Institutional Asset and Liability Management

Group Assignment

Words counting:

Executive Summary

The purpose of this report is to critically evaluate that Bank of Queensland’s liquidity and credit risk management during 2000 and 2010.

The report first deals with liquidity risk. It starts with analysing liquidity risk by using various ratios such as quick ratio, financing gap etc. It then followed by evaluate the management of liquidity risk within 11years respectively. After comparing the actual ratio and real management, recommendations are provided.

Similar analysis to credit risk, it is first analysed through expert system, loan credit rating and derivative financial instruments to evaluate BOE’s credit risk management. Finally, recommendations for improving risk management are provided.

Most information we obtained from the company annual reports, bank homepages, textbook and relevant database such as Finanalysis and Bankscope. Thus, the information we provided is reliable.

Table of Content

1. Introduction……………………………………………………………………………… 5

1.1 Background of Bank of Queensland …………………………………………………5

1.2 Structure……………………………………………………………………………… 5

2. Liquidity Risk………………………………………………………………………… 6

2.1 Causes of liquidity Risk………………………………………………………………6

2.2 Measurement of liquidity risk………………………………………………………8

2.2.1 Quick ratio………………………………………………………………………… 8

2.2.2 Financing gap………………………………………………………………………… 9

2.2.3 Liquidity Ratio………………………………………………………………………… 9

2.2.4 Non-Core Fund Dependent Ratio……………………………………………………10

2.3 Management of liquidity risk…………………………………………………………12

2.4 Recommendations……………………………………………………………………13

3 Credit risks ………………………………………………………………………… 16

3.1 Measurement of credit risk …………………………………………………………16

3.1.1 Credit standards for loan ……………………………………………………………16

3.1.2 Derivative financial instruments…………………………………………………… 17

3.1.3 Credit rating………………………………………………………………………… 18

3.2 Credit risk management of BOQ……………………………………………………… 20

3.3 Recommendation…………………………………………………………………… 20

4. Conclusion………………………………………………………………………… 21

5. Bibliography………………………………………………………………………… 22

Appendix………………………………………………………………………… 25

Checklist………………………………………………………………………… 26

1. Introduction
1.1 Background of Bank of Queensland
BOQ is a 136-year old organization with branches in every Australian state and territory. It listed on the ASX and comprising of three business lines of banking, finance and insurance, their goal is to be the real alternative in Australian financial services.

The BOQ difference is that Owner-Managers run their branches. So local people not only run their branches, they own them. Their Owner-Managers live locally, know their customers well and are willing to go the extra mile to ensure that their customers always receive exceptional personal service. In striving to achieve their objectives, the Bank undertakes to value and service their customers, look after their staff, reward their shareholders and partner with the community.

1.2 Structure
This report will first critically evaluate how the bank has managed liquidity risk and credit risk between 2000 and 2010 in terms of various ratios. Then it will provide bank’s risk management with regard to the two risks. Finally, it will compare the ratio analysis and banks risk management and provide recommendations for improving risk management of this bank

2. Liquidity Risk

Liquidity risk is the risk that a bank will be unable to make payment or meet withdrawal demands as they become due. It is because a bank may have already suffered from shortage of liquidity, since there is a higher liquidity needs than available liquidity level (Saunders & Cornett 2006).

2.1 Causes of liquidity Risk

Generally, there are two major causes of liquidity risk which are liability-side reason and asset-side reason.

Firstly, liability-side reason arises when a bank’s liability holders, such as, depositors and creditors, demand cash via cash withdrawals (Saunders & Cornett 2006). Cash and liquid assets are less risky with low returns, as compared with other forms of asset classes, hence, banks are more likely to hold longer-maturity assets, rather than those liquid assets, to increase interest revenue. Unfortunately, higher liquidity risk might be constituted when demand for cash withdrawals is excessive, since bank may not have enough liquid assets to pay (Saunders & Cornett 2006). As compared with a large amount of short-term liabilities, especially demand deposit, bank only got a large amount of assets (Saunders & Cornett 2006).

In addition, the holder’s demand deposit accounts are entitled with the right to claim back on any day, the face value of deposits in cash. Consequently, in order to pay off these excessive cash withdrawals with limited liquid assets, bank may need to borrow additional funds or sell assets, which may constitute to a great solvency problem (Saunders & Cornett 2006).

Despite most of the assets can be turned into cash, however, some assets that are sold before maturity, are worth much less than the face value at maturity, so called ‘fire-sale price’, which greatly affects the solvency of the bank (Saunders & Cornett 2006).

On the other hand, bank may borrow additional loan, but when a bank is near its credit limit, it may not able to get further loan, inability of bank to meet cash withdrawal demand, will lead to social distrust, or even bank run (Saunders & Cornett 2006). Hence, liability-side reason is one of the major causes of liquidity risk.

Secondly, asset-side reason arises when there is increasing demand of loan withdrawals, by those borrowers who got approval of loan commitments and credit lines. As a result, there is increasing demand of liquidity, further pushing up the bank’s liquidity risk (Saunders & Cornett 2006).

2.2 Measurement of liquidity risk

In order to analysis BOQ’s liquidity position and management technique, a variety of liquidity ratios have been used, including 1) quick ratio 2) financing gap 3) liquidity ratio 4) non-core fund dependent ratio 5) borrowed funds to total assets ratio, as explaining in the following:

2.2.1 Quick ratio

Total assets/Total Liabilities

The higher the greater the liquidity

Graph 1: Quick ratio

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As the graph shows, the quick ratio remains above 1 during the 11 years, which means it is able to meet current obligations by using liquid assets. It fluctuated from 1.051 to the peak at 1.069 in 2005, followed by a hit to the bottom at only 1.045 in 2007 and recovery to 1.066 until now. The lowest ratio occurred in 2007 due to the GFC.

2.2.2 Financing gap

Graph 2: Financing gap

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As the graph financing gap shows, there is an increasing trend of BOQ’s financing gap within 11 years period. During the first five years (2000-2004), it had negative financing gap. But until 2005, it suddenly increased from negative 24 million to 381 million due do the huge jump in average loans. Afterwards, it reached the peak at 521 million in 2009 which due to the 2008 GFC and dropped back to 363 million in 2010.

2.2.3 Liquidity Ratio

Liquid assets / Total assets

It helps to indicate how many liquid assets that yield no or less returns, has been invested by a bank, as well as the liquidity position of a bank (Saunders & Cornett 2006).

Graph 3: Liquidity ratio

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It shows the liquidity ratio of BOQ had been going up and down during the period of 2000-2010. During 2000-2005, the liquidity position of BOQ was quiet stable, by maintaining its liquidity ratio around 3-5%. However, the ratio has decreased with around 2% during 2006-2010 as the Bank had invested a large amount of money in total assets, with only small proportion invested in short tem assets. In such a case, BOQ has largely increased its liquidity risk, since it may not have enough short term assets to convet into cash, in case of excessive deposit withdrawals or loan withdrawals (BOQ Annual Report, 2010).

2.2.4 Non-Core Fund Dependent Ratio

(Non-core liabilities-short term investment)/ (Earning assets-short term investment)

This ratio measures the degree of liquidity risk that indicates how dependent a bank is on volatile sources of funds, which is non-core liabilities, after subtracting short-term investment (Saunders & Cornett 2006). The higher the ratio indicates a bank is subject to more liquidity risk, since such a reliance on funding source may not available in terms of financial stress or adverse changes in market conditions (Bessis 2002).

Graph 4:Non-Core Fund Dependent Ratio

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It shows the ratio had an increasing trend from 2000-2007, followed by a decreasing trend from 2008-2010. Therefore, BOQ was subjected to higher liquidity risk in previously years, than later years. It was because BOQ had largely increased its reliance over non-core liabilities to fund its long-term assets, relatively to the amount to earning assets and short-term investment. During 2006-2008, where global financial crisis occurred, BOQ had subjected to the highest non-core dependent ratio, which was nearly 30% (BOQ Annual Report, 2010).

2.3 Management of liquidity risk

Generally, it is known that high exposure to liquidity risk can affects the operation and continuity of any financial institutions; hence, several policies have been formulated to reduce liquidity risk. In our case, it is noticeable that BOQ has been working hard to manage its liquidity risk, through implementation of a variety of policies.

• BOQ has a policy regarding to the maintenance of a stable, core retail deposit base, which helps to build up a more stable funding source, which has been done quite successfully as depicted in graph 5.

Graph 5:Core deposits

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• BOQ aims to reduce liquidity risk exposure through the diversification of the funding bases, for example, in 2010, BOQ increases the account payable and other liabilities by $114.3m and borrowings including subordinated notes increased by $23.3m. Also, by a comparison between 2006 and 2010, we can see that BOQ has successfully widen its funding bases, through the inclusion of borrowings including subordinates notes and securitisation liabilities, since these funding bases were not included in 2006, but included in following years.

• In order to meet any excessive withdrawal demands, BOQ has been focused on the retention of adequate levels of high quality assets and reserve, for instance, in 2010,the short term money has been increased by $117.3m from 2009; In 2007, the short term money had been increased by $265.6 from 2006.

• Management of cash flow mismatches has been facilitated through continuously forecast actual cash flows and matching maturity profiles of financial assets and liabilities, to ensure there is liquid assets to meet any liabilities that will due soon. In conclusion, liquidity risk has a major impact on the bank, hence, BOQ has implemented a variety of policies to reduce liquidity risk (BOQ Annual Report, 2010).

2.4 Recommendations

• According to the loan to deposit ratio analysis completed in the above section, it is noticeable that both ratio are pretty high during 2006-2010. Loan to deposit ratio were calculated as 141% in 2006, such an extremely high ratio was caused by too much total loans. BOQ should aware that when the ratio is growing up, higher liquidity risk is exposed. BOQ should restructure its asset and liabilities, try to balance the amount of loan and amount of assets, that is, if BOQ intend to increase the amount of total loans, then, the amount of assets should be increased proportionately as well (Saunders & Cornett 2006).

• The non-core fund dependent ratio indicates that BOQ has a heavy reliance over non-core fund, in which subject to high liquidity risk, due to these non-core funds may not available in times of financial distress. BOQ is strongly recommended that it should reduce its reliance over non-core fund, instead, build up a more stable, reliable fund source or diversify its funding base, in order to ensure the availability of the fund (Saunders & Cornett 2006).

• The liquidity ratio indicates that BOQ did not hold enough liquid assets as compared to the amount of total assets. Hence, high liquidity risk is exposed as BOQ may not have enough cash to meet further demand withdrawals. Hence, BOQ should increase its proportion of liquid assets and maintain a more stable reserve (Saunders & Cornett 2006).

• In order to fill the positive financing gap, BOQ must fund it by using its cash and liquid assets and /or borrowing funds in the money market (Saunders, 2008) The amount of borrowed funds or financing requirement BOQ needs is the financing gap plus its liquid assets. The financing requirement graph as follow:

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It indicates that the amount of requirement is more than the gap. In other words, the larger that BOQ’s financing gap and liquid asset holdings, the larger the amount of funds it needs to borrow in the money markets. As a result, the greater is its exposure to liquidity problems. Thus, BOQ suffered from the liquidity risk most severely during 2006 to 2009 and dropped 300 million in 2010. So, BOQ should monitor the amount of the liquid assets.

3 Credit risk

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. (BIS Homepage, 2011)

3.1 Measurement of credit risk

3.1.1 Credit standards for loan

While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause serious banking problems continues to be directly related to lax credit standards for individual borrowers or company (BIS Homepage, 2011).

For most banks, loans are the largest and most obvious source of credit risk. As the graph shows, BOQ’s loan amount has an increasing trend. It increased from 3042.6 millions to 31725.2 millions which is 10 times as much as before.

The following graph is BOE’s credit standard for loan. Compare with Australia PARSER standards, the credit standard for loan is moderate high.

[pic](Source: Bank of Queensland Homepage, 2011)

3.1.2 Derivative financial instruments

Banks are increasingly facing credit risk in various financial instruments other than loans including financial futures, swaps and options.

We show the derivative financial instruments that bank held from 2000 to 2010

below:

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It is clearly show from the chart that from the year 2000 to 2005 bank did not hold any derivative financial instruments as the bank is exposed to changes in interest rates and foreign exchange rates from its activities. However, from the year 2006 to 2010 the bank increases it dramatically from $34.8m to $148.1m, which is over $100m. It is because according to treasury policy, the bank can hold derivative financial instruments for trading purpose. Also derivatives that not qualify for hedge accounting are accounted for trading instruments.
The consolidated entity uses the following derivative financial instruments to hedge risks such as interest rate swaps, forward rate agreements, interest rate options, cross currency swaps and forward foreign exchange contracts. Derivative financial instruments are not held for speculative purposes.
Derivative financial instruments designated as hedges are accounted for on the same basis as the underlying exposure. Interest rate swaps, cross currency swaps and forward rate agreements, interest payments and receipts under swap contracts and realized gains and losses on forward rate agreements are recognized on an accruals basis in the statement of financial performance as an adjustment to interest expense.
3.1.3 Credit rating

A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers’ likelihood of default (Christian, 2009).

Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. Individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations use the credit rating (Christian, 2009).

Credit rating of a financial institution is obtained depends on both business and financial risk. Next page is the credit rating released by three rating agencies including Standard & Poor’s, Fitch and Moody’s Investors Service for BOQ.

|Rating agency |short term |long term |outlook |Bank deposits |Issuer rating |
|Standard & Poor's |A2 |BBB+ |Stable |- |- |
|Fitch |F2 |BBB |Positive |- |- |
|Moody's Investors Service |P1 |- |Stable |A2 |A2 |

(Source: Bankscope, Bank of Queensland, 2010)

The positive rating to the bank refers to the success of the application of latest ‘owner-managed branch’ approach and the acquisition of Home Building Society Ltd. Nevertheless, the bank's expansion of setting up more branches increased its market share as well as competitiveness in Queensland. The improving credit rating will benefit the bank for more easily and cheaper cost of financing.

3.2 Credit risk management of BOQ

• The bank has adopted a policy of only dealing with creditworthy counterparties and obtaining sufficient collateral where appropriate, as a means of mitigating the risk of financial loss from defaults. • Document credit risk management principles which are disseminated to all staff involved with the lending process • The Consolidated Entity holding derivative financial instruments for trading purpose. Credit risk on derivative contracts is minimised, as counterparties are recognised financial intermediaries with acceptable credit rating determined by a recognised. • A series of management reports detailing industry concentrations, counterparty concentrations, loan grades and security.
3.3 Recommendation

• Establishing an appropriate credit risk environment • Operating under a sound credit-granting process • Maintaining an appropriate credit administration, measurement and monitoring process, thus, ensuring adequate controls over credit risk (BIS Homepage, 2011) Since it is found that Audit and Risk Committee manage the overall risk whereas no specific department charge for managing and monitoring the credit risk. As a result, it seems the bank has little protection in holding credit derivatives and insurance in case if borrower defaults. In contrast, the solution will be relatively simple: by setting up a risk management department will solve such a problem.

4. Conclusion

Bank of Queensland has developed a risk management program to measure and control its liquidity risk and credit risk.

BOQ liquidity risk level is moderate low, although the quick ratio is above 1, which means good, but after analysing other ratio the bank still need to more liquid assets to fill the financing gap. The management of the liquidity risk is overall satisfied, however, there are still several improvements can be done.

BOQ has increased its derivative financial instruments, credit rating and credit standards for loan to reduce its credit risk. The overall management of credit risk is good, but still needs to improve.

5. Bibliography

1. Saunder, A., & Cornett, M. M. 2006. Financial institutions management: A risk management approach. Mcgraw-Hill, Newyork

2. Bessis, 2002. Risk management in banking (2nd ed). John Wiley & Sons Ltd, Great Britain.

3. Bank of Queensland Annual Report, 2010.

http://www.boq.com.au/shareholder_annual_report.htm

4. BIS Homepage,2011. Principles for Sound Liquidity Risk Management and Supervision.

http://www.bis.org/publ/bcbs54.htm

5. Bank of Queensland Homepage, 2011. http://www.boq.com.au

6. Christian, K. 2009. Credit rating and the impact on Capital structure. Grin Verlag, Norderstedt Germany

7. Bankscope data base,2011, Bank of Queensland report.

6. Appendix

Liquidity Ratio

|year |short-term money |Total assets |liquidity ratio |
|2000 |106.66 |3689.60 |2.9% |
|2001 |83.01 |4221.90 |2.0% |
|2002 |155.80 |5280.20 |3.0% |
|2003 |314.30 |7203.20 |4.4% |
|2004 |299.00 |9927.60 |3.0% |
|2005 |530.20 |11065.70 |4.8% |
|2006 |213.50 |15797.10 |1.4% |
|2007 |479.10 |20037.30 |2.4% |
|2008 |399.50 |29775.20 |1.3% |
|2009 |353.80 |34012.00 |1.0% |
|2010 |471.10 |38570.90 |1.2% |

Non-Core Fund Dependent Ratio

|year |non-core |short-term |earnings assets | |deposit |total liabilities|non-core fund |
| |liabilities |investment | | | | |dependent ratio |
|2000 |333.20 |
|2000 |3,176.80 |
|2001 |3699.1 |
|2002 |4471.1 |
|2003 |6114.2 |
|2004 |8302.4 |
|2005 |8713 |
|2006 |9949.6 |

|year |Derivative financial instruments |
|2000 |0 |
|2001 |0 |
|2002 |0 |
|2003 |0 |
|2004 |0 |
|2005 |0 |
|2006 |34.8 |
|2007 |35.3 |
|2008 |74.9 |
|2009 |58.7 |
|2010 |148.1 |
|Year |Avrage loans |Avrage deposits |Financing gap($m) |
|2000 |3042.6 |3176.8 |-134.2 |
|2001 |3569.3 |3699.1 |-129.8 |
|2002 |4413.7 |4471.1 |-57.4 |
|2003 |5761 |6114.2 |-353.2 |
|2004 |8278.4 |8302.4 |-24 |
|2005 |9094.3 |8713 |381.3 |
|2006 |14052 |9949.6 |4102.4 |
|2007 |17600.8 |12720.3 |4880.5 |
|2008 |25246.8 |20036.5 |5210.3 |
|2009 |28310.8 |24197.2 |4113.6 |
|2010 |31725.2 |28088.5 |3636.7 |

|liquidity assets |Financing requirement |
|106.66 |-27.54 |
|83.01 |-46.79 |
|155.8 |98.4 |
|314.3 |-38.9 |
|299 |275 |
|530.2 |911.5 |
|213.5 |4315.9 |
|479.1 |5359.6 |
|399.5 |5609.8 |
|353.8 |4467.4 |
|471.1 |4107.8 |

7. Checklist

| |The length of the paper must not be less than 2500 and be more exceed 3000 word including reference, | |
| |appendix and endnotes ( Please show word count in first page) | |
| |Title of the assignment is provided with 16 font in bold | |
| |Sectional titles are provided in bold and 14 font | |
| |All materials are be provided in double space | |
| |Both sides of the paper are justified with 2.5 inch margin | |
| |Figure , text, word or tables are aligned | |
| |Provided unbroken Table or Figure ( keep it in same page) in Appendix | |
| |Checked grammar, syntax and alignment | |
| |Table heading is provided above the table | |
| |Provided word count | |
| |Page number provided where there is direct quote | |
| |Closed all space or gaps between words and sentences | |
| |Provided references as per guidelines for references | |

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