alm_in_banks

Asset Liability Management in Banks

ASSET LIABILITY MANAGEMENT IN BANKS

Submitted in partial fulfillment of the requirements

for (Master of Management Studies)

(Year 2008-2010)

PROJECT GUIDE Prof. Gazia Sayed

SUBMITTED BY

Name: Richa Motiramani

(MMS II) Roll No. M-08-29

Batch: (2008 - 2010)

IES Management College and Research Centre

University of Mumbai

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CERTIFICATE

This is to certify that project titled: Asset Liability Management in

Banks has been submitted by Ms. Richa Motiramani towards partial

fulfillment of the requirements of the Master of Management

Studies (MMS) degree course 2008 - 2010 and has been carried out by

her under the guidance of Ms. Gazia Sayed at the IES Management

College and Research Centre affiliated to the University of Mumbai.

The matter presented in this report has not been submitted for any

other purpose in this Institute.

_______________________ ___________________________

Guide : Prof. Gazia Sayed Director : Dr.Dinesh D. Harsolekar

Place : Place :

Date : Date :

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ACKNOWLEDGEMENT

Like every project needs direction this one is no exception. I would therefore,

like to express my sincere gratitude to Prof. Gazia Sayed for helping me in this

project. Her valuable suggestions and insights have helped achieve much

more than what was conceived of the project at its inception. I would also like

to thank my friends who were also a great support while working on the

project.

I believe the project would have been incomplete without their support.

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TABLE OF CONTENTS

Sr.

No. Topic

Pg.

No.

1. Executive Summary 6.

2. Asset Liability Management 7.

3. Components of Financial Statements 9.

3.1 Balance Sheet 9.

3.2 Profit & Loss Account 11.

4. Rate Sensitive Assets and Liabilities 13.

5. Risk Associated with Asset Liability Management 14.

6. Purpose of Asset Liability Mismatch 18.

7. Addressing the Mismatches 19.

8. Elements of Asset Liability Management 21.

9. Three Pillars of ALM 23.

10. Asset Liability Committee – ALCO 25.

10.1 Process of ALCO 27.

10.2 Organization Structure of ALCO 28.

11. ALM Approach 29.

11.1 Liquidity Risk Management 29.

11.2 Asset Management 32.

11.3 Liability Management 33.

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12. Procedure for examining Asset Liability Management 35.

13. Regulatory Framework 38.

14. Issues in implementation of ALM 40.

15. Techniques of ALM 42.

15.1 Gap Analysis Model 42.

15.2 Duration Gap Analysis Model 46.

15.3 Simulation Analysis 47.

15.4 Value at Risk 49.

16. GAP & NII 50.

17. Bibliography 54.

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1. EXECUTIVE SUMMARY

Asset Liability Management is the most important aspect for the Banks to

manage Balance Sheet Risk, especially for managing of liquidity risk and

interest rate risk. Failure to identify the risks associated with business and

failure to take timely measures in giving a sense of direction threatens the

very existence of the institution.

Implementing Asset Liability Management (ALM) function in banks is not only a

regulatory requirement in India but also an imperative for strategic bank

management. With profit becoming the a key-factor, it has now become

imperative for banks to move towards integrated balance sheet management

where components of balance sheet and its different maturity mix will be

looked at profit angle of the bank.

Asset Liability Management is based on three pillars and they are ALM

Information System, ALM Organization and ALM Process. ALM brings to bear a

holistic and futuristic perspective to the balance sheet management. Banks

provide services that exposes them to various risks like credit risk, liquidity

risk, interest rate risk to name a few. It is therefore appropriate for banks to

focus on ALM when they face different types of risks.

There are different techniques used by banks for Asset Liability Management

and they are GAP analysis Model, Duration Gap analysis Model, Simulation

Model and Value at Risk.

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2. ASSET LIABILITY MANAGEMENT

As financial intermediaries banks are known to accept deposit to lend money

to entrepreneurs to make profit. They essentially intermediate between the

opposing liquidity needs of depositors and borrowers. In the process, they

function with an embedded mismatch between highly liquid liabilities on the

one side and less liquid and long term assets on the other side of their balance

sheets. Over and above this balance sheet conflict, they also stand exposed to

a wide array of risk such as market risk, transformation risk, credit risk,

liquidity risk, forex risk, legal risk, operation risk, reputational risk, interest rate

risk, etc. The recognition of three main risk i.e. Interest Rate Risk, Liquidity

Risk and Credit Risk gave rise to the concept of Asset Liability Management.

Asset-Liability Management (ALM) can be termed as a risk management

technique designed to earn an adequate return while maintaining a

comfortable surplus of assets beyond liabilities. Banks are exposed to several

risks which are multi-dimensional. The main direct financial risks are interest

rate risk, liquidity risk, credit risk and market risk. The initial focus of the ALM

function would be to enforce the risk management discipline viz. managing

business after assessing the risks involved. The objective of good risk

management programmes should be that these programmes will evolve into a

strategic tool for bank management. The asset-liability management function

would involve planning, directing and controlling the flow, level, mix, cost and

yield of the consolidated funds of the Bank. It takes into consideration interest

rates, earning power, and degree of willingness to take on debt and hence is

also known as Surplus Management. It enables banks to sustain their required

growth rate by systematically managing market risk, liquidity risk, capital risk,

etc.

The objective of ALM is to manage risk and not eliminate it. Risks and rewards

go hand in hand. One cannot expect to make huge profits without taking a

huge amount of risk. The objectives do not limit the scope of the ALM

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functionality to mere risk assessment, but expanded the process to the taking

on of risks that might conceivably result in an increase in economic value of

the balance sheet.

Apart from managing the risks ALM should enhance the net worth of the

institution through opportunistic positioning of the balance sheet. The more

leveraged an institution, the more critical is the ALM function with enterprise.

The objectives of Asset-Liability Management are as follows:

To protect and enhance the net worth of the institution.

Formulation of critical business policies and efficient allocation of Capital.

To increase the Net Interest Income (NII)

It is a quantification of the various risks in the balance sheet and optimizing

of profit by ensuring acceptable balance between profitability, growth and

risks.

ALM should provide liquidity management within the institution and choose

a model that yields a stable net interest income consistently while ensuring

liquidity.

To actively and judiciously leverage the balance sheet to stream line the

management of regulatory capital.

Funding of banks operation through capital planning.

Product pricing and introduction of new products.

To control volatility of market value of capital from market risk.

Working out estimates of return and risk that might result from pursuing

alternative programs.

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3. COMPONENTS OF FINANCIAL STATEMENT

3.1 Balance Sheet

Liabilities

1. Capital: Capital represents owner’s contribution/stake in the bank. It serves

as a cushion for depositors and creditors. It is considered to be a long term

sources for the bank.

2. Reserves & Surplus: It includes Statutory Reserves, Capital Reserves,

Investment Fluctuation Reserve, Revenue and Other Reserves, Balance in

Profit and Loss Account

3. Deposits: This is the main source of bank’s funds. The deposits are

classified as deposits payable on ‘demand’ and ‘time’. This includes

Demand Deposits, Savings Bank Deposits and Term Deposits

4. Borrowings: Borrowings include Refinance / Borrowings from RBI, Inter-bank

& other institutions

a) Borrowings in India i.e. Reserve Bank of India, Other Banks and Other

Institutions & Agencies

b) Borrowings outside India

5. Other Liabilities & Provisions: It can be grouped as Bills Payable, Interest

Accrued, Unsecured redeemable bonds, and other provisions.

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Liabilities AssetsCapital Cash and Bank BalancesReserves & Surplus InvestmentsDeposits AdvancesBorrowings Fixed Assets Other Liabilities Other Assets

Contingent Liabilities


Assets

1. Cash & Bank Balances: This includes cash in hand including foreign notes,

balances with Reserve Bank of India in current and other accounts

2. Investments: This includes investments in India i.e. Government Securities,

Other approved Securities, Shares, Debentures and Bonds, Subsidiaries and

Sponsored Institutions, Others and investments abroad.

3. Advances: Bills Purchased and Discounted, Cash Credits, Overdrafts &

Loans repayable on demand, Term Loans, Secured by tangible assets,

Covered by Bank/ Government Guarantees.

4. Fixed Assets: This includes premises, land, furniture & fixtures, etc.

5. Other Assets: This includes Interest accrued, Tax paid in advance/tax

deducted at source, Stationery and Stamps, Non-banking assets acquired in

satisfaction of claims, Deferred Tax Asset (Net) and Others.

For ALM these assets and liabilities are classified into different time periods

called maturity buckets, depending on maturity profile and interest rate

sensitivity. As per Reserve Bank of India guidelines issued for ALM

implementation in bank in 1999, there are eight time buckets T-1 to T-8

classified respectively as follows:

(i) 1 to 14 days

(ii) 15 to 28 days

(iii) Over 3 months and upto 6 months

(iv) Over 6 months and upto 1 year

(v) 1 year and upto 3 years

(vi) 3years and upto 5 years

(vii)Over 5 years

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Contingent Liabilities

Bank’s obligations under Letter of Credits, Guarantees, Acceptances on behalf

of constituents and Bills accepted by the bank are reflected under this heads.

3.2 Profit and Loss Account

Profit and Loss Account includes:

Income

1. Interest Earned: This includes Interest/Discount on Advances / Bills, Income

on Investments, Interest on balances with Reserve Bank of India and other

inter-bank funds

2. Other Income: This includes Commission, Exchange and Brokerage, Profit

on sale of Investments, Profit/(Loss) on Revaluation of Investments, Profit

on sale of land, buildings and other assets, Profit on exchange transactions,

Miscellaneous Income

Expenses

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Cash 1-14 days bucketsExcess balance over required CRRSLR shown under 1-14 days bucket

Investments Respective maturity bucketsAdvances Respective maturity bucketsOther Assets Respective maturity buckets

Assets - Repayment inflows into the Banks

Bank Balance

Captial Over 5 years bucketReserves & Surplus Over 5 years bucketDeposits Respective maturity bucketsBorrowings Respective maturity bucketsOther Liabilties and provisions Respective maturity bucketsContingent Liabilities Respective maturity buckets

Liabilities - Repayment outflows from the Bank


1. Interest Expense: This includes Interest on Deposits, Interest on Reserve

Bank of India / Inter-Bank borrowings and others.

2. Operating Expense: This includes Payments to and Provisions for

employees, Rent, Taxes and Lighting, Printing and Stationery,

Advertisement and Publicity, etc.

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4. Rate Sensitive Assets & Rate Sensitive Liabilities

Those asset and liability whose interest costs vary with interest rate changes

over some time horizon are referred to as Rate Sensitive Assets (RSA) or Rate

Sensitive Liabilities (RSL). Those assets or liabilities whose interest costs do

not vary with interest rate changes over some time horizon are referred to as

Non Rate Sensitive Assets (NRSA) or Non Rate Sensitive Liabilities (RSL). It is

very important to note that the critical factor in the classification of time

horizon chosen. An asset or liability that is time sensitive in a certain time

horizon may not be sensitive in shorter time horizon and vice versa. However,

over a significantly long time horizon, virtually all assets and liabilities are

interest rate sensitive. As the time horizon is shortened, the rate of rate

sensitive to non rate sensitive assets and liabilities falls.

The table below shows the classification of the assets and liabilities of the bank

according to their interest rate sensitivity.

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Liabilities Type Assets TypeDemand Deposits NRSL Cash NRSACurrent Accounts NRSL Short Term Securities RSAMoney Market Deposits RSL Long Term Securities NRSAShort Term Deposits RSL Variable Rate Loans RSAShort Term Savings NRSL Short Term Loans RSARepo Transactions RSL Long Term Loans NRSAEquity NRSL Other Assets NRSA


5. RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT

Risk can be defined as the chance or the probability of loss or damage. In the

case of banks these include credit risk, capital risk, market risk, interest rate

risk, liquidity risk, operations risk and foreign exchange risks. These categories

of financial risk require focus, since financial institutions like banks do have

complexities and rapid changes in their operating environments.

1.Credit Risk: The risk of counter party failure in meeting the payment

obligation on the specific date is known as credit risk. Credit risk

management is an important challenge for financial institutions and failure

on this front may lead to failure of banks. Credit risk plays a vital role in the

way banks perform. It reflects the profitability, liquidity and reduced Non

Performing Assets.

The other important issue is contract enforcement. Legal reforms are very

critical in order to have timely contract enforcement. Delays and loopholes

in the legal system significantly affect the ability of the lender to enforce the

contract. The legal system and its processes are notorious for delays

showing scant regard for time and money that is the basis of sound

functioning of the market system. Credit Risk Management is the process

that puts in place systems and procedures enabling banks to:

Identify and measure the risk involved in credit proposition, both at

individual transaction and portfolio level.

Evaluate the impact of exposure on bank’s financial statements.

Access the capability of the risk mitigates to hedge/insure risks.

Design an appropriate risk management strategy to arrest risk mitigation.

2.Capital Risk: Capital risk is the risk an investor faces that he or she may

lose all or part of the principal amount invested. It is the risk a company

faces that it may lose value on its capital. The capital of a company can

include equipment, factories and liquid securities. Capital adequacy focuses

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on the weighted average risk of lending and to that extent, banks are in a

position to realign their portfolios between more risky and less risky assets.

3.Market Risk: Market risk refers to the risk to an institution resulting from

movements in market prices, in particular, changes in interest rates, foreign

exchange rates, and equity and commodity prices. Market risk is also

referred to as “systematic risk”. This risk cannot be diversified. Market risk

is related to the financial condition, which results from adverse movement in

market prices. This will be more pronounced when financial information has

to be provided on a marked-to-market basis since significant fluctuations in

asset holdings could adversely affect the balance sheet of banks. The

problem is accentuated because many financial institutions acquire bonds

and hold it till maturity. When there is a significant increase in the term

structure of interest rates, or violent fluctuations in the rate structure, one

finds substantial erosion of the value of the securities held. Market risk is

often propagated by other forms of financial risk such as credit and market-

liquidity risks. For example, a downgrading of the credit standing of an

issuer could lead to a drop in the market value of securities issued by that

issuer. Likewise, a major sale of a relatively illiquid security by another

holder of the same security could depress the price of the security.

4. Interest Rate Risk: Banks in the past were primarily concerned about

adhering to statutory liquidity ratio norms and to that extent they were

acquiring government securities and holding it till maturity. But in the

changed situation, namely moving away from administered interest rate

structure to market determined rates, it becomes important for banks to

equip themselves with some of these techniques, in order to immunize

banks against interest rate risk.

Interest risk is the change in prices of bonds that could occur as a result of

change: n interest rates. In measuring its interest rate risk, an institution

should incorporate re-pricing risk (arising from changing rate relationships

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across the spectrum of maturities), basis risk (arising from changing rate

relationships among yield curves that affect the institution’s activities) and

optionality risks (arising from interest rate related options embedded in the

institution’s products).

There are certain measures available to measure interest rate risk. These

include:

Maturity: Since it takes into account only the timing of the final principal

payment, maturity is considered as an approximate measure of risk and in

a sense does not quantify risk. Longer maturity bonds are generally

subject to more interest rate risk than shorter maturity bonds.

Duration: Is the weighted average time of all cash flows, with weights

being the present values of cash flows. Duration can again be used to

determine the sensitivity of prices to changes in interest rates. It

represents the percentage change in value in response to changes in

interest rates.

Dollar duration: Represents the actual dollar change in the market value

of a holding of the bond in response to a percentage change in rates.

Convexity: Because of a change in market rates and because of passage

of time, duration may not remain constant. With each successive basis

point movement downward, bond prices increase at an increasing rate.

Similarly if rates increase, the rate of decline of bond prices declines. This

property is called convexity.

5. Liquidity Risk: Liquidity Risk is the risk stemming from the lack of

marketability of an investment that cannot be bought or sold quickly

enough to prevent or minimize a loss. It is usually reflected in a wide bid-

ask spread or large price movements. It arises from the potential inability

of the Bank to generate adequate cash to cope with a decline in deposits or

increase in assets. To a large extent, it is an outcome of the mismatch in

the maturity patterns of assets and liabilities.

There are two types of liquidity i.e. market liquidity and funding liquidity.

Liquidity risk broadly comprises three sub-types:

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Funding Risk: The need to replace net outflows of funds whether due to

withdrawal of retail deposits or non-renewal of wholesale funds.

Time Risk: The need to compensate for non-receipt of expected inflows

of funds, e.g. when a borrower fails to meet his repayment

commitments.

Call Risk: The need to find fresh funds when contingent liabilities become

due. Call risk also includes the need to be able to undertake new

transactions when desirable.

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6. Purpose of Asset Liability Mismatch

ALM is no longer a standalone analytical function. There are micro and macro

level objectives of ALM.

At micro level, the objective functions of the ALM are two-fold. It aims at

profitability through price matching while ensuring liquidity by means of

maturity matching. Price matching basically aims to maintain spreads by

ensuring that the deployment of liabilities will be at a rate higher than the

costs. Similarly, liquidity is ensured by grouping the assets/liabilities based on

their maturing profiles. The gap is then assessed identify the future financing

requirements. This ensures liquidity. However, maintaining profitability by

matching prices and ensuring liquidity by matching the maturity levels is not

an easy task. The following tables explain the process involved in price

matching and maturity matching.

At macro-level, ALM leads to the formulation of critical business policies,

efficient allocation of capital and designing of products with appropriate pricing

strategies.

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7. ADDRESSING THE MISMATCHES

A key issue that banks need to focus on is the maturity of its assets and

liabilities in different tenors. A typical strategy of a bank to generate revenue

is to run mismatch, i.e. borrow short term and lend longer term. However,

mismatch is accompanied by liquidity risk and excessive longer tenor lending

against shorter-term borrowing would put a bank’s balance sheet in a very

critical and risky position.

To address this risk and to make sure a bank does not expose itself in

excessive mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month,

1-3 months, 3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-5

years, over 5 year) maturity profile of the assets and liabilities is prepared to

understand mismatch in every bucket.

However, as most deposits and loans of a bank matures next day (call,

savings, current, overdraft etc.), bucket-wise assets and liabilities based on

actual maturity reflects huge mismatch; although all of the shorter tenor

assets and liabilities will not come in or go out of the bank’s balance sheet.

As a result, banks prepare a forecasted balance sheet where the assets and

liabilities of the nature of current, overdraft etc. are divided into ‘core and non-

core’ balances, where core is defined as the portion that is expected to be

stable and will stay with the bank; and non-core to be less stable. The

distribution of core and non-core is determined through historical trend,

customer behavior, statistical forecasts and managerial judgment; the core

balance can be put into over 1 year bucket whereas non-core can be in 2-7

days or 3 months bucket.

An example of Forecasted balance can be as follows:

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Assets Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+Reserve Assets 1,000 200 300 - - - 500 -Interbank Placing 750 250 - 250 250 - - -Assets 4,000 300 250 1,400 300 250 1,000 500Other Assets 500 200 - - - - 300 -Total Assets 6,250 950 550 1,650 550 250 1,800 500

Liabilities Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+Interbank Deposits -1,000 -750 - -250 - - - -Other Deposits -4,500 -1,200 -1,000 -1,200 -100 -200 -800 -Capital & Reserves -500 - - - - -100 -400 -Other Liabilities -250 -250 - - - - - -Total Liabilities -6,250 -2,200 -1,000 -1,450 -100 -300 -1,200 0

Off Balance Sheet Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+Commitments -2,000 - - - -150 -1,850 - -Forward Contracts 250 - 100 50 100 - - -Total Off Balance Sheet -1,750 0 100 50 -50 -1,850 0 0

Net Mismatch -1,750 -1,250 -350 250 400 -1,900 600 500

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8. Elements of Asset Liability Management

There are nine elements related to ALM and they are as follows:

1. Strategic framework: The Board of Directors are responsible for setting

the limits for risk at global as well as domestic levels. They have to decide

how much risk they are willing to take in quantifiable terms. Also it is

necessary to determine who is in chare of controlling risk in the

organization and their responsibilities.

2. Organizational framework: All elements of the organization like the ALM

Committee, sub–committees, etc., should have clearly defined roles and

responsibilities. ALM activities should be supported by the top management

with proper resource allocation and personnel committee.

3. Operational framework: There should be a proper direction for risk

management with detailed guidelines on all aspects of ALM. The policy

statement should be well articulated providing a clear direction for ALM

function.

4. Analytical framework: Analytical methods in ALM require consistency,

which includes periodic review of the models used to measure risk to avoid

miscalculation and verifying their accuracy. Various analytical components

like Gap, Duration, Stimulation and Value-at-Risk should be used to obtain

appropriate insights.

5. Technology framework: An integrated technological framework is

required to ensure all potential risks are captured and measured on a

timely basis. It would be worthwhile to ensure that automatic information

feeds into the ALM systems and he latest software is utilized to enable

management perform extensive analysis, planning and measurement of all

facets of the ALM function.

6. Information reporting framework: The information – reporting

framework decides who receives information, how timely, how often and in

how much detail and whether the amount and type of information received

is appropriate and necessary for the recipient’s task.

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7. Performance reporting framework: The performance of the traders and

business units can easily be measured using valid risk measurement

measures. The performance measurement considers approaches and ways

to adjust performance measurement for the risks taken. The profitability of

an institution comes from three sources: Asset, Liabilities and their efficient

management.

8. Regulatory compliance framework: The objective of regulatory

compliance element is to ensure that there is compliance with the

requirements, expectations and guidelines for risk – based capital and

liquidity ratios.

9. Control framework: The control framework covers the control over all

processes and systems. The emphasis should be on setting up a system of

checks and balances to ensure the integrity of data, analysis and reporting.

This can be ensured through regular internal / external reviews of the

function.

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9. THREE PILLARS OF ALM

The three pillars of Asset-Liability Management are as follows:

1. ALM Information Systems

2. ALM Organization

3. ALM Process

Pillar 1: ALM Information System

It includes Management Information System, Information availability, accuracy,

adequacy and expediency. A good information system gives the bank

management a complete picture of the bank's balance sheet. Considering the

large network of branches and the lack of an adequate system to collect

information required for ALM which analyses information on the basis of

residual maturity and behavioral pattern it will take time for banks in the

present state to get the requisite information. The problem of ALM needs to be

addressed by following an ABC approach i.e. analyzing the behavior of asset

and liability products in the top branches accounting for significant business

and then making rational assumptions about the way in which assets and

liabilities would behave in other branches. In respect of foreign exchange,

investment portfolio and money market operations, in view of the centralized

nature of the functions, it would be much easier to collect reliable information.

The data and assumptions can then be refined over time as the bank

management gain experience of conducting business within an ALM

framework. The spread of computerization will also help banks in accessing

data.

Pillar II: ALM Organization

The board should have overall responsibility for the management of risks and

should decide the risk management policy of the bank and set the limits for

liquidity, interest rate, foreign exchange and equity price risk. The

responsibility of ALM is on the treasury department of the banks. The results of

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balance sheet analysis along with recommendations is place in Asset Liability

Committee (ALCO) meeting by the treasurer where important decisions are

made are made to minimize risk and maximize returns. The Alco committee

comprising of the senior management of bank is responsible for Balance Sheet

risk management. The size of ALCO varies from organization to organization.

CEO heads the committee. The objective of the ALCO is to derive the most

appropriate strategy for the banks in terms of the mix of assets and liabilities

given its expectation for the future and the potential consequences of interest-

rate movements, liquidity constraints, foreign exchange exposure and capital

adequacy. It is the responsibility of the committee to ensure all strategies

conform to the bank’s risk appetite and levels of exposure as determined by

the Board Risk Committee.

Pillar3: ALM Process

The basic ALM processes involving identification, measurement and

management of risk parameter .The RBI in its guidelines has asked Indian

banks to use traditional techniques like Gap Analysis for monitoring interest

rate and liquidity risk. However RBI is expecting Indian banks to move towards

sophisticated techniques like Duration, Simulation, VaR in the future. For the

accrued portfolio, most Indian Private Sector banks use Gap analysis, but are

gradually moving towards duration analysis. Most of the foreign banks use

duration analysis and are expected to move towards advanced methods.

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10. ASSET LIABILITY COMMITTEE – ALCO

The Asset-Liability Committee (ALCO) consisting of the bank's senior

management including CEO should be responsible for ensuring adherence to

the limits set by the Board as well as for deciding the business strategy of the

bank (on the assets and liabilities sides) in line with the bank's budget and

decided risk management objectives.

The ALM desk consisting of operating staff should be responsible for analyzing,

monitoring and reporting the risk profiles to the ALCO. The staff should also

prepare forecasts (simulations) showing the effects of various possible

changes in market conditions related to the balance sheet and recommend the

action needed to adhere to bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning

from risk-return perspective including the strategic management of interest

rate and liquidity risks. Each bank will have to decide on the role of its ALCO,

its responsibility as also the decisions to be taken by it. The business and risk

management strategy of the bank should ensure that the bank operates within

the limits/parameters set by the Board. The business issues that an ALCO

would consider, inter alia, will include product pricing for both deposits and

advances, desired maturity profile of the incremental assets and liabilities, etc.

In addition to monitoring the risk levels of the bank, the ALCO should review

the results of and progress in implementation of the decisions made in the

previous meetings. The ALCO would also articulate the current interest rate

view of the bank and base its decisions for future business strategy on this

view. In respect of the funding policy, for instance, its responsibility would be

to decide on source and mix of liabilities or sale of assets. Towards this end, it

will have to develop a view on future direction of interest rate movements and

decide on a funding mix between fixed vs floating rate funds, wholesale vs

retail deposits, money market vs capital market funding, domestic vs foreign

currency funding, etc. Individual banks will have to decide the frequency for

holding their ALCO meetings.

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Top Management, the CEO/CMD or ED should head the Committee. The Chiefs

of Investment, Credit, Funds Management/Treasury (forex and domestic),

International banking and Economic Research can be members of the

Committee. In addition the Head of the Information Technology Division should

also be an invitee for building up of MIS and related computerization. Some

banks may even have sub-committees.

The size (number of members) of ALCO would depend on the size of each

institution, business mix and organizational complexity.

Committee composition

Permanent members:

Chairman

Managing Director/CEO

Financial Director

Risk Manager

Treasury Manager

ALCO officer

Divisional Managers

By invitation:

Economist

Risk Consultants

Purposes and Tasks of ALCO :

Formation of an optimal structure of the Bank’s balance sheet to provide

the maximum profitability, limiting the possible risk level;

Control over the capital adequacy and risk diversification;

Execution of the uniform interest policy;

Determination of the Bank’s liquidity management policy;

Control over the state of the current liquidity ratio and resources of the

Bank;

Formation of the Bank’s capital markets policy;

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Control over dynamics of size and yield of trading transactions

(purchase/sale of currency, state and corporate securities, shares,

derivatives for such instruments) as well as extent of diversification

thereof;

Control over dynamics of the basic performance indicators (ROE, ROA, etc.)

as prescribed in the Bank's policy.

10.1 Process of ALCO

10.2 Organization Structure of ALCO

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11. ALM APPROACH

ALM in its most apparent sense is based on funds management. Funds

management represents the core of sound bank planning and financial

management. Although funding practices, techniques, and norms have been

revised substantially in recent years, it is not a new concept. Funds

management is the process of managing the spread between interest earned

and interest paid while ensuring adequate liquidity. Therefore, funds

management has following three components, which have been discussed

briefly.

1. LIQUIDITY RISK MANAGEMENT

Bank’s liquidity management is the process of generating funds to meet

contractual or relationship obligations at reasonable prices at all times. New

loan demands, existing commitments, and deposit withdrawals are the basic

contractual or relationship obligations that a bank must meet.

Liquidity Tracking

Measuring and managing liquidity needs are vital for effective operation of the

Company. By assuring the Company’s ability to meet its liabilities as they

become due, liquidity management can reduce the probability of an adverse

situation. The importance of liquidity transcends individual institutions, as

liquidity shortfall in one institution can have repercussions on the entire

system. The ALCO should measure not only the liquidity positions of the

Company on an ongoing basis but also examine how liquidity requirements are

likely to evolve under different assumptions. Experience shows that assets

commonly considered being liquid, such as govt. securities and other money

market instruments, could also become illiquid when the market and players

are unidirectional. Therefore, liquidity has to be tracked through maturity or

cash flow mismatches. For measuring and managing net funding requirement,

29


the use of a maturity ladder and calculation of cumulative surplus or deficit of

funds at selected maturity dates is adopted as a standard tool.

Analysis of following factors throws light on a bank’s adequacy of liquidity

position:

a. Historical Funding requirement

b. Current liquidity position

c. Anticipated future funding needs

d. Sources of funds

e. Options for reducing funding needs

f. Present and anticipated asset quality

g. Present and future earning capacity and

h. Present and planned capital position

To satisfy funding needs, a bank must perform one or a combination of the

following:

a. Dispose off liquid assets

b. Increase short term borrowings

c. Decrease holding of less liquid assets

d. Increase liability of a term nature

e. Increase Capital funds

Statement of Structural Liquidity

It Places all cash inflows and outflows in the maturity ladder as per residual

maturity. Maturity Liabilities are cash outflow and Maturity Assets are cash

inflows. The mismatches in the first two buckets cannot exceed 20% of

outflows. It shows the structure as of a particular date. Banks can fix the

tolerance level for other maturity buckets.

Assets and Liabilities to be reported as per their maturity profile into 8

maturity buckets:

a. 1 to 14 days

30


b. 15 to 28 days

c. 29 days and up to 3 months

d. Over 3 months and up to 6 months

e. Over 6 months and up to 1 year

f. Over 1 year and up to 3 years

g. Over 3 years and up to 5 years

h. Over 5 years

An example of structural liquidity statement:

Outflow 1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total

Capital - - - - - - - 200 200Liab-fixed Int 300 200 200 600 600 300 200 200 2600Liab-floating Int 350 400 350 450 500 450 450 450 3400Others 50 50 - - - - 0 200 300

Total outflow 700 650 550 1050 1100 750 650 1050 6500

Inflow 1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total

Investments 200 150 250 250 300 100 350 900 2500Loans-fixed Int 50 50 0 100 150 50 100 100 600Loans - floating int 200 150 200 150 150 150 50 50 1100Loans BPLR Linked 100 150 200 500 350 500 100 100 2000Others 50 50 0 0 0 0 0 200 300

Total Inflow 600 550 650 1000 950 800 600 1350 6500

Addressing the Mismatches

Mismatches can be positive or negative

Positive Mismatch: Maturing Assets > Maturing Liabilities

Negative Mismatch: Maturing Liabilities > Maturing Assets

In case of positive mismatch, excess liquidity can be deployed in money

market instruments, creating new assets & investment swaps etc.

31

1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total

Gap -100 -100 100 -50 -150 50 -50 300 0Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0

Gap % to Total Outflow -14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57 0.00


For negative mismatch, it can be financed from market borrowings

(Call/Term), Bills rediscounting, Repos & deployment of foreign currency

converted into rupee.

Strategies

To meet the mismatch in any maturity bucket, the bank has to look into

taking deposit and invest it suitably so as to mature in time bucket with

negative mismatch.

The bank can raise fresh deposits of Rs 300 crore over 5 years maturities

and invest it in securities of 1-29 days of Rs 200 crores and rest matching

with other out flows.

2. ASSET MANAGEMENT

Many banks (primarily the smaller ones) tend to have little influence over the

size of their total assets. Liquid assets enable a bank to provide funds to

satisfy increased demand for loans. But banks, which rely solely on asset

management, concentrate on adjusting the price and availability of credit and

the level of liquid assets. However, assets that are often assumed to be liquid

are sometimes difficult to liquidate. For example, investment securities may be

pledged against public deposits or repurchase agreements, or may be heavily

depreciated because of interest rate changes. Furthermore, the holding of

liquid assets for liquidity purposes is less attractive because of thin profit

spreads. Asset liquidity, or how "salable" the bank's assets are in terms of both

time and cost, is of primary importance in asset management. To maximize

profitability, management must carefully weigh the full return on liquid assets

(yield plus liquidity value) against the higher return associated with less liquid

assets. Income derived from higher yielding assets may be offset if a forced

sale, at less than book value, is necessary because of adverse balance sheet

fluctuations.

Seasonal, cyclical, or other factors may cause aggregate outstanding loans

and deposits to move in opposite directions and result in loan demand, which

32


exceeds available deposit funds. A bank relying strictly on asset management

would restrict loan growth to that which could be supported by available

deposits. The decision whether or not to use liability sources should be based

on a complete analysis of seasonal, cyclical, and other factors, and the costs

involved. In addition to supplementing asset liquidity, liability sources of

liquidity may serve as an alternative even when asset sources are available.

3. LIABILITY MANAGEMENT

Liquidity needs can be met through the discretionary acquisition of funds on

the basis of interest rate competition. This does not preclude the option of

selling assets to meet funding needs, and conceptually, the availability of

asset and liability options should result in a lower liquidity maintenance cost.

The alternative costs of available discretionary liabilities can be compared to

the opportunity cost of selling various assets. The major difference between

liquidity in larger banks and in smaller banks is that larger banks are better

able to control the level and composition of their liabilities and assets. When

funds are required, larger banks have a wider variety of options from which to

select the least costly method of generating funds. The ability to obtain

additional liabilities represents liquidity potential. The marginal cost of liquidity

and the cost of incremental funds acquired are of paramount importance in

evaluating liability sources of liquidity. Consideration must be given to such

factors as the frequency with which the banks must regularly refinance

maturing purchased liabilities, as well as an evaluation of the bank's ongoing

ability to obtain funds under normal market conditions.

The obvious difficulty in estimating the latter is that, until the bank goes to the

market to borrow, it cannot determine with complete certainty that funds will

be available and/or at a price, which will maintain a positive yield spread.

Changes in money market conditions may cause a rapid deterioration in a

bank's capacity to borrow at a favorable rate. In this context, liquidity

represents the ability to attract funds in the market when needed, at a

reasonable cost vis-à-vis asset yield. The access to discretionary funding

33


sources for a bank is always a function of its position and reputation in the

money markets.

Although the acquisition of funds at a competitive cost has enabled many

banks to meet expanding customer loan demand, misuse or improper

implementation of liability management can have severe consequences.

Further, liability management is not riskless. This is because concentrations in

funding sources increase liquidity risk. For example, a bank relying heavily on

foreign interbank deposits will experience funding problems if overseas

markets perceive instability in U.S. banks or the economy. Replacing foreign

source funds might be difficult and costly because the domestic market may

view the bank's sudden need for funds negatively. Again over-reliance on

liability management may cause a tendency to minimize holdings of short-

term securities, relax asset liquidity standards, and result in a large

concentration of short-term liabilities supporting assets of longer maturity.

During times of tight money, this could cause an earnings squeeze and an

illiquid condition.

Also if rate competition develops in the money market, a bank may incur a

high cost of funds and may elect to lower credit standards to book higher

yielding loans and securities. If a bank is purchasing liabilities to support

assets, which are already on its books, the higher cost of purchased funds may

result in a negative yield spread.

Preoccupation with obtaining funds at the lowest possible cost, without

considering maturity distribution, greatly intensifies a bank's exposure to the

risk of interest rate fluctuations. That is why banks that particularly rely on

wholesale funding sources, management must constantly be aware of the

composition, characteristics, and diversification of its funding sources.

12. Procedure for examining Asset Liability Management

34


In order to determine the efficacy of Asset Liability Management one has to

follow a comprehensive procedure of reviewing different aspects of internal

control, funds management and financial ratio analysis. Below a step-by-step

approach of ALM examination in case of a bank has been outlined.

Step 1

The bank/ financial statements and internal management reports should be

reviewed to assess the asset/liability mix with particular emphasis on: -

Total liquidity position (Ratio of highly liquid assets to total assets).

Current liquidity position (Minimum ratio of highly liquid assets to demand

liabilities/deposits).

Ratio of Non Performing Assets to Total Assets.

Ratio of loans to deposits.

Ratio of short-term demand deposits to total deposits.

Ratio of long-term loans to short term demand deposits.

Ratio of contingent liabilities for loans to total loans.

Ratio of pledged securities to total securities.

Step 2

It is to be determined that whether bank management adequately assesses

and plans its liquidity needs and whether the bank has short-term sources of

funds. This should include: -

Review of internal management reports on liquidity needs and sources of

satisfying these needs.

Assessing the bank's ability to meet liquidity needs.

Step 3

The banks future development and expansion plans, with focus on funding and

liquidity management aspects have to be looked into. This entails: -

35


Determining whether bank management has effectively addressed the

issue of need for liquid assets to funding sources on a long-term basis.

Reviewing the bank's budget projections for a certain period of time in the

future.

Determining whether the bank really needs to expand its activities. What

are the sources of funding for such expansion and whether there are

projections of changes in the bank's asset and liability structure?

Assessing the bank's development plans and determining whether the bank

will be able to attract planned funds and achieve the projected asset

growth.

Determining whether the bank has included sensitivity to interest rate risk

in the development of its long term funding strategy.

Step 4

Examining the bank's internal audit report in regards to quality and

effectiveness in terms of liquidity management.

Step 5

Reviewing the bank's plan of satisfying unanticipated liquidity needs by: -

Determining whether the bank's management assessed the potential

expenses that the bank will have as a result of unanticipated financial or

operational problems.

Determining the alternative sources of funding liquidity and/or assets

subject to necessity.

Determining the impact of the bank's liquidity management on net

earnings position.

Step 6

Preparing an Asset/Liability Management Internal Control Questionnaire which

should include the following: -

36


1. Whether the board of directors has been consistent with its duties and

responsibilities and included: -

A line of authority for liquidity management decisions.

A mechanism to coordinate asset and liability management decisions.

A method to identify liquidity needs and the means to meet those needs.

Guidelines for the level of liquid assets and other sources of funds in

relationship to needs.

2. Does the planning and budgeting function consider liquidity requirements?

3. Are the internal management reports for liquidity management adequate in

terms of effective decision making and monitoring of decisions.

4. Are internal management reports concerning liquidity needs prepared

regularly and reviewed as appropriate by senior management and the board

of directors.

5. Whether the bank's policy of asset and liability management prohibits or

defines certain restrictions for attracting borrowed means from bank related

persons (organizations) in order to satisfy liquidity needs.

6. Does the bank's policy of asset and liability management provide for an

adequate control over the position of contingent liabilities of the bank?

7. Is the foregoing information considered an adequate basis for evaluating

internal control in that there are no significant deficiencies in areas not

covered in this questionnaire that impair any controls?

37


13. Regulatory Framework

The central bank of a country has to ensure that in its drive for profitability and

market share the banking sector does not expose itself and by extension the

market to high levels of risk. Credit risk traditionally has been and still is the

biggest risk faced by this sector and has been addressed through various

central bank relations and guidelines.

The RBI has already come out with guidelines governing market risk including

the need for banks to constitute an ALCO. However, given the state of data

availability most bank ALCOs are not able to hold meaningful discussions on

balance sheet risks. Discussions in most ALCOs that do meet regularly are

oriented towards treasury activity rather than taking a view of the entire

balance sheet. This is again mainly due to lack of data on the other businesses

of the bank. However, given the increasing volatility in interest and exchange

rates it is becoming critical for banks to manage their market risks. It is

therefore likely that the RBI would introduce more detailed guidelines for ALM.

A look at the regulatory guidelines in the more developed markets on ALM

could provide clues to the main features of any guidelines that may be

introduced by the RBI.

1. As a measure of liquidity management, banks are required to monitor their

cumulative mismatches across all time buckets in their Statement of Structural

Liquidity by establishing internal prudential limits with the approval of the

Board / Management Committee. As per the guidelines, the mismatches

(negative gap) during the time buckets of 1-14 days and 15-28 days in the

normal course are not to exceed 20 per cent of the cash outflows in the

respective time buckets.

2. Having regard to the international practices, the level of sophistication of

banks in India and the need for a sharper assessment of the efficacy of

liquidity management, these guidelines have been reviewed and it has been

decided that :

38


(a) The banks may adopt a more granular approach to measurement of

liquidity risk by splitting the first time bucket (1-14 days at present) in the

Statement of Structural Liquidity into three time buckets viz. Next day, 2-7

days and 8-14 days.

(b) The Statement of Structural Liquidity may be compiled on best available

data coverage, in due consideration of non-availability of a fully networked

environment. Banks may, however, make concerted and requisite efforts to

ensure coverage of 100 per cent data in a timely manner.

(c) The net cumulative negative mismatches during the Next day, 2-7 days, 8-

14 days and 15-28 days buckets should not exceed 5 %, 10%, 15 % and 20

% of the cumulative cash outflows in the respective time buckets in order

to recognize the cumulative impact on liquidity.

(d) Banks may undertake dynamic liquidity management and should prepare

the Statement of Structural Liquidity on daily basis. The Statement of

Structural Liquidity, may, however, be reported to RBI, once a month, as on

the third Wednesday of every month.

3. The format of Statement of Structural Liquidity has been revised suitably and

is furnished at Annex I. The guidance for slotting the future cash flows of banks

in the revised time buckets has also been suitably modified and is furnished at

Annex II. The format of the Statement of Short-term Dynamic Liquidity may

also be amended on the above lines.

4. To enable the banks to fine tune their existing MIS as per the modified

guidelines, the revised norms as well as the supervisory reporting as per the

revised format would commence with effect from the period beginning January

1, 2008 and the reporting frequency would continue to be monthly for the

present. However, the frequency of supervisory reporting of the Structural

Liquidity position shall be fortnightly, with effect from the fortnight beginning

April 1, 2008.

14. ISSUES IN IMPLEMENTATION OF ALM

1. Policy: Lack of a coherent, documented and practical policy is a big hindrance

to ALM implementation. Most often, ALCO membership itself may not be aware

39

http://rbidocs.rbi.org.in/rdocs/content/PDFs/80880.pdf

http://rbidocs.rbi.org.in/rdocs/content/PDFs/80879.pdf


of implications of risks being measured and impact. Policies should address all

issues concerning the bank, all policies should be clearly explained to all

members of board, apart from ALCO and these must be documented. Proper

revisions to this document, a quarterly review needs to be organized as well as

parameters may be changing due to change in situations.

2. Understanding of complexities: Many people in a bank need to understand risk

measurements and risk mitigation procedures. Measurement of risk is a fairly

simple phenomenon and does go on regardless. Formalization of

understanding, especially at a top level, will be helpful as it would help in

decision –making.

3. Organization and culture: ALM function needs to be separated clearly from

operations as it involves control and strategy functions. Risk organization in

banks generally land up reporting to treasury, as they are people who come

closest to understanding complex financial instruments. The fact that they are

a business unit, in charge of ‘risk taking’ is overlooked. ‘Risk Taking’ and ‘Risk

management’ are generally two distinct parts of any organization and both

must report to a board completely independently. Openness and transparency

are essential to a proper risk organization. Most organizations react badly to

some positions going wrong by taking more risks and enter vicious cycle of

risks. Thus, it is required to follow policy implicitly in both letter and spirit.

4. Data and Models: Data may not be available at all times in requisite format. It

must be remembered that many data items are assumptions and gaps must

be measured in perspective. There was a case of a manual branch of a bank

that was closed for 6 months in a year due to inclement weather and was

largely inaccessible. As data may not be obtained from this branch for 6

months, appropriate assumptions have to be made in any event. The

argument is that for all other purposes, assumptions are being made. Sensible

options need to be chosen and manual branch without computer was an

example. However, in modern banking, it is mapping of models to zero coupon

bonds that are an issue. Once again, arguments are that this should exist

within the bank. Based on sophistication required, multiple models may be

40


used to validate this conversion. This is strictly outside ALM framework but

integrates into ALM framework.

5. Unrealistic goals: An ALCO secretary was seen desperately trying to tweak with

parameters to ‘show’ less gaps in liquidity reports. A zero gap is not practical.

Returns are expected for taking risks. Banks assume market and credit risk

and hence they make returns. ALCO’s job is to correctly determine positions

and put in place appropriate remedial measures using appropriate risks. It is

not to show things as good when they are not.

41


15. TECHNIQUES OF ASEET LIABILITY MANAGEMENT

15.1 GAP Analysis Model: Under the Gap analysis method, the various assets and

liabilities are grouped under various time buckets based on the residual

maturity of each item or the next repricing date, if on floating rate, whichever

is earlier. Then the gap between the assets and liabilities under each time

bucket is worked out. Since the objective is to maximize the NII, it will be

sufficient if this is done only with respect to rate sensitive assets and liabilities.

If the rate sensitive assets equal the rate sensitive liabilities, it is known as the

Zero Gap or matched book position. If the rate sensitive assets are more than

the rate sensitive liabilities, it is referred to as positive gap position and if the

rate sensitive assets are less than the rate sensitive liabilities, it is known as

negative gap position. The decision to hold a positive gap or a negative will

depend on the expectation on the movement of interest rates. The effect of an

upward movement or a downward movement in the interest rate on the NII will

also depend on the position taken. These effects are given in the table below:

GAP Position

Changes in Interest Rates

Changes in Interest Income

Changes in Interest Expense

Change in NI I

Positive Increase Increase Increase IncreasePositive Decrease Decrease Decrease DecreaseNegative Increase Increase Increase DecreaseNegative Decrease Decrease Decrease IncreaseZero Increase Increase Increase NoneZero Decrease Decrease Decrease None

Positive gap indicates a bank has more sensitive assets than liabilities and the

NII will generally rise (fall) when interest rate rises (fall)

Negative gap indicates a bank has more sensitive liabilities than assets and

the NII will generally fall (rise) when interest rates rise (fall)

It measures the direction and extent of asset-liability mismatch through either

funding or maturity gap. It is computed for assets and liabilities of differing

42


maturities and is calculated for a set time horizon. This model looks at the

repricing gap that exists between the interest revenue earned and the bank's

assets and the interest paid on its liabilities over a particular period of time. It

is sometimes referred to as periodic gap because banks use gap analysis

report to measure the interest rate sensitivity of RSA and RSL for different

periods. These periods are known as maturity buckets which vary across

banks, depending on the operating strategy.

Positive Gap Negative Gap

Rate Sensitive Assets are more than

Rate Sensitive Liabilities

Rate Sensitive Liabilities are more

than Rate Sensitive Assets

Assets mature before Liabilities Liabilities mature before Assets

Short-term assets funded with long-

term liabilities

Long-term assets funded with short-

term liabilities

If interest rate increase, NII also

increase

If interest rate increase, NII also

decrease

Assumptions

Contractual Repayment Schedule i.e. no early repayment or option like

feature

On Schedule Payments i.e. there is no early repayments or defaults

Parallel Shift in Yield Curve i.e. both short-term and long-term interest rate

change by the same amount.

Advantages

Simple to analyze

Easy to implement

Helps in future analysis of Interest Rate Risk

Helps in projecting the NII for further analysis

Limitations

It does not incorporate future growth or changes in the mix of assets and

liabilities.

43


It in not take time value of money or initial net worth into account.

The periods used in the analysis are arbitrary and repricing is assumed to

occur at the midpoint of the period.

It does not provide a single reliable index of interest rate.

Example of GAP

ABC bank for which maturity Pattern of assets and liabilities as on a particular

date i.e. 31st December 2009

Here, Rs. 705.55 Cr in the deposit liability of deposits means that as on

December 31st, 2009 the bank was liable to repay this amount including the

interest during the next 14 days on account of the deposits received by the

bank till date. Similarly, Rs. 376.05 Cr in the loans and advances indicates as

on 31st December 2009 the bank was expected to get back this amount during

the next 14 days of the loans and advances it has given till date.

44

Maturity Buckets

DepositsBorrow

ings

Foreign Currency Liabilities

Loans & Advances

Investment in Securities

Foreign Currency Assets

1D - 14D 705.55 0.59 52.66 376.05 88.33 61.2715D-28D 405.95 0.00 4.08 147.52 5.00 1.2729D-3M 1,681.74 8.81 17.85 563.54 44.33 16.623M-6M 1,806.75 5.14 12.64 777.92 121.03 44.366M-1Y 3,955.82 3.16 25.12 1,133.48 104.12 0.001Y-3Y 7,014.37 23.89 20.00 4,757.43 1,375.00 8.873Y-5Y 3,807.50 2.10 0.00 2,113.26 1,379.36 0.005Y+ 6,085.70 0.00 0.00 2,674.40 9,254.56 0.00Total 25,463.38 43.69 132.35 12,543.60 12,371.73 132.39

Rate Sensitive Liabilities Rate Sensitive AssetsABC Bank Maturity Pattern of Assets and Liabilities as on 31.12.2009


Maturity Buckets

RSL = Total

Outflows

RSA = Total

Inflows

GAP = RSA - RSL

Cumulative GAP

GAP Ratio =

RSA/ RSL

ΔNI I = GAP ΔI (for ΔI =

0.25% decrease)

1D - 14D 758.80 525.65 -233.15 -233.15 0.69 0.5815D-28D 410.03 153.79 -256.24 -489.39 0.38 1.2229D-3M 1,708.40 624.49 -1,083.91 -1,573.30 0.37 3.933M-6M 1,824.53 943.31 -881.22 -2,454.52 0.52 6.146M-1Y 3,984.10 1,237.60 -2,746.50 -5,201.02 0.31 131Y-3Y 7,058.26 6,141.30 -916.96 -6,117.98 0.87 15.33Y-5Y 3,809.60 3,492.62 -316.98 -6,434.96 0.92 16.095Y+ 6,085.70 11,928.96 5,843.26 -591.70 1.96 1.48

Results

Observations

From the results GAP amount is negative till 3-5 year period and positive for

the last period, which means ABC bank can be grouped as liability sensitive.

Long-term assets are funded with short-term liabilities and the bank will

benefit as NII increases with decrease in interest rates a shown in the above

table for a decrease in the rate of interest of 0.25%. Cumulative GAP amount is

also negative for all time periods. GAP ratio is between 0.3 and 0.92 up to 3-5

year period indicating that inflows are always less than outflows and for the

last time period inflows are double the outflows.

To reduce Rate Sensitivity

Buy long-term securities, lengthen the maturities of loan and convert floating

rate loans to term loans.

To increase Asset Sensitivity

Buy short-term securities, shorten the maturities of loan and convert term

loans to floating rate loans.

45


To reduce Liability Sensitivity

Pay premium to attract long-term deposits and issue ling-term subordinated

debt.

To increase Liability Sensitivity

Pay premium to attract short-term deposits and borrow more non-core

purchased liability.

15.2 Duration Analysis: The Gap method ignores time value of money. . Under

the duration method, the effect of a change in the interest rate on NII is

studied by working out the duration gap and not the gap based on residual

maturity.

a. Timing and the magnitude of the cash flows is ascertained and calculated.

b. By using appropriate discounting factor, the present value of each of the

cash flows needs to be worked out.

c. The time weighted value of the present value of the cash flows is

calculates.

d. The sum of the time weighted value of the cash flows divided by the sum

of the present values will give the duration of a particular asset.

Duration analysis is useful in assessing the impact of the interest rate changes

on the market value of equity i.e. asset-liability structure.

Advantages

46

Assets Liabilities EquityPositive Increase Decrease Decrease DecreasePositive Decrease Increase Increase IncreaseNegative Increase Decrease Decrease IncreaseNegative Decrease Increase Increase DecreaseZero Increase Decrease Decrease NoneZero Decrease Increase Increase None

DGAP Position

Changes in Interest Rates

Change in Market value


Duration Gap analysis serves as a strategic tool for evaluating and

controlling interest rate risk.

It improves the maturity gap and cumulative gap models by taking into

account the timing and market value of cash flows rather them time

maturity.

It offers flexibility in spread management.

Instead of changing the maturity structure of assets and liabilities, Duration

Gap analysis puts emphasis on change of mix of assets or liabilities

whichever is feasible.

Limitations

It requires extensive data on specific characteristics and current market

pricing schedules of financial instruments.

It requires high degree of analytical expertise regarding issues such as

term structure of interest rates and yield curve dynamics.

15.3 Simulation Analysis: It analyzes the interest-rate risk arising from both

current and planned business. Gap analysis and duration analysis as stand-

alone tool for asset-liability management suffer from their inability to move

beyond the static analysis of current interest rate risk exposures. Basically

simulation models utilize computer power to provide what if scenarios.

What if:

The absolute level of interest rate shift

There are non parallel yield curve changes

Marketing plans are under-or-over achieved

Margins achieved in the past are not sustained/improved

Bad Debts and prepayment levels change in the different interest rate

scenarios

There are changes in the funding mix e.g. an increasing reliance on short-

term funds for balance sheet growth.

Accurate evaluation of current exposures of asset and liability portfolios to

interest rate risk.

47


Changes in multiple target variables such as NII, Capital adequacy and

liquidity.

There are certain criteria for the simulation model to succeed. These pertain to

accuracy of data and reliability of the assumptions made. In other words, one

should be in a position to look at alternatives pertaining to prices, growth

rates, reinvestments, etc., under various interest rate scenarios. This could be

difficult and sometimes contentious. it is also to be noted that the managers

might not want to document their assumptions and data is not easily available

for differential impacts of interest rates on several variables. Hence, simulation

models need to be used with the caution. The use of simulation model calls for

commitment of substantial amount of time and resources.

Assumptions

Expected changes and the levels of interest rates and the shape of yield

curve

Pricing strategies for assets and liabilities

The growth, volume and mix of assets and liabilities

Advantages

It is easy to approximate very complex and discounted payoffs

It is very flexible

It can incorporate multiple time periods

It captures majority of the option risk

Limitations

It is computationally intensive

It requires maintenance of pricing models

15.4 Value at Risk (VAR) Model: Under VAR credit rating is given to each of the

borrowers and its migration over the years form a part of the calculation of the

credit value at risk over a given time horizon. This is due to credit risk, which

emanates not only from counter party default, but also from slippage in credit

quality. Thus, the volatility of value due to changes in the quality of the credit

48


needs to be estimated to calculate VAR. In general; banks review financial

statements of borrowers once a year and allot credit ratings. But there is no

explicit theory to guide time horizon on risk assessment. Any risk assessment

model shall normally predict relative risk than absolute risk. The objective of

any risk assessment model is to initiate risk mitigating actions, irrespective of

the time horizons. Hence, any risk measurement model can be tailored to suit

different time horizons based on actual need.

Advantages

Translates portfolio exposures into potential profit and loss

Aggregates and reports multi-product, multi-market exposures into one

number

Uses risk factors and correlations to create a risk weighted index

Monitors VAR limits

Meets external risk management disclosures and expectations.

Limitations

This study is useful only for normal operative accounts to predict their

probability of default.

This model does not take already defaulted customers into account.

Macro level changes in an industry, changes in government policies, etc.,

may result in distorted results.

In this methodology if the VAR measurement is for shorter duration, the risk

assessment is more accurate.

16. GAP AND NII

ALM is heavily dependent on the movements of interest rates in the market. It

builds up Assets and Liabilities of the bank based on the concept of Net

Interest Income (NII) or Net Interest Margin (NIM). Even though maturity dates

49


are same, if there is a mismatch between amount of assets and liabilities it

causes interest rate risk and affects NII.

Factors affecting NII

Changes in the level of interest rates

Changes in the composition of assets and liabilities

Changes in the volume of earning assets and interest-bearing liabilities

outstanding

Changes in the relationship between the yields on earning assets and rates

paid on interest-bearing liabilities

Example

NII = (Yield x Assets) – (Cost x Liabilities)

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NII = 78.5 - 37.2 = 41.3

NIM = 41.3/850 = 4.86%

GAP = 500 – 600 = -100

Impact of changes

1% increase in short time rates

50

Particulars Assets Yield Libilities Cost

Rate Sensitive 500 8% 600 4%Fixed Rate 350 11% 220 6%Non Earning 150 - 100 -Equity - - 80 -

Total 1000 1000

Hypothetical Balance Sheet



Total 1000 1000

1% increase in short time rates


NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NII = 83.5 - 43.2 = 40.3

NIM = 40.3 / 850 = 4.74%

GAP = 500 - 600 = -100

With a negative gap, more liabilities than assets reprice higher; hence NII &

NIM fall

1% decrease in spreads

NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)

NII = 81 - 46.2 = 34.8

NIM = 34.8 / 850 = 4.09%

GAP = 500 - 600 = -100

NII & NIM fall (rise) with a decrease (increase) in the spread. This is because, if

liabilities are short-term and assets are long-term, the spread will widen as the

yield curve increases in slope and narrow when the yield curve decreases in

slope and/or inverts.

Proportionate doubling in size

51



Total 2000 2000

Doubling in size


Rate Sensitive 500 8.5% 600 5.5%Fixed Rate 350 11% 220 6%Non Earning 150 - 100 -Equity - - 80 -

Total 1000 1000

1% decrease in spread


NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6

NIM = 82.6 / 1700 = 4.86%

GAP = 1000 - 1200 = -200

NII & GAP doubled, but NIM remains the same.

Net interest income varies directly with the changes in the volume of earning

assets and interest bearing liabilities, regardless of the level of interest rates.

If RSA increase, fixed assets decrease and RSL decrease, fixed liabilities

increase

Particulars Assets Yield Liabilities Cost

Rate sensitive 540 8% 560 4%Fixed rate 310 11% 260 6%Non earning 150 - 100 -Equity - - 80 -

Total 1000 1000

NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)

NII = 77.3 - 38 = 39.3

NIM = 39.3 / 850 = 4.62%

GAP = 540 - 560 = -20

Although the banks GAP is lower the banks NII is also lower.

Changes in portfolio composition and risk

52


To reduce risk, a bank with a negative GAP would try to increase RSAs

(variable rate loans or shorter maturities on loans and investments) and

decrease RSLs (issue relatively longer - term CDs and fewer fed funds

purchased).

Changes in portfolio composition also raise or lower interest income and

expense based on the type of change.

Summary of GAP and NII

53

GAP

Interest Rate Change Impact on NII

Positive Increases PositivePositive Decreases NegativeNegative Increases NegativeNegative Decreases Positive


BIBLIOGRAPY

Asset Liability Management in Banks – ICFAI

Bank Financial Management – Indian Institute of Banking and Finance

www.rbi.org

www.investopedia.com

www.allbankingsolutions.com

www.iibf.org.in

www.fimmda.org

54

http://www.fimmda.org/

http://www.iibf.org.in/

http://www.allbankingsolutions.com/

http://www.investopedia.com/

http://www.rbi.org/

alm_in_banks

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