The integration of performance measurement and asset-and-liability management / John Singleton Janse van Rensburg

The financial intermediation function that a bank performs dictates the existence of a risk-reward trade-off embedded within a bank's balance sheet. The process of risk management focuses on achieving the broader organisational objectives relating to this risk-reward trade-off. Measuring the contribution of risk to profitability is pivotal in assessing the optimality of a bank's risk-reward trade-off. Conventional accounting-based performance measures such as return on assets and return on equity do not incorporate the risk effects as part of the performance assessment. Risk-adjusted performance measurement assessments, such as risk-adjusted return on capital, acknowledge the impact of risk in measuring the profitability of a bank. Interest rate risk is an important source of bank profitability. The Asset-and-Liability Management function of a bank is tasked with the management of interest rate risk in the 'banking book' of its balance sheet. Managing interest rate risk demands that the sources of interest rate risk for example, reprice risk, yield curve risk, option risk and basis risk are clearly identified and measured. The impact of interest rate risk can be assessed from two perspectives namely, the earnings perspective and the economic value perspective. Measuring the impact of interest rate risk conventionally involves a number of techniques, each of which has inherent strengths and weaknesses. Simulation modelling techniques deploying earnings-at-risk and economic value of equity analyses respectively, most accurately quantifies the earnings and economic value perspectives to the effects of interest rate risk. The methods of repricing gap analyses and duration analyses present efficiency constraints in measuring interest rate risk although complimentary to developing a complete interest rate risk metrics framework.Matched-Term Funds Transfer Pricing is an important component in measuring the risk-adjusted net interest margin for the risk-adjusted performance measurement process. Matched-Term Funds Transfer Pricing system isolates the business units from the effects of interest rate risk by transferring the interest rate risk or mismatch spread (profit or loss) to the Central Funding Unit or Asset-and-Liability Management unit. Business units are therefore allocated the net interest margin components relating to the controllable risk elements for which management responsibility is assumed. Business units use the risk-adjusted performance measurement results to develop balance sheet and pricing strategies that are sensitised to asset and liability management and interest rate risk management objectives through the Matched-Term Funds Transfer Pricing mechanism. These business strategies should be included in the measurement of interest rate risk by the asset-and-liabilitymanagement simulation model. The asset-and-liability management process can therefore optimise the interest rate risk management process. The integration of the Matched-TermFunds Transfer Pricing, Asset-and-Liability Management and banking book interest rate risk management processes institutes a risk-optimisation approach to risk management compared against the conventional risk-control perspective to the function of risk management.