ALCO portfolios are one of the main tools available to banks to manage some of the structural risks on balance sheets (liquidity risk and interest rate risk) and, as a secondary objective, to contribute to the stability of earnings generation. They are a portfolio of financial assets, mainly composed of government bonds, which is governed by the bank's Assets and Liabilities Committee (ALCO).
A bank’s main activity is the intermediation between customers with monetary surpluses, who deposit their balances through current accounts, deposits, etc. (usually short-term products) and customers with financing needs who apply for loans (products with a longer maturity term). Additionally, this activity may be composed of fixed-rate and variable-rate products (both assets and liabilities).
Asset (loans) and liability (deposits) products generate the following structural risks:
- Structural liquidity risk: risk of incurring difficulties in meeting payment obligations, derived from deposit withdrawals or inability to finance in organized markets. To mitigate this risk, financial institutions maintain minimum liquidity buffers, which allow them to meet their payment obligations in times of crisis.
- Structural interest rate risk: movements in market interest rates cause changes in the net interest income and the book value of a company.
- Other structural risks generated by banking activities, such as exchange rate risk.
With regard to structural interest rate risk, it is to be noted that current accounts as well as time deposits (liabilities) are usually an important source of funding for banks, and are usually remunerated at a fixed rate. Although current accounts have the possibility of immediate availability of funds, historical analysis of their behavior confirms the stability of these funds over time and, therefore, they are usually characterized by medium-term maturities (mainly accounts of individuals with no defined maturity). Additionally, part of these balances are characterized as insensitive, which means that cost evolution has little relation with the evolution of interest rates.
On the asset side, the main type of loans in Spain's lending activity are mortgages, the vast majority of which are generated at variable rates. This implies that prices are adjusted periodically throughout the product’s lifespan. Furthermore, a large portion of business loans are also granted at variable rates. On the other hand, consumer loans are granted at a fixed rate. In short, on the asset side, there is a higher proportion of variable-rate loans than fixed-rate loans.
This balance sheet structure means that banks may have a higher proportion of fixed-rate liabilities than assets, as well as longer maturities in their liability products. This balance sheet profile would imply losses in net interest income when faced with falling interest rate scenarios (and gains in rising interest rate scenarios).
Who manages structural risks?
The committee in charge of controlling, supervising and managing a bank’s balance sheet, and the risks assumed in it, is the ALCO (Assets and Liabilities Committee), which is made up of members from different areas (CEO, finance, risk, research and business areas). This committee usually meets on a monthly basis.
In the specific case of BBVA, considering its decentralized risk management model, monthly ALCOs are held both at a corporate level and in each of the Group’s subsidiaries, in which the evolution of the structural risks of all of them is reviewed.
One of the main tools used to manage structural interest rate risk and liquidity risk is the ALCO portfolio. Given BBVA's decentralized risk management, there are ALCO portfolios in each of the Group's subsidiaries.
What is an ALCO portfolio and what impact does it have on interest rate structural risks and on the capital ratio?
An ALCO portfolio is composed of fixed income instruments, mainly local, high credit quality, sovereign bonds, which have maximum liquidity in the event they have to be sold before its maturity in the secondary market.
This portfolio helps to manage structural interest rate risk, offsetting the higher duration and proportion of fixed-rate instruments on the liability side. Additionally, ALCO portfolios help manage structural liquidity risk, as it is the instrument of choice to profitably invest the liquidity buffers required by both regulatory and internal liquidity metrics. An ALCO portfolio has a limited impact on the capital ratio due to its reduced RWA (Risk-Weighted Assets) consumption , as it is mostly composed of sovereign bonds.
Another objective of ALCO portfolios is to support the bank's income statement, either through net interest income (where the coupons of the bonds that are part of the portfolio are accounted for) or through net trading income (where capital gains - or losses, as the case may be - derived from the sale of bonds are registered).
What are the accounting implications of an ALCO portfolio?
The financial assets comprising an ALCO portfolio may have different types of accounting classifications depending on the objectives sought. Financial assets may be classified as HTC&S (Held To Collect and Sell) if their objective is to hedge interest rate risk and to be able to be sold in advance if needed. Under this classification, bonds are valued on a daily basis ('fair value') and changes in valuation are recorded in equity (Other Comprehensive Income). Once these financial assets are sold, the gain or loss on the sale is reclassified from equity to results (net trading income).
The instruments can also be classified as HTC (Held To Collect). In this case, the entity's objective is to collect the coupons paid by the instrument until maturity, without the need to perform a daily valuation.