Asset Liability Management

CHAPTER 1

INTRODUCTION

Asset Liability Management

ALM is a comprehensive and dynamic framework for measuring, monitoring and

managing the market risk of a bank. It is the management of structure of balance

sheet (liabilities and assets) in such a way that the net earnings from interest is

maximized within the overall risk-preference (present and future) of the

institutions.

In banking, asset and liability management is the practice of managing risks that

arise due to mismatches between the assets and liabilities (debts and assets) of the

bank.

Banks face several risks such as the liquidity risk, interest rate risk, credit risk and

operational risk. Asset Liability Management (ALM) is a strategic management

tool to manage interest rate risk and liquidity risk faced by banks, other financial

services companies and corporations.

Banks manage the risks of Asset liability mismatch by matching the assets and

liabilities according to the maturity pattern or the matching the duration, by

hedging and by securitization. Much of the techniques for hedging stem from the

delta hedging concepts introduced in the Black-Scholes model and in the work of

Robert C. Merton and Robert A. Jarrow. The early origins of asset and liability

management date to the high interest rate periods of 1975-6 and the late 1970s and

early 1980s in the United States. Van Deventer, Imai and Mesler (2004), chapter 2,

outline this history in detail.

Modern risk management now takes place from an integrated approach to

enterprise risk management that reflects the fact that interest rate risk, credit risk,

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market risk, and liquidity risk are all interrelated. The Jarrow-Turnbull model is an

example of a risk management methodology that integrates default and random

interest rates. The earliest work in this regard was done by Robert C. Merton.

Increasing integrated risk management is done on a full mark to market basis rather

than the accounting basis that was at the heart of the first interest rate sensivity gap

and duration calculations

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CHAPTER 2RELEVANCE AND IMPORTANCE

OF ASSET LIABILITY MANAGEMENT

Asset Liability Management (ALM) as a concept is gradually gaining

currency in Indian conditions in the wake of the on-going financial sector reforms,

particularly reforms relating to interest rate deregulation.

The technique of managing both Assets and liabilities together has come

into being as a strategic response of banks to inflationary pressure, volatility in

interest rates and severe recessionary trends which marked the global economy in

the 70’s and 80’s .

There are three distinct phases of the evolution of the concept. While the

First phase witnessed the advent of highly volatile global financial environment in

the 70’s the second phase was marked by the explosive growth of new financial

products leading the banks in developed economies to focus on liability

management and spread management .In the decade to follow , due to new

regulatory standards, better internal policy development and rapid advancement in

information technology , the Experimentations of last 2/3 decades have converged

into comprehensive technique of managing entire bank balance sheet in a cohesive

manner , which later came to be known as Asset-Liability management .

Although the process is too complex to practice, it is perhaps the only

solution for banks to survive in dynamic environment which requires to stress on

total balance sheet management.

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THREE PILLARS OF ALM

ALM process rests on three pillars:

1. ALM information systems

=> Management Information System

=> Information availability, accuracy, adequacy and expediency

2. ALM organization

=> Structure and responsibilities

=> Level of top management involvement

3. ALM process

=> Risk parameters

=> Risk identification

=> Risk measurement

=> Risk management

=> Risk policies and tolerance levels.

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CHAPTER 3

SCOPE AND OBJECTIVES OF ALM

The ALM functions extend to liquidly risk management, management of market

risk, trading risk management, funding and capital planning and profit planning

and growth projection.

A sound ALM system should focus on:

1. review of interest rate outlook

2. fixation of interest/ product pricing on both asset and liabilities

3. examining loan portfolio

4. examining investment portfolio

5. measuring foreign exchange risk and

6. managing liquidity risk

7. Review of actual performance vis-à-vis projections in respect of net profit,

interest spread and other balance sheet ratio.

8. budgeting and strategic planning

9. Examining the profitability of new products.

Since management of risk is fundamental to sound banking practice, no bank can

afford to err on this count. If poorly managed, a bank can experience earning,

liquidity and ultimately capital adequacy problem.

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Hence the primary objective of the asset liability management is not to

eliminate risk; but to manage it in such a way that the volatility of net interest

income is minimized in the short term horizon and net economic value of the

organization is protected in long term horizon. Broadly the objectives would

include controlling the volatility of net income, net interest margin, capital

adequacy, liquidity risk and finally ensuring an acceptable balance between

profitability growth and risk.

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CHAPTER 4

NEED FOR ALM: AN ANTIDOTE FOR VOLATILITY

With the onset of financial sector reforms and the liberalization process growing

from strength to strength, Indian banks are now being more and more exposed to

uncertainty. Under the protective wings of administered framework of yesteryears ,

hardly, was it necessary to monitor spread as interest on both assets and liabilities

side were as per the guidelines of RBI . So also the sourcing and funding pattern

which was equally subjected to control leaving insignificantly narrow space for the

management to use its discretion.

However, things have changed too rapidly since 1991. As the veil of

regulations gradually giving into the more autonomous system, post reform

banking scenario is marked by

1. Partial deregulation of deposit rates in a phased manner and with rapid

frequency

2. Freeing interest rate on lending over Rs.2 lacs

3. Allowing new players in the market

4. Introduction of new products in the market

5. Greater use of information technology with increasing MIS capability.

All these developments have increased the volatility of the market in so far

as the movement of funds from one segment of the market to another is concerned.

Besides the trend towards greater integration of money market, foreign exchange

market and capital market is more visible. With the emergence of an active debt

market, the volatility in the market condition is expected to be further accentuated.

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In this changing scenario where risks and opportunities are plenty, banks can no

longer ignore to examine their competitive ability to emerge as active players in

market. Besides, Indian banks are under compulsion to take active interest in the

market development as a matter of survival. Public sector banks, more conspicuous

by their inherent organizational and systematic deficiencies are more under

pressure to adopt the new technique of better asset liability management as a

strategic response to the increasing trends towards globalised competition.

BENEFTS OF ALM

It is a tool that enables bank managements to take business decisions in a more

informed framework with an eye on the risks that bank is exposed to. It is an

integrated approach to financial management, requiring simultaneous decisions

about the types of amounts of financial assets and liabilities - both mix and volume

- with the complexities of the financial markets in which the institution operates.

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MATURITY BUCKETS

Maturity buckets are different time intervals.

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

Buckets:

i. 1 to 14 days

ii. 15 to 28 days

iii. 29 days and up to 3 months

iv. Over 3 months and up to 6 months

v. Over 6 months and up to 1 year

vi. Over 1 year and up to 3 years

vii. Over 3 years and up to 5 years

viii. Over 5 years

ix. In which the value of a particular asset or liability is placed depending upon

its residual maturity.

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CHAPTER 5

ASSET LIABILITY MANAGEMENT COMMITTEE

ALM ORGANISATION IN BANKS

o Successful implementation of the risk management process would require

strong commitment on the part of the senior management in the bank, to

integrate basic operations and strategic decision making with risk management.

The Board should have overall responsibility for management of risks and

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

liquidity, interest rate, foreign exchange and equity price risks.

o 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.

o The ALM Support Groups 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.

o 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.

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o The business issues that an ALCO would consider, inter alia, will include

product pricing for deposits and advances, desired maturity profile and mix 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.

o 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 funding

mixes 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.

CHAPTER 6

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BASIS OF ASSET LIABILITY MANAGEMENT

Traditionally, banks and insurance companies used accrual system of accounting

for all their assets and liabilities. They would take on liabilities - such as deposits,

life insurance policies or annuities. They would then invest the proceeds from these

liabilities in assets such as loans, bonds or real estate. All these assets and

liabilities were held at book value. Doing so disguised possible risks arising from

how the assets and liabilities were structured.

Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the

same money at 7 % to a highly rated borrower for 5 years. The net transaction

appears profitable-the bank is earning a 100 basis point spread - but it entails

considerable risk. At the end of a year, the bank will have to find new financing for

the loan, which will have 4 more years before it matures. If interest rates have

risen, the bank may have to pay a higher rate of interest on the new financing than

the fixed 7 % it is earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is

in serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on

its financing. Accrual accounting does not recognize this problem. Based upon

accrual accounting, the bank would earn Rs 100,000 in the first year although in

the preceding years it is going to incur a loss.

The problem in this example was caused by a mismatch between assets and

liabilities. Prior to the 1970's, such mismatches tended not to be a significant

problem. Interest rates in developed countries experienced only modest

fluctuations, so losses due to asset-liability mismatches were small or trivial. Many

firms intentionally mismatched their balance sheets and as yield curves were

generally upward sloping, banks could earn a spread by borrowing short and

lending long.

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Things started to change in the 1970s, which ushered in a period of volatile interest

rates that continued till the early 1980s. US regulations which had capped the

interest rates so that banks could pay depositors, was abandoned which led to a

migration of dollar deposit overseas. Managers of many firms, who were

accustomed to thinking in terms of accrual accounting, were slow to recognize this

emerging risk. Some firms suffered staggering losses. Because the firms used

accrual accounting, it resulted in more of crippled balance sheets than

bankruptcies. Firms had no options but to accrue the losses over a subsequent

period of 5 to 10 years.

One example, which drew attention, was that of US mutual life insurance company

"The Equitable." During the early 1980s, as the USD yield curve was inverted with

short-term interest rates sky rocketing, the company sold a number of long-term

Guaranteed Interest Contracts (GICs) guaranteeing rates of around 16% for periods

up to 10 years. Equitable then invested the assets short-term to earn the high

interest rates guaranteed on the contracts. But short-term interest rates soon came

down. When the Equitable had to reinvest, it couldn't get even close to the interest

rates it was paying on the GICs. The firm was crippled. Eventually, it had to

demutualize and was acquired by the Axa Group.

Increasingly banks and asset management companies started to focus on Asset-

Liability Risk. The problem was not that the value of assets might fall or that the

value of liabilities might rise. It was that capital might be depleted by narrowing of

the difference between assets and liabilities and that the values of assets and

liabilities might fail to move in tandem. Asset-liability risk is predominantly a

leveraged form of risk.

CHAPTER 7

ASSET LIABILITY MANAGEMENT APPROACH13 | P a g e

Asset Liability Management

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.

A. Liquidity Management

Liquidity represents the ability to accommodate decreases in liabilities and to fund

increases in assets. An organization has adequate liquidity when it can obtain

sufficient funds, either by increasing liabilities or by converting assets, promptly

and at a reasonable cost. Liquidity is essential in all organizations to compensate

for expected and unexpected balance sheet fluctuations and to provide funds for

growth. The price of liquidity is a function of market conditions and market

perception of the risks, both interest rate and credit risks, reflected in the balance

sheet and off-balance sheet activities in the case of a bank. If liquidity needs are

not met through liquid asset holdings, a bank may be forced to restructure or

acquire additional liabilities under adverse market conditions. Liquidity exposure

can stem from both internally (institution-specific) and externally generated

factors. Sound liquidity risk management should address both types of exposure.

External liquidity risks can be geographic, systemic or instrument-specific. Internal

liquidity risk relates largely to the perception of an institution in its various

markets: local, regional, national or international. Determination of the adequacy

of a bank's liquidity position depends upon an analysis of its: -

Historical funding requirements

Current liquidity position

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Anticipated future funding needs

Sources of funds

Present and anticipated asset quality

Present and future earnings capacity

Present and planned capital position

As all banks are affected by changes in the economic climate, the monitoring of

economic and money market trends is key to liquidity planning. Sound financial

management can minimize the negative effects of these trends while accentuating

the positive ones. Management must also have an effective contingency plan that

identifies minimum and maximum liquidity needs and weighs alternative courses

of action designed to meet those needs. The cost of maintaining liquidity is another

important prerogative. An institution that maintains a strong liquidity position may

do so at the opportunity cost of generating higher earnings. The amount of liquid

assets a bank should hold depends on the stability of its deposit structure and the

potential for rapid expansion of its loan portfolio. If deposit accounts are composed

primarily of small stable accounts, a relatively low allowance for liquidity is

necessary.

Additionally, management must consider the current ratings by regulatory and

rating agencies when planning liquidity needs. Once liquidity needs have been

determined, management must decide how to meet them through asset

management, liability management, or a combination of both.

B. Asset Management

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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 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.

C. Liability Management

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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

CHAPTER 8

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RISK MANAGEMENT

RISK MANAGEMENT IN BANKS

Risk management in banks

Risks are inherent in banking business. Risk may be simply defined as the

probability of loss or damage. Given the complexities of bank balance sheets and

rapidity of changes, chances of loss or risks are not only complex in nature but also

varied in dimension. Interplay of simultaneous risks makes the ALM both

interesting and dangerous and requires the exercise to move beyond a work out for

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NON- FINANCIAL FINANCIAL

CONTIGENCY RISKSYSTEMIC RISK

OPERATIONAL RISK CREDIT RISK

MARKET RISK

LIQUIDITY RISK

INTEREST RATE RISK FOREX - RISK

Asset Liability Management

insulating profitability risk. Broadly speaking banks are exposed to the following

five types of financial risks.

(A) CREDIT RISK

The risk of the counter failure in performing the repayment

obligation on due date is known as credit risk. Traditionally credit risk

management is the primary challenge for financial institution and such risk are

regulated by laid down credit/loan policy of the institution. Misjudgment of credit

risk may lead to eventual fall of banks. The problems of many of the Japanese

banks, failure of savings and loan association in USA in the 80’s are cases in

example. Even though the credit risk is managed by credit policy, there is a strong

inter-relationship between market risk and credit risk. To the extent credit risk is

caused by market risk variables, management of such risks becomes part of ALM.

In a highly volatile interest rate environment, loan defaults may increase thereby

deteriorating the credit quality.

(B) INTEREST RATE RISK

By traditional definition interest rate risk means changes in the

interest income due to changes in the rate of interest. While this focus is not

misplaced, it is definitely incomplete in as much as it overlooks an important

aspects changes in the interest rate resulting in the value of Assets/Liabilities. Thus

interest rate risk may be viewed from two different but complementary

perspectives – earning sensitivity to rate fluctuations and price sensitivity of

instruments/products to changes in interest rate. Absence of appropriate

management of interest rates, among other factors, is one of the reasons which had

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accentuated the spell of liquidity problems experienced in the recent past. Changes

in the interest rates can affect banks with regards to changes in:

Market value of Assets/liabilities and off balance sheet items, ultimately impacting

the value of net worth.

Net interest income due to mismatching in the repricing terms of the assets and

liabilities.

Net income as a result in changes in income.

Net interest margin due to changes in interest income.

Net income margin owing to changes in interest income and sensitivity of non

interest income to rate changes.

Net margin for the changes mentioned above (b) to (e)

Capital asset ratio due to changes in net margin.

Fluctuations in interest rates, being a very common phenomenon,

thus lead to a host of risks of different dimensions to which assets and liabilities of

banks are perennially exposed. These risks are as under:

RATE LEVEL RISK: Refers to the possibility of rates going up or down during a

given period. The general changes in interest rates is a key factor in deciding the

mix of asset/liabilities in terms of maturity, type etc.

VOLATILITY RISK: Frequency in the changes in interest rate will affect the

business volume, product mix and pricing of both assets and liabilities. In a

dynamic environment such volatility in rates will have substantial impact on the

cash flow and net present value.

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PREPAYMENT RISK: Risks of prepayment of assets resulting in fall of margin.

BASIS RISK: Where two rates do not move simultaneously thereby impacting the

cash flow in a given time frame.

REAL INTEREST RATE RISK: In a inflationary economy the challenge is to

manage the real interest cost adjusted to inflation levels.

EVENT RISK: Basically refers to risk associated with unforeseen events and is

organization specific in nature.

(C) LIQUIDITY RISK:

Liquidity risk is the potential inability to generate cash to cope

with the decline in deposits or increase in assets. Liquidity risk originates from the

mismatches in the maturity patterns of asset and liability. There are obvious

relationship between liquidity risk and interest rate risk. Banks protect their

liquidity position generally by controlling mismatch between maturities of asset

and liabilities, focusing on core deposits- the most permanent source of liquidity,

and other liquid assets. Since banks deal with assets and liabilities with varied

maturity pattern and risk profile, what they need is to strike a reasonable trade-off

between being overly liquid and relatively illiquid. One of the basic indicators of

liquidity measurement is the ratio of volatile liability to loans.

(D) CAPITAL RISK:

Maintaining adequate capital on a continuous basis is the sine qua

non for sound banking practices. Each bank has to assess how much capital they

would require to fulfill the regulatory norms. More than that, in a business situation

banks require capital to insulate themselves from the risks of business they

undertake and, hence, risks relating to credit, liquidity, interest rates and movement

of market prices. Since it is imperative for every bank to understand the

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importance of capital adequacy as also the economic level of capital, management

of capital risk is also one of the important plank of the overall balance-sheet

management.

(E) MARKET RISK:

Market risk is the risk to a bank’s financial condition that would

result from adverse movement in market prices. Primarily the impact of market

risks is observed in the movement of portfolio value. There is a strong inter-

relationship between interest rate risk and market risks variables. Inadvertently

taken market risk could prove to be dangerous for banks. The fall of Barings and

the trouble faced by Daiwa are the cases in point.

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CHAPTER 9

RESERVE BANK GUIDELINES FOR ALM

The Reserve bank of India issued draft guidelines in September, 1998 for putting

in place a comprehensive Asset Liability Management (ALM) system in banks.

The draft guidelines were reviewed by the Reserve Bank in the light of the issued

raised/ suggestions made by the banks. The final guidelines revised on the basis of

the feed received, were implemented effective April 1, 1999. The banks have been

advised to set up an internal Asset Liability Committee headed by the Chief

Executive officer/ Chairman and Managing Director or Executive Director. The

Management Committee or any specific committee of Board is required to oversee

the implementation of the Asset Liability Management system and review its

functioning periodically.

TECHNIQUES FOR ASSESSING ALM RISK

Techniques for assessing asset-liability risk came to include Gap Analysis and

Duration Analysis. These facilitated techniques of managing gaps and matching

duration of assets and liabilities. Both approaches worked well if assets and

liabilities comprised fixed cash flows. But cases of callable debts, home loans and

mortgages which included options of prepayment and floating rates, posed

problems that gap analysis could not address. Duration analysis could address

these in theory, but implementing sufficiently sophisticated duration measures was

problematic. Accordingly, banks and insurance companies started using Scenario

Analysis.

Under this technique assumptions were made on various conditions, for example: -

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Several interest rate scenarios were specified for the next 5 or 10 years. These

specified conditions like declining rates, rising rates, a gradual decrease in rates

followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all.

Assumptions were made about the performance of assets and liabilities under each

scenario. They included prepayment rates on mortgages or surrender rates on

insurance products.

Assumptions were also made about the firm's performance-the rates at which new

business would be acquired for various products, demand for the product etc.

Market conditions and economic factors like inflation rates and industrial cycles

were also included.

Based upon these assumptions, the performance of the firm's balance sheet could

be projected under each scenario. If projected performance was poor under specific

scenarios, the ALM committee would adjust assets or liabilities to address the

indicated exposure. Let us consider the procedure for sanctioning a commercial

loan. The borrower, who approaches the bank, has to appraise the banks credit

department on various parameters like industry prospects, operational efficiency,

financial efficiency, management qualities and other things, which would influence

the working of the company. On the basis of this appraisal, the banks would then

prepare a credit-grading sheet after covering all the aspects of the company and the

business in which the company is in. Then the borrower would then be charged a

certain rate of interest, which would cover the risk of lending.

But the main shortcoming of scenario analysis was that, it was highly dependent on

the choice of scenarios. It also required that many assumptions were to be made

about how specific assets or liabilities will perform under specific scenarios.

Gradually the firms recognized a potential for different type of risks, which was

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overlooked in ALM analyses. Also the deregulation of the interest rates in US in

mid 70 s compelled the banks to undertake active planning for the structure of the

balance sheet. The uncertainty of interest rate movements gave rise to Interest Rate

Risk thereby causing banks to look for processes to manage this risk. In the wake

of interest rate risk came Liquidity Risk and Credit Risk, which became inherent

components of risk for banks. The recognition of these risks brought Asset

Liability Management to the centre-stage of financial intermediation. Today even

Equity Risk, which until a few years ago was given only honorary mention in all

but a few company ALM reports, is now an indispensable part of ALM for most

companies. Some companies have gone even further to include Counterparty

Credit Risk, Sovereign Risk, as well as Product Design and Pricing Risk as part of

their overall ALM.

Now a day's a company have different reasons for doing ALM. While some

companies view ALM as compliance and risk mitigation exercise, others have

started using ALM as strategic framework to achieve the company's financial

objectives. Some of the business reasons companies now state for implementing an

effective ALM framework include gaining competitive advantage and increasing

the value of the organization.

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CHAPTER 10

APPROACH BY MANAGEMENT TO QUANTIFY THE RISK

Even though a considerable degree of interest rate deregulation has taken

place and the proverbial interest rate volatility hitherto unfamiliar to the Indian

banks are slowly being visible, quantification of risk relating to interest rate has not

received the kind of attention it deserves. Failure to mange interest rate risk

optimally may wreak havoc on banks in as much as they can lose more through

interest rate movement than through bad credit decisions. Especially it is more

crucial to banks in India in view of the large proportion of their assets are in the

form of fixed interest government securities. Hence, management of interest rate

risk is s important and so the quantification of risk without which risk management

its impracticable. Universally, there are four principal approaches used to quantify

the risk .These are under:

GAP METHOD: The Gap Approach addresses to the rate sensitivity of assets and

liabilities. The gap is the differences between the existing Rate Sensitivity Assets

(RSA) and Rate Sensitive Liabilities (RSL) in a particular time period. It ignores

the time, in the chosen period, the assets and liabilities would need to be reprised

and, hence, shorter the period more sensitive is the model. Interest rate risk is

minimized if the gap is managed to near zero for each period.

SIMULATION: Simulation involves a series of ‘what if’ analyses of the impact of

interest rate changes on the net income. It therefore requires forecasting the asset

liability picture under different scenarios, ascribing probabilities to them and

choosing the most optimum model. The method being more dynamics, its utility

depends upon the accuracy of forecasts.

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DURATION METHOD: Duration method evaluates the impact of interest rate

changes on the market value of assets and liabilities. The duration of an asset or

liability is calculated as the weighted average maturity of the resultant cash flows,

the weights being the present value of the cash flow. Duration, expressed in the

time periods, is less than the maturity for coupon bonds and is equal to maturity for

a zero coupon bond. Greater the value of duration gap, higher is the interest rate

risk exposure of the assets/liabilities. The method, being too complex, is however,

far more flexible. How much interest rate risk a bank should assume, however,

depends upon how risk savvy or risk averse the bank is.

VALUE AT RISK METHOD: The method enables to work out

depreciation/appreciation in the value of assets/liabilities due to change in interest

rate so as to indicate the trend in economic value of portfolio. Impact of interest

rate changes on the value of ‘off market’ items of balance sheets such as loan,

deposits etc. need to be calculated under different rate scenarios for evaluating the

opportunity cost/benefits of carrying such assets/liabilities in a longer time frame.

Although this is a new approach for quantification of risks, this is emerging as a

very useful tool for calculating the net worth of the organization at a particular

time so as to focus on the longer term risk implications of the decisions that have

already been taken/or to be taken.

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CHAPTER 11

MANAGEMENT OF OFF-BALANCE-SHEET ACTIVITIES

In simplistic terms, banks are in a business of buying (borrowing) and selling

(lending) money. Interest is the rent earned or paid for the use of money for the

term of the related loans, investment or deposits. The margin of interest earned and

interest paid is the primary source of earning for most banks.

Moving from the conceptual framework, we now break down the earnings so

that mangers will be in a position to see how with a given asset base the income

earned is determined and then takes remedial measures:

THREE-STAGE APPROACH FOR ASSET/LIABILITY MANAGEMENT

Step 1 General

Asset management

Liability management

Capital management

Loan position management

Long-term debt management

Liquidity management

Step 2 Specific

Investment management

Loan management

Fixed asset management

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Step 3 Income and Expenditure Revenues management

Interest cost

Overhead cost

Taxes

It would be obvious to anyone that higher the percentage of earning assets in the

total assets, other things being equal, the higher would be the level of interest

income. We have seen from the table above that buildings/equipment/cash earn

little interest but need to be supported.

As regards composition of earning assets, higher interest flows from loan/cash

credit advances than from investment.

From the above analysis, it is clear that achieving higher interest through managing

interest is the crux of the problem. Higher level of interest rate risk and cost of

funds over a period of time.

Coming to the cost of funds, the higher the ratio of interest- is bearing funds to

average assets, the higher would be the level of expenses and the lower would be

the level of net income. Obviously, banks that have substantial current accounts or

heavily capitalized would have above average level of income.

In a break-up of interest-bearing funds, current and savings accounts are generally

the lowest cost funds. Obviously, any bank with an easy access to these funds will

have lower cost and higher earnings. Those banks that are forced to have high cost

deposits will obviously have higher costs and less income.

All these days bankers in India never showed any particular concern about

asset/liability mismatches or about GAP management. A bank asset/liability GAP

is the difference in reprising between its earning assets and its costing liabilities.

Interest rate fluctuations impact both the level of interest income and interest

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expenses. They also effect the level of net interest income. Maximizing net interest

income overtime requires co-ordination of funding and investment decision.

A bank’s policies regarding the setting of rates and maturities on loans and

deposits may be influenced by overriding marketing considerations, which in turn

may be independent of conscious spread management decision. Customer

preferences, local competition, national economic condition, etc, may limit a

bank’s option in managing its spread. Trade-offs in terms of interest rate yield

versus maturity yield versus credit quality, and pricing versus balance sheet growth

may limit flexibility. Maintaining or improving the net interest margin requires

management to focus continuously on identifying, quantifying and controlling the

interest rate risk related to the structure of its earning asset and interest bearing

liability bases. Good spread management does not happen by chance-

managements must work on these problems all the time to build and maintain

quality earnings stream.

It may be useful to look at the characteristics of successful banks published

by the American Bankers Association and the Bank Administration Institute:

High performance banks have higher returns on their assets.

Interest payments, personnel cost and occupancy expenses were all lower for high

performance banks.

Loan losses were generally less than one-half of other banks.

The extraordinary profitability was due to better ROA rather than higher equity

multiplier (EM)

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CHAPTER 12

BASLE AGREEMENT

There has been much debate about who should set capital standards for

banks-the banks themselves or the regulatory agencies. It has been argued that

bank’s themselves are best judges of their capital requirement in the long run, The

counter agreement is that while a bank may make efficient use of all the

information it may have some of the more pertinent information needed to asses a

bank’s true level of risk exposure may be deliberately hidden and it becomes the

regulators job to bring this out for proper assessment of its capital requirement to

cover possible losses.

The incidence of bank failures at international level in the early 1980s seems

to have clinched the argument in favor of regulatory agencies determining the

minimum capital requirement of all banks, irrespective of their own internal or

market situation. These minimum requirements were initially mandated in the

U.S.A by congressional passage of the International Lending and Supervision Act

of 1983. In 1987, the Federal Reserve Board, representing United States and

representatives from eleven other leading industrialized countries announced

preliminary agreement on new capital standard – often referred to as the Basle

Agreement that would be uniformly applied to all banks in their respective

jurisdictions. Formally approved in July 1988, those new requirements are

designed to encourage banks to strengthen their capital position, reduce inequality

in the regulatory rules of different nations and consider the risk to the banks on

their off-balance commitments they have made in recent years. The new capital

requirements were phased in gradually overtime and became fully enforceable in

January 1993, through adjustments and modification continue to be made.

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Sources of Capital

Under the terms of Basle Agreement the sources of bank’s capital are

divided into two tiers a Tier I capital (core capital) includes paid up capital,

statutory reserve and other disclosed free reserve , Tier II capital (supplementary

capital) comprises of undisclosed reserve and cumulative preference shares,

revaluation reserves, general provision and loss reserve, hybrid and subordinate

debts etc.

Indian Standards set by Narasimham Committee

In the Indian context, the committee on Banking Sector Reforms

(Narasimham Committee II) observed that the capital ratios of Indian banks were

generally low and some banks were seriously undercapitalized. The committee

pointed out that adequacy of capital has been traditionally regarded as a sign of

banking strength irrespective of whether the institution is owned by government or

otherwise. It recommended that banks in India should also conform to the

standards laid down by the Basle committee. Accordingly Reserve Bank of India

has laid down that all commercial banks should attain the minimum CRAR of 8 %,

which has to be increased from 8% to 10% in a phased manner with an

intermediate target of 9 % by March 2000.

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CHAPTER 13

RECOMMENDATION

The central element for the entire ALM exercise is the availability of

adequate and accurate information with expedience and the existing systems in

many Indian banks do not generate information in the manner required for ALM.

Collecting accurate data in a timely manner will be the biggest challenge

before the banks, particularly those having wide network of branches but lacking

full scale computerization. However, the introduction of base information system

for risk measurement and monitoring has to be addressed urgently.

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 sample branches

accounting for significant business and then making rational assumptions about the

way in which assets and liabilities would behave in other branches

The ALCO Committee should meet weekly instead of monthly.

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CHAPTER 14

CONCLUSION

The rapid changes in banking and financial services market are creating

opportunities and challenges. Increased competition in the financial services

industry and increased synergies provided by banks result into important benefit to

customers. But the increased size, breath, complexity and geographic scope of

banking have increased the challenges of managing and of regulating and

supervising banks.

The central banks worlds wide are also reviewing their positions with regard

to electronic, commerce, internal banking and electronic money applications.

While freedom is essential to foster efficiency, it also raises an equally important

question of appropriate regulatory framework, given the wide divergence between

private and social interest in ensuring stability of the financial system.

As bank’s internal risk management and management technologies improve

and as depth and sophistication of financial markets increases, bank supervisors

should continually find ways to incorporate market advances into their prudential

policies, when appropriate.

Bank should have their obligation to their shareholders, creditors and

customer to measure and manage risk appropriately.

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BIBLIOGRAPHY

BOOKS:

Banking Law and Practice in India

WEBSITES:

www.riskglossary.com/link/asset_liability_management.com

www.aspratt.com/store/805.phpalm_in_pb

www.mpsaz.com

www.tcul.coop/asset_liability_management.html

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