Toronto-Dominion Tests New Asset/Liability Analysis System

Toronto-Dominion Bank is piloting a new method of valuing embedded options in loan portfolios developed by the Kamakura Corporation, a Tokyo-based risk consultancy house.

The Kamakura system is being tested by staff at Toronto-Dominion's asset/liability management department at the bank's Toronto headquarters.

It is integrated with bank-wide risk management software supplied by Treasury Services Corp. (TSC), a California-based software house.

These asset/liability management systems are used to produce monthly interest rate risk reports and weekly liquidity reports for Toronto-Dominion's senior management, say bank officials.

"The Kamakura system is very new," says David Tanner, vice president of asset/liability management at Toronto-Dominion. It "promises to be pretty good" compared to rival systems, he adds.

According to Tanner, the combined TSC/Kamakura software allows the bank to run what-if simulations on its loans books under both interest rate and customer behaviour scenarios.

TSC acts as the basic "database and application" provider to Toronto-Dominion's asset/liability management department, he adds.

The Kamakura module is a separate add-on, designed specifically to analyse loans and mortgages with embedded options.

These complex loans and mortgages are becoming increasingly popular in retail banking, says Tanner: hence the need for more complex option-adjusted valuation algorithms.

The TSC system is installed on Unix hardware at Toronto-Dominion's headquarters, linked to the bank's central mainframe.

This mainframe stores loan and mortgage deals made by Toronto-Dominion's network of branches. Around 90 per cent of the bank's business is based in North America.

A TSC-supplied interface downloads the details of the bank's asset/liability books from the mainframe, storing the information in an Oracle-based relational database.

Granular detail

Capturing this loans and mortgage data in a such a granular form is a vital feature of TSC's system, says Tanner.

As a result of this detail, the bank can run scenario analyses and query the information in a very flexible manner, he adds.

Tanner says this sort of flexible questioning would be "very difficult" to achieve without using relational database technology such as that supplied by Oracle and TSC.

Toronto-Dominion first installed TSC's system around 18 months ago, he adds. It replaced the bank's previous asset/liability management software, which was developed in-house.

Flexibility isn't the only issue for asset/liability managers, says Tanner: "speedy processing" is also an important factor.

The client/server architecture underlying TSC's software allows the bank to go "from soup to nuts in four business days for interest rate risk management."

The weekly liquidity reports can be processed overnight, he adds - which is useful for the occasional periods when the bank feels it prudent to increase the frequency of its liquidity monitoring.

Tanner stresses that Toronto-Dominion is only using the TSC/Kamakura system for the asset/liability management side of its global risk management.

This covers the bank's commercial loans, mortgages and long-term securities, he says - the bulk of Toronto-Dominion's $80 billion portfolio.

Money market instruments, bonds, foreign exchange and derivatives fall under a separately managed trading book, explains Tanner.

The chief difference between the two lies in the accounting methods used to analyse them, he adds. The shorter-term trading division uses mark-to-market accounting, while the bank's retail portfolio is accounted for on an accrual basis.

Tanner points out that the long-term retail nature of a bank's loans and mortgages book poses a different set of risk management problems to its wholesale side.

In particular, Toronto-Dominion's asset/liability department has to worry about customer credit issues and mortgage pre-payment behaviour, on top of purely financial risks.

Economic questions

A trading risk manager dealing with a book of securities and derivatives will concentrate on "economic" questions when analysing risk, says Tanner.

"The questions we need to ask are economic as well, but they go beyond that," he adds, "We also need to ask ourselves what will happen to the portfolio cashflows under different customer behaviour scenarios."

Moreover, the two sides of Toronto-Dominion's operations are organised in different fashions. "Retail banking is a very centralised function," says Tanner, "All the retail cashflows end up in a central point."

In contrast, Toronto-Dominion's investment banking operations are dispersed geographically - and thus require a more decentralised approach to risk management.

Tanner points out that while trading risk management techniques - especially those involving derivatives - have advanced considerably in the past few years, attention has only recently started turning to banks' retail portfolios.

"Right now, the theory is in its infancy," he says. The bank's recent upgrade of its asset/liability management systems was motivated by a need to stay at the competitive edge of this growing area, he adds.

Summit sign-up

Toronto-Dominion's investment banking arm recently signed up for trading and risk management software from New York-based Summit Systems (Derivatives Engineering & Technology, October 30, 1995).

The bank had originally intended on building its trading systems in-house, but switched to Summit after cost over-runs in the original project.

California-based TSC specialises in producing risk database and analysis software for retail finance operations.

Los Angeles-based First Interstate Bancorp recently began installing a bank-wide risk and profitability management system from TSC across its branches in the western states of the U.S. (RMO, November 20, 1995).

Kamakura, founded in 1990, is an analytics, software and consulting house specialising in applying advanced mathematical techniques to financial markets.

Much of its work has been on risk management and asset/liability management in the retail sector, including research work on using exotic swaps to hedge credit card loans.