Publications

	Table of Contents
p. 5 of 8 BACK | NEXT I. Introduction II. Borrower's Demand for New Loan Products III. Proposed New Libor-Based Loan Products IV. Withdrawal and Conversion of Pool-Based Loans V. Funding Risk Management Strategy VI. Implementation and Resource Requirements VII. Conclusion and Recommendations Appendixes

Review of Asian Development Bank's Financial Loan Products

---

V. Funding and Risk Management Strategy

102. ADB has been offering LIBOR-based products to certain types of borrowers since 1994, when the MBL window was established. The financial operation of LIBOR-based lending under this window has been governed by a Board-approved risk management framework or strategy known as the matched-funding policy. As the proposed new LBL product can be considered as an expansion of the MBL window, the Board-approved matched-funding policy for risk management will naturally apply to the proposed new LBL product window. The major difference is that matched-funding for MBL is done at loan approval, while matched-funding for the new product will be done at the time of disbursements.

103. Matched funding is essentially one type of asset and liability management strategy. Under this strategy, ADB would fund LBLs with liabilities having broadly the same characteristics in terms of interest rate (fixed or floating), currency, and maturity. This would enable ADB to minimize the risk to income from mismatches in those three areas. In simple terms, fixed-rate loans should be funded with fixed-rate borrowings with corresponding matching repayment schedules and maturities,⁷ and floating-rate loans with floating rate liabilities. Each individual LBL transaction will therefore be hedged, thus controlling the very sources of risk.⁸

104. A discussion of the funding and risk management strategy will therefore help in the understanding of how ADB will manage the financial risk in LBL lending. As with ADB’s other loan products, the funding strategy for LBL lending will be designed to secure the required volume of borrowing in a timely fashion and at the most attractive available cost. Under such strategy, funding for the LBL product will be raised through diversification across markets, instruments, and maturities and by taking advantage of timing flexibility. In line with its comparative advantage, ADB will fund LBL products mainly through fixed-rate borrowings in various currency markets and simultaneously engage in a combination of interest rate and currency swaps to convert, if necessary, such borrowings into a desired interest rate structure and currency composition.

105. The objective of the risk management strategy is to manage the currency composition, maturity profile, and interest rate characteristics of the portfolio of liabilities supporting the LBL product within the prescribed principle of matched funding. To eliminate exchange risk in a single currency lending, ADB will match the LBLs in any one currency with liabilities in the same currency, as prescribed by the Charter. In many cases, ADB has obtained blanket consents from member countries to raise funds in their markets and denominate the borrowings in their currency.⁹ With the introduction of the LBL product, ADB plans to obtain “evergreen” consents to be able to borrow (and swap) in the currencies in which it has made loan commitments, so long as the loans are outstanding (para. 19).

106. The interest rate risk on LBL products will be managed by using interest rate swaps to closely align the interest rate characteristics of the loan portfolio with those of the underlying liabilities. Under this approach, all borrowings for funding the LBL products will initially be swapped into floating-rate liabilities with the floating rate of interest payable by ADB under the swaps based on six-month LIBOR. Pending disbursements, the proceeds of the borrowings will be invested in the liquid asset portfolio with the primary objective of managing the so-called “warehousing” risk. There are two potential sources of warehousing risk. First, ADB will be exposed to the risk of short-term interest rate movements (within six months) between the LIBOR reset date of liabilities and the rate-fixing date for liquid assets. Another potential source relates to the risk that, prior to disbursements, the cost of liabilities may be higher than the investment return, i.e., cost of carry on a floating-to-floating basis. The magnitude of the warehousing risk will be almost eliminated by matching the maturity or repricing intervals of the liquid assets and the underlying liabilities. To provide flexibility in the investment of an LBL liquid asset portfolio, ADB may temporarily bridge finance disbursements of LBL loans by issuing euro-commercial paper funding through the interbank market, and using equity funds. Such bridge-financing will allow ADB to avoid the costs of liquidating its LBL investments. ADB will replace the bridge-financing with long-term liabilities as proceeds from maturing LBL investments are received.

107. ADB does not need to match the maturity of floating-rate loans and floating-rate liabilities. In theory, a refunding risk would arise to the extent that the maturities of the floatingrate loan portfolio were longer than those of the allocated floating-rate liabilities. Because refunding will be done on the same interest rate basis, i.e., six-month LIBOR, there would be no interest rate basis risk. The risk will be limited to an access risk or roll-over risk, and the possibility that its funding spread relative to LIBOR on the refunding date would become less attractive. As long as ADB maintains its high credit standing, refunding will not entail any risk to ADB. Maturity mismatch for fixed-rate loans will however entail interest rate risks.

108. The remaining risk is the reset mismatch. The lending rate reset dates in LBLs differ among themselves and may not coincide with the LIBOR reset dates of funding. By having standard lending rate reset dates for loans that are dispersed evenly across the year, i.e., 1^st and 15^th of each month and six months thereafter, ADB will have more flexibility to synchronize the reset dates of its floating-rate liabilities to occur on the same lending rate reset dates of loans, thus avoiding some reset risks. In addition, interest rate movements between the reset dates for liabilities and loans will tend to even out over time. However, complete matching of the reset dates and amounts cannot be achieved because the timing of borrowing and lending operations is influenced by dynamic factors such as market conditions. Thus, reset risks will have to be monitored, controlled, and managed on a portfolio basis as under the present practice for the MBL.¹⁰

109. When the interest rate on the disbursed amount will have to be fixed from time to time in accordance with the borrowers’ request, ADB will convert the initial floating rate liabilities to fixed-rate funding through interest-rate swaps. The fixed interest rate of the LBLs will be mainly based on the fixed-rate of interest payable by ADB under the interest-rate swaps. This, combined with the maturity matching of loans and swaps, allows ADB to completely eliminate interest rate risk associated with fixed-rate loans. The maturity matching of loans and swaps means that ADB will accept conversion into the fixed-rate only for loans with remaining maturities that are available in the swap market. In this way, fixed-rate loans are squarely matched with corresponding fixed-rate obligations, i.e., perfectly market-covered.

110. In summary, the matched funding approach to risk management requires that each LBL transaction be hedged. This will ensure that, at the aggregate level of the portfolio, the amount of interest (exclusive of the prevailing lending spread of 60 basis points) billed to the borrowers should suffice to recover the amount of interest paid out to service the liabilities allocated to fund the LBL products. Notwithstanding the adoption of the matched-funding policy, the risk profile of the LBL portfolio will be measured and managed through the use of various quantitative techniques, including the MBL window’s Value-at-Risk approach. In addition, counterparty credit risk associated with swap transactions would be mitigated by ADB’s practice of only entering into long-term swaps with counterparties meeting conservative risk guidelines.

111. Another potential source of risk is lending at a fixed spread over a defined cost base rate. This risk arises because of the possibility that the actual spread earned by ADB on LBL assets could be eroded if its actual borrowing cost becomes higher than the cost base rate.

112. There are two ways in which this risk could affect ADB’s lending spread. First, there is the risk that, due to changes in ADB’s funding cost margin relative to the cost base rate during the period between loan commitment (i.e., when the spread is fixed) and disbursement, new disbursements on loans already committed may have to be funded at a cost higher than the cost base rate. This is generally referred to as the funding lag risk (i.e., time lag between loan commitment and disbursements/borrowings). The longer is the funding lag the greater is the risk. Second, if the maturity of ADB’s borrowing and lending differs and ADB has to refinance its borrowings, it may not be able to do so at a cost equal to or lower than the cost base rate. The greater is the maturity mismatch the bigger is the risk.

113. Based on these considerations, ADB adopted a policy of matched-funding when the fixed spread MBL window was introduced in 1994. Under such policy, ADB is required to fund MBL loans near the time of approval to protect its lending spread in line with prevailing practices then in other MDBs which are offering private sector loans. This approach resulted in maintaining a level of liquid assets equivalent to 100 percent of the undisbursed balances of MBL loans.

114. In practice, however, ADB’s sub-LIBOR funding cost reflects its “AAA” credit rating. The risk that ADB’s future borrowing cost may become higher than the cost base rate could only be triggered if its credit standing in the market deteriorates, which in turn can be triggered by loan defaults by one or more of its borrowers. Thus, under normal financial conditions, it is not likely that ADB’s funding cost would become higher than the cost base rate. On this basis, and taking into account that the risk on fixed spread pricing would be mitigated by the system of rebate and surcharge, Management judges that the present minimum liquidity policy for pool-based loans, i.e., 40 percent of undisbursed loan balances can also be applied to LBL loans.

115. Although the system of rebate and surcharge would not apply to private sector loans, Management judges that the fixed-spread pricing for LBL private sector loans would not entail significant risks to ADB for the following three reasons. First, in the absence of a rebate mechanism for LBL private sector loans, ADB would in effect be keeping its sub-LIBOR funding cost margin in contrast to the rebate feature of LBL public sector loans. The additional income from sub-LIBOR funding cost margin on LBL private sector loans may be considered as additional reserves to act as buffer against the risk, albeit remote, that ADB’s funding cost may become higher than the cost base rate. Second, because private sector loans are generally disbursed faster than public sector loans and have shorter maturities than public sector loans, the funding lag and refunding risks of private sector loans are considerably smaller than public sector loans.

116. Third, this judgement was also based on the experience that ADB has gained on its fixed-spread MBL window. When the MBL was introduced in 1994, ADB gave weight to the generally accepted principles that the funding spread of any borrower could change over time due to market factors such as changes in interest rate expectations and swap opportunities. While these remain true, experience has shown that these factors would not be as critical as the deterioration of ADB’s credit standing due to default by its borrower(s).

117. On the basis of the above three reasons, it is concluded that the risk on fixed-spread pricing on new LBL private sector loans need not be managed by maintaining 100 percent liquidity coverage. Thus, the present minimum liquidity policy of ADB can be applied on future LBL loans for private sector borrowers, i.e., 40 percent of undisbursed loan balances. For the same reasoning, it is Management’s judgement that undisbursed loan balances of existing MBL loans need not be fully covered by liquidity. It is therefore proposed that the present minimum liquidity policy of 40 percent of undibursed loan balances be applied to outstanding MBL loans.

118. In accordance with the global swap authorization approved by the Board of Directors on an annual basis, ADB has the authority to undertake currency and interest rate swaps and other derivative transactions in connection with its borrowings. ADB has followed the practice of obtaining the approval of the country in whose currency the proceeds of the borrowings will be exchanged under the currency swap transaction, regardless of whether the country is an ADB member.¹¹ With the introduction of a common currency such as the euro, it is difficult for ADB to continue this practice, in particular given that 4 of the 12 countries comprising the Economic and Monetary Union are not ADB members.¹² To provide flexibility in the execution of currency swaps involving the euro, the current practice of obtaining the approval of nonmember countries will be discontinued.¹³ ADB will continue to obtain all approval mandated by the Charter.

119. In connection with the risk management of the LBL product, particularly regarding conversion options, ADB needs to be able to undertake swaps as and when currency and interest rate conversions are requested by the borrowers. Under current practice, swaps relating to the risk management of the MBL window are authorized by the Board on an annual basis. Currently, this practice does not impede ADB’s risk management operations due to the relatively small amount of MBL loans. However, the practice will not be suitable for LBL risk management because the amount of the LBLs will be sizable. Thus, it is proposed that the Board authorize ADB to undertake currency and interest rate swaps from time to time in connection with the risk management of the LBLs. The timing and amounts of individual swaps will depend on the borrowers’ request for currency and interest rate swaps. In addition, ADB will need to undertake hedging transactions involving forward rate agreements and interest rate futures contracts to manage the reset risk.

____________________

Back IV. Withdrawal and Conversion of Pool-Based Loans	Next VI. Implementation and Resource Requirements