Asset and Liability Management

ASSETS AND LIABILITY MANAGEMENT
INTRODUCTION
Ever since the initiation of the process of deregulation of the Indian banking system and gradual freeing of interest rates to market forces, and consequent injection of a dose of competition among the banks, introduction of asset-liability management (ALM) in the public sector banks (PSBs) has been suggested by several experts. But, initiatives in this respect on the part of most bank managements have been absent. This seems to have led the Reserve Bank of India to announce in its monetary and credit policy of October 1997 that it would issue ALM guidelines to banks. While the guidelines are awaited, an informal check with several PSBs shows that none of these banks has moved decisively to date to introduce ALM. One reason for this neglect appears to be a wrong notion among bankers that their banks already practice ALM. As per this understanding, ALM is a system of matching cash inflows and outflows, and thus of liquidity management. Hence, if a bank meets its cash reserve ratio and statutory liquidity ratio stipulations regularly without undue and frequent resort to purchased funds, it can be said to have a satisfactory system of managing liquidity risks, and, hence, of ALM. The actual concept of ALM is however much wider, and of greater importance to banks' performance. Historically, ALM has evolved from the early practice of managing liquidity on the bank's asset side, to a later shift to the liability side, termed liability management, to a still later realization of using both the assets as well as liabilities sides of the balance sheet to achieve optimum resources management. But that was till the 1970s. 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. The induction of credit risk into the issue of determining adequacy of bank capital further enlarged the scope of ALM in later 1980s. In the current decade, earning a proper return of bank equity and hence maximization of its market value has meant that ALM covers the management of the entire balance sheet of a bank. This implies that the bank managements are now expected to target required profit levels and ensure minimization of risks to acceptable levels to retain the interest of investors
T.Y.B.com (Banking & Insurance) - Sem. V
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in their banks. This also implies that costing and pricing policies have become of paramount importance in banks.
MEANING OF ASSET LIABILITY MANAGEMENT:

Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus 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 earning from interest is maximized within the overall risk-preference (present and future) of the institutions. But in the last decade the meaning of ALM has evolved. It is now used in many different ways under different contexts. ALM, which was actually pioneered by financial institutions and banks, are now widely being used in industries too. The Society of Actuaries Task Force on ALM Principles, Canada, offers the following definition for ALM: "Asset Liability Management is the on-going process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints." ALM is the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. It is the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organization's financial objectives, given the organization's risk tolerances and other constraints. ALM is relevant to, and critical for, the sound management of the finances of any organization that invests to meet its future cash flow needs and capital requirements.
Traditionally, ALM has focused primarily on the risks associated with changes in interest rates. Currently, ALM considers a much broader range of risk including equity risk, liquidity risk, legal risk, currency risk and sovereign or country risk.
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ASSETS AND LIABILITY MANAGEMENT PURPOSE OF ASSET LIABILITY MISMATCH

ALM is no longer a standalone analytical function. There are micro and macro level objectives of ALM. At micro level, the objective functions of the ALM are two-fold. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. Similarly, liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. The gap is then assessed identify the future financing requirements. This ensures liquidity. However, maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not an easy task. The following tables explain the process involved in price matching and maturity matching. At macro-level, ALM leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies.
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ASSETS AND LIABILITY MANAGEMENT ELEMENTS OF ASSET LIABILITY MANAGEMENT

There are nine elements related to ALM and they are as follows: 1. Strategic framework: The Board of Directors are responsible for setting the limits for risk at global as well as domestic levels. They have to decide how much risk they are willing to take in quantifiable terms. Also it is necessary to determine who is in charge of controlling risk in the organization and their responsibilities. 2. Organizational framework: All elements of the organization like the ALM Committee, subcommittees, etc., should have clearly defined roles and responsibilities. ALM activities should be supported by the top management with proper resource allocation and personnel committee. 3. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. The policy statement should be well articulated providing a clear direction for ALM function. 4. Analytical framework: Analytical methods in ALM require consistency, which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. Various analytical components like Gap, Duration, Stimulation and Valueat-Risk should be used to obtain appropriate insights. 5. Technology framework: An integrated technological framework is required to ensure all potential risks are captured and measured on a timely basis. It would be worthwhile to ensure that automatic information feeds into the ALM systems and he latest software is utilized to enable management perform extensive analysis, planning and measurement of all facets of the ALM function. 6. Information reporting framework: The information reporting framework decides who receives information, how timely, how often and in how much detail and whether the amount and type of information received is appropriate and necessary for the recipients task. 7. Performance reporting framework: The performance of the traders and business units can easily be measured using valid risk measurement measures. The performance measurement considers approaches and ways to adjust performance measurement for the risks taken. The profitability of an institution comes from three sources: Asset, Liabilities and their efficient management.
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8. Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements, expectations and guidelines for risk based capital and liquidity ratios. 9. Control framework: The control framework covers the control over all processes and systems. The emphasis should be on setting up a system of checks and balances to ensure the integrity of data, analysis and reporting. This can be ensured through regular internal / external reviews of the function.
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ASSETS AND LIABILITY MANAGEMENT COMPONENTS OF FINANCIAL STATEMENT Balance Sheet

Liabilities Assets Capital Cash and Bank Balances Reserves & Surplus Investments Deposits Advances Borrowings Fixed Assets Other Liabilities Other Assets Contingent Liabilities
Liabilities
1. Capital: Capital represents owners contribution/stake in the bank. It serves as a cushion for depositors and creditors. It is considered to be a long term sources for the bank. 2. Reserves & Surplus: It includes Statutory Reserves, Capital Reserves, Investment Fluctuation Reserve, Revenue and Other Reserves, Balance in Profit and Loss Account 3. Deposits: This is the main source of banks funds. The deposits are classified as deposits payable on demand and time. This includes Demand Deposits, Savings Bank Deposits and Term Deposits 4. Borrowings: Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions a) Borrowings in India i.e. Reserve Bank of India, Other Banks and Other Institutions & Agencies b) Borrowings outside India 5. Other Liabilities & Provisions: It can be grouped as Bills Payable, Interest Accrued, Unsecured redeemable bonds, and other provisions.
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ASSETS AND LIABILITY MANAGEMENT Assets

1. Cash & Bank Balances: This includes cash in hand including foreign notes, balances with Reserve Bank of India in current and other accounts 2. Investments: This includes investments in India i.e. Government Securities, Other approved Securities, Shares, Debentures and Bonds, Subsidiaries and Sponsored Institutions, Others and investments abroad. 3. Advances: Bills Purchased and Discounted, Cash Credits, Overdrafts & Loans repayable on demand, Term Loans, Secured by tangible assets, Covered by Bank/ Government Guarantees. 4. Fixed Assets: This includes premises, land, furniture & fixtures, etc. 5. Other Assets: This includes Interest accrued, Tax paid in advance/tax deducted at source, Stationery and Stamps, Non-banking assets acquired in satisfaction of claims, Deferred Tax Asset (Net) and Others. For ALM these assets and liabilities are classified into different time periods called maturity buckets, depending on maturity profile and interest rate sensitivity. As per Reserve Bank of India guidelines issued for ALM implementation in bank in 1999, there are eight time buckets T-1 to T-8 classified respectively as follows: (i) 1 to 14 days (ii) 15 to 28 days (iii) Over 3 months and upto 6 months (iv) Over 6 months and upto 1 year (v) 1 year and upto 3 years (vi) 3years and upto 5 years (vii) Over 5 years
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Assets - Repayment inflows into the Banks Cash 1-14 days buckets Excess balance over required CRR Bank Balance SLR shown under 1-14 days bucket Investments Respective maturity buckets Advances Respective maturity buckets Other Assets Respective maturity buckets Liabilities - Repayment outflows from the Bank Captial Over 5 years bucket Reserves & Surplus Over 5 years bucket Deposits Respective maturity buckets Borrowings Respective maturity buckets Other Liabilties and provisions Respective maturity buckets Contingent Liabilities Respective maturity buckets
Contingent Liabilities
Banks obligations under Letter of Credits, Guarantees, and Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.
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PROFIT AND LOSS ACCOUNT Profit and Loss Account includes:
Income
1. Interest Earned: This includes Interest/Discount on Advances / Bills, Income on Investments, Interest on balances with Reserve Bank of India and other inter-bank funds 2. Other Income: This includes Commission, Exchange and Brokerage, Profit on sale of Investments, Profit/(Loss) on Revaluation of Investments, Profit on sale of land, buildings and other assets, Profit on exchange transactions, Miscellaneous Income
Expenses
1. Interest Expense: This includes Interest on Deposits, Interest on Reserve Bank of India / Inter-Bank borrowings and others. 2. Operating Expense: This includes Payments to and Provisions for employees, Rent, Taxes and Lighting, Printing and Stationery, Advertisement and Publicity, etc.
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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY MANAGEMENT IN INDIAN CONTEXT

The post-reform banking scenario in India was marked by interest rate deregulation, entry of new private banks, and gamut of new products along with greater use of information technology. To cope with these pressures banks were required to evolve strategies rather than ad hoc solutions. Recognizing the need of Asset Liability management to develop a strong and sound banking system, the RBI has come out with ALM guidelines for banks and FIs in April 1999.The Indian ALM framework rests on three pillars: -
The ALM process rests on three pillars: ALM information systems

=> Management Information System => Information availability, accuracy, adequacy and expediency
ALM organization
=> Structure and responsibilities => Level of top management involvement
ALM process
=> Risk parameters => Risk identification => Risk measurement => Risk management => Risk policies and tolerance levels.
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ASSETS AND LIABILITY MANAGEMENT Pillar 1: ALM Information System

It includes Management Information System, Information availability, accuracy, adequacy and expediency. A good information system gives the bank management a complete picture of the bank's balance sheet. Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioral pattern it will take time for banks in the present state to get the requisite information. The problem of ALM needs to be addressed by following an ABC approach i.e. analyzing the behavior of asset and liability products in the top branches accounting for significant business and then making rational assumptions about the way in which assets and liabilities would behave in other branches. In respect of foreign exchange, investment portfolio and money market operations, in view of the centralized nature of the functions, it would be much easier to collect reliable information. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. The spread of computerization will also help banks in accessing data.
Pillar II: ALM Organization

The board should have overall responsibility for the management of risks and should decide the risk management policy of the bank and set the limits for liquidity, interest rate, foreign exchange and equity price risk. The responsibility of ALM is on the treasury department of the banks. The results of balance sheet analysis along with recommendations is place in Asset Liability Committee (ALCO) meeting by the treasurer where important decisions are made are made to minimize risk and maximize returns. The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. The size of ALCO varies from organization to organization. CEO heads the committee. The objective of the ALCO is to derive the most appropriate strategy for the banks in terms of the mix of assets and liabilities given its expectation for the future and the potential consequences of interest-rate movements, liquidity constraints, foreign exchange exposure and capital adequacy. It is the responsibility of the committee to ensure all strategies conform to the banks risk appetite and levels of exposure as determined by the Board Risk Committee.
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ASSETS AND LIABILITY MANAGEMENT Pillar3: ALM Process

The basic ALM processes involving identification, measurement and management of risk parameter .The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. However RBI is expecting Indian banks to move towards sophisticated techniques like Duration, Simulation, VaR in the future. For the accrued portfolio, most Indian Private Sector banks use Gap analysis, but are gradually moving towards duration analysis. Most of the foreign banks use duration analysis and are expected to move towards advanced methods.
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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY COMMITTEE ALCO

Asset-Liability Committee (ALCO) is the top most committee to oversee implementation of ALM system, to be headed by CMD or ED. ALCO would consider 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. The ALM desk consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to bank's internal limits. The ALCO is a decision making unit responsible for balance sheet planning from riskreturn perspective including the strategic management of interest rate and liquidity risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the decisions to be taken by it. The business and risk management strategy of the bank should ensure that the bank operates within the limits/parameters set by the Board. The business issues that an ALCO would consider, inter alia, will include product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. In respect of the funding policy, for instance, its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end, it will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs. floating rate funds, wholesale vs retail deposits, money market vs. capital market funding, domestic vs foreign currency funding, etc. Individual banks will have to decide the frequency for holding their ALCO meetings.
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Top Management, the CEO/CMD or ED should head the Committee. The Chiefs of Investment, Credit, Funds Management/Treasury (forex and domestic), International banking and Economic Research can be members of the Committee. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerization. Some banks may even have sub-committees. The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity.
Committee composition
Permanent members:

Chairman Managing Director/CEO Financial Director Risk Manager Treasury Manager ALCO officer Divisional Managers
By invitation:

Economist Risk Consultants
Purposes and Tasks of ALCO:
Formation of an optimal structure of the Banks balance sheet to provide the maximum profitability, limiting the possible risk level;
Control over the capital adequacy and risk diversification; Execution of the uniform interest policy; Determination of the Banks liquidity management policy; Control over the state of the current liquidity ratio and resources of the Bank; Formation of the Banks capital markets policy; Control over dynamics of size and yield of trading transactions (purchase/sale of currency state and corporate securities, shares, derivatives for such instruments) as well as extent
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of diversification thereof Control over dynamics of the basic performance indicators (ROE, ROA, etc.) as prescribed in the Bank's policy.
PROCESS OF ALCO
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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY MANAGEMENT APPROACH

ALM in its most apparent sense is based on funds management. Funds management represents the core of sound bank planning and financial management. Although funding practices, techniques, and norms have been revised substantially in recent years, it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Therefore, funds management has following three components, which have been discussed briefly.
1. LIQUIDITY RISK MANAGEMENT

Banks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.
Liquidity Tracking
Measuring and managing liquidity needs are vital for effective operation of the Company. By assuring the Companys ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. The ALCO should measure not only the liquidity positions of the Company on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions. Experience shows that assets commonly considered being liquid, such as govt. securities and other money market instruments, could also become illiquid when the market and players are unidirectional. Therefore, liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirement, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool.
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Analysis of following factors throws light on a banks adequacy of liquidity position: a. Historical Funding requirement b. Current liquidity position c. Anticipated future funding needs d. Sources of funds e. Options for reducing funding needs f. Present and anticipated asset quality g. Present and future earning capacity and h. Present and planned capital position
To satisfy funding needs, a bank must perform one or a combination of the following: a. Dispose off liquid assets b. Increase short term borrowings c. Decrease holding of less liquid assets d. Increase liability of a term nature e. Increase Capital funds
Statement of Structural Liquidity

It Places all cash inflows and outflows in the maturity ladder as per residual maturity. Maturity Liabilities are cash outflow and Maturity Assets are cash inflows. The mismatches in the first two buckets cannot exceed 20% of outflows. It shows the structure as of a particular date. Banks can fix the tolerance level for other maturity buckets.
Assets and Liabilities to be reported as per their maturity profile into 8 maturity buckets: a. 1 to 14 days b. 15 to 28 days c. 29 days and up to 3 months d. Over 3 months and up to 6 months e. Over 6 months and up to 1 year f. Over 1 year and up to 3 years g. h. Over 3 years and up to 5 years Over 5 years
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An example of structural liquidity statement:

Outflow Capital Liab-fixed Int Liab-floating Int Others Total outflow 1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total 200 200 300 200 200 600 600 300 200 200 2600 350 400 350 450 500 450 450 450 3400 50 50 0 200 300 700 650 550 1050 1100 750 650 1050 6500
1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total Inflow Investments 200 150 250 250 300 100 350 900 2500 Loans-fixed Int 50 50 0 100 150 50 100 100 600 Loans - floating int 200 150 200 150 150 150 50 50 1100 Loans BPLR Linked 100 150 200 500 350 500 100 100 2000 Others 50 50 0 0 0 0 0 200 300 Total Inflow 600 550 650 1000 950 800 600 1350 6500
1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total Gap -100 -100 100 -50 -150 50 -50 300 0 Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0 Gap % to Total Outflow -14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57 0.00
Addressing the Mismatches

Mismatches can be positive or negative Positive Mismatch: Maturing Assets > Maturing Liabilities Negative Mismatch: Maturing Liabilities > Maturing Assets In case of positive mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.
For negative mismatch, it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.
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Strategies
To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.
The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.
2. ASSET MANAGEMENT
Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting the price and availability of credit and the level of liquid assets. However, assets that are often assumed to be liquid are sometimes difficult to liquidate. For example, investment securities may be pledged against public deposits or repurchase agreements, or may be heavily depreciated because of interest rate changes. Furthermore, the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. Asset liquidity, or how "salable" the bank's assets are in terms of both time and cost, is of primary importance in asset management. To maximize profitability, management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. Income derived from higher yielding assets may be offset if a forced sale, at less than book value, is necessary because of adverse balance sheet fluctuations. Seasonal, cyclical, or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand, which 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.
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ASSETS AND LIABILITY MANAGEMENT 3. LIABILITY MANAGEMENT

In the broadest sense liability management involves the planning and co-ordination of all the banks sources of funds in order to maintain liquidit y, profitabilit y and safet y to maintain long-term growth. Effective liabilit y management ensures that funds are available over the short term to meet reserve requirements and to provide adequate liquidit y, and over the long term to satisfy loan demand and to provide investment earnings. The basic concerns of liability management are how a bank can best influence the volume, cost and stability of the various types of funds it can obtain. Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. This does not preclude the option of selling assets to meet funding needs, and conceptually, the availability of asset and liability options should result in a lower liquidity maintenance cost. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. The major difference between liquidity in larger banks and in smaller banks is that larger banks are better able to control the level and composition of their liabilities and assets. When funds are required, larger banks have a wider variety of options from which to select the least costly method of generating funds. The ability to obtain additional liabilities represents liquidity potential. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities, as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions. The obvious difficulty in estimating the latter is that, until the bank goes to the market to borrow, it cannot determine with complete certainty that funds will be available and/or at a price, which will maintain a positive yield spread. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. In this context, liquidity represents the ability to attract funds in the market when needed, at a reasonable cost vis--vis asset yield. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets.
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Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand, misuse or improper implementation of liability management can have severe consequences. Further, liability management is not riskless. This is because concentrations in funding sources increase liquidity risk. For example, a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U.S. banks or the economy. Replacing foreign source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities, relax asset liquidity standards, and result in a large concentration of short-term liabilities supporting assets of longer maturity. During times of tight money, this could cause an earnings squeeze and an illiquid condition. Also if rate competition develops in the money market, a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities. If a bank is purchasing liabilities to support assets, which are already on its books, the higher cost of purchased funds may result in a negative yield spread. Preoccupation with obtaining funds at the lowest possible cost, without considering maturity distribution, greatly intensifies a bank's exposure to the risk of interest rate fluctuations. That is why banks that particularly rely on wholesale funding sources, management must constantly be aware of the composition, characteristics, and diversification of its funding sources.
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The Basel Committee on Banking Supervision principles could be used, as the Best practice (Basel principle in the further). The following are the most important principles related to A/L Risk management:
Amendment to the Capital Accord to incorporate market risk (2005) Principles for the Management and Supervision of Interest Rate Risk (2004) Management of Liquidity Risk in Financial Groups (2006) Sound Practices for Managing Liquidity in Banking Organizations (2000) Liquidity Risk: Management and Supervisory Challenges (2008) BASEL II
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ASSETS AND LIABILITY MANAGEMENT PROCEDURE FOR EXAMINATION OF ASSET LIABILITY MANAGEMENT
In order to determine the efficacy of Asset Liability Management one has to follow a comprehensive procedure of reviewing different aspects of internal control, funds management and financial ratio analysis. Below a step-by-step approach of ALM examination in case of a bank has been outlined.
Step 1
The bank/ financial statements and internal management reports should be reviewed to assess the asset/liability mix with particular emphasis on:
Total liquidity position (Ratio of highly liquid assets to total assets). Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits).
Ratio of Non Performing Assets to Total Assets. Ratio of loans to deposits. Ratio of short-term demand deposits to total deposits. Ratio of long-term loans to short term demand deposits. Ratio of contingent liabilities for loans to total loans. Ratio of pledged securities to total securities.
Step 2
It is to be determined that whether bank management adequately assesses and plans its liquidity needs and whether the bank has short-term sources of funds. This should include:
Review of internal management reports on liquidity needs and sources of satisfying these needs.
Assessing the bank's ability to meet liquidity needs.
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ASSETS AND LIABILITY MANAGEMENT Step 3

The banks future development and expansion plans, with focus on funding and liquidity management aspects has to be looked into. This entails:
Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis.
Reviewing the bank's budget projections for a certain period of time in the future. Determining whether the bank really needs to expand its activities. What are the sources of funding for such expansion and whether there are projections of changes in the bank's asset and liability structure?
Assessing the bank's development plans and determining whether the bank will be able to attract planned funds and achieve the projected asset growth.
Determining whether the bank has included sensitivity to interest rate Risk in the development of its long term funding strategy.
Step 4
Examining the bank's internal audit report in regards to quality and effectiveness in terms of liquidity management.
Step 5
Reviewing the bank's plan of satisfying unanticipated liquidity needs by:
Determining whether the bank's management assessed the potential expenses that the bank will have as a result of unanticipated financial or operational problems.
Determining the alternative sources of funding liquidity and/or assets subject to necessity.
Determining the impact of the bank's liquidity management on net earnings position.
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ASSETS AND LIABILITY MANAGEMENT Step 6

Preparing an Asset/Liability Management Internal Control Questionnaire which should include the following: 1. Whether the board of directors has been consistent with its duties and responsibilities and included: o o o o
A line of authority for liquidity management decisions. A mechanism to coordinate asset and liability management decisions. A method to identify liquidity needs and the means to meet those needs. Guidelines for the level of liquid assets and other sources of funds in relationship to needs.
2. Does the planning and budgeting function consider liquidity requirements? 3. Are the internal management reports for liquidity management adequate in terms of effective decision making and monitoring of decisions. 4. Are internal management reports concerning liquidity needs prepared regularly and reviewed as appropriate by senior management and the board of directors. 5. Whether the bank's policy of asset and liability management prohibits or defines certain restrictions for attracting borrowed means from bank related persons (organizations) in order to satisfy liquidity needs. 6. Does the bank's policy of asset and liability management provide for an adequate control over the position of contingent liabilities of the bank? 7. Is the foregoing information considered an adequate basis for evaluating internal control in that there are no significant deficiencies in areas not covered in this questionnaire that impair any controls?
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ASSETS AND LIABILITY MANAGEMENT LIQUIDITY AND ASSET LIABILITY MANAGEMENT

Asset-liability management (ALM) is the process of planning, organizing, and controlling asset and liability volumes, maturities, rates, and yields in order to minimize interest rate risk and maintain an acceptable profitability level. Simply stated, ALM is another form of planning. It allows managers to be proactive and anticipate change, rather than reactive to unanticipated change. An MFIs liquidity is directly affected by ALM decisions. Managers must always analyze the impact that any ALM decision will have on the liquidity position of the institution. Liquidity is affected by ALM decisions in several ways:
Any changes in the maturity structure of the assets and liabilities can change the cash requirements and flows. Savings or credit promotions to better serve clients or change the ALM mix could have a detrimental effect on liquidity, if not monitored closely. Changes in interest rates could impact liquidity. If savings rates are lowered, clients might withdraw their funds and cause a liquidity shortfall. Higher interest rates on loans could make it difficult for some clients to meet interest payments, causing a liquidity shortage.
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ASSETS AND LIABILITY MANAGEMENT BASIS OF ASSET LIABILITY MANAGEMENT IN BANKS

Banks are always aiming at maximizing profitability at the same time trying to ensure sufficient liquidity to repose confidence in the minds of the depositors on their ability in servicing the deposits by making timely payment of interest/returning them on due dates and meeting all other liability commitments as agreed upon. To achieve these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the various risks involved in these areas. This concept has gained importance in Indian conditions in the wake of the ongoing 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 seventies and eighties. Asset Liability Management (ALM) is a strategic approach of managing the balance sheet dynamics in such a way that the net earnings are maximized. This approach is concerned with management of net interest margin to ensure that its level and riskiness are compatible with the risk return objectives. Assets and Liabilities Management (ALM) is a dynamic process of planning, organizing, coordinating and controlling the assets and liabilities their mixes, volumes, maturities, yields and costs in order to achieve a specified Net Interest Income (NII). The NII is the difference between interest income and interest expenses and the basic source of banks profitability. The easing of controls on interest rates has led to higher interest rate volatility in India. Hence, there is a need to measure and monitor the interest rate exposure of Indian banks. 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
T.Y.B.com (Banking & Insurance) - Sem. V Page 27

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. 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, were 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 shortterm 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 AssetLiability 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. The capital of most financial institutions is small relative to the firm's assets or liabilities, and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. The diagram illustrates the evolution over time of a hypothetical company's assets and liabilities. Over the period shown, the assets and liabilities change only slightly, but those slight changes dramatically reduce the company's capital (which, for the purpose of this example, is defined as the difference between assets and liabilities). The capital falls by over 50%, a development that would threaten almost any institution.
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Example: Asset Liability Risk.
Asset-liability risk is leveraged by the fact that the values of assets and liabilities each tend to be greater than the value of capital. In this example, modest fluctuations in values of assets and liabilities result in a 50% reduction in capital.
Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset liability management (ALM) departments to assess asset-liability risk. They established ALM committees comprised of senior managers to address the risk. Techniques for assessing asset-liability risk came to include gap analysis and duration analysis. These facilitated techniques of gap management and duration matching of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. Options, such as those embedded in mortgages or callable debt, 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 also performed scenario analysis. With scenario analysis, several interest rate scenarios would be specified for the next 5 or 10 years. These might specify declining rates, rising rate's, a gradual decrease in rates followed by a sudden rise, etc. Scenarios might specify the behavior of the entire yield curve, so there could be scenarios with flattening yield curves, inverted yield curves, etc. Ten or twenty scenarios might be specified in all. Next, assumptions would be made about the

performance of assets and liabilities under each scenario. Assumptions might include prepayment rates on mortgages or surrender rates on insurance products. Assumptions might also be made about the firm's performancethe rates at which new business would be acquired for various products. 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 might adjust assets or liabilities to address the indicated exposure. A shortcoming of scenario analysis is the fact that it is highly dependent on the choice of scenarios. In a sense, ALM was a substitute for market-value accounting in a context of accrual accounting. It was a necessary substitute because many of the assets and liabilities of financial institutions could notand still cannotbe marked to market. This spirit of market-value accounting was not a complete solution. A firm can earn significant mark-to-market profits but go bankrupt due to inadequate cash flow. Some techniques of ALMsuch as duration analysisdo not address liquidity issues at all. Others are compatible with cash-flow analysis. With minimal modification, a gap analysis can be used for cash flow analysis. Scenario analysis can easily be used to assess liquidity risk
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ASSETS AND LIABILITY MANAGEMENT MONITORING ASSET LIABILITY MANAGEMENT POSITION

In order to successfully monitor the ALM position of a savings institution: Managers must have effective liquidity management plans in place. Managers must be able to identify the core or stable deposit base in the institution and match that against longer-term assets to reduce the interest rate risk. Stable deposits include: equity, certificates of deposit with penalties for early withdrawal, retirement savings, savings with a stated purpose, and regular savings accounts with small balances. Within each savings account type managers must determine the amount or percentage of funds that can be used to fund longer-term loans. Managers must be able to identify the minimum net margin (gross income cost of funds) necessary to fund financial costs, operating expenses, and contributions to capital. All of this can be accomplished if the institution has
1. An effective management information systemmanual or computerizedthat provides the necessary data; 2. formal, written liquidity and ALM policies, 3. tools in place to monitor liquidity, the gap position of the institution, the core deposits, and the net margin; and 4. a commitment by both officials and managers to change both deposit and loan interest rates as demanded by the local market.
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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY MANAGEMENT POLICY

As in all operational areas, ALM must be guided by a formal policy that was developed and written by the officials with the assistance of operational management. The policy should be reviewed by officials annually and revised as needed. The ALM and liquidity policies may be two separate policies or one comprehensive policy. In any case, the ALM and liquidity policies cannot be written in isolation, as decisions on lending, investments, liabilities, and equity are all interrelated. The ALM policy should discuss:
Who is responsible for monitoring the ALM position of the institution? What tools will be used to monitor ALM? How often the ALM position will be analyzed and discussed with officials and management. What are the acceptable parameters or ranges for ALM ratios or indicators?
In addition, management must have established the following to strengthen ALM: Short and long-term minimum capital or equity/total assets goal ratios. The maximum percentage of assets to be held by any one client, in different types of loans and investments, in fixed rate investments and loans with a maturity greater than one year, and invested in fixed assets. The desired diversification of savings and deposits to eliminate potential concentration risk (having too much in any one type of deposit or with any one client). Maximum maturities for all types of loans, investments, and deposits. Establishment of fixed or variable interest rate loans and deposits. Pricing strategies for loans and savings products that are based on what it actually costs to offer the products and what the local market will bear. Liquidity management, ensuring that the institution maintains sufficient cash plus liquid assets to meet withdrawal and disbursement demands and pay expenses, is essential in savings mobilization. ALM, the process of planning, organizing, and controlling asset and liability volumes, maturities, rates, and yields in order to minimize interest rate risk and maintain an acceptable profitability level, is another key component of savings mobilization. The two are very closely tied. A savings institution must have

effective liquidity and asset-liability management in order to ensure that low-cost funds will always be available for savers when they demand repayment of their funds deposited.
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ASSETS AND LIABILITY MANAGEMENT RATE SENSITIVE ASSETS & RATE SENSITIVE LIABILITIES
Those asset and liability whose interest costs vary with interest rate changes over some time horizon are referred to as Rate Sensitive Assets (RSA) or Rate Sensitive Liabilities (RSL). Those assets or liabilities whose interest costs do not vary with interest rate changes over some time horizon are referred to as Non Rate Sensitive Assets (NRSA) or Non Rate Sensitive Liabilities (RSL). It is very important to note that the critical factor in the classification of time horizon chosen. An asset or liability that is time sensitive in a certain time horizon may not be sensitive in shorter time horizon and vice versa. However, over a significantly long time horizon, virtually all assets and liabilities are interest rate sensitive. As the time horizon is shortened, the rate of rate sensitive to non rate sensitive assets and liabilities falls. The table below shows the classification of the assets and liabilities of the bank according to their interest rate sensitivity.
Liabilities Demand Deposits Current Accounts Money Market Deposits Short Term Deposits Short Term Savings Repo Transactions Equity
Type NRSL NRSL RSL RSL NRSL RSL NRSL
Assets Cash Short Term Securities Long Term Securities Variable Rate Loans Short Term Loans Long Term Loans Other Assets
Type NRSA RSA NRSA RSA RSA NRSA NRSA
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RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT

Risk can be defined as the chance or the probability of loss or damage. In the case of banks these include credit risk, capital risk, market risk, interest rate risk, liquidity risk, operations risk and foreign exchange risks. These categories of financial risk require focus, since financial institutions like banks do have complexities and rapid changes in their operating environments.
MARKET RISK CAPITAL RISK INTEREST RATE RISK
CREDIT RISK
TYPES OF RISK
LIQUIDITY RISK
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1.
Credit Risk: The risk of counter party failure in meeting the payment obligation on
the specific date is known as credit risk. Credit risk management is an important challenge for financial institutions and failure on this front may lead to failure of banks. Credit risk plays a vital role in the way banks perform. It reflects the profitability, liquidity and reduced Non Performing Assets.
The other important issue is contract enforcement. Legal reforms are very critical in order to have timely contract enforcement. Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. The legal system and its processes are notorious for delays showing scant regard for time and money that is the basis of sound functioning of the market system. Credit Risk Management is the process that puts in place systems and procedures enabling banks to:
Identify and measure the risk involved in credit proposition, both at individual transaction and portfolio level. Evaluate the impact of exposure on banks financial statements. Access the capability of the risk mitigates to hedge/insure risks. Design an appropriate risk management strategy to arrest risk mitigation.
2.
Capital Risk: One of the sound aspects of the banking practice is the maintenance of
adequate capital on a continuous basis. Capital risk is the risk an investor faces that he or she may lose all or part of the principal amount invested. It is the risk a company faces that it may lose value on its capital. The capital of a company can include equipment, factories and liquid securities. Capital adequacy focuses on the weighted average risk of lending and to that extent, banks are in a position to realign their portfolios between more risky and less risky assets.
3.
Market Risk:
Market risk refers to the risk to an institution resulting from
movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and commodity prices. Market risk is also referred to as systematic risk. This risk cannot be diversified. Market risk is related to the financial condition, which results from adverse movement in market prices. This will be more pronounced when financial information has to be provided on a marked-to-market basis since

significant fluctuations in asset holdings could adversely affect the balance sheet of banks. The problem is accentuated because many financial institutions acquire bonds and hold it till maturity. When there is a significant increase in the term structure of interest rates, or violent fluctuations in the rate structure, one finds substantial erosion of the value of the securities held. Market risk is often propagated by other forms of financial risk such as credit and market-liquidity risks. For example, a downgrading of the credit standing of an issuer could lead to a drop in the market value of securities issued by that issuer. Likewise, a major sale of a relatively illiquid security by another holder of the same security could depress the price of the security.
4.
Interest Rate Risk: It is the exposure of a banks financial condition to adverse

movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose a significant threat to a banks earning and capital base. Interest rate risk management policy: undertaking a risk exposure, by which the Bank does not incur a loss that would put at risk its profitability, equity or its safe functioning, or gives an opportunity of realizing profit by taking advantage of the movements of interest rates. The bank measures separately the exposure that comes from different sources of interest rate risk. The bank manages the risk by setting up limits based on the maximal acceptable loss, with stress testing, scenario analysis. The bank overall limit for the interest rate risk exposure is based on capital requirement measured by repricing gap with BIS weight. Limit is 25% of the core capital. Banks in the past were primarily concerned about adhering to statutory liquidity ratio norms and to that extent they were acquiring government securities and holding it till maturity. But in the changed situation, namely moving away from administered interest rate structure to market determined rates, it becomes important for banks to equip themselves with some of these techniques, in order to immunize banks against interest rate risk. Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. In measuring its interest rate risk, an institution should incorporate repricing risk (arising from changing rate relationships across the spectrum of maturities), basis risk (arising from changing rate relationships among yield curves that affect the
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institutions activities) and optionality risks (arising from interest rate related options embedded in the institutions products). There are certain measures available to measure interest rate risk. These include:
Maturity: Since it takes into account only the timing of the final principal payment,
maturity is considered as an approximate measure of risk and in a sense does not quantify risk. Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds.
Duration: Is the weighted average time of all cash flows, with weights being the
present values of cash flows. Duration can again be used to determine the sensitivity of prices to changes in interest rates. It represents the percentage change in value in response to changes in interest rates.
Dollar duration: Represents the actual dollar change in the market value of a
holding of the bond in response to a percentage change in rates.
Convexity: Because of a change in market rates and because of passage of time,

duration may not remain constant. With each successive basis point movement downward, bond prices increase at an increasing rate. Similarly if rates increase, the rate of decline of bond prices declines. This property is called convexity.
5.
Liquidity Risk: Liquidity Risk is the risk stemming from the lack of marketability
of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. It is usually reflected in a wide bid-ask spread or large price movements. It arises from the potential inability of the Bank to generate adequate cash to cope with a decline in deposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturity patterns of assets and liabilities.
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There are two types of liquidity i.e. market liquidity and funding liquidity. Liquidity risk broadly comprises three sub-types:
Funding Risk: The need to replace net outflows of funds whether due to withdrawal
of retail deposits or non-renewal of wholesale funds.
Time Risk: The need to compensate for non-receipt of expected inflows of funds,
e.g. when a borrower fails to meet his repayment commitments.
Call Risk: The need to find fresh funds when contingent liabilities become due. Call
risk also includes the need to be able to undertake new transactions when desirable.
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ASSETS AND LIABILITY MANAGEMENT ADDRESSING THE MISMATCHES

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 turnout to be risky for the bank. The mismatches for cash flows for 1-14 days and 15-28 days buckets are to be kept to the minimum (not to exceed 20% each of cash outflows for those buckets). A key issue that banks need to focus on is the maturity of its assets and liabilities in different tenors. A typical strategy of a bank to generate revenue is to run mismatch, i.e. borrow short term and lend longer term. However, mismatch is accompanied by liquidity risk and excessive longer tenor lending against shorter-term borrowing would put a banks balance sheet in a very critical and risky position.
To address this risk and to make sure a bank does not expose itself in excessive mismatch, a bucket-wise (e.g. next day, 2-7 days, 7 days-1 month, 1-3 months, 3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4 years, 4-5 years, over 5 year) maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket.
However, as most deposits and loans of a bank matures next day (call, savings, current, overdraft etc.), bucket-wise assets and liabilities based on actual maturity reflects huge mismatch; although all of the shorter tenor assets and liabilities will not come in or go out of the banks balance sheet.
As a result, banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current, overdraft etc. are divided into core and non-core balances, where core is defined as the portion that is expected to be stable and will stay with the bank; and noncore to be less stable. The distribution of core and non-core is determined through historical trend, customer behavior, statistical forecasts and managerial judgment; the core balance can be put into over 1 year bucket whereas non-core can be in 2-7 days or 3 months bucket. An example of Forecasted balance can be as follows:
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Assets Reserve Assets Interbank Placing Assets Other Assets Total Assets
Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+ 1,000 200 300 500 750 250 250 250 4,000 300 250 1,400 300 250 1,000 500 500 200 300 6,250 950 550 1,650 550 250 1,800 500
Liabilities Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+ Interbank Deposits -1,000 -750 -250 Other Deposits -4,500 -1,200 -1,000 -1,200 -100 -200 -800 Capital & Reserves -500 -100 -400 Other Liabilities -250 -250 Total Liabilities -6,250 -2,200 -1,000 -1,450 -100 -300 -1,200 0
Off Balance Sheet Total Call 2D-7D 8D-1M 1M-3M 3M-1Y 1Y-5Y 5Y+ Commitments -2,000 -150 -1,850 Forward Contracts 250 100 50 100 Total Off Balance Sheet -1,750 0 100 50 -50 -1,850 0 0
Net Mismatch -1,750 -1,250 -350 250 400 -1,900 600 500
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ASSETS AND LIABILITY MANAGEMENT INFORMATION TECHNOLOGY AND ASSET LIABILITY MANAGEMENT
Many of the new private sector banks and some of the non-banking financial companies have gone in for complete computerization of their branch network and have also integrated their treasury, Forex, and lending segments. The information technology initiatives of these institutions provide significant advantage to them in asset-liability management since it facilitates faster flow of information, which is accurate and reliable. It also helps in terms of quicker decision-making from the central office since branches are networked and accounts are considered as belonging to the bank rather than a branch. The electronic fund transfer system as well as Demat holding of securities also significantly alters mechanisms of implementing asset-liability management because trading, transaction, and holding costs get reduced. Simulation models are relatively easier to consider in the context of networking and also computing powers. The open architecture, which is evolving in the financial system, facilitates cross-bank initiatives in asset-liability management to reduce aggregate unit cost. This would prove as a reliable risk reduction mechanism. In other words, the boundaries of asset-liability management architecture itself is changing because of substantial changes brought about by information technology, and to that extent the operations managers are provided with multiple possibilities which were not earlier available in the context of large numbers of branch networks and associated problems of information collection, storage, and retrieval. In the Indian context, asset-liability management refers to the management of deposits, credit, investments, borrowing, Forex reserves and capital, keeping in mind the capital adequacy norms laid down by the regulatory authorities. Information technology can facilitate decisions on the following issues: Estimating the main sources of funds like core deposits, certificates of deposits, and call borrowings. Reducing the gap between rate sensitive assets and rate sensitive liabilities, given a certain level of risk Reducing the maturity mismatch so as to avoid liquidity problems. Managing funds with respect to crucial factors like size and duration.
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ASSETS AND LIABILITY MANAGEMENT REGULATORY FRAMEWORK (GUIDELINES ON ASSET LIABILITY MANAGEMENT)
The central bank of a country has to ensure that in its drive for profitability and market share the banking sector does not expose itself and by extension the market to high levels of risk. Credit risk traditionally has been and still is the biggest risk faced by this sector and has been addressed through various central bank relations and guidelines. The RBI has already come out with guidelines governing market risk including the need for banks to constitute an ALCO. However, given the state of data availability most bank ALCOs are not able to hold meaningful discussions on balance sheet risks. Discussions in most ALCOs that do meet regularly are oriented towards treasury activity rather than taking a view of the entire balance sheet. This is again mainly due to lack of data on the other businesses of the bank. However, given the increasing volatility in interest and exchange rates it is becoming critical for banks to manage their market risks. It is therefore likely that the RBI would introduce more detailed guidelines for ALM. A look at the regulatory guidelines in the more developed markets on ALM could provide clues to the main features of any guidelines that may be introduced by the RBI. 1. As a measure of liquidity management, banks are required to monitor their cumulative mismatches across all time buckets in their Statement of Structural Liquidity by establishing internal prudential limits with the approval of the Board / Management Committee. As per the guidelines, the mismatches (negative gap) during the time buckets of 1-14 days and 15-28 days in the normal course are not to exceed 20 per cent of the cash outflows in the respective time buckets. 2. Having regard to the international practices, the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management, these guidelines have been reviewed and it has been decided that : (a) The banks may adopt a more granular approach to measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the Statement of Structural Liquidity into three time buckets viz. Next day, 2-7 days and 8-14 days. (b) The Statement of Structural Liquidity may be compiled on best available data coverage, in due consideration of non-availability of a fully networked environment. Banks may,

however, make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner. (c) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed 5 %, 10%, 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognize the cumulative impact on liquidity. (d) Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. The Statement of Structural Liquidity, may, however, be reported to RBI, once a month, as on the third Wednesday of every month.
3. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. The guidance for slotting the future cash flows of banks in the revised time buckets has also been suitably modified and is furnished at Annex II. The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines.
4. To enable the banks to fine tune their existing MIS as per the modified guidelines, the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1, 2008 and the reporting frequency would continue to be monthly for the present. However, the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly, with effect from the fortnight beginning April 1, 2008.
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ASSETS AND LIABILITY MANAGEMENT ISSUES IN IMPLEMENTATION OF ALM

1.
Policy:
Lack of a coherent, documented and practical policy is a big hindrance to ALM
implementation. Most often, ALCO membership itself may not be aware of implications of risks being measured and impact. Policies should address all issues concerning the bank, all policies should be clearly explained to all members of board, apart from ALCO and these must be documented. Proper revisions to this document, a quarterly review needs to be organized as well as parameters may be changing due to change in situations.
2.
Understanding of complexities: Many people in a bank need to understand risk

measurements and risk mitigation procedures. Measurement of risk is a fairly simple phenomenon and does go on regardless. Formalization of understanding, especially at a top level, will be helpful as it would help in decision making.
3.
Organization and culture:
ALM function needs to be separated clearly from
operations as it involves control and strategy functions. Risk organization in banks generally land up reporting to treasury, as they are people who come closest to understanding complex financial instruments. The fact that they are a business unit, in charge of risk taking is overlooked. Risk Taking and Risk management are generally two distinct parts of any organization and both must report to a board completely independently. Openness and transparency are essential to a proper risk organization. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. Thus, it is required to follow policy implicitly in both letter and spirit.
4.
Data and Models: Data may not be available at all times in requisite format. It must be
remembered that many data items are assumptions and gaps must be measured in perspective. There was a case of a manual branch of a bank that was closed for 6 months in a year due to inclement weather and was largely inaccessible. As data may not be obtained from this branch for 6 months, appropriate assumptions have to be made in any event. The argument is that for all other purposes, assumptions are being made. Sensible options need to be chosen and manual branch without computer was an example. However, in modern banking, it is mapping of models to zero coupon bonds that are an issue. Once again, arguments are that

this should exist within the bank. Based on sophistication required, multiple models may be used to validate this conversion. This is strictly outside ALM framework but integrates into ALM framework.
5.
Unrealistic goals:
An ALCO secretary was seen desperately trying to tweak with
parameters to show less gaps in liquidity reports. A zero gap is not practical. Returns are expected for taking risks. Banks assume market and credit risk and hence they make returns. ALCOs job is to correctly determine positions and put in place appropriate remedial measures using appropriate risks. It is not to show things as good when they are not.
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ASSETS AND LIABILITY MANAGEMENT TECHNIQUES OF ASEET LIABILITY MANAGEMENT

As interest rated in both the liability and the asset side were deregulated, interest rates in various market segments such as call money, CDs and the retail deposit rates turned out to be variable over a period of time due to competition and the need to keep the bank interest rates in alignment with market rates. Consequentl y the need to adopt comprehensive Asset - liabilit y strategy emerged, the key objectives of which were as under. The volume, mix and cost/return of both liabilities and assets need to be planned and monitored in order to achieve the banks short and long term goals. Management control would comprehensively embrace all the business segments like deposits borrowing, credit, investments, and foreign exchange. It should be coordinated and internall y consistent so that the spread between the banks earnings from assets and the costs of issuing liabilities can be maximized. Suitable pricing mechanism covering all products l ike credit,
payments, custodial financial advisory services should be put in place to cover all costs and risks
1. GAP ANALYSIS MODEL:

Under the Gap analysis method, the various assets and liabilities are grouped under various time buckets based on the residual maturity of each item or the next repricing date, if on floating rate, whichever is earlier. Then the gap between the assets and liabilities under each time bucket is worked out. Since the objective is to maximize the NII, it will be sufficient if this is done only with respect to rate sensitive assets and liabilities. If the rate sensitive assets equal the rate sensitive liabilities, it is known as the Zero Gap or matched book position. If the rate sensitive assets are more than the rate sensitive liabilities, it is referred to as positive gap position and if the rate sensitive assets are less than the rate sensitive liabilities, it is known as negative gap position. The decision to hold a positive gap or a negative will depend on the expectation on the movement of interest rates. The effect of an upward movement or a downward movement in the interest rate on the NII will also depend on the position taken. These effects are given in the table below:
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GAP Position Positive Positive Negative Negative Zero Zero Changes in Interest Rates Increase Decrease Increase Decrease Increase Decrease Changes in Interest Income Increase Decrease Increase Decrease Increase Decrease Changes in Interest Expense Increase Decrease Increase Decrease Increase Decrease Change in NII Increase Decrease Decrease Increase None None
Positive Gap indicates a bank has more sensitive assets than liabilities and the NII will generally rise (fall) when interest rate rises (fall). Negative Gap indicates a bank has more sensitive liabilities than assets and the NII will generally fall (rise) when interest rates rise (fall). It measures the direction and extent of asset-liability mismatch through either funding or maturity gap. It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. This model looks at the repricing gap that exists between the interest revenue earned and the bank's assets and the interest paid on its liabilities over a particular period of time. It is sometimes referred to as periodic gap because banks use gap analysis report to measure the interest rate sensitivity of RSA and RSL for different periods. These periods are known as maturity buckets which vary across banks, depending on the operating strategy.
2. DURATION ANALYSIS:
The Gap method ignores time value of money. Under the duration method, the effect of a change in the interest rate on NII is studied by working out the duration gap and not the gap based on residual maturity. a. Timing and the magnitude of the cash flows is ascertained and calculated. b. By using appropriate discounting factor, the present value of each of the cash flows needs to be worked out. c. The time weighted value of the present value of the cash flows is calculates.
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d. The sum of the time weighted value of the cash flows divided by the sum of the present values will give the duration of a particular asset. Duration analysis is useful in assessing the impact of the interest rate changes on the market value of equity i.e. asset-liability structure.
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Case Study
Case DetailsOrganization- United Western Bank Country- India Industry- Bank
Abstract:
The case describes the growth and collapse of United Western Bank Limited (UWBL), a private sector commercial bank in India. Since the late 1990s, UWBL was facing several problems including asset-liability mismanagement, inefficient management of bank's assets, irregular transactions with some of its major shareholders like Makharia Group, conflicts between the bank's major shareholders regarding the ownership of the bank and poor governance. These problems collectively resulted in the collapse of UWBL. In order to protect the interests of the creditors of UWBL, the Government of India (GoI) announced the merger of the bank with IDBI Bank. The case further details the terms of the merger and ends with a brief analysis of the future prospects of the merged entity.
Issues:
Analyze the reasons that led to the fall of United Western Bank Discuss the importance of proper asset-liability management in a bank Examine the role of RBI as a banking industry regulating authority and debating on the justifiability of its actions in the UWBL fiasco Appreciate the importance of efficient and transparent management
ASSETS AND LIABILITY MANAGEMENT The Moratorium

On September 02, 2006, the Government of India (GOI) imposed a moratorium on the Satara based United Western Bank Limited (UWBL), one of the largest private sector commercial banks in India. The moratorium order was passed in response to an application by the Reserve Bank of India (RBI) citing the poor financials of UWBL due to its inefficient management. The moratorium was for three months from 14.00 hours on September 02, 2006 till December 01, 2006 or an earlier date, in case of any alternative arrangement. During the period of the moratorium, the bank was permitted to make some specific payments as mentioned in the order and depositors were allowed to withdraw only up to Rs.10,000 in total from their savings/current account or any other deposit account through any of the branches of the bank. The withdrawal of money through the ATMs of the bank was prohibited. However, RBI relaxed the withdrawal limit in a few specific cases. Commenting on this, Anand Sinha (Sinha), Executive Director, RBI, said, "Withdrawals in excess of Rs. 10,000 will be allowed by the RBI in connection with medical expenses, higher education, to pay obligatory expenses in connection with marriages and other unavoidable emergencies." According to RBI, the moratorium was imposed in order to protect the interests of the depositors of UWBL. The bank, set up in the late 1930s, had been operating for nearly 69 years. Over the years, it became one of the major private sector commercial banks in western India. The core business of the bank comprised of lending to the agriculture sector, small and medium enterprises (SME), the sugar industry and various government sponsored programs. It had 130 branches in the rural and semi-urban areas of Western India. On September 13, 2006, the RBI announced the merger of the Industrial Development Bank of India (IDBI) and UWBL. The merger came into effect from October 03, 2006. IDBI offered a price of Rs. 28 per share to UWBL's shareholders.
IDBI benefited from UWBL's vast branch network as the merged entity had 425 branches as against 195 of IDBI alone. The asset base of IDBI increased by Rs. 71.6 billion. Commenting on the merger, Kirit Somaiya (Somaiya), the President of Investors Grievances Forum said, "For the first time, the interests of both depositors and shareholders have been fully protected."
ASSETS AND LIABILITY MANAGEMENT Background Note

UWBL was founded by Waman Ganesh Chirmule (Chirmule) in 1936. It started its operations on March 08, 1937 (Refer Exhibit I for the logo of UWBL). In the year 1951, UWBL was declared as a Scheduled Bank, under 'Other Indian Scheduled Commercial Banks (in the private sector)' group. In 1956, the Union Bank of Kolhapur was merged with UWBL followed by the merger of Satara Swadeshi Commercial Bank Limited too in 1961. In 1969, UWBL obtained the status of a 'B' class bank and was upgraded to 'A' class in 1974.Over the decades, UWBL became one of the most preferred private sector commercial banks in western India. It had a vision of being 'A technology savvy, customer centric progressive bank with a national presence, driven by the highest standards of corporate governance and guided by sound ethical values.' UWBL offered diversified products like automobile finance, housing finance, corporate finance, export finance, finance for education, finance to SMEs, etc...
The Problems
There were several problems that led to the fall of UWBL that once had reached the 'A' class bank category. Irregular transactions with some of its major shareholders, conflicts between its major shareholders regarding the ownership of the bank, poor governance and inefficient management of capital were the main reasons for its collapse.
Transactions with the Makharia Group

On May 30, 1998, UWBL was penalized for Rs. 1 million by the RBI for irregular transactions with the Makharia Group of companies (MGC) . The Makharia family was given loans for purchasing UWBL's shares (in its 1995 rights issue) through its flagship company - Emtex Industries (India) Limited (Emtex) . UWBL provided an overdraft facility of Rs 68.8 million to Emtex. Also, a letter of credit (LC) was sanctioned to MGC. According to RBI, the credit facility was granted to Emtex "for the sole purpose of enabling the Makharia group of companies to subscribe to the rights issue of the bank." Besides this, RBI felt that the LC facility was provided with the intention of preventing MGC's loan account
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with UWBL from becoming non-performing assets (NPAs) . UWBL paid the penalty on June 16, 1998.
The Fall
Industry experts felt that a long battle over the ownership of the bank had led to poor governance and control systems at UWBL. The exact shareholding of Makharias in the bank was not clear. According to the Mumbai Stock Exchange (MSE) records, the Makharias owned around 3% of the shares whereas the actual figure was much higher.
The Steps Taken

About 17 commercial banks including ICICI Bank, Canara Bank, Federal Bank, Andhra Bank, Standard Chartered Bank, Allahabad Bank and others expressed their interest in acquiring UWBL. Finally, on September 13, 2006, RBI announced that Union Western Bank Ltd would merge with IDBI.
IDBI announced that the financial performance of UWBL would be merged with the financial performance of IDBI in the third quarter of the financial year 2006-07.
The Road Ahead

Analysts felt that the amalgamation of UWBL with IDBI would support IDBI's growth. IDBI wanted to expand its branch network. By acquiring UWBL, IDBI got access to its 230 branches that covered all the commercially important places in Maharashtra. With the RBI having restricted branch licenses in over-banked urban centers, this access would help IDBI's expansion. Analysts opined that the merger would sustain the momentum of IDBI's growth in terms of deposits by widening its retail presence.
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CONCLUSION
ALM has evolved since the early 1980's. Today, financial firms are increasingly using market value accounting for certain business lines. This is true of universal banks that have trading operations. Techniques of ALM have also evolved. The growth of OTC derivatives markets has facilitated a variety of hedging strategies. A significant development has been securitization, which allows firms to directly address asset-liability risk by removing assets or liabilities from their balance sheets. This not only eliminates asset-liability risk; it also frees up the balance sheet for new business. Thus, the scope of ALM activities has widened. Today, ALM departments are addressing (non-trading) foreign exchange risks as well as other risks. Also, ALM has extended to non-financial firms. Corporations have adopted techniques of ALM to address interest-rate exposures, liquidity risk and foreign exchange risk. They are using related techniques to address commodities risks. For example, airlines' hedging of fuel prices or manufacturers' hedging of steel prices are often presented as ALM. Thus it can be safely said that Asset Liability Management will continue to grow in future and an efficient ALM technique will go a long way in managing volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities so as to earn a sufficient and acceptable return on the portfolio.
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BIBLIOGRAPHY
REFERENCE BOOKS:
Asset Liability Management in Banks ICFAI Bank Financial Management Indian Institute of Banking and Finance
WEBSITES: www.rbi.org www.allbankingsolutions.com www.iibf.org.in www.fimmda.org www.managementparadise.com www.coolavenues.com www.riskglossary.com www.icmrindia.org www.investopedia.com
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ASSETS AND LIABILITY MANAGEMENT

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT

MEANING OF ASSET LIABILITY MANAGEMENT:

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT PURPOSE OF ASSET LIABILITY MISMATCH

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ASSETS AND LIABILITY MANAGEMENT ELEMENTS OF ASSET LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT COMPONENTS OF FINANCIAL STATEMENT Balance Sheet

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ASSETS AND LIABILITY MANAGEMENT Assets

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ASSETS AND LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY MANAGEMENT IN INDIAN CONTEXT

The ALM process rests on three pillars: ALM information systems

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT Pillar 1: ALM Information System

Pillar II: ALM Organization

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT Pillar3: ALM Process

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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY COMMITTEE ALCO

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ASSETS AND LIABILITY MANAGEMENT

Economist Risk Consultants

Purposes and Tasks of ALCO:

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ASSETS AND LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT ASSET LIABILITY MANAGEMENT APPROACH

1. LIQUIDITY RISK MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT

Statement of Structural Liquidity

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT

An example of structural liquidity statement:

Addressing the Mismatches

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ASSETS AND LIABILITY MANAGEMENT

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT 3. LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT

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ASSETS AND LIABILITY MANAGEMENT

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Assessing the bank's ability to meet liquidity needs.

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ASSETS AND LIABILITY MANAGEMENT Step 3

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ASSETS AND LIABILITY MANAGEMENT Step 6

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ASSETS AND LIABILITY MANAGEMENT LIQUIDITY AND ASSET LIABILITY MANAGEMENT

T.Y.B.com (Banking & Insurance) - Sem. V

ASSETS AND LIABILITY MANAGEMENT BASIS OF ASSET LIABILITY MANAGEMENT IN BANKS

ASSETS AND LIABILITY MANAGEMENT

ASSETS AND LIABILITY MANAGEMENT