Question

1. Assume that a bank expects to attract most of its funds through short-term CDs and would prefer to use most of its funds to provide long-term loans. How could it follow this strategy and still reduce interest rate risk?

Answer 1

This concept is known as ALM (asset-liability management) mismatch.

Banks prefer to borrow short term in certificate of deposits to reduce their borrowing costs & lend long term to increase their interest income from loans (ie assets).

Greater number of financial institutions are enhancing their risk management function by adding to the
responsibilities of the ALM function. These have included enhancing the role of the head of Treasury and the asset
and liability committee (ALCO), using other risk exposure measures such as option-adjusted spread and value-at risk (VaR)and integrating the traditional interest-rate risk management with credit risk and operational risk. The
increasing use of credit derivatives has facilitated this integrated approach to risk management

• using the VaR tool to asses risk exposure;
• integrating market risk and credit risk
• using new risk-adjusted measures of return
• optimising portfolio return
• proactively managing the balance sheet; this includes giving direction on securitisation of assets (removing them from the balance sheet), hedging credit exposure using credit derivatives and actively enhancing returns

from the liquidity book, such as entering into stock lending and repo