Asset Liability Management in Banks

Asset Liability Management in Banks1Components of a Bank Balance Sheet LiabilitiesAssetsCapitalReserve & SurplusDepositsBorrowingsOther Liabilities Cash & Balances with RBIBal. With Banks & Money at Call and Short NoticesInvestmentsAdvancesFixed Assets6. Other Assets2Banks profit and loss accountA banks profit & Loss Account has the following components:

Income: This includes Interest Income and Other Income.II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.3What is Asset Liability Management??The process by which an institution manages its balance sheet in order to allow for alternative interest rate and liquidity scenarios

Banks and other financial institutions provide services which expose them to various kinds of risks like credit risk, interest risk, and liquidity risk

Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management.4Evolution of ALMIn the 1940s and the 1950s, there was an abundance of funds in banks in the form of demand and savings deposits. Hence, the focus then was mainly on asset management

But as the availability of low cost funds started to decline, liability management became the focus of bank management efforts

In the 1980s, volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. ALM began to extend beyond the bank treasury to cover the loan and deposit functions

Banks started to concentrate more on the management of both sides of the balance sheet5Asset ManagementAsset Management: the attempt to earn the highest possible return on assets while minimizing the risk.Get borrowers with low default risk, paying high interest ratesBuy securities with high return, low riskDiversified portfolioManage liquidity Asset Management - Credit Risk: Overcoming Adverse Selection and Moral Hazard Screening and information collectionSpecialization in lending (e.g. energy sector)Diversification - by industry and geographyMonitoring and enforcement of restrictive covenantsLong-term customer relationshipsCollateral and compensating balances7An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio

It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are:1. Net Interest Income (NII)2. Net Interest Margin (NIM)3. Economic Equity Ratio83 tools used by banks for ALM9ALM Information SystemsUsage of Real Time information system to gather the information about the maturity and behavior of loans and advances made by all other branches of a bank

ABC Approach : analysing the behaviour of asset and liability products in the top branches as they account for significant businessthen making rational assumptions about the way in which assets and liabilities would behave in other branchesThe data and assumptions can then be refined over time as the bank management gain experience

The spread of computerisation also help banks in accessing data.10ALM OrganizationThe board should have overall responsibilities and should set the limit for liquidity, interest rate, foreign exchange and equity price risk

The Asset - Liability Committee (ALCO)ALCO, consisting of the bank's senior management (including CEO) should be responsible for ensuring adherence to the limits set by the BoardIs responsible for balance sheet planning from risk - return perspective including the strategic management of interest rate and liquidity risksThe role of ALCO includes product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities,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 fundingIt should review the results of and progress in implementation of the decisions made in the previous meetings

1107-Dec-14ALM OrganisationBoard should have overall responsibility for management of riskBoard should decide risk management policy and procedure, set prudential limits, auditing, reporting and review mechanism in respect of liquidity, interest rate and forex riskALCOConsisiting of banks senior management including CEO Responsible for adherence to the polices and limits set by BoardResponsible for deciding business strategies (on asset liability side) in line with banks business and risk objectivesALM Support GroupConsisting of operating staffResponsible for analysing, monitoring and reporting risk profiles to ALCOPrepare forecasts showing effects of various possible changes in market conditions affecting balance sheet and suggesting action to adhere to banks internal limits1207-Dec-14ALM Organisation (Contd.)ALCO decision making unit responsible for Balance Sheet planning from risk-return perspective which includes management of liquidity, interest rate and forex risksPricing of deposits and advances, desired maturity profile etc.Monitoring the risk levels of the bankReview of the results and progress of implementation of decisions made in previous meetingFuture business strategies based on banks current view on interest ratesTo decide on source and mix of liabilities or sale of assetsTo develop future direction of interest rate movementsTo decide on funding mix between fixed and floating rate funds, wholesale vs. retails deposits, short term vs. long term deposits etc.ALM Process14Categories of RiskRisk is the chance or probability of loss or damage

Credit RiskMarket RiskOperational RiskTransaction Risk /default risk /counterparty riskCommodity riskProcess riskPortfolio risk /Concentration riskInterest Rate riskInfrastructure riskSettlement riskForex rate riskModel riskEquity price riskHuman riskLiquidity risk15But under ALM risks that are typically managed are.16Liquidity RiskLiquidity risk arises from funding of long term assets by short term liabilities, thus making the liabilities subject to refinancing

17Liquidity Risk ManagementBanks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times

Liquidity Management is the ability of bank to ensure that its liabilities are met as they become due

Liquidity positions of bank should be measured on an ongoing basis

A standard tool for measuring and managing net funding requirements, is the use of maturity ladder and calculation of cumulative surplus or deficit of funds as selected maturity dates is adopted

18Statement of Structural LiquidityAll Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:1 to 14 days15 to 28 days29 days and up to 3 monthsOver 3 months and up to 6 monthsOver 6 months and up to 1 yearOver 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years19Statement of structural liquidityPlaces all cash inflows and outflows in the maturity ladder as per residual maturity

Maturing Liability: cash outflow

Maturing Assets : Cash Inflow

Classified in to 8 time buckets

Mismatches in the first two buckets not to exceed 20% of outflows

Shows the structure as of a particular date

Banks can fix higher tolerance level for other maturity buckets.20An Example of Structural Liquidity Statement

21Addressing the mismatchesMismatches can be positive or negative

Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.

In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.

For ve mismatch, it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee. 22Interest Rate RiskInterest Rate risk is the exposure of a banks financial conditions to adverse movements of interest rates

Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a banks earnings and capital base

Changes in interest rates also affect the underlying value of the banks assets, liabilities and off-balance-sheet item

Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM)

NIM = (Interest income Interest expense) / Earning assets

23Risk Measurement TechniquesVarious techniques for measuring exposure of banks to interest rate risks

Maturity Gap AnalysisDurationSimulationValue at Risk

24Maturity gap method (IRS)THREE OPTIONS:A) Rate Sensitive Assets>Rate Sensitive Liabilities= Positive GapB) Rate Sensitive Assets