayable at every IR-reset date and
assumed to be repaid.
• To be a liquidity gap table, the IR-derivatives
must enter with their cash flows, not with their
notionals (notionals are used in IR-gap table).
• So, maybe this table is an IR-gap table ...
If it was a liquidity gap table:

• This bank has a net funding need
in the next 1M of 1,351,090,000 GBP
and in the subsequent 2 months of
1,234,540,000 GBP.
• Note that all term funding positions are bucketed
at their legal maturity, i.e. with the (worst case)
assumption of “no roll-over”.
• Note that all term assets are bucketed at legal
maturity, i.e. with (best case) assumption of
“not roll over”.
244
• Some products cannot enter with their contractual profile

because customers deviate from contracts. Thus, the behaviour needs to be modelled.
- Demand deposits: are not demanded daily => split into core and unstable portion
Core portion: bucketed in long maturity
Unstable portion: bucketed short-term / ON
Example:
[ON, 1W): 10%, [1W, 1M): 15%, [1M, 3M): 15%, [3M, 6M): 15%,
[6M, 12M): 15%, [12M, 24M): 10%, [24M, 36M): 10%, [36M, ∞): 10%
- Credit lines, liquidity facilities: model drawdown behaviour
(average and peak drawings, average drawing: funded long-term,
peak drawings: backed with liquidity reserve)
- Prepayment of loans: some loans allow customers to prepay. Prepayment rates to be
estimated because bucketing the loan at its contractual schedule would be wrong.
Prepayment rates: often used historical (averages and peaks),
sometimes augmented by explanatory macroeconomic factors like GDP,
IR-differential (today’s rate of a new mortgage – contract rate of existing mortgage)
245
• Limiting the funding gap: what should be the maximum tolerable funding gap (= limit)?
- Sum of all lines that the bank has with other banks
But: (1) This amount is not known with certainty to us. (2) This amount can change
from one day to another, if the other bank runs out of capital / liquidity, they will
not lend to us anymore. And even if they have plenty of capital and liquidity, they
might not want to lend to us when there are rumours in the market that we are
struggling ... (but this is when we would need money).
- Liquidity reserves: ... next slide
in case of rumours
246
• Limiting the funding gap: what should be the maximum tolerable funding gap (= limit)?
- Sum of all lines that the bank has with other banks
- Liquidity reserves [ ] = capacity to be self-funded, effectively counterbalances
any unexpected liquidity needs.
• We would have a limit breach ( ) in either case: without additional liquidity

reserve (after 2 weeks) and with additional liquidity reserve after 7 weeks
• Banks are usually OK with breaches after 4 weeks (1 month), because the regulation
(LCR) also only cares for the next 4 weeks (30 days).
• Also: after 30 days, a bank Survival time т = 4 weeks
should have been able to
convince investors that it is
fundamentally healthy and
only has a liquidity problem,
not a solvency problem.
• Thus: new funding should in case of rumours
be available.
247
• Interest rate gap:

- Interest rate gap report:
Gap [in bucket i] = volume of assets that have a fixed rate in that bucket
– volume of liabilities that have a fixed rate in that bucket
Used to approximate ΔNII = gapcum * Δr
- PVBP-report: by how much market
value changes in case that yield
curve shifts by 1 bp:
(1 basis point = 0.01% = 1/10,000)
Euro:
(i) PVBP > 0: ON, 1W, 1M, 2M, >= 5Y
Increase of 1bp increases value
=> fixed rate Liab. > fixed-rate A.
(ii) PVBP < 0: 3M – 4Y
=> fixed rate A. > fixed rate Liab.
Because fixed rate assets lose in value (PVBP<0), fixed rate liabilities gain in value
(PVBP>0) if yield curve shifts by +1 bp. In a bucket with PVBP > 0 across all assets and
liabilities, this means that fixed-rate liabilities dominate (and vice versa).
• Only fixed rate assets and fixed rate liabilities to be included
(for liquidity gap analysis: all assets and all liabilities to be included).
248
• Duration gap analysis:

- same as PVBP, duration is a measure of the sensitivity of the market value (and not
NII) w.r.t. interest rate changes:
N
PV
dPV   dri
i 1 ri
NPV PVBP  PVBP  y  dPV

mod D   PVBP
PV
NPV mod D   PV  mod D  y ( D)   PV  [~ PVBP / PV ]  y ( D)

  PVBP  y ( D)  NPV PVBP
- => Gap (interest rate sensitivity) can also be approx’ed as (modified) duration gap:
ΔNPV = –modD * Δy
Total
modD
Instead of PVBP, the table would

contain modD for the different buckets.
- Attention: modD is only a good approximation for small Δy (say <0.30%). Only parallel
shifts (because yield is shifted, not zero rates).
249
B
• Example for the relation between PVBP and modD as IR-sensitivity measures:
N
PV 5yr fixed Coupon Bond
dPV dPV   dri  0.044373 Nominal 100
i 1 ri Coupon 3%
ΔPV PV  PV ( y0 )  PV ( y0  0.01%) ~ dPV Interest Rate Curve:

maturity (m) swap rate zero rate
(%) (%)
PV 12 3,19 3,19
PVBP PVBP   443.73
0.01% 24 3,25 3,25
D and modD 36 3,40 3,40
also approximable by PV01
5
48 3,50 3,51
Duration
 PV (i ) * t (i ) mod D   PV 01  4,57  4.54  mod D exact
60 3,65 3,67
D i 1
 4,71 PV
PV D  mod D * (1  y )  4,73  4.71  D exact 5y-Coupon CashFlow PV
3% 3 2,91
Modified mod D  D  4,54 3% 3 2,81
duration (1  y )
3% 3 2,71
3% 3 2,61
3% 103 86,02
ΔNPV NPV  PVBP  y  443.73  0.7%  3.1061 Present Value 97,07

Yield (%) 3,65
PV01 (form.
ΔNPV der.)
(via modD) NPV   PV  mod D  y ( D )  97.07  4.54  0.7%  3.0849 –443,73
PV01 (econ.) –0,044373
250
B
• Example to compute duration gap and interest rate exposure:1

0: Given is the following balance sheet:
Markt Markt
Note that all instruments Rate value Assets Liabilities value Rate
100.0 Cash Term deposit, 1Y 620.0 5.00%
are at par.
Senior unsecured
12.00% 700.0 Commercial loan, 3Y corporate bond issue, 3Y 300.0 7.00%
8.00% 200.0 Treasury bond, 6Y Equity 80.0
1000 Σ Σ 1000
1: Compute the duration of the positions:
Cash flows x Time buckets
Position Coupon 0 1 2 3 4 5 6
Cash 100.0
3y-commercial loan 12% 700.0 84.0 84.0 784.0 0.0 0.0 0.0
Treasury bond, 6Y 8% 200.0 16.0 16.0 16.0 16.0 16.0 216.0
Term deposit, 1Y 5% 620.0 651.0
Senior unsecured corporate bond issue,
7% 3Y 300.0 21.0 21.0 321.0
Present values x Time buckets

Mod
Position 0 1 2 3 4 5 6 yield NPV(yield) Duration [y] PV
Cash -100.0 100.0 0.00 0.00 100.0
3y-commercial loan -700.0 75.0 67.0 558.0 0.0 0.0 0.0 12.00% 0.00 2.69 700.0
Treasury bond, 6Y -200.0 14.8 13.7 12.7 11.8 10.9 136.1 8.00% 0.00 4.99 200.0
Term deposit, 1Y -620.0 620.0 0.0 0.0 0.0 0.0 0.0 5.00% 0.00 1.00 620.0
Senior unsecured corporate bond issue, 3Y
-300.0 19.6 18.3 262.0 0.0 0.0 0.0 7.00% 0.00 2.81 300.0
*) See XLS-worksheet “26. Duration Gap EVE”

251
B

0: Given is the following balance sheet:
Markt Markt
Rate value Assets Liabilities value Rate
Senior unsecured
1000 Σ Σ 1000
1: Compute the duration of the positions:
Cash flows x Time buckets
Position Coupon 0 1 2 3 4 5 6
Cash 100.0
3y-commercial loan 12% 700.0 84.0 84.0 784.0 0.0 0.0 0.0
Treasury bond, 6Y 8% 200.0 16.0 16.0 16.0 16.0 16.0 216.0
Term deposit, 1Y 5% 620.0 651.0
7% 3Y 300.0 21.0 21.0 321.0

Mod
Cash -100.0 100.0 0.00 0.00 100.0
Treasury bond, 6Y -200.0 14.8 13.7 12.7 11.8 10.9 136.1 8.00% 0.00 4.99 200.0
Term deposit, 1Y -620.0 620.0 0.0 0.0 0.0 0.0 0.0 5.00% 0.00 1.00 620.0
-300.0 19.6 18.3 262.0 0.0 0.0 0.0 7.00% 0.00 2.81 300.0

252
B

2: Compute the duration gap:
Weighted duration of assets: 2.88 years

Weighted duration of liabilities: 1.59 years
Duration gap (DGAP): 1.42 years
e sheet:
MV Liab.
Markt Markt DGAP  D Assets
 Assets
 D Liabs.
Rate value Assets Liabilities value Rate MV
Senior unsecured
1000 Σ Σ 1000

253
B

3: Compute the change in EVE (i) analytically and (ii) approximated with DGAP:
(i) Analytically:
IR-shift: 1% Present values x Time buckets

No Position Coupon 0 1 2 3 4 5 6 yield NPV(yield) New PV
Cash -100.0 100.0 100.0
3y-commercial loan 12% -700.0 74.3 65.8 543.4 0.0 0.0 0.0 12.00% -16.53 683.5
Treasury bond, 6Y 8% -200.0 14.7 13.5 12.4 11.3 10.4 128.8 8.00% -8.97 191.0
Term deposit, 1Y 5% -620.0 614.2 0.0 0.0 0.0 0.0 0.0 5.00% -5.85 614.2
7% 3Y -300.0 19.4 18.0 254.8 0.0 0.0 0.0 7.00% -7.73 292.3
Economic Value of Equity (EVE)
Markt Markt
(i) Analytically: Rate value Assets Liabilities value Rate
Senior unsecured
974.50 Σ Σ 974.50
Change in equity value: -11.92
(ii) Approximated with DGAP:

Duration gap: 1.419
Average yield on total assets: 10.00%
Yield shift: 1.00%
Change in equity value: -12.902 ≈ -11.92
y
EVE   DGAP  MV Assets
*) See XLS-worksheet “26. Duration Gap EVE” (1  y Assets )
254
7.E Cost of funding
• What are the funding costs of a loan with the following amortisation schedule?
Hypothetically
matched funded
Loan, 500 mEUR ON-tranche

200 mEUR
1.05% p.a.
Amortisation
schedule:
1W-tranche 200 mEUR
ON: 40%,
1.07% p.a.
1W: 40%,
3M: 20%
3M-tranche
100 mEUR
1.15% p.a.
• Break-even funding rate = discount rate that

equates PV(repayment CFs) = amount funded
1
200  (1  1.05%  )
500  365
1
(1  WACF ) 365
7
200  (1  1.07%  ) XLS – Goalseek
 365
7 1.1426% p.a. (= Internal Rate of Return,
(1  WACF ) 365
yield, ...)
90
100  (1  1.15%  )
 365
90
(1  WACF ) 365
• Loan officer should charge a loan rate of ≥ 1.1426% p.a. to cover the funding cost.
• A loan rate of <1.1426% would generate a loss in terms of funding cost.
255
B
7.F Generic ALM policy for different banks
• ALM Policy (1/2)

• Asset-Liability Committee (ALCO):
Chief Executive Officer (CEO), Chief Financial Officer (CFO),
head of retail banking, head of corporate banking, head of treasury,
head of risk management, head of internal audit
Chair: CFO
• Scope: group and subsidiary balance sheets
• Objectives:
- Interest rate risk:
- Ratio of interest-rate sensitive assets to interest-rate sensitive liabilities
- Gap reports
- Risk reports
- Banks’ expectation on future level of interest rates
- Stress test for unexpected rate changes (how do volumes react?)
- Current interest rates for loans and deposits
- Liquidity risk:
- Maturity distribution (and funding distribution) of liquidity reserve
- Current liquidity gap profile and expected future gap profile
• Interest rate risk policy: ...
• Liquidity policy: ...
256
B
7.F Generic ALM policy for different banks
• ALM Policy (2/2)

• Asset–Liability Committee (ALCO): ...
• Objectives:...
• Interest rate risk policy:
- Keep earnings volatility against a curve shift low
- 80% < Air/ Lir – cumulative ratio < 110%, for 6M buckets, 12M buckets
- Corrective actions of stress tests might drop NII by more than 10%
- More sophisticated banks: volume gap, duration gap, PVBP gap
- +/–15% < gap-to-earnings assets +/–20%
- Simulations: define starting balance sheet and income statement
(might be today’s balance sheet + expected / planned growth)
run interest rate scenarios (+/–100bps, +/– 250bps parallel, steepening / flattening,
increase in IR-volatility, change in swap spreads) and derive new balance sheet
Measure ΔNII due to shock
• Liquidity policy:
- 85% < loans-to-deposits < 95%
- 90% < loans to core deposits < 95%
- Corrective actions if outside of intervals
• Target return level (if ALM is profit centre): 14% – 15% target RoE
257
B
7.G Securitisation
• Method of balance sheet management, because portfolios of loans are sold (to SPVs)
- Might: reduce credit risk exposure on assets, reduce funding cost, improve
shareholder value generation r EUR Assets Liabilities EUR r
Debt 96 10%
10.20% 100 Loans
Subord. 2 10.20%
Equity 2 25%
Asset return  10.20%  96%  10%  2%  RoE  2%  10.20%
 RoE  19.80%  25%  cost of equity
Funding cost BS  95%  10%  2%  10.20%  2%  25%  10.30%
r EUR Assets Liabilities EUR r
Debt 86.4 10%

10.20% 90 Loans
Lowered
Subord. 1.80 10.20% funding
Equity 1.80 25% cost
Securitisation: 0.20% Servicing cost
Sec‘ed Debt 9 9.80%
10.20% 10
loans Subord. 1 10.61%
Sold to investors
Funding cost SecPF  90%  9.80%  10%  10.61%  0.20%  10.08%

RoE  19.13% (because securitisa tion makes a profit : 10 * ( 10.20% - 10.08%))
(10.2% * 90%  10% * 86.4%  10.2% *1.8%  RoE *1.8%  10% * (10.2% - 10.08%))
B
7.H Middle Office
• Controls ALM-function
• Funding model:
- Funding “cash”: each business line owns its proportion of overall cash
- Funding “Balance sheet”:
- Treasury owns all cash
- Business units sell and buy cash to / from treasury
- Treasury is cash broker between cash providing (depositing) and cash looking
(lending) business units
Lending Unit Treasury Depositing Unit
ALM
Loan Notional Notional Deposit

3Y, 6% 3Y, 1%
Bullet Bullet
• Selling / buying cash at funds transfer price (FTP): ...
259
B
7.H Middle Office
• Controls ALM-function
• Funding model: ...
• Selling / buying cash at funds transfer price (FTP):
- Rate of lending to treasury and borrowing from treasury
- Rate that treasury would also pay on external borrowings
(thus, business units are not penalised when borrowing from treasury instead of
borrowing from external sources. Units get market prices.)
- Sometimes: treasury charges bid-ask-spread to cover operational cost in treasury
(salaries, IT-infrastructure, etc.)
- Maturity-specific prices
• Treasury book split into “term portfolio” (with transfer price: term premium)
and “overnight pool” (with transfer price ON-rate)
260
Agenda
0. Introduction
5. The yield curve
20. Appendix
261
Agenda
...
A. Trading approach
B. Interest rate hedging tools
C. Interest rate swap hedging application
D. Interest rate risk exposure and option hedging
E. Hedging using bond future contracts
F. Hedging credit risk with credit derivatives
10....
262
8.A Trading approach
• ALM: to speculate (take positions, profit centre) or to hedge

• Trading strategies:
- Maturity speculation: long-term receiving vs. short-term paying
(funded: long-term loans funded by short-term deposits,
derivative: receiver swap)
- Speculation on spread between 2 types of collateral:
(1) Owning collateral (trading at Libor – x bp)
repo (= receiving cash and lending the collateral)
using the cash to buy CD with Libor + y bp
=> Spread earned: (y – x) bp (as long as spread doesn’t tighten!)
(2) Owning GC collateral
repo (= receiving cash and lending the GC collateral)
using the cash to lend against emerging market collateral (+4%)
=> Earns the spread, risking that spread tightens
- Special collateral: ...
263
8.A Trading approach
• ALM: to speculate (take positions, profit centre) or to hedge

• Trading strategies:
- Maturity speculation
- Speculation on spread between 2 types of collateral:
- Special collateral: instruments that are “en vogue”, i.e. demanded because:
- government bond to be issued is shortened by traders
- outright short-selling (betting on a price drop)
- hedging (shortening gov-bond that corporate bond is benchmarked against)
- derivatives trading creating demand for specific stock
- dividend speculation: if expected to pay low dividend
=> those that have shortened the instrument must buy it back which generates the
extra demand
- Consequences of “being traded special”:
- giving it away (in a repo) lowers the repo (funding) rate (below GC 1 collateral)
- receiving it in a reverse repo makes the repo more expensive
(above GC collateral)
*) GC : General Collateral
264
8.B Interest rate hedging tools
• Interest rate policy

- Targets and limits for IR-exposure
- Measure to quantify IR-exposure
- Daily measurement and monitoring of deviation from targets and breaching limits
- Potential actions to return exposure back within limits
- IR-scenarios: parallel shifts, pivotal shifts
- No IR-risk in customer portfolios
• 1. Trading book IR-exposure: DV01, in trading systems
• 2. Customer book: no IR-risk left in customer book. Transferred (via internal swaps)
to IR-mgt in treasury.
• 3. ALCO book: contains special items
- Solvency risk buffer 1: Equity capital (usually duration = 10y)
- Liquidity risk buffer
- Placements with local branches and money markets (intra-firm financing)
- IR-hedges at group level
- FTP sweep book
265
Interest rate futures Forward Rate Agreements Interest rate swaps Options Bond futures
• To hedge interest rates in future periods [of 90 days length]

• Traded futures: Sterling future, Eurodollar, Euribor futures
• Rate of a future fixed-term deposit (buy future)/ loan (sell future) of 90 days maturity
• Derivative, because the deposit is actually never exchanged, only the interest rate
streams are paid / received.
• Example: As of 1 June:
6.78% (93.22)
Locks in 6.78% at
As of 1 Sept:
1 June for [1 Sept
6.25% (93.705)
– 1 Dec] going Sept
– Future short
time
1 June 1 Sept 1 Dec

(today)
Effective lending rate = 6.25% + (93.705 – 93.22)/100

= 6.25% + 0.485% = 6.735% = the one from the future contract at 1 June
266
• Eurodollar future currently traded at 4.9% (duration: 0.25)

Mod
Cash -100.0 100.0 0.00 0.00 100.0
Treasury bond, 6Y -200.0 14.8 13.7 12.7 11.8 10.9 136.1 8.00% 0.00 4.99 200.0
Term deposit, 1Y -620.0 620.0 0.0 0.0 0.0 0.0 0.0 5.00% 0.00 1.00 620.0
-300.0 19.6 18.3 262.0 0.0 0.0 0.0 7.00% 0.00 2.81 300.0
2: Compute the duration gap:
Weighted duration of assets: 2.88 years

Weighted duration of liabilities: 1.59 years
Duration gap (DGAP): 1.42 years
DA  MV Risk sensitiveAssets DA  MV Risk sensitiveLiab. DF  MVF

  0
(1  i Assets) (1  i Liab. ) (1  i Future)
2.88  900 1.59  920 0.25  MVF
  0
(1  10%) (1  6%) (1  4.9%)
MVF  4096.82
• Hedging locks in interest rate risk, i.e. Modified Duration = 0.
267
• The OTC1-equivalent of futures (thus: customisable in volume, maturity, rate)

• Quoted as (e.g.) 3 x 15: 5.5% meaning that this FRA guarantees an interest rate for
the period [in 3M – in 15M] a rate of 5.5% p.a.
*) OTC: Over-the-Counter, i.e. directly settled between the two contract partners and not via a third (exchange) party.
268
8.C Interest rate swap hedging application
• Exchange of floating against fixed interest rate cash flows linked to a certain
notional
• Traded OTC (or on inter-bank trading platforms)
• Cleared: centrally (e.g. via Eurex Clearing, LCH Clearnet, SwapClear, ...)
• By far, largest IR-derivative market
Libor + 1% p.a. Libor – 0.125% p.a.
Bank loan Gilt
Company Company
Afraid of Libor going up ... Prefers fixed rate or afraid of

=> Payer swap (from comp. perspective) Libor going down ...
=> Receiver swap (from comp. perspective)
Libor + 1% p.a. Libor – 0.125% p.a.
Bank loan Gilt
Company Libor p.a. Libor p.a.
Swap Swap Company
6.75% p.a. 5.50% p.a.
counterparty counterparty
Hedge against increasing interest rates, because Hedge against decreasing interest rates, because
pays fix: –(L + 1%) + L – 6.75% = 7.75% p.a. received fix: +(L – 0.125%) – L + 5.50% = +5.375%.
269
B
8.C Interest rate swap hedging application
• Present value hedges:
Optimal hedge ratio = PVBPbond / PVBPswap
5Y, 6.50% coupon, semi-annual, act / 365, 1,000,000 EUR
PVBPbond = Mduration(today(), today() + 5*365 , 6.50%, 0%, 2, 3 ) / (1+6.50%)

*1,000,000*0.01% = 417 EUR
• PVBPSwap = 400 EUR

=> Optimal hedge ratio = PVBPbond / PVBPswap = 417 EUR / 400 EUR = 1.0425
• Bond and swap only strictly match at the day preceding an interest reset date as the
PVBP of the floating leg will be close to zero. (The floating leg is a short-term fixed-
rate bond. If tomorrow is reset date, this is an ON-bond, i.e. very low interest rate.
If the next reset date is in 6M, the PVBP of the floating leg is not zero and thus the
PVBPSwap <> PVBPFixed Bond of fixed leg ).
• Overnight index swaps: floating leg is not indexed to 3M / 6M Libor, but to an
Overnight rate like EONIA, SONIA, etc.
270
8.D Interest rate risk exposure and option hedging
• Example: Table 8.5
• Caps: max[Libor – Strike, 0]: pays out in increasing rates
Is a hedge for those that lose in increasing rates
(e.g. floating-rate borrowers, fixed-rate investors)
• Floors: max[Strike – Libor, 0]: pays out in decreasing rates
Is a hedge for those that lose in decreasing rates
(e.g. floating rate investors, fixed-rate borrowers)
• Options:
- Hedge downside / risk, keep upside / chance
- Have asymmetric payoff profile (E[payoff] <> 0)
=> have a price to compensate the writer of the option to take the downside
=> price = EQ[payoffT]/(1+rT)T
• Example: => next slide
271
8.D Interest rate risk exposure and option hedging
• Example: table 8.5 r Volume Assets Liabilities Volume r
8% 140 Loans, fixed Dep., floating 100 3%
• Caps: max[Libor – Strike, 0]: pays out in increasing rates 7%
5%
40
20
Bonds, fixed Dep., fixed
Bonds, floating NIBLs
60
20
3%
0%
• Floors: max[Strike – Libor, 0]: pays out in decreasing rates 200 Σ
Capital
Σ
20
200
0%
(without cap)
(15.2)
+20 floating assets

–100 floating liab.
= –80 IR-GAP
(4.8) (3.8) (5.8) => +1% => NII-
(10.2) (11.0) (9.4) reduction
(5.10%) (5.50%) (4.70%)
(7.84%1)
*) 7.84% = –(9.4 – 10.2) /10.2

272
B
8.E Hedging using bond future contracts
• The underlying of an interest rate futures is the interest rate, the underlying of a
bond future is a (hypothetical) bond
• Physical delivery of bond at maturity
• Exchange-traded, i.e. settled at central clearing house
• Contract does not specify a particular bond (via its ISIN), but only notional coupon
=> Many bonds are deliverable
=> Every bond has a conversion factor (published by exchange) to equalise coupon
and accrued interest across all deliverable bonds
=> Cheapest among them is “cheapest to deliver”
Hedge ratio = volatility of bond hedged / volatility of hedging instrument
The more volatile the bond, the more future contracts are needed
Number of contracts = Nominal(bond) / Nominal(future) * BPVBond / BPVfut
BPVfut = BPVCTD-bond / ConvFactorCTD-bond
273
8.F Hedging credit risk with credit derivatives
• Credit Default Swap (particular credit risk derivative):

- Sells the credit risk without selling the loan (synthetic credit risk)
because bank does not want the borrower to realise that it is not the bank
anymore that bears the credit risk, but someone else. Some borrowers have
prohibited the sale of their loan. ...
- “Buy protection”  exposure is transfered to CDS-counterparty
- Example: we buy protection against BMW-default from Deutsche Bank.
If underlying BMW defaults, Deutsche Bank pays us LGD [EUR]. From BMW’s
liquidator, we receive Recovery [EUR].
Recovery [EUR] + LGD [EUR] = Notional, thus we recover the full notional.
Note: Now, the only credit risk that is left is that Deutsche Bank might default (=
credit counterparty risk). If Deutsche Bank posts collateral ( the CDS is
collateralised), the counterparty credit risk is almost zero: in case Deutsche
defaults, we use the collateral to buy a new CDS (restoring the default
protection).
- CDS only exist for large borrowers, like: sovereigns, large corporates (Vestas,
Danske, Grundfos, ...) and sectors
- There are no CDS for retail or SME customers => credit risk only transferable on
the portfolio level, i.e. for a package of loans (e.g. Credit-linked Note (CLN) or ABS)
274
Agenda
0. Introduction
5. The yield curve
9. Asset–liability management IV: The ALCO
20. Appendix
275
• Variations in interest income

• Main drivers for fluctuations in income
• Short-term income projections
• Monthly ALCO-pack: prepared by treasury
• Management reporting:
lending margins, interest income, deviations from last projections, customer business
• Business planning:
performance of existing businesses (return on capital) to identify outperformers and
underperformers
Discussion of new business (if accepted => business line to go ahead)
• Hedging policy:
risk-taking, limits, hedge instruments to be used
276
The message of each plot becomes more pronounced by adding objective
benchmarks that assess whether actual figures underperform or outperform.
• ALCO reporting:
Cumulative liquidity gap: Inflows & outflows by business line: Fixed vs. floating rates:
When are large funding needs? Which business line needs funding? In which buckets are the highest gaps?
Asset volume and asset income: Volumes and income per business line
What asset income expected for which bucket? Which business lines generate highest return?1
Nice plots, but what is
missing?
=> Objective benchmarks
that state that the actual
figures are outperforming
/ underperforming.
Useful benchmarks:
planning figures, peer
group values
*) Note that the highest income does not mean “highest shareholder value”: the business line might have to take excessive risks to
generate a high income. Other lines might have less income, but are much safer. => Risk-adjusted benchmarks are important. 277
Agenda
0. Introduction
5. The yield curve
20. Appendix
278
Agenda example:
- IR: gaps vs. gap limits, change of
limits?
- Ly: gaps vs. gap limits, change of
limits?
Profit centre Forecast LCR and liquidity needs
Cost centre Funding: trends, concentration,
Profit centre promotions, forecast
Profit centre - Deviation of regulatory
Profit centre ratios from their minima
- Assess current profitability of
Profit centre business lines, capital allocation, -
Cost centre adequacy, forecast
Cost centre - Market trends (IR-impact, stock/
fixed markets) and impact on risk and
Profit centre trading activities
- Change policies, limits, etc.
Profit centre - Review hedging policy (size,...)
Cost centre - Review internal funds transfer pricing
Profit centre - Set market risk measure (volume,
VaR, Expected shortfall, ...)
- Set and review stress test scenarios
- Review new trading activities
- Educate other participants on ALM-
policy related issues.
279
1st Line of Defense 2nd Line of Defense
Treasury (Risk-)Controlling Finance / Quality Performance

Operative Strategic treasury Accounting control / KPI
treasury
Committees: Money market / Liquidity Limit mgt. Liquidity Internal Valuation /
ExCo, ALCO, Repos / Security management, management, audit pricing
RICO, ... borrowings Funding mgt. Funding mgt. (3rd LoD)
Strategic / Fixed income Collateral Reporting Reporting Regulatory Limit system/
operational management (limit usage / (BS, P&L, ...) affairs Early warning
treasury (e.g. LCR-buffer-Mgt) breaches) system
Separation of Derivatives FX Mgt. Validation and Accounting External Risk models
duties Interest rate risk in the model change P&L audit (KRI) & Stress
(business units) banking book (IRRBB) tests
Allocation of Equity Active credit portfolio KRI KPI Cash
responsibilities mgt. flowmodel
(behavioural)
Outsourcing Securitisation / Capital management Contingency planning / Tax balance Regulatory
Syndication Balance sheet mgt. Investor relation sheet ratios
Regulatory treasury Regulatory Validation &

(Mgt. of CRR-ratios) reporting Backtesting
Treasury services
280
Risk management committee at Deutsche Bank1
Our Risk ExCo, as the most senior

functional committee of our risk
management, identifies, controls and
manages all risks including risk
concentrations at Group level, and is
a center of expertise concerning all
risk related topics of the business
divisions. It is responsible for risk
policy, the organisation and
governance
of risk management and oversees
the execution of risk and capital
management including identification,
analysis and risk mitigation, within
the scope of the risk and capital
strategy (Risk and Capital
Demand Plan) approved by the
Management Board. The Risk ExCo
is supported by sub-committees that
are responsible for dedicated areas
of risk management, including
several policy committees, the Cross
Risk Review Committee (“CRRC”)
and the Group Reputational Risk
Committee (“GRRC”).
*) Annual report 2013, p. 64 (PDF-page 152).

281
CAPITAL & LIQUIDITY RISK – EXECUTIVE SUMMARY 30

SEPTEMBER 2009
Report Summary Status Outlook
Capital & Liquidity Risk

EUR Sep-09 Aug-09 Limit •Treasury Capital ratios all within limits.
Capital Adequacy Ratio 18.50% 18.26% 15.00% •Liquidity levels continue to decrease, however all ratios remained within limits
during the month;
Total Capital 578M 585M
•11.6% of bank funding comes from ABC Commercial Bank, breaching an internal
Liquidity - 8 days 8.76% 9.77% 3.00% Counterparty funding limit of 10%
Liquidity - 1 month 0.49% 4.70% -3.00% •Loan/Deposit ration continues to decrease, within the set target of 85%
Loan/Deposit Ratio 79% 81% •Adjusted Maximum Cash Outflow survival horizon is 9 days to 1mth.
Capital Status Outlook
All Capital ratios within limits; The decrease in Capital from August to September is largely due to FX fluctuations. There remains no offsetting currency capital against GBP and “Other”
currency risk-weighted assets.
Capital Ratios Stress Tests

The stress test suite takes into account a number of potential events, both internal and external
000,000's EUR Sep-09 Aug-09 Limit
that, which although extreme, are considered plausible.
Capital Adequacy ratio 18.50% 18.26% 15.00%
Total Capital 578 585 Change Capital Change
Total Capital Utilisation 469 480 Scenario RWA in RWA Capital change Ratio in ratio
Corporate Banking 389 401 465 Unstressed (forecast for Dec 09) 3,427 0 586 0 17% 0.00%
Treasury 70 70 80
Deterioration FX rates: 5% deterioration in GBPvEUR
Private Banking 4 4 5
and USDvEUR FX rates (USD rate =1.50, GBP rate =0.75) 3,505 78 595 9 17% -0.12%
Other Assets 5 4 58
Asset and P&L grow th: Increase RWA by forecast
Free Capital 109 104.4 increase in assets and reserves to 31 Decem ber 2008 3,813 386 588 2 15% -1.68%
Available Lending capacity* 730 696 €40 m illion bad debt: Reduce EUR RWA and capital by
*Only half the lending capacity is available for use as €40m illion 3,387 -40 546 -40 16% -0.98%
the bank maintains a 10% buffer on its capital. Creation of 40bp provision: 3,413 -14 572 -14 17% -0.33%
Total Utilisation has decreased in September due to FX fluctuations. 10% decline in securities: Reduce EUR RWA and capital
by 10% of the total value of securities (10% of €878
m illion) 3,412 -14 515 -71 15% -2.02%
Sep-09 Aug-09 Dow ngrade of portfolio using ratings m igrations
RWA RWA during a recession 3,452 25 586 0 17% -0.12%
000,000's EUR Capital Capital Capital Capital Paym ent of dividend: Reduce reserves by 10% 3,427 0 545 -41 16% -1.20%
€EUR 409 195 409 203 Break-even bad debt loss: Reduce EUR RWA and capital
by €85m illion 3,342 -85 501 -85 15% -2.10%
$USD 176 157 176 157
£GBP 0 63 0 65
Changes in capital ratio are graded as follows: Grading applied to the break-even loss:
Other 0 53 0 55
 Less than 0.5%  Less than €50m
585 469 585 480  Between 0.5% and 2%  Between €50m and €100m
 More than 2%  More than €100m
The currency mix of the capital balance sheet (risk weighted assets) gives a natural
hedge against FX movement in USD.
However, there is currently no offsetting currency capital to allocate against GBP and The stress tests set out above are conducted monthly and reflect the stressed capital
other currency risk weighted assets. values against a base capital and risk weighted asset amount as at 31 August 2009
282
CAPITAL & LIQUIDITY RISK – EXECUTIVE SUMMARY 30

SEPTEMBER 2009
Liquidity Status Outlook
All reg ratios within limits and Loan/Dep ratio continues to be within target level; The Maturity Transformation measure is within the set internal limit; Customer deposits are below the set
internal limit of 40% of total funding; There remains an internal counterparty funding limit breach of 14.0%; The adjusted cumulative cashflow survival horizon is 2 weeks.
Liquidity Ratios
The Loan/Deposit ratio increased to 81% by the
end of August, after the restrictions on treasury
for placing deposits on the interbank market
Loan Deposit Ratio
were slightly relaxed, now allowing a limited
100% amount to be deposited for 3 mths and 6mths.
London Branch 30-Sep-2009 31-Aug-2009
Actual Target The ratio remains below the target level of 85%.
Internal Internal 95%
Ratio lim it FSA lim it Ratio lim it FSA lim it 90%
Overnight 16.52% 14.31%
Sight - 8 days 8.76% 3.00% 0.00% 9.77% 3.00% 0.00% 85%
Sight - 1 m onth 0.49% -3.00% -5.00% 4.70% -3.00% -5.00% 80%
20% Liquidity 12 m ths Sight - 8 days 75%
15%
Sight - 1mth Maximum
70%
Cumulative Outflow
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09
Jul-09
Aug-09
Sep-09
10% Bank cashflow survival horizon
1E+09
5%
0% 500000000
Maturity
-5% Transformation
Sep Nov Jan Mar May Jul Sep
0
Average asset tenor < 24 times average liability tenor Sight 2-8 days 9d-1m 1m-3m 3m-6m 6m-1y 1y-3y 3y-5y > 5y
1-mth liquidity has decreased in September, this is primarily due to a drop in

marketable securities since last month.
-5E+08
Funding
Report Date Concentration
-1E+09
Average Liabilities Average Assets Maturity Limit
No source > 25% / €1bn
Tenor (except customer
(days) – min*Customer
depositsTransformation
Tenor (days)
deposits are
40%) Effect
30/09/2009 19 262 Limit currently below
14 the 24 -1.5E+09
minimum internal limit of

Funding Source Balance % Funding Within
(€000,000's) (Y/N)
Customer - Corporate 508 12% Y 40% of all funding. -2E+09
Customer - Local authority and agency 139 3% Y
Customer - Private 1,198 29% N
Institutional - Financial Institutions 792 19% Y *The bank’s top 5 non- -2.5E+09 Inflows Outflows Cumulative Cashflow Adjusted cumulative cashflow
group funders account for
Inter-Bank 303 7% Y
Inter-Group (Net Balance) 249 6% Y
Other 15 0% Y 25.4% of total funding.
Total Liabilities 3,204
Commercial Bank of ABC •The “Cumulative cashflow” is based on contractual cash flows and no adjustment has been made for
Bank's Top 5 Counterparties Balance % Funding currently
Limit accounts for 14.0%
Breach asset/liability behaviour or “”stickiness”.
(€000,000's)
of bank funding, breaching •The “Cumulative cashflow” survival horizon remains negative (overnight inflows do not cover
the internal outflows).
N limit of 10%.
COMMERCIAL BANK OF ABC 575 14.0% 10% Y
•"Adjusted cumulative cashflow” is arrived at after factoring in sale/repo of marketable securities

CENTRAL BANK OF ABC 227 5.5% 10%
BANK OF XYZ 220 5.4% 10% N
ABC LOCAL AUTHORITY 130 3.2% 10% N (bonds, FRNs, CDs). “Overnight” data is unadjusted.
ABC BANK 105 2.6% 10% N •The "Adjusted cumulative cashflow” survival horizon is 9days -1mth, compared to 2months in
283
Total 30.7% August 2009.
Agenda
0. Introduction
5. The yield curve
20. Appendix
284
Agenda
0. Introduction
5. The yield curve
20. Appendix
285
Agenda
...
A. Bank liquidity
B. The "10 principles of liquidity mgt"
C. Liquidity risk management: The UK regulator's view
D. Bank's liquidity policy
E. The liquid asset buffer
F. The contingency funding plan
14. ...
286
12.A Bank liquidity
• Liquidity Risk (definition of Deutsche Bank, Annual Report 2013, PDF-page 272):
Risk arising from our potential inability to meet all payment obligations when they
come due or only at excessive costs.
• Management board:
defines our liquidity risk strategy, and in particular our tolerance for liquidity
(= survival time to determine buffer size, limits)
• Treasury:
function is responsible for the management of our liquidity and funding risk globally as
defined in the liquidity risk strategy. Our liquidity risk management framework is
designed to identify, measure and manage our liquidity risk position.
• Liquidity Risk Control: responsible for the internal reporting on liquidity and funding
which is submitted to the Management Board at least weekly via a Liquidity Scorecard.
In addition LRC is responsible for validation of the bank’s liquidity risk models.
• Operational (intraday) liquidity mgt:
managing daily payments queue, forecasting CFs and factoring Central Banks access.
• Tactical (weekly / monthly) liquidity mgt:
dealing with access to secured and unsecured funding sources.
• Strategic liquidity:
maturity profile of all assets and liabilities (Funding Matrix) and our issuance strategy.
287
12.A Bank liquidity: Liquidity risk sources
Assets Liabilities
Cash Liquidity management is to
Liquid assets Volatile ensure that outflows are
portion covered even under very
Unsecured
Haircuts adverse scenarios
short-term
Liquidate deposits Unexpected by (i) inflows or (ii) by
for secured st liquidity-generating actions,
liquid Long-term high
assets portion outflows i.e. Lt + Ft + CFt+ ≥ CFt-
for secured lt
=> Need to estimate cash
Secured short-term flows under many scenarios
to determine the size of
Illiquid Assets Secured long-term required liquidity reserve
(Lt + Ft)
Unsecured long-term
=> Many products have
Unexpected
Equity uncertain cash flows
low inflows
(demand deposits) and even
Cash New funding simple products have
uncertain prolongation at
Off-Balance sheet maturity. Finally, new
payment obligations business is always uncertain.
(Guarantees, loan
commitments, …) => Need models
CFt  CFt 
Generate Lt  Ft !
!  100%
Lt  Ft  CFt  CFt 
new
 
funding CFt  CFt
288
12.A Bank liquidity
The crisis was triggered by solvency concerns (IKB, Fannie Mae) but materialised as liquidity crisis (banks run out of
funding). Mistrust spread and inter-bank funding was frozen until market had a clear opinion on who is strong and
who is weak => solvency phase “Lehman”.
2. Liquidity Crisis 3. Insolvency Crisis

1. Before (Pre-Lehman) (Post-Lehman) 4. Impr. 5. Sov
Source: ECB, Monthly bulletin, Oct 2010, p. 59 ff.

289
12.B The “10 principles of liquidity management”
1. Fund illiquid assets with core customer deposits (because the latter are more stable
and at lower risk to be withdrawn, LCR-outflow weight: 5%!, NSFR-ASF-weight: 90%!)
But keep in mind: interest rate wise, deposits are short-term (imperfect floaters)
2. Use long-term wholesale funding (deposits from insurance companies, other banks,
investment funds, ...), if core customer deposits are not available.
(NSFR-ASF-weight: 100%!)
3. If using wholesale funding, equally spread maturities.
4. Maintain liquidity buffers of instantly liquid assets
(cash, central bank deposits, government bonds, AA-rated corporate and covered
bonds with minimum issuance volume of 500 mio EUR, AA-rated, but volume >250
mio, ...)
5. Liquidity contingency plan: process that describes who should do what in times of a
liquidity shortage
6. Know your central bank access possibilities (and test them)
7. Know all contractual and non-contractual, but reputational Ly lines to SPVs, etc.
8. Use multiple metrices to gather the complete Ly situation
9. Internal funds transfer pricing must correctly measure and transfer funding cost and
buffer cost
10. Risk mgt policy must be owned by Board (see example Deutsche Bank)
290
B
12.C Liquidity risk management: The UK regulator’s view
1. Internal Liquidity Adequacy Assessment process (ILAAP)

(compare: ICAAP: Internal Capital Adequacy Assessment Process)
2. Once a year to be reported to regulator (UK: PRA1, DK: FSA)
3. Report:
- Objective of report
- Bank’s financials (balance sheet, P&L-forecast)
- Survival time (time without external support) in stress scenarios and
in “business as usual” scenario
3 types of stress tests:
a) name-specific:
- liquidity / solvency rumour against the bank
- multi-notch downgrade
b) market-stress:
- unforeseen short-term market-wide dislocations that seed uncertainty and
concerns => withdrawals / retention of own liquidity
- uncertainty of value of financial assets (e.g. Subprime securitisations)
- certain asset classes remain illiquid for long time
c) Combination of a & b:
- Description of bank’s liquidity risk management ...
*) Prudential Regulation Authority (PRA)
291
B
1. Internal Liquidity Adequacy Assessment process (ILAAP)

(compare: ICAAP: Internal Capital Adequacy Assessment Process)
2. Once a year to be reported to regulator (UK: PRA1, DK: FSA)
3. Report:
- ...
- Description of bank’s liquidity risk management
- governance and processes:
treasury: respect limits, controlling: monitor limits, board: oversight
- methodologies: risk metrics (survival time, LCR, loan-to-deposit ratios, NSFR,
funding concentration, available unencumbered assets,
market lock-out horizon, ...)
- Funding diversification:
- distribution of 10 largest creditors / markets (retail / wholesale)
- daily use of ILAAP

292
B
1. Regulatory risk drivers:

- Drastic reduction / complete dry up of money market funds
(CD, CP, Medium Term Notes)
- Deposits that need to be withdrawn in case of downgrade (e.g. local authorities,
government agencies, central banks, money market funds, insurance companies)
- One product depositors are prone to withdraw quickly
- Deposits from large corporates (with active treasuries / Bloomberg (to quickly pick
up news, etc.)
- Secured funding might disappear (if secured with low quality collateral)
- Dependence on parent entities (intra-group funding risk)
- Insufficient collateral for payment systems
- Cross-currency Ly risk: e.g. if Danske NY is funded via Danske Copenhagen (with
DKK funding and swapped into USD, FX-swaps might not be available in a stress
situation)
- Retail funding risk: internet accounts, wealthy retail customers, one account
customers are prone to quickly withdraw
- Off-balance sheet items: contingent liabilities (credit / liquidity lines), letters of
guarantees, liquidity lines for conduits / SPVs
- Hampered market liquidity for certain assets (e.g. Low quality collateral)
293
12.D Bank’s liquidity policy1
*) cf. Choudhry (2012), p. 614

294
12.E The liquid asset buffer
1. Composition:
- Highly liquid, high-quality government bonds (e.g. Bund, DK-Bill)
- Central bank reserves
- African / Asian / Islamic / Inter-American Development Bank
- European / Nordic Investment Bank
- Issues of IMF, BIS, ...
*) cf. Choudhry (2012), p. 614

295
12.E The liquid asset buffer: Securities eligible for LCR – buffer
Level 1 Level 2A Level 2B
Unrated
EU or non- A+ BBB+ BB+ B+ CCC+ (RW Min
DA Position EU e.g. AAA - AA- - A- - BBB- - BB- - B- - CCC- CRSA) HC Issue Min OC
10-1a Coins and banknotes 0%
10-1 (bi) Central banks EU 0%
10-1 (bii) Central banks Non-EU 0%
10-1(ci, Central gov., Regional, local,
ciii, c v) public sector treated as central EU Greece 0%
Regional, local, public sector, not
11-1a treated as central EU Greece (20%) 15%
10-1(cii, Central gov., Regional, local,
iv) treated as central Non-EU U.S. 0%
Regional, local, not treated as
11-1b central Non-EU U.S. (20%) 0%
10-1d CB, central gov., any rating Any 0%
Bonds from public sector banks,
10-1e promotional lendrs EU KfW 0%
Multilateral dev. banks/
10-1g international organisations Any 0%
10-1f Covered Bonds EU PB (10%) 7% 500 2%
11-1c Covered Bonds EU PB (20%) 15% 250 7% (2% if ≥AA-)

12-1e Covered Bonds EU PB Rating of CovB not specified 30% 250 10%
11-1d Covered Bonds Non-EU U.S. CovB (10%) 15% 250 7% (2%, if ≥ 500m)
11-1e Corporate Bonds 15% 250
12-1b Corporate Bonds 50% 250
12-1a, 13gi Asset Backed-Securities RMBS 25% 100
12-1a, 13giii Asset Backed-Securities CMBS 35% 100
12-1a, 13g iv Asset Backed-Securities Auto loans 25% 100
12-1a, 13g v Asset Backed-Securities Consumer 35% 100
12-1c Shares 50%
Restricted-use committed ECB-
12-1d Ly-facilities
12-1f For Islamic finance banks 50%
§ 15 CIUs L1, L2A, L2B: depending on underlyings Ø
§ 16 Deposits at network CB Lx if always invested in Lx, else: Level 2B + 25% haircut ≤25%
296
12.E The liquid asset buffer: How much does the buffer cost and how much
would deposits be charged for 15% buffer usage (on average)?
With Basel III

 Example: (red figures: Basel III – calibration)
Yield Volume Assets Liabilities Volume Yield
lt 5Y 5% E + 0.80%
Euribor 100% Govt 6M 95%*1/6
(E) Floater 6M 95%*1/6
– 0.35% (HC=0%) 5Y mt 95% E + 0.10%
... ...
6M 95%*1/6
 0.35%  5%  0.80%  (1  5%)  0.10%)

Reserve cost 
[bp p.a. / 1€ UexpCF 1
(1  0%)  (1  (1  5%)  )
]
6
 0.60% p.a. per 1 unit unexpected outflow
 Application: e.g. demand deposits

 FTP[6M:50%/12M:25%/12M:25%] = 0.43%
 FTP[15% unexpected outflows] = 15% * 0.60% = 0.09%
 FTPDemand Deposits = 0.43% – 0.09%
= 0.34% p.a.
297
12.E The liquid asset buffer: e.g. Deutsche Bank
DB Annual report 2013, PDF-page 278
Total assets [in EUR]: Jyske Bank,

31.12.2013: 37.4 bn € (~20% of 196 bn)
298
12.F Liquidity Contingency Plan
Declare Usual liquidity providers refuse funding

Contingency Unfavourable “headlines”
Meyer, Chief Risk Officer, 0176-…
Crisis Committee Leyton, Head of Capital Markets, 0151-…
Bessant, Investor Relations, 0162-…
1. Draw Central Bank facilities
2. Repo
Processes Decisions 3. Security sale
4. Draw bank facilities (signalling effect !!)
5. Stop lending business
Communication Communication monopol: crisis committee
time, media, prepared statements (!)
Abolish Crisis committee: unanimously, written form
Contingency Initiate “business as usual”
299
Agenda
0. Introduction
5. The yield curve
20. Appendix
300
Agenda

A. Key liquidity risk metrics
B. Strategic Ly metrics
C. Tactical Ly metrics
15. ...
301
A) Key metrics, B) Strategic, C) Tactical
A) Key liquidity metrices (almost all banks)

1. Loan-to-deposit ratio
2. 1-week liquidity ratio: periodic gap / cumulated funding gap
3. 1M-liquidity ratio: internal 30d liquidity ratio
4. Cumulative liquidity model: daily, available liquidity / deficit for next 12M
5. Funding concentration report (6 largest depositors, % of funding from which market)
6. Inter-entity lending: % of funding / lending from / to intragroup entities
B) Strategic liquidity metrics:
1. LCR
2. NSFR
3. Long-term liquidity limits:
liabilites / assets over 1 year > 98%
Why % are decreasing? Because cover larger period !!!
C) Tactical liquidity metrics
... Next slide
302
A) Key metrics, B) Strategic, C) Tactical
A) Key liquidity metrices (almost all banks): previous slide

B) Strategic liquidity metrics: previous slide
C) Tactical liquidity metrics
1. Contractual maturity mismatches
2. Available unencumbered assets: reported to regulators, important because these
assets can be used in case of default to satisfy any investor
Encumbered assets have been separated for the specific obligor (secured funding)
3. Funding concentration by time band: no peak maturing positions
4. Undrawn commitment report: volume of potentially drawn commitments
5. Surplus funding capacity: liquidity capacity after a stress scenario
6. Aggregate limits metrics: per marktet (wholesale funding, retail funding, ...)
7. Market-lock out horizon / survival period: number of weekdays that bank can
autonomously survive (only using internal liquidity buffer)
Stress scenarios => survival period  Ly buffer determination => next slide
303
13.B Strategic liquidity metrics
Extract from “European regulation at a glance” (= slide 98)
Pillar 1 (CRR) Pillar 2 (National law) Pillar 3 (CRR)
Core Equity • Disclosure
Tier 1 ratio => www....
Tier 1
ratio
Total capital
ratio
Leverage
ratio
Liquidity buffer • Internal models for cash flows

≥ 100%3 • For risk management and planning
O – min(75%*O, I) • Why additional stress tests (apart from
LCR-stress test)?
Minimum Liquidity buffer = O – min(75%*O, I) LCR: not bank-specific weights
(standardised approach, not an
Liquidity internal model!), only 30 days,
Coverage not 15, not 45, no concentration risk
ratio • Determine the minimum buffer:
Board sets “Minimum survival time”
(e.g. 40 days)
• Internal stress tests
=> does bank survive in the most
conservative scenario? 40 days without
external help?
NSFR
Quarterly reporting (except of LCR: monthly): ratios + components

1) x% : buffer for systemically important financial institutions (SIFI), 1% – 3.5% 4) OBS: Off-balance sheet items
2) 304
y% : countercyclical buffer for slowing down lending, 0% – 2.5%
3) Gradual compliance: 2015: ≥60%, 2016: ≥70%, 2017: ≥80%, 2018: ≥90%, 2019: ≥100%
13.B Strategic liquidity metrics
DB Annual report 2013, PDF-page 279
305
13.B Strategic liquidity ratios: LCR
Assets Liabilities
100%* 0% 0% 100%
Cash flows > 30d Cash flows > 30d
Cash Stable 5%
Retail
Public Debtor Securities Less stable 10%
Deposits at central banks Small Stable 5%
Deposits
Business
Unsecured
80% AA ≤ Less Stable 10%
Wholesale
Corp. / Covered Bonds
60% A- ... AA- Corp., Firm only holds deposits 40%
Non-fin.
Others (ABS, CDOs,...) Operating deposits 25%
50% Performing loans Others
0% – 100% Reverse R. (depends on collat.) Repos, ≤30d (depends on collateral) 0% – 100%
Mark-to-Market of Derivatives Hist. lookback mio €

Market Price
Fluctuations Derivative collateral 20%
3-notch Downgrade Collateral mio €
10% Retail LCR stress scenario assumes several risks

to materialise simultaneously
10% Credit Non-
Comm. Liquidity (Rating) Significant Downgrade
financial
Liquidity Lines
Corp. Partial loss of Deposits
Call Risk
Others Calls on Off-Balance Sheet exposures
tbd Other contingent outflows Funding Risk Loss of unsecured wholesale funding
Planned Outflows (new business,.) Asset Liquidity Significant increase of secured funding HC
Liquidity (Market) Increase in derivative collateral calls
Off-Balance Sheet items
13.B Strategic liquidity ratios: LCR
Assets Liabilities
100%* 0% 0% 100%
Cash flows > 30d Cash flows > 30d
Cash Stable 5%
Retail
Public Debtor Securities Less stable 10%
Deposits at central banks Small Stable 5%
Deposits
Business
Unsecured
80% AA ≤ Less Stable 10%
Wholesale
Corp. / Covered Bonds
60% A- ... AA- Corp., Firm only holds deposits 40%
Non-fin.
Others (ABS, CDOs,...) Operating deposits 25%
50% Performing loans Others
0% – 100% Reverse R. (depends on collat.) Repos, ≤30d (depends on collateral) 0% – 100%
Mark-to-Market of Derivatives Hist. lookback mio €

Market Price
Fluctuations Derivative collateral 20%
3-notch Downgrade Collateral mio €
10% Retail
10% Credit Non-

Comm.
financial
Liquidity Lines
Corp.
LCR =
Others
tbd Other contingent outflows –

Planned Outflows (new business,.)
Off-Balance Sheet items

Example of liquidity dash board
308
13.C Tactical liquidity metrics
Assumptions on legal cash flows, prolongation and new business drive the
maturity ladder
1. Volume evolution (exponential):

Vt+1 = Vt*(1+legal*(1-prolongation) + new business)
2. Volume evolution (linear):

Complete position withdrawn / repaid: T
Constant rate: ΔV = V0/T
Vt+1 = max(0,Vt – ΔV*(1-prolongation) + new business)
3. CFt+1 = Vt+1 – Vt
309
a) Legal run-off: Loans and deposits mature and we assume here that maturing loans
are repaid and maturing deposits are withdrawn. Moreover, no new loans / deposits.
L’y Reserve
Assets
Vt+1 = Vt*(1–5%*(1 – 0*prolongation) + 0*new business)
Loans
Liabilities
Deposits
Vt+1 = Vt*(1 – 8%*(1 – 0*prolongation) + 0*new business)
310
Legal + prolongations
L’y Reserve
Assets
Vt+1 = Vt*(1 – 5%*(1 – 8%) + 0*new business)
Loans
Liabilities
Deposits
Vt+1 = Vt*(1 – 8%*(1 – 24%) + 0*new business)
311
Legal + prolongations+ new business
L’y Reserve
Assets
Vt+1 = Vt*(1 – 5%*(1 – 8%) + 1.0%)
Loans
Liabilities
Deposits
Vt+1 = Vt*(1 – 8%*(1 – 24%) + 1.7%)
312
Liquidity risk results from a quicker run-off of funding that cannot be replaced or covered
by liquidating assets. Assumptions Survival time
Lt+1 = Lt*(1 – x%*(1-prolongation) + new business)
Lt+1 = Lt*(1 – 5%*(1-0*prolongation) + 0*new business) 7 weeks
Dt+1 = Dt*(1 – 8%*(1 – 0*prolongation) + 0*new

business)
Lt+1 = Lt*(1 – 5%*(1 – 8%) + 0*new business) 16 weeks
Dt+1 = Dt*(1 – 8%*(1 – 24%) + 0*new business)
Lt+1 = Lt*(1 – 5%*(1 – 8%) + 1.0%) 33 weeks
Dt+1 = Dt*(1 – 8%*(1 – 24%) + 1.7%)
313
Liquidity stress scenario is not 0% prolongation on assets and liabilities, but it is
asymmetric: 100% prolongation on asset side, 0% prolongation on deposits!
Assumptions Survival time
legal Prol. New B.

Lt+1 = Lt*(1 –30% *(1– 100% ) + 1% ) 2 weeks
(with 24 DKK
Liquidity
Dt+1 = Dt*(1 – 8% *(1– 0% ) + 0% )
reserve)
314
How much reserve should the bank hold if the Board requires a survival time
of 6 weeks?
Assumptions Survival time
legal Prol. New B.

Lt+1 = Lt*(1 –30% *(1– 100% ) + 1% ) 2 weeks Lt+1 = Lt*(1 + 1%)
(with 24 DKK
Liquidity
Dt+1 = Dt*(1 – 8% *(1– 0% ) + 0% ) Dt+1 = Dt*(1 – 8%)
reserve)
 
 ( A A
i 0
t t 1 )  R   ( Lt  Lt 1 )  0
i 0
X t 1  X t  (1  d X )
 A0  A1    A1  A2   ...  R  L0  L1 ...  0
 A0  A0  (1  d A )   A0  (1  d A )  A0  (1  d A )2   ...
 R  L0  L0  (1  d L ) ...  0
A0  (1  (1  d A ) )  R  L0  (1  (1  d L ) )  0
Numerical, τ 6weeks
R  44.0DKK
315
How is the survival time set?
Depending on the buffer cost and how much the Board wants to spend for the compliance.
1 Board’s Liquidity Risk Appetite: Legend: 7
Compute cost(MST)
Set Minimum Survival Period1 (MSP) NCO: Net Cash Outflow
aST: actual Survival Time
aSP: actual Survival Period
2 6
Identify positions that might cause:
Cost model:
- Unexpectedly high outflows
Cost = f(buffer)
- Unexpectedly low inflows
CFt+ aST < MSP ≤ aST‘

3 5
buffer‘
Define scenarios / events that might trigger buffer0
unexpectedly high outflows and / or unexpectedly NCO with buffer‘ Add extra buffer‘
low inflows NCO with buffer AND / OR
=> cash flow excess / gap per day: reduce liquidity risk
Lenght of scenario: turn-around point NCO w/o buffer
CFt-
4 Using the counterbalancing actions from No

contingency funding plan:
can cash flow gap be closed for every day Yes
(at least) until survival period ?
1) Survival period: = minimum period to withstand liquidity stress without external support.
316
B
13.C Liquidity Governance: Management vs. Liquidity Controlling
FTP alternatives and
Finance
comprehensive pricing
Internal costing by FTP
Other risk types

Risk
“driving” liquidity
appetite
risk
Monitoring: - Stress: actual survival time

Risk
Risk Liquidity > limited (minimum) survival time Documentation

tolerance risk Liquidity and liquidity risk - Going concern: &
(Survival inventory / measurement Funding limits > funding gaps Reporting
period) sources LABs: Statistical / behavioural
cash flow forecasting model
Stress testing
Limits Funding Plan
Set up and execute funding plan
Management of liquidity buffer

ALCO
Treasury
ALM: funding strategy / limits /

budgets / new products
Contingency funding plan
Unit Embedded process Model

317
B
13.C Liquidity Governance: Management vs. Liquidity Controlling
 Banks are expected to define their risk appetite and risk
tolerance.
Risk appetite Risk tolerance
 Define ‘benchmarks’ to set a target level of  Define ‘limits’ to set maximum level of
liquidity risk liquidity risk
 Positive / negative deviations of the  Negative deviations of limit will not be
benchmark will be tolerated tolerated
 No linkage to Contingency Funding Plan (CFP)  Linkage to Contingency Funding Plan (CFP)
 Measure for global benchmarks: Net Liquidity  Measures for global limits: Minimum Survival
Position Target (NLPT) for various time Period (MSP), Minimum Net Liquidity Position
buckets (MNLP) for various time buckets
 Global benchmarks should be de-cascaded  Global limits are sufficient, but for
into business units and products operational purpose in Treasury units global
limits should be de-cascaded into business
units and products
 Responsibility: Treasury  Responsibility: Risk controlling
*Survival period (SP) is the time that a bank wants to survive without any external support.
318
13.D Reporting framework
Liquidity management approach
Short-term view (≤ 12M) Long-term view (> 12M)

Regulatory Internal / Economic Regulatory Internal / Economic
Illiquidity Risk Illiquidity risk („ZahlungsunfähigkeitsR“) L’y Maty MM Illiquidity risk Liquidity Maturity MM
LiqV
LCR1 <1Y - LAB Concentration risk NSFR1 ≥1Y-LAB LVaR
Monitoring tools
monthly monthly quarterly monthly
Risk case Stress case Stress scenarios Expected case Risk case Stress case
daily daily monthly monthly LVaR ≤ CapitalLiqui Stress LVaR
NLP1 ≥ 0 SP ≥ 3M SP ≥ 3M LVaR > CapitalLiqui reported
NLP1 < 0 & NLP2 > 0 SP ≥ 1M SP ≥ 1M (first time)

(OK in distressed SP < 1M SP < 1M LVaR > CapitalLiqui
Ly-situation) (2 consec. months)
1M < SP < 3M
SP ≤ 1M
(A) Scenarios:
• Risk Case: consideration of unexpected cash flows under current market conditions (base case, all currencies in EUR converted and USD isolated, expected
Definition of management
loan roll-over rates, planned new business)

• Distressed Case: deterioration of current markets (distressed conditions, market liquidity crisis)
• Stressed case: risk case + scenario-specific shock (e.g. downgrade, UCD-appreciation, severe economic downturn)
variables:
(B) Illiquidity risk: Survival Period: defined minimum survival time without external new funds reflecting the Board’s risk appetite
• NLP1 = cum. Gaps + LP1 => relevant condition in normal scenario
• NLP2 = NLP1 + LP2 => relevant condition for distressed liquidity situation or scenario with constraint funding
• LP1: counterbalancing capacity 1 (highly liquid and liquid bonds, ECB-eligible loans, secured and unsecured funding, asset reduction)
• LP2: counterbalancing capacity 2 (liquidity buffer, e.g. highly liquid and liquid bonds, ECB-eligible loans, to cover unexpectedly high liquidity needs in
distressed and stressed scenarios. The required amount of LP2 equals the liquidity need in the most severe scenario
• LVaR: Liquidity Value at Risk; with 99%-probability highest loss if closing all long-term (≥12M) funding gaps. Basis is the 99%-funding spread scenario.
• Stress-LVaR: Proxy for the sensitivity of the LVaR towards a spread increase
(C) Distressed liquidity scenario: decreasing / constant deposits, low overall volume, impaired lt-unsecured funding (only small private placements possible)
319
1) LCR/NSFR obligatory reporting since 31.3.2014 and compliance requirement by EU commission
B
2. Operating Model “Liquidity Management”
D. Risk Tolerance vs. Limits
Illustrative Limit System
Base Case Stress Case

Funding ratios
Time Time
buckets > 1Y > 2Y > 3Y > 5Y > 10Y Liquidity buffer buckets > 1Y > 2Y > 3Y > 5Y > 10Y Liquidity buffer
Group 90% 80% 80% 80% 80% Group 90% 80% 80% 80% 80%
EUR 90% 80% 80% 80% 80% In EUR bn EUR 90% 80% 80% 80% 80% In EUR bn
CCY 1 90% 80% 80% 80% 80% In USD bn CCY 1 90% 80% 80% 80% 80% In USD bn
CCY 2 90% 80% 80% 80% 80% In ZAR bn CCY 2 90% 80% 80% 80% 80% In ZAR bn
Net cumulative gaps in „going-concern“ Net cumulative gaps in Stress Case

Legal entity 2 Legal entity 2
Legal entity 1 Legal entity 1 In absolute terms and
relative to Base Case
Group Group
320
Agenda
0. Introduction
5. The yield curve
20. Appendix
321
Agenda

A. The concept of internal funds pricing
B. Benchmark funds transfer pricing policy
C. Product pricing examples
17....
322
15.A The concept of internal funds pricing
1. Importance of funds transfer pricing:

- price in all cost components of a loan / deposit / derivative / any product
(the same as the cost of a car is the sum of the cost of all individual components)
- allocate costs, risks and benefits appropriately
(this means: if two business lines have a different risk profile (e.g. the investment
bank and the retail bank) they should have two different FTP-curves.
Very often, there is one (average) cost of funds which penalises resilience and
favours volatile business lines. This is a problem if a commercial bank has to
outsource its trading activities into a separate (self-funded) entity (in EU: Volcker
Rule). This entity cannot be funded by cheap retail deposits anymore, but has to fund
at (competitive) capital market rates. This separation stops with the implicit cross-
subsidisation of trading units and potentially reduces the profitability of trading
units (and bonuses of investment bankers).
- cost of funds for illiquid (non-securitisable / non-repoable) assets:
bank’s secondary market / public senior unsecured curve
- cost of funds for securitisable assets (prime mortgages, ...): bank’s covered bond
curve (if not 100% of prime mortgage securitised, but 80%:
blended curve = 80%*covered bond curve + 20% senior unsecured curve
323
Example
 A bank makes a 3Y-term deposit and invests it into a 3Y-term loan.
Our bank Capital market, today
Lending Unit Depositing Unit Assets Liabilities

Loan, 3Y, 6% Deposit, 3Y, 1%
New wholesale,
Loan Deposit unsecured for our bank
Retail
3Y, 3Y, Lending Retail
Funding
1Y
0.75%
...
...
3Y
2.25%
6% 1% Corporate
Lending
Inter-bank Corproate Swap
Lending Funding
Bullet Bullet 1Y ... 3Y
PD = 0.79% Un-
LGD = 100% Investment 0.50% ... 1.50%
Portfolio Whole- secured
Segment: Retail sale
Credit risk: IRBA
Secured
Liquidity
Reserve Capital
 Bank management: business units contract profitable loans and profitable deposits.
 Risks are to be transferred and to be managed centrally (pooled!) in treasury.
 The required infrastructure (staff, buildings, IT) is centrally managed by “Operations”.
 Questions to be answered:
What are profitable loans (minimum loan rate) and what are profitable deposits (maximum deposit rate)?
What are the prices for internal transfer of risks and services?
324
Example: Assumed pricing environment
New wholesale,
unsecured for our bank
1Y ... 3Y
0.75% ... 2.25%
Swap
1Y ... 3Y
0.50% ... 1.50%
325
Example: Transfer and transfer pricing
Central
Lending Unit Depositing Unit
Management Units
Notional Notional
+ 1.50% Swap [3Y] Liquidity –1.50% Swap [3Y]

+ 0.75% Funding spread4 [3Y] Management –0.75% Funding spread4 [3Y]
Loan Deposit
3Y, +1.50%
[3Y]
–6M –6M
-Euribor Euribor
– 1.50%
[3Y]
3Y,
6% Interest Rate
1%
Management
Bullet Bullet
PD = 0.79% Credit Risk
LGD = 100% 2.50%
Credit Risk
Segment: Retail (= 0.79% (EL) + 20%*8.55%
Management
Credit risk: IRBA (UL3)
Operations Operations
Operations
0.25%: Operating cost (e.g. HR, Facilities) 0.25%: Operating cost
1.00% 5.00%1 2.00%2 1.00%

Break-even- Break-even-
Net margin Net margin
(Minimum) rate (Maximum) rate
1) 5.00% = 1.50% + 0.75% + 2.50% + 0.25% 2) 2.00% = 1.50% + 0.75% – 0.25%

3) 8.55% = Φ[ (Φ-1[1%] + √0.15*Φ-1[99.9%]) / √(1-0.15) – 1% ] * 100%, 4) 0.75% = 2.25% (Wholesale, 3Y) – 1.50% (Swap, 3Y)
326
15.A The concept of internal funds pricing: Divisional P&L versus Accounting P&L
Interest Interest
From previous slide: Value P&L ValueDivision
Income Expenses
Loan, Central Deposit, Interest

6% – 1% = + 5%
3Y, 6% Management Units 3Y, 1% Income
= =
+0.75% Liquidity –0.75%
+ 0.75% –0.75% 0% Ly Mgt
Management
+1.50% Interest Rate –1.50%
+ 1.50% –1.50% 0% IR-Mgt
Management
Credit Risk
Management
+0.79%
EL LLP + 0.79% –0.79% LLP 0%
+1.71% CR-Mgt
UL Capital + 1.71% –1.71% Capital C. 0%
+0.25% Operations +0.25% + 0.25% + 0.25% –0.50% Adm. Exp. 0% Oper.

(e.g. HR, Facilities)
+1.00% Business (Net m.) +1.00%

+ 1.00% + 1.00% + 2.00% Business
Lending Deposit.
 Accounting P&L groups all income and all expenses, but 2% 3.71% 2%
does not show which income belongs to which expense Value Profit Value
(=> FTP => ValueDivision) before before before
tax tax tax
 FTP maps financial accounting  managerial accounting
 FTP (and choice of curve) does not change the results,
it only changes the allocation of (sub-)results (divisions, products)
1) C
327
Now: 1Y deposit1
Interest Interest
Income Expenses

6% – 1% = + 5%
= =
+0.75% Liquidity –0.25% 0.50%
+ 0.75% – 0.25% Ly Mgt
Management (–0.75%) (0%)
+1.50% Interest Rate –0.50% 1.00%
+ 1.50% – 0.50% IR-Mgt
Management (–1.50%) (0%)
Credit Risk
Management
+0.79%
EL LLP + 0.79% – 0.79% LLP 0%
+1.71% CR-Mgt
UL Capital + 1.71% – 1.71% Capital C. 0%
+0.25% Operations +0.25% + 0.25% + 0.25% – 0.50% Adm. Exp. 0% Oper.

+1.00% Business (Net m.) –0.50% + 0.50% Busines

+ 1.00% + 0.50%
Lending Deposit. (2%) s
(+1.00%)
 Same accounting P&L (Interest income, profit, etc.), although 2% 3.71% 2%
different income structure (risk-free net margin ↘, risky income from Value Profit Value
liquidity and interest rate mismatches ↗) before before before
tax tax tax
 Business is penalised for deficient deposit (provides 1% to customer
although break-even (maximum) rate for 1Y is 0.50%!)
1) Note that this view is not complete => see next slide.
328
Now: 1Y deposit and capital cost for mismatch risks
Interest Interest
Income Expenses

6% – 1% = + 5%
Liquidity Mgt = =
+0.75% –0.25% 0.45%
+0.75% –0.25% + 0.75% – 0.25% –0.05%1 Ly Mgt
+0.75% ? Cap. (0%)
+0.75% ?
Interest Rate Mgt 0.80%
+1.50% –0.50% + 1.50% – 0.50% –0.20%2 IR-Mgt
+1.50% –0.50% (0%)
+1.50% ? Cap.
+1.50% ?
Credit Risk Mgt
+0.79%
EL LLP + 0.79% – 0.79% LLP 0%
+1.71% CR-Mgt
UL Capital + 1.71% –1.71% Capital C. 0%
+0.25% Operations +0.25% + 0.25% + 0.25% –0.50% Adm. Exp. 0% Oper.

+1.00% Business (Net m.) –0.50% Busines

+ 1.00% + 0.50% + 0.50%
Lending Deposit. s
1) Assume that 2.33 σ of Δ funding spread = + 0.75%, i.e. with 99% 1.75%
3.71%
1.75%
probability, 1Y-funding spread <= 1.00%. If funding spread increases (2.00%) (2.00%)
to 1.00% => loss of 0.25%. => Capital = 0.25%. Value Profit Value
Capital cost = 20%*0.25% = 0.05%. before before before
2) Assume that 2.33 σ of Δ 1Y-swap rate = + 2.00%. If swap rate tax tax tax
increases to 2.50% => loss of 1.00%. => Capital = 1.00%.
Capital cost = 20%*1.00% = 0.20%.
329
15.B Benchmark funds transfer pricing policy
1. Transfer pricing policy:

1.1 Objectives:
- consistent (not constant!) liquidity pricing across business lines
- transfers interest rate and funding risk to treasury
- transfer pricing cost must be used for product pricing (to derive break-even rates)
1.2 Types of cost:
- direct cost: actual rates payable for each tenor
- indirect cost: liquidity buffer cost
1.3 Gross approach with marginal cost, e.g.
1.3.1 Gross: each loan and each deposit is priced on a stand-alone basis.
If a loan is netted with a deposit (net = 0), both loan and deposit have their
own transfer price and not a transfer price of 0 because the net volume is 0.
1.3.2 Marginal: each instrument received its individual tenor-dependent rate and not
a rate averaged across all instruments (and thus averaged across all tenors)
1.4 Components:
- cost of funds
- regulatory cost (e.g. Additional cost for LCR, if LCR requires higher buffer)
- Ly buffer cost
- Bid-offer-spread: in some banks to reflect the administrative cost that Treasury has
to be an internal market maker for liquidity
330
15.B Benchmark funds transfer pricing policy
1. Transfer pricing policy:

1.1 Objectives:
1.2 Types of cost:
1.3 Gross approach with marginal cost, e.g.
1.4 Components:
- cost of funds
- regulatory cost (e.g. Additional cost for LCR, if LCR requires higher buffer)
- Ly buffer cost
- Bid-offer-spread: in some banks to reflect the administrative cost that Treasury has
to be an internal market maker for liquidity
1.5 Methodology how to derive curve:
- which bonds to construct curve
- which interpolation
- curve at which point in time
- alternaties if curve is unavailable
- plausibility checks to ensure accuracy of curve
331
15.C Product pricing examples
0: A bank is facing the following funding cost:
Initial Step level: Maturity [Y] 1 2 3 4 5 6 7

0.50% 0.50% Swap level 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
0.10% 0.25% Funding spread 0.10% 0.35% 0.60% 0.85% 1.10% 1.35% 1.60%
Senior unsecured 0.60% 1.35% 2.10% 2.85% 3.60% 4.35% 5.10%
Funding environment
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
1 2 3 Years 4 5 6 7
Swap level Senior unsecured
332

0.50% 0.50% Swap level 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
0.10% 0.25% Funding spread 0.10% 0.35% 0.60% 0.85% 1.10% 1.35% 1.60%
This is a matched-funded calculatory
assumption. By no means this implies that
Funding environment it is actually 4Y funded!!!
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00% 1 (0.80%)  15%1 (99.9%)
Capitalrequired[%]  [[ ]  0.80%]  45%
1 2 3 Years 4 5 16 15% 7
Swap level
Capital Senior
Required * Target unsecured
= 3.88%*15%
PD * LGD = 0.80%*45%
333
2: Assume the loan has been granted at 5%. How much margin/ shareholder value has been generated?
loan rate: 5.00% p.a.

margin/ SH-value: 0.76% p.a.
3: Compute the RAROC of the loan:
RAROC = 19.50% p.a.
334

0.50% 0.50% Swap level 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
0.10% 0.25% Funding spread 0.10% 0.35% 0.60% 0.85% 1.10% 1.35% 1.60%
This is an opportunity-based funding assumption:
how much would it cost the bank
Funding environment alternatively to fund 2 years monies ...?
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
1 2 3 Years 4 5
Funding 6 – (!) operating
cost 7 cost = 1.35% – 0.45%
Swap level Senior unsecured
335
Summary
1. A primer on bank business and balance-sheet risk Why banks exist? Products, Risks, Revenues, RAROC
2. Bank regulatory capital Basel III / CRR, Pillar 1: xCR, LR, LCR, NSFR, Pillar 2
3. Banking and credit risk Default / migration risk, ratings, Credit risk+, CMetrics
4. A primer on securitisation Correlation, Tranche design, Crisis, regulatory capital
5. The yield curve Types, spot / forwards, discount curve, shapes
6. Asset–liability management I IR and liquidity gaps, IR returns and IR risks
7. Asset–liability management II Types of Ly, IR-gaps: NII, Duration gaps: EVE

ALM: cost / profit centre, IR-futures / IR FRA / IR Swaps
8. Asset–liability management III: Trading and hedging principles / IR Opt.
9. Asset–liability management IV: The ALCO Composition, Agenda, actionable: figure against limits
10. The ALCO: Terms of reference and treasury operating model Risk committee, Treasury organisation, ALCO report

12. Principles of bank liquidity management Ly risk sources, ILAAP, Policy, Ly buffer, cost, CFP
13. Liquidity risk metrics Key metrics, legal / prol / new bus. / stress / survival time

15. Internal funds transfer pricing policy Funding & buffer cost, transfer & price, break-even

19. Repetition and exam logistics 19 March, 2pm–5 pm, questions, course evaluation
20. Appendix
336
You have been very
attentive students!
I wish you a successful
exam!
Dr. Christian Schmaltz,

Aarhus University
Email:
chsch@asb.dk
337

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THE PRINCIPLES OF BANKING:

STRATEGY, CAPITAL AND ASSET-LIABILITY MANAGEMENT

19. Repetition and exam logistics

After the course, you should be able to ...

Background and relation to other courses

• We mention regressions, correlations and other econometric concepts.

The main reference is Moorad’s book:

• I have chosen it for its practical approach,

The course material consists of:

Will be uploaded when needed.

Liquid Liquid Capital

1) Slide like in PTIA-slides.

1) Based on Choudhry (2012), Table 1.1, p. 4

Loans / Car Certificates Investment funds Saving Plan

Loans /Credit Card Wealth Management

Mortgages / Fixed-rate Custody

Mortgages / Variable-rate Assets Liabilities

Mortgages / Pre-payment Option Other Claims Unsecured

Financing Cash Management Asset Management International Business Risk Management

Export and trade finance Currencies Certificates Payment services

Bank’s own debt issuances Cash pooling

Bank’s own equity issuances Treasury management

Assets Liabilities Information management

Other Claims Unsecured Portals and frontends

Finance leases (real estate) Pfandbrief Investment funds

Operating leases Ship Pfandbrief

Real estate loans Public sector Pfandbrief

Ship loans Lettres de Gage Publiques

Unsecured loans Repo (spot sale)

RE / infrastructure loans Assets Liabilities

Other Claims Unsecured

5. Money market trading 6. Liquidity management

Deposits to other banks Currencies Funding liquidity reserve Cash pooling

Other Claims Unsecured

5. Money market trading

Instruments Products Products Instruments

5. Money market trading

Inflows CF+t Outflows CF-t

Liquidity Maturity Ladder

35% (on profit), 0.17% on total assets

29% corporate tax rate

1) Danske Bank, Annual report 2014, p. 65

• Wish long-term • Wish liquid investments

• Information disclosure • Must diversify a lot

• Amounts > 50 mio 1. Capital • Lender must manage

• Expensive funding 2. Crowd • Lender must diversify a lot

10 years 3 months 2) Liquidity

DKK EUR 3) FX mismatch

Defaultable 1 € paid in => 1 € paid back 4) Credit mismatch

1 mio 0.01 mio Amount mismatch

Liquidity reserve Capital Bank1 manages

Danish Central Bank

BMW Bank Ltd.

1) Based on Choudhry (2012), Table 1.1, p. 4

1. Corporate and Investment Bank (CIB)

Global Banking Example:

Net Interest Activities:

Sales & Trading (debt & other products) 9181

Net Interest Activities:

Transaction services 4006

Discretionary Pf/ fund mgt 2108

Net Interest Activities:

Discretionary Pf/ fund mgt 213