OBJECTIVES OF THE STUDY

Though Basel Capital Accord and subsequent RBI guidelines have given a structure for

ALM in banks, the Indian Banking system has not enforced the guidelines in total. The

banks have formed ALCO as per the guidelines; but they rarely meet to take decisions.

Public Sector banks are yet to collect 100% of ALM data because of lack of

computerization in all branches. With this background, this research aims to find out the

status of Asset Liability Management across all commercial banks in India. The

discussion paper has following objectives to explore:

To study the types of assets and liabilities in bank’s balance sheet.

What is asset liability management and how it is implied in banks?

To study the Portfolio-Matching behavior of Indian Banks in terms of nature and

strengths of relationship between Assets and Liability.

To find out the component of Assets explaining variance in Liability and vice-versa.

To study the impact of ownership over Asset Liability management in Banks.

To study impact of ALM on the profitability of different bank-groups.

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MEANING OF BANK

People earn money to meet their day-to-day expenses on food, clothing, education ofchildren, housing, etc. They also need money to meet future expenses on marriage, higher education of children, house building and other social functions. These are heavy expenses, which can be met if some money is saved out of the present income. Saving of money is also necessary for old age and ill health when it may not be possible for people to work and earn their living.

The necessity of saving money was felt by people even in olden days. They used to hoard money in their homes. With this practice, savings were available for use whenever needed, but it also involved the risk of loss by theft, robbery and other accidents. Thus, people were in need of a place where money could be saved safely and would be available when required. Banks are such places where people can deposit their savings with the assurance that they will be able to withdraw money from the deposits whenever required. People who wish to borrow money for business and other purposes can also get loans from the banks at reasonable rate of interest.

Bank is a lawful organization, which accepts deposits that can be withdrawn ondemand. It also lends money to individuals and business houses that need it.

Banks also render many other useful services – like collection of bills, payment of foreign bills, safe-keeping of jewellery and other valuable items, certifying the credit-worthiness of business, and so on.

Banks accept deposits from the general public as well as from the business community. Any one who saves money for future can deposit his savings in a bank. Businessmen have income from sales out of which they have to make payment for expenses. They can keep their earnings from sales safely deposited in banks to meet their expenses from time to time. Banks give two assurances to the depositors –

Safety of deposit, and

Withdrawal of deposit, whenever needed

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On deposits, banks give interest, which adds to the original amount of deposit. It is a great incentive to the depositor. It promotes saving habits among the public. On the basis of deposits banks also grant loans and advances to farmers, traders and businessmen for productive purposes. Thereby banks contribute to the economic development of the country and well being of the people in general. Banks also charge interest on loans. The rate of interest is generally higher than the rate of interest allowed on deposits. Banks also charge fees for the various other services, which they render to the business community and public in general. Interest received on loans and fees charged for services which exceed the interest allowed on deposits are the main sources of income for banks from which they meet their administrative expenses.

The activities carried on by banks are called banking activity. ‘Banking’ as an activity involves acceptance of deposits and lending or investment of money. It facilitates business activities by providing money and certain services that help in exchange of goods and services. Therefore, banking is an important auxiliary to trade. It not only provides money for the production of goods and services but also facilitates their exchange between the buyer and seller.

There are laws which regulate the banking activities in our country. Depositing money in banks and borrowing from banks are legal transactions. Banks are also under the control of government. Hence they enjoy the trust and confidence of people. Also banks depend a great deal on public confidence. Without public confidence banks cannot survive

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ROLE OF BANKING

Banks provide funds for business as well as personal needs of individuals. They play a significantrole in the economy of a nation. Let us know about the role of banking.

It encourages savings habit amongst people and thereby makes funds available for productiveuse.

It acts as an intermediary between people having surplus money and those requiring moneyfor various business activities.

It facilitates business transactions through receipts and payments by cheques instead ofcurrency.

It provides loans and advances to businessmen for short term and long-term purposes.

It also facilitates import export transactions.

It helps in national development by providing credit to farmers, small-scale industries andself-employed people as well as to large business houses which lead to balanced economic development in the country.

It helps in raising the standard of living of people in general by providing loans for purchaseof consumer durable goods, houses, automobiles, etc

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TYPES OF BANKS

a) Central BankA bank which is entrusted with the functions of guiding and regulating the banking system of a country is known as its Central bank. Such a bank does not deal with the general public. It acts essentially as Government’s banker; maintain deposit accounts of all other banks and advances money to other banks, when needed. The Central Bank provides guidance to other banks whenever they face any problem. It is therefore known as the banker’s bank. The Reserve Bank of India is the central bank of our country.The Central Bank maintains record of Government revenue and expenditure under various heads. It also advises the Government on monetary and credit policies and decides on the interest rates for bank deposits and bank loans. In addition, foreign exchange rates are also determined by the central bank.Another important function of the Central Bank is the issuance of currency notes, regulating their circulation in the country by different methods. No other bank than the Central Bank can issue currency.

b) Commercial BanksCommercial Banks are banking institutions that accept deposits and grant short-term loans and advances to their customers. In addition to giving short-term loans, commercial banks also give medium-term and long-term loan to business enterprises. Now-a-days some of the commercial banks are also providing housing loan on a long-term basis to individuals. There are also many other functions of commercial banks, which are discussed later in this lesson.

Types of Commercial banks: Commercial banks are of three types i.e., Public sector banks,Private sector banks and Foreign banks.

(i) Public Sector Banks: These are banks where majority stake is held by the Government of India or Reserve Bank of India. Examples of public sector banks are: State Bank of India, Corporation Bank, Bank of Baroda and Dena Bank, etc. Public Sector Banks comprise 19 nationalized banks and State Bank of India and its 7 associate banks.

(ii) Private Sectors Banks: In case of private sector banks majority of share capital of the bank is held by private individuals. These banks are registered as companies with limited liability. For example: The Jammu and Kashmir Bank Ltd., Bank of Rajasthan Ltd., Development Credit Bank Ltd, Lord Krishna Bank Ltd., Bharat Overseas Bank Ltd., Global Trust Bank, Vysya Bank, etc.

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(iii) Foreign Banks: These banks are registered and have their headquarters in a foreign country but operate their branches in our country. Some of the foreign banks operating in our country are Hong Kong and Shanghai Banking Corporation (HSBC), Citibank, American Express Bank, Standard & Chartered Bank, Grindlay’s Bank, etc. The number of foreign banks operating in our country has increased since the financial sector reforms of 1991.

c) Development BanksBusiness often requires medium and long-term capital for purchase of machinery and equipment, for using latest technology, or for expansion and modernization. Such financial assistance is provided by Development Banks. They also undertake other development measures like subscribing to the shares and debentures issued by companies, in case of under subscription of the issue by the public. Industrial Finance Corporation of India (IFCI) and State Financial Corporations (SFCs) are examples of development banks in India.

d) Co-operative BanksPeople who come together to jointly serve their common interest often form a co-operative society under the Co-operative Societies Act. When a co-operative society engages itself in banking business it is called a Co-operative Bank. The society has to obtain a license from the Reserve Bank of India before starting banking business. Any co-operative bank as a society is to function under the overall supervision of the Registrar, Co-operative Societies of the State .As regards banking business, the society must follow the guidelines set and issued by the Reserve Bank of India.

Types of Co-operative Banks:There are three types of co-operative banks operating in our country. They are primary credit societies, central co-operative banks and state co-operative banks. These banks are organized at three levels, village or town level, district level and state level.

(i) Primary Credit Societies: These are formed at the village or town level with borrower and non-borrower members residing in one locality. The operations of each society are restricted to a small area so that the members know each other and are able to watch over the activities of all members to prevent frauds.

(ii) Central Co-operative Banks: These banks operate at the district level having some of the primary credit societies belonging to the same district as their members. These banks provide loans to their members (i.e., primary credit societies) and function as a link between the primary credit societies and state co-operative banks.

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(iii) State Co-operative Banks: These are the apex (highest level) co-operative banks in all the states of the country. They mobilize funds and help in its proper channelization among various sectors. The money reaches the individual borrowers from the state co-operative banks through the central co-operative banks and the primary credit societies.

e) Specialized BanksThere are some banks, which cater to the requirements and provide overall support for setting up business in specific areas of activity. EXIM Bank, SIDBI and NABARD are examples of such banks. They engage themselves in some specific area or activity and thus, are called specialized banks. Let us know about them.

i. Export Import Bank of India (EXIM Bank): If you want to set up a business for exportingproducts abroad or importing products from foreign countries for sale in our country, EXIM bank can provide you the required support and assistance. The bank grants loans to exporters and importers and also provides information about the international market. It gives guidance about the opportunities for export or import, the risks involved in it and the competition to be faced, etc.

ii. Small Industries Development Bank of India (SIDBI):If you want to establish asmall-scale business unit or industry, loan on easy terms can be available through SIDBI. It also finances modernization of small-scale industrial units, use of new technology and market activities. The aim and focus of SIDBI is to promote, finance and develop small-scale industries.

iii. National Bank for Agricultural and Rural Development (NABARD): It is a centralor apex institution for financing agricultural and rural sectors. If a person is engaged in agriculture or other activities like handloom weaving, fishing, etc. NABARD can provide credit, both short-term and long-term, through regional rural banks. It provides financial assistance, especially, to co-operative credit, in the field of agriculture, small-scale industries, cottage and village industries handicrafts and allied economic activities in rural areas.

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FUNCTIONS OF COMMERCIAL BANKS

The functions of commercial banks are of two types:

(A) Primary functions; and(B) Secondary functions.

Let us discuss details about these functions.

(i) Primary functionsThe primary functions of a commercial bank include:a) Accepting deposits; andb) Granting loans and advances.

a) Accepting depositsThe most important activity of a commercial bank is to mobilize deposits from the public. People who have surplus income and savings find it convenient to deposit the amounts with banks. Depending upon the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow along with the interest earned. If the rate of interest is higher, public are motivated to deposit more funds with the bank. There is also safety of funds deposited with the bank. b)  Grant of loans and advancesThe second important function of a commercial bank is to grant loans and advances. Such loans and advances are given to members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances varies according to the purpose and period of loan and also the mode of repayment.

i) LoansA loan is granted for a specific time period. Generally commercial banks provide short-term loans .But term loans, i.e., loans for more than a year may also be granted. The borrower may be given the entire amount in lump sum or in installments. Loans are generally granted against the security of certain assets. A loan is normally repaid in installments. However, it may also be repaid in lump sum.

ii) AdvancesAn advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that loans may be granted for longer period, but advances are normally granted for a short period of time. Further the purpose of granting advances is to meet the day-to-day requirements of business. The rate of

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interest charged on advances varies from bank to bank. Interest is charged only on the amount withdrawn and not on the sanctioned amount.

Types of AdvancesBanks grant short-term financial assistance by way of cash credit, overdraft and bill discounting.

a) Cash CreditCash credit is an arrangement whereby the bank allows the borrower to draw amount up to a specified limit. The amount is credited to the account of the customer. The customer can withdraw this amount as and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted as per terms and conditions agreed with the customers.

b) OverdraftOverdraft is also a credit facility granted by bank .A customer who has a current account with the bank is allowed to withdraw more than the amount of credit balance in his account. It is a temporary arrangement. Overdraft facility with a specified limit may be allowed either on the security of assets, or on personal security, or both.

c) Discounting of BillsBanks provide short-term finance by discounting bills, i.e. making payment of the amount before the due date of the bills after deducting a certain rate of discount. The party gets the funds without waiting for the date of maturity of the bills. In case any bill is dishonored on the due date; the bank can recover the amount from the customer.

ii) Secondary functionsIn addition to the primary functions of accepting deposits and lending money, banks perform anumber of other functions, which are called secondary functions. These are as follows-

a. Issuing letters of credit, travelers cheque, etc.

b. Undertaking safe custody of valuables, important document and securities by providing safe deposit vaults or lockers. c. Providing customers with facilities of foreign exchange dealings.

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d. Transferring money from one account to another; and from one branch to another branch of the bank through cheque, pay order, demand draft.

e. Standing guarantee on behalf of its customers, for making payment for purchase of goods, machinery, vehicles etc.

f. Collecting and supplying business information.

g. Providing reports on the credit worthiness of customers.

h. Providing consumer finance for individuals by way of loans on easy terms for purchase of consumer durables like televisions, refrigerators, etc.

i. Educational loans to students at reasonable rate of interest for higher studies, especially for professional courses

E-banking (Electronic Banking)With advancement in information and communication technology, banking services are also made available through computer. Now, in most of the branches you see computers being used to record banking transactions. Information about the balance in your deposit account can be known through computers. In most banks now a days human or manual teller counter is being replaced by the Automated Teller Machine (ATM). Banking activity carried on through computers and other electronic means of communication is called ‘electronic banking’ or ‘e-banking’. Let us now discuss about some of these modern trends in banking in India.

•  Automated Teller MachineBanks have now installed their own Automated Teller Machine (ATM) throughout the country at convenient locations. By using this, customers can deposit or withdraw money from their own account any time.

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•  Debit CardBanks are now providing Debit Cards to their customers having saving or current account in the banks. The customers can use this card for purchasing goods and services at different places in lieu of cash. The amount paid through debit card is automatically debited (deducted) from the customers’ account.

•  Credit CardCredit cards are issued by the bank to persons who may or may not have an account in the bank. Just like debit cards, credit cards are used to make payments for purchase, so that the individual does not have to carry cash. Banks allow certain credit period to the credit cardholder to make payment of the credit amount. Interest is charged if a cardholder is not able to pay back the credit extended to him within a stipulated period. This interest rate is generally quite high.

•  Net BankingWith the extensive use of computer and Internet, banks have now started transactions over Internet. The customer having an account in the bank can log into the bank’s website and access his bank account. He can make payments for bills, give instructions for money transfers, fixed deposits and collection of bill, etc.

•  Phone BankingIn case of phone banking, a customer of the bank having an account can get information of his account, make banking transactions like, fixed deposits, money transfers, demand draft, collection and payment of bills, etc. by using telephone.As more and more people are now using mobile phones, phone banking is possible through mobile phones. In mobile phone a customer can receive and send messages (SMS) from and to the bank in addition to all the functions possible through phone banking.

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PRE-FINANCIAL SECTOR REFORMS (1991)

Geographical spread of Bank branches

Directed Investments / Credit Programs

Administered Rates of Interest

Accrual based accounting

Problems of Recovery of Loans

Deterioration in Quality of Assets /Loans

Erosion of Profits

No Computerization

Trade Union Issues

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BANKING REFORMS 1993 ONWARDS

L-P-G Policy of GOI since 1991

Technological Changes – ATMs / Internet

New Products and Services : Competition

Narasimhma Committee - I / II on Financial / Banking Sector Reforms (1991 & 1997)

Capital Adequacy Ratio : IRAC Norms : NPAs

Priority Sector Loans: Reduce from 40 to 10%?

Reduce SLR (40%) and CRR (15%)

Benchmark Prime Lending Rates

Enactment / Amendments to various laws

Market determined Rates of Interest

No directed lending or investments

Organizational Changes : Transparency

4 way classification of Loan Accounts / Assets

Provisioning for Losses o/a NPAs & Std Assets

ALM (1999) and Risk Management, KYC in Banks

Non Performing Assets definition revised from 4 quarters (1993) dues in Principal & Interest to 3 (1994) to 2 (1995) quarters and now from April 01, 2004 – just 90 days / 1 quarter

Basel II norms for Bank Supervision from 2008

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RISK MANAGEMENT IN BANKS

Risk and its management has assumed greater significance in recent years due to changing risk perception in banks. Risk has been present always in the banking business but the discussion on managing the same has gained prominence only lately.

Bankers world-wide have come to realize that the growing deregulation of local markets and their gradual integration with global markets have deepened their anxieties. With growing sophistication in banking operations, while lending and deposits – taking have continued to remain the mainstay of a majority of commercial banks, many have branched into derivatives trading, securities underwriting and corporate advisory businesses.

Some banks have even expanded their traditional credit product lines to include asset securitization and credit derivatives. Still other have greatly increased their transaction processing, custodial services or asset management businesses in the pursuit of increased fee income. As a consequence, the issue of risk management has gained new recognition in recent times.

With improvements in information technology, more and more banks will possibly venture into the relative new world of on-line electronic banking covering apart from traditional banking, providing of bill presentation and payment services. This would mean an increase in the diversity and complexity of risks. Banks would have to develop risk management systems that are rigorous and comprehensive, yet flexible enough to address newer risks they assume.

MAJOR RISKS

Four risks confront banks viz., credit risk, interest rate risk, foreign exchange risk and liquidity risk.

A. CREDIT RISK

The credit risk remains the predominant risk for most banks, despite changes in banking over the last few years. Even in normal times, credit risk attracts considerable attention of credit planners and is extremely important.

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The credit risk depends on both internal and external factors. The external factors are the state of the economy, swings in commodity prices and equity prices, foreign exchange rates interest rates, etc.

The internal factors are deficiencies in loan policies and administration of loan portfolio which would cover weaknesses in the area of prudential credit concentration limits, appraisal of borrowers’ financial position, excessive dependence on collateral and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance etc. Such risks may extend beyond the conventional credit products such as loans and letters of credit and appear in more complicated, less conventional forms, such as credit derivatives or tranches of securitized assets or outstanding commitments.

B. INTEREST RATE RISK

The second category risk that has gained prominence is interest rate risk. Interest rate risk arises because banks fix and refix interest rates on their resources and on the assets on which they are deployed at different times.

Changes in interest rates can significantly impact the interest income, depending on assets and liabilities are reset. Any such mismatch in cash flows (fixed asset or liabilities) or reprising dates (floating assets or liabilities) expose bank’s net interest margin to variations.

C. FOREIGN EXCHANGE RISK

Third important category of risk pertains to foreign exchange risk. The risk inherent in running open foreign exchange positions has become pronounced in recent years owing to the wide variation in exchange rates.

Such risks arise owing to adverse exchange rate movements, which may affect a banks open position, either spot or forward, or a combination of the two, in any individual foreign currency.

D. LIQUIDITY RISK

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The final major category of financial risk is liquidity risk. The liquidity risk arises from funding of long-term assets by short-term liabilities or resources, thereby making the liabilities subject to rollover or refinancing risk.

Those banks that fund their domestic assets with foreign currency deposits with them may be particularly susceptible to liquidity risk when sharp fluctuations in exchange rates and market turbulence make it difficult to retain sources of financing.

Beyond the four basic financial risks, banks have a host of other concerns. Some of them, like operating risk, are due to natural outgrowth of their business. Banks employ standard risk avoidance techniques to mitigate them. In other cases, for instance, where counter-party risk is seen as significant, it is evaluated using standard credit risk procedures.

Likewise, most bankers would view legal risks as arising from their credit decisions or, more likely, from absence of proper procedure while finalizing a financial contract. It does not require very sophisticated tools to cover such risk.

In managing credit risk, the key issue is to recognize the need to apply a consistent evaluation and rating scheme of all investment opportunities. This is essential in order for credit decisions to be made in a consistent manner.

Prudential limits need to be laid down on various aspects of credit, viz., benchmark current debt/equity and profitability ratios, debt service coverage ratios, concentration limits for single/group borrower, maximum exposure limits to industry etc. There should be provision of some flexibility to allow for very special features.

A comprehensive risk scoring system needs to be developed that serves as a single point

indicator of diverse risk factors of counter-party.

As for managing interest rate risk, most banks make a clear distinction between their trading activity and their balance sheet exposure. As regards trading book, Value-at-Risk (VaR) is presently the standard approach. The Var method is employed to access the potential loss that could crystallize on portfolio due to variations in market interest rate and prices. For balance sheet exposure to interest rate risk, banks rely on ‘gap reporting system’; identify asymmetry in reprising of assets and liabilities commonly known as gap

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and putting in place a gap reporting system. This is often supplemented with balance sheet simulation models to investigate the effect of interest rate variation on reported earnings over a medium-time horizon.

Coming to foreign exchange risk, limits are key elements of risk management in foreign exchange trading, as they are for all trading business. As a general characterization, banks with active trading positions have tended to adopt the VaR approach to measure the risk associated with exposure. For banks that could not develop VaR, some stress testing is required to be conducted to evaluate the potential loss associated with changes in exchange rate. This is done for small movements in the exchange rates, as well as for historical maximum movements.

The final point is the measurement of liquidity risk. There are several traditional ratios for liquidity risk measurements, viz ; loans to total assets, loans to core deposits, ratio of large liabilities to earning asset and loan losses to net loans. In addition, prudential limits are placed on various measures like inter-bank borrowings and core deposits vis-à-vis core assets.

Several points need to be tackled as regarding positioning appropriate risk management strategies. There is an increasing trend towards centralising risk management with integrates treasury management to benefit from information synergies on aggregate exposure, as well as scale economies and easier reporting to top management.

The primary responsibility of understanding the risks run by the bank and ensuring that such risks are appropriately addressed should be vested with the Board of Directors. At organisational level, overall risk management needs to be vested with an independent Risk Management Committee or Executive Committee of top executives entrusted with the responsibility of identifying, measuring and monitoring the risk profile of the bank that reports directly to the directly to the Board Of Directors.

The committee should develop policies and procedures, verify the models used for pricing complex products and identify newer risks impacting bank’s balance sheet. Finally, adherence to risk parameters of the various operating departments of the bank should also be overseen by the committee.

Observers are by now unanimous in their view that developing sound and healthy financial institutions, especially banks, is a sine qua non for maintaining overall stability of the financial system.

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Keeping this in view, the Reserve Bank has issued broad guidelines for risk management systems in banks. This has placed the primary responsibility of laying down risk parameters and establishing the risk management and control system on the Board of Directors of the bank.

However, the implementation of the integrated risk management could be assigned to a risk management committee or alternately, a committee of top executives that reports to the board. The risk management guidelines also require banks to constitute a high level credit policy committee to deal with issues pertaining to credit sanction, disbursement and follow-up procedures and to manage and control credit risk for the bank as a whole.

The Reserve Bank advised banks to set up a credit risk management department to enforce and monitor compliance of the risk parameters and prudential limits set by the Board or credit policy committee. The set of guidelines issued by RBI is purposed to serve as a benchmark to the banks, which are yet to establish an integrated risk management system.

However, it is to be recognized that, in view of diversity and varying size of balance sheet items as between banks, it might neither be possible nor necessary to adopt a uniform risk management system.

The design of risk management framework should, therefore, be oriented towards the bank’s own requirement dictated by the size and complexity of business, risk philosophy, market perception and the existing level of capital. While doing so, banks may critically evaluate their existing risk management system in the light of the guidelines issued by the Reserve Bank and should identify the gaps in the existing risk management practices and the policies and strategies for complying with the guidelines.

In addition to the risk management guidelines, the levels of transparency and standards of disclosure have gradually been enhanced over the years so as to provide a clearer picture of balance sheet to informed readers.

Accordingly, from the year ended March 31, 2000, an enhanced set of disclosures are required to be disclosed by banks as ‘Note to Accounts’ to their balance sheet. Such disclosures and transparency practices are aimed at improving the process of expectation

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formation by market players about behavior and eventually lead to effective decision-making in banks.

In addition, RBI has laid down credit concentrations norms, both for individual borrowers as well as to a group as a whole.

ISSUES:

1. First, risk management is closely related to ALM. Any mismatch between assets and liabilities increases risks, whether it is interest rate risk, credit risk or liquidity risk. Accurate risk identification and classification of past losses into expected and unexpected losses would help in positioning comprehensive internal controls. Not a simple proposition, it requires in depth study and analysis of financial and other markets.

2. Secondly, the evaluation of credit rating continues to be an imprecise process. Overtime one should expect that the banks rating procedures should be compatible with rating systems elsewhere in the capital market and have the same degree of objectivity.

3. A third area where improvements seem warranted is the analysis of ex-post outcomes from lending. Credit losses are, currently not preciously related to credit rating. They need to be more closely tracked by the banks than they currently are. In short, credit pricing, credit rating and expected losses ought to be demonstrably linked.

4. Fourthly, interest rate risk approaches include both the trading systems; there has been a considerable improvement. The VaR methodology has converted a rather subjective hand-on process of risk control to more quantitative one.

5. Finally, as banks move more towards off-balance sheet activities must be better integrated into overall risk management and strategic decision making. Currently, they are ignored when bank risk management is considered or are at a fairly primitive stage. If reasonable exposure estimates are to be obtained, much more need to be done including building up of a strong Management Information System (MIS) backed up by a sound database.

ALM – INTRODUCTION

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Economic Factors Economic Policies

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BANKS

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DEFINITION OF ALM 23 | P a g e

ALM is defined as, “the process of decision – making to control risks of existence, stability and growth of a system through the dynamic balances of its assets and liabilities.”

The text book definition of ALM is “a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power and degree of willingness to take on debt. It is also called surplus- management”.

WHAT IS ALM?

• An attempt to match:

Assets and Liabilities

• In terms of:

Maturities and Interest Rates Sensitivities

• To minimize:

Interest Rate Risk and Liquidity Risk

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ASSET LIABILITY MANAGEMENT

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ASSET MANAGEMENT LIABILITY MANAGEMENT

How liquid are the asset of the banks

How easily can the bank generate loans from market

Asset Liability Management (ALM) defines management of all assets and liabilities (both

off and on balance sheet items) of a bank. It requires assessment of various types of risks

and altering the asset liability portfolio to manage risk.

Till the early 1990s, the RBI did the real banking business and commercial banks were

mere executors of what RBI decided. But now, BIS is standardizing the practices of

banks across the globe and India is part of this process.

The success of ALM, Risk Management and Basel Accord introduced by BIS depends on

the efficiency of the management of assets and liabilities. Hence these days without

proper management of assets and liabilities, the survival is at stake.

A bank’s liabilities include deposits, borrowings and capital. On the other side of the

balance sheets are assets which are loans of various types which banks make to the

customer for various purposes. To view the two sides of banks’ balance sheet as

completely integrated units has an intuitive appeal. But the nature, profitability and risk

of constituents of both sides should be similar.

The structure of bank’s balance sheet has direct implications on profitability of banks

especially in terms of Net Interest Margin (NIM). So it is absolute necessary to maintain

compatible asset-liability structure to maintain liquidity, improve profitability and

manage risk under acceptable limits.

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NEED FOR ASSET LIABILITY MANAGEMENT

Risk is inherent in banking and is unavoidable. Asset Liability Management is not to avoid but to manage risks (mismatch) at the same time sustaining the profitability. This requires periodic monitoring of risk exposures which involves arrangements for collecting and analyzing information. It involves ability to anticipate, forecasts and to act so as to structure the bank’s business to profit from it.

Asset liability management seek to contain risk while pursuing profit at the same time. The risks are not independent from each other. They are in practice inter-linked and hence do not offer specific solution easily. Therefore, techniques do not give solutions straight away. Asset management like all management depends ultimately on judgment and decision making.

Asset liability management is concerning with all aspects of business involving financial decisions. Thus there is a considerable technicalities to make policy, to ensure consistent implementation and to monitor the results.

Generally large banks constituted a committee with representatives drawn from all main functions of the bank, called Asset Liability Committee (ALCO) for the management. This committee operates typically just below the board. In smaller banks the responsibilities is vested with the board of management.

ALM involves both long term and short term policy decisions. While the long term policies need to be approved by the highest level, the short term policy needs delegation of both responsibility and authority. There is a need to develop accounting and supervisory system to ensure smoother implementations of ALM function.

Decisions would also involve the geographical dispersal of dealing markets, the dealing parties and dealing offices/personnel. Also the institutionalizing of ALM requires certain investments in training, information and communication system, developing new types of business products, etc.

To conclude, the doctrine of return versus risk suggests that no institution should avoid taking risk. However, the question of scales, dimension and magnitude of risk as well as return to be defined, in implemented and monitored. The ALM techniques provide a framework for same in effective manner.

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IMPORTANCE OF ALM

There are several reasons for the growing importance of ALM function. More important are the exposures of the institution directly and indirectly to the risk situations and the need to safeguard the position proactively. The following recent trend also necessitates the ALM function in banks.

i. Financial volatilityii. Explosion of new financial products

iii. Regulatory initiativesiv. Heightened awareness of top management

i. Financial Volatility

During the past decade we have witnessed heightened volatility in the financial market in India and rest of the world. Increased volatility results in greater uncertainties in profitability, portfolio value and solvency. When there is a risk, there is a need for risk management, which is effective. ALM has become critical in the volatile financial environment of the recent past. The financial volatility is examined in detail under interest rate risk discussed separately.

ii. New Financial Product Innovation

The second reason for growing importance of ALM is the explosive growth of new financial products. These products are innovated by the market players in India and abroad and the agencies like RBI, FIMMDA, SEBI, etc; also introduced several new products during the last decade. While analyzing new products, we need to understand:

Product mechanics Pricing Applications Potential risks

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iii. Regulatory Initiatives

The regulatory agencies throughout the world have taken several measures to enhance sophistication and regulation of ALM. The Basel Committee on bank supervision issued an amendment in January 1996, to the Capital Accord 1988, to incorporate Market Risk in the supervisory norms. The supervisory authorities were asked to implement the same by year-end 1997.

Accordingly, RBI issued guidelines in February 1999; the ALM system was to cover at least 60% of the assets and liabilities of the banks effective from 1 April 1999 and 100% from 1 April 2000.

iv. Management Recognition

The high profile head-line making derivatives disasters, losses related to market risks, the affect of interest rate movements on the income of banks, have enhanced the level of awareness of top management. They have begun to take greater interest, ask more questions and want to improve the oversight of the risk management system in banks.

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OBJECTIVE OF ASSET-LIABILITY MANAGEMENT

The objective of ALM is “Exposure by choice, not by chance” i.e. “Risk by choice and not by chance”, “Clean bet and not confused bet”, “bet with your head, not over our head”.

Thus the objective of ALM is not to eliminate risk but to manage it. In this endeavour risk and reward go together.

Setting and articulating risk management objective is the first logical step in establishing professional ALM function. Without clear objective, it is not possible to decide whether a particular decision or transaction is right or wrong.

Also, a particular transaction cannot be measured in isolation, but in the context of its contribution to the accomplishment of the overall objectives.

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FRAMEWORK FOR ALM FUNCTION

In order to have effective ALM function, it is necessary to put in place all necessary elements. A piecemeal approach may be in effective and inappropriate. The nine essential elements of an ALM function are:

a. Strategic Framework - A proactive product planning and pricing tool

b. Organizational Framework - Clearly defined roles and responsibilities of ALCO

c. Analytical Framework – Use of analytical tools like gap, duration, simulation, etc.

d. Technology Framework – Automation and software selection and performance

e. Operational Framework - Well documented & approved ALM procedure manual

f. Performance measurement Framework - Asset based financial spread or liability based financial spread or profit through market based transformation.

g. Information Reporting Framework - For clear, useful, timely information.

h. Regulatory Compliance Framework - To comply with various requirements

i. Control Framework – Checks & balances for integrity of data, analysis, reporting, etc.

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ALM ORGANISATION

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Board of Directors

Management Committee

Asset Liability Committee (ALCO)

Asset Liability Management Cell

Finance Planning Department

Credit Analysis Department

Credit Risk Management Department

Treasury

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Investment and Loan Departments

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ALM STRATEGIES

Asset liability management can be done in three different ways:

i. On-Balance sheet: Business strategies involving product mix and pricing of loan, deposits and other borrowings.

ii. On-Balance sheet: Investment strategies involving maturity mix and rate characteristics of investment securities.

iii. Off-Balance sheet: Use of derivatives to manage Asset-liability risks

Off balance sheet strategies like swap transactions is relatively fast as compared to on-balance sheet strategy of accomplishing desired product mix/pricing changes takes time and effort.

The hedging process is easy and fast where as frequent product mix/pricing may cause confusion to customers.

The cost of off-balance sheet strategy and on-balance sheet strategy need to be considered as both involve costs.

One should not rush to use derivatives simply because they are available. Effective Asset Liability Management does not necessarily require derivatives.

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Even in the markets, where the derivatives are ALM is critical and necessary as a risk management tool.

RBI GUIDELINES FOR ALM

As per RBI guidelines, commercial banks are to distribute the outflows/inflows in different residual maturity period known as time buckets.  The Assets and Liabilities were earlier  divided  into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to their maturity (also called residual maturity).  All the liability figures are outflows while the asset figures are inflows.   In September, 2007, having regard to the international practices, the level of sophistication of banks in India, the need for a sharper assessment of the efficacy of liquidity management and with a view to providing a stimulus for development of the term-money market, RBI revised these guidelines and it was provided that

(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. Thus, now we have 10 time buckets. After such an exercise, each bucket of assets is matched with the corresponding bucket of the liability.   When in a particular maturity bucket, the amount of maturing liabilities or assets does not match, such position is called a mismatch position, which creates liquidity surplus or liquidity crunch position and depending upon the interest rate movement, such situation may turn out to be risky for the bank.    Banks are required to monitor such mismatches and take appropriate steps so that bank is not exposed to risks due to the interest rate movements during that period.

(b) 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.

The Board’s of the Banks have been entrusted with the overall responsibility for the management of risks and is required to decide the risk management policy and set limits for liquidity, interest rate, foreign exchange and equity price risks.

Asset-Liability Committee (ALCO) is the top most committee to oversee the implementation of ALM system and it is to be headed by CMD or ED.  ALCO considers product pricing for deposits and advances, the desired maturity profile of the incremental assets and liabilities in addition to monitoring the risk levels of the bank. It will have to articulate current interest rates view of the bank and base its decisions for future business strategy on this view. 

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