Asset Liability Management Optimisation

CHAPTER 3Customer Behaviour and Its Impact on Interest Rate and Liquidity Risk

SIGNIFICANCE AND IMPACT OF BEHAVIOURAL ISSUES IN THE BANKING BOOK

To analyse behaviour, banks combine statistical information with some assumptions. An interesting characteristic of behaviour assumption is that it does not always follow market conditions. In some cases, clients or counterparties behave contrary to their own interest but in ways that are aligned with their psychological demands. In other cases, behaviour is driven by rumours or loss of confidence in the financial institutions. The impact of behavioural issues can be seen in terms of both interest rate and liquidity risk exposure.

One of the biggest challenges of ALM is the management of the interest rate risk associated with customer products with an undefined interest rate commitment. Even the regulator demands a documented and validated approach to how the interest rate commitments are derived and managed in the bank (Enthofer and Haas 2016). In products with undetermined maturity, interest rate risk that is not fully transferred to ALM/ Treasury causes significant residual risk left within the business, and therefore earnings and equity volatility, which has to be monitored and managed by ALCO.

Balance sheet items require behavioural assumptions in order to manage the interest rate risk correctly, as raising interest rates may reduce the net interest margin given the banks' limited ability to raise client rates in line with the ...