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6.Tools and Techniques

6.Tools and Techniques

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Published by Hariharan Mani

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Published by: Hariharan Mani on Jun 28, 2012
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Tools and Techniques
TOOLS OF ALM
 Techniques for assessing asset-liability risk includes
Gap Analysis
and
DurationAnalysis
. These facilitated techniques of managing gaps and matching duration of assets and liabilities. Both approaches worked well if assets and liabilitiescomprised fixed cash flows. But cases of callable debts, home loans andmortgages which included options of prepayment and floating rates, posedproblems that gap analysis could not address. Duration analysis could addressthese in theory, but implementing sufficiently sophisticated duration measureswas problematic. Accordingly, banks and insurance companies started using
Scenario Analysis
.Under this technique assumptions were made on various conditions, for example: -
Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradualdecrease in rates followed by a sudden rise, etc. Ten or twenty scenarioscould be specified in all.
Assumptions were made about the performance of assets and liabilitiesunder each scenario. They included prepayment rates on mortgages orsurrender rates on insurance products.
Assumptions were also made about the firm's performance-the rates atwhich new business would be acquired for various products, demand for theproduct etc.
Market conditions and economic factors like inflation rates and industrialcycles were also included.
QUANTITATIVE ANALYSIS:
Quantitative analysis can assists in determining the level of exposure. Examinersshould perform this analysis as a part of each exam. Ratios and trends are thefocus of quantitative analysis. The following ratios are used to assists theexaminers to examine the ALM position.
Net Loans/ Total Assets :
This ratio measures the percentage of totalassets that are invested in loan portfolio. Management should haveestablished a maximum goal ratio to avoid liquidity problem.
 
Tools and Techniques
Core deposit ratio:
This ratio is used to identify stable deposits that thecompany can rely on ,rather than seasonal swing, which can be used tofund long term assets. The more stable the fund, the easier it is to controlliquidity and ALM. Therefore a high percentage is desirable and indicates asolid company.
Liquid assets/Total assets:
This ratio measures the percentage of totalassets that are invested in liquid assets. Liquid assets often pay no interestor have a lower yield because there is very little risk. Only enough funds tomeet liquidity needs should be maintained in liquid assets.
Liquid assets- Short term Payables/Member Deposits:
The adequacyof the company’s liquid cash reserves to satisfy clients savings withdrawalafter paying all immediate obligations is measured by this ratio. The goal isto have just enough liquid funds to meet all member requests andoperating expenses, with any excess funds invested in interest bearingaccounts.
Loan Turnover ratio:
This ratio estimates how quickly the company willconvert the loan portfolio into cash. The lower the result the faster the loanportfolio matures. ALM should be easier because the loan portfoliorepayment is high, thus allowing management access to fund to provide forsufficient liquidity and funding of new loans and investment. The examinerscan also analyze the changes to the ratio over various timeframes, thiswould provide an indication of the effect of recent decisions on the averageterm of the loan portfolio.
External Credit/Total Assets:
This ratio measures the level of externalcredit. Examiners should ensure that the credit union is not dependent onexternal sources to fund normal daily operations and long term needs;external credit should be used only to fund short-term liquidity shortfalls.
Net Interest margin:
This calculation begins with gross income anddetermines the amount available to cover operating expenses andcontributions to capital after all interest and dividends on savings havebeen paid. Management should determine the minimum net interestmargin that must be maintain in order to meet all operating expenses andcapital contributions. Analyzing the net interest margin trend providesinsight to the effect of management’s past pricing decision.
 
Tools and Techniques
GAP ANALYSIS
: It is the tool that helps the company to compare its actualperformance with its potential performance. The goal of gap analysis is to identifythe gap between theoptimized allocationand integration of the inputs, and the current level of allocation. This helps provide the company with insight into areaswhich could be improved. The gap analysis process involves determining,documenting and approving the variance between business requirements andcurrent capabilities. Gap analysis naturally flows frombenchmarkingand otherassessments. Once the general expectation of performance in the industry isunderstood, it is possible to compare that expectation with the company's currentlevel of performance. This comparison becomes the gap analysis. It measures at agiven date the gaps between rate sensitive liabilities (RSL) and rate sensitiveassets (RSA) (including off-balance sheet positions) by grouping them into timebuckets according to residual maturity or next repricing period, whichever isearlier. An asset or liability is treated as rate sensitive if i) within the time bucketunder consideration, there is a cash flow; ii) the interest rate resets/repricescontractually during the time buckets; iii) administered rates are changed and iv)it is contractually pre-payable and withdrawal allowed before contractedmaturities. Thus,
GAP= RSA – RSLGAP RATIO= (RSA - RSL)/Total Assets
Gap analysis is performed on a spreadsheet. The assets and liabilities are assignedto time periods (0-1 years, 1-2 years, etc) based on their maturities. This isrelatively simple for components in which the amount matures on a specific date.But more complex if RSA & RSL does not have a stated maturity such as deathclaims.

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