Asset Liability Management An Indian Perspective

on 30 September 2008

Asset-Liability Management in Indian Context

WHAT IS ASSET-LIABILITY MANAGEMENT? Asset-Liability Management is nothing more than the management of risk to earnings from changes in financial markets that are caused by the mix of assets and liabilities of the bank. Asset-Liability Management refers to the process by which an institution manages its balance sheet in order to allow for alternative interest rate and liquidity scenarios. Due to the nature of services provided by banks and other financial institutions various kinds of risks like credit risk, interest rate risk and liquidity risk are exposed to them. Asset-Liability Management provides institution protection that makes such risks acceptable. It enables institutions to measure and monitor risks and provide suitable strategies for their management. It, therefore, becomes appropriate for institutions to focus on Asset-Liability Management while facing different types of financial risks. Asset-Liability Management includes a formalization of this understanding as well as quantifying and managing these risks. EARLIER PHASE: Asset-Liability Management was given birth amid interest rate changes that boggled bankers and upset a system that had been working happily for decades. It drifts in and out of consciousness depending on the whims of interest rates. In the 1940s and the 1950s, there was an abundance of funds in banks in the form of demand and saving deposits. As the cost of deposits was low, banks had to develop a mechanism by which they could utilize these funds efficiently. In the 1970s, bankers lived on the 3-6-3 rule, borrow at 3%, lend at 6%, and make a 3% spread. And in those days of low inflation and regulated deposit rates, it wasnt a bad little rule of thumb. Then the focus was mainly on Asset Management. When the cost of funds started to increase focus of the management was liability management. With an increase in volatility in interest rates and with a severe recession damaging several economies, banks started to concentrate more on the management of both side of balance sheet. CATEGORIES OF RISKS: Risk in a way 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 and the liquidity risk. Since financial institutions like banks have complexities and frequent changes in their operating environments, these kind of risks require more focus. (A) Credit Risk: The risk of counter party failure to meet the payment obligations on the specific date is known

as credit risk. Management of this risk is an important challenge for financial institution and failure on this front may lead to failure of banks. It is worthwhile to note that the willingness to pay, which is measured by the character of the party, and the ability to pay need not necessarily go together. In the countries like India, Contract enforcement is another important issue. Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. (B) Capital Risk: Maintenance of adequate capital on a continuous basis is one of the sound aspects of the banking practice. Capital adequacy also focuses on weighted average risk of lending and to that extent, banks are in a position to re-align their portfolios between more risky and less risky asset. (C) Market Risk: It is related to the financial condition, which results from adverse movement in market prices. The problem, in Indian context, 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 fluctuation in the rate structure, one finds substantial erosion of the value of the securities held. (D) Interest Rate Risk: Interest rate risk is the change in prices of bonds that could occur as a result of change in the rate of interest. It also consider change in impact on interest income due to change in interest rates. Banking industry in India has substantially more issues associated with interest rate risks, which is due to circumstances outside its control. This poses extra challenges to the banking sector. Over the time AssetLiability Managers have developed a number of different ways to quantify the risk being taken. These include: urity: Since it takes into account only the timing of the final principal payment, maturity is considered as approximate measure of risk and in a sense does not quantify risk. ation: is the weighted average time of all cash flows, with weights being the present values of cash flows. It can again be used to determine the sensivity of prices to change in interest rates. nvexity: Because of a change in market rates and passage of time, duration may not remain constant. With each successive basis point movement downward, bond prices increases at an increasing rate. Similarly, if rate increase, the rate of decline of bond prices declines. This property is called convexity. (E) Liquidity Risk: It is the potential inability to generate adequate cash to cope with a decline in deposits or increase in assets. To a large extent, it is an outcome of mismatch in the maturity patterns of assets and liabilities. RISK MEASUREMENT TECHNIQUES: There are various techniques for measuring exposure of banks to interest rate risk. i. Gap Analysis Model: One of the original methods for measuring interest rate risk was a straightforward exercise. One simply added up the assets that would reprice over a given period and subtracted the liabilities repricing in the same period. ii. Duration Model: Duration is an important measure of the interest rate sensivity of assets and liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and liabilities. It is the weighted average time to maturity of all the preset values of cash flows.

iii.

Income Sensivity: Asset-liability managers tried a more direct approach. By building a model of the balance sheet-the various product balances and the interest rates that would be changed in a given rate environment a picture could be developed of how earnings would act if rates changed.

iv.

Value Sensivity: This approach looked at the balance sheet as though it were a large bond portfolio. This approach is very straightforward. The cash flows implied by the current holdings can be laid out and discounted back to create a present value for each instrument held and for the sum total for all instrument.

v.

Simulation Model: This model helps to introduce a dynamic element in the analysis of interest rate risk. Simulation models utilize computer power to provide WHAT IF scenarios. It is very important to combine technical expertise with an understanding of issues in the organization. Accuracy of data and reliability of the assumption made are certain requirement for a simulation model to succeed.

EMERGING ISSUES IN THE INDIAN CONTEXT: With the onset of liberization, Indian banks are now more exposed to uncertainty and to global competition. This makes it imperative to have proper asset-liability management system in place. The following points bring out the reasons as to why asset-liability management is necessary in the Indian context. 1. In the context of a bank, asset-liability management refers to the process of managing the net interest margin within a given level of risk. Net Interest Margin=Net interest income/Average earning assets Net interest margin can be viewed as the spread on earning assets. Efficient management of net interest margin becomes essential as the basic objective of banks is to maximize income while reducing their exposure to risk. 2. Several banks have inadequate and inefficient management system that have to be altered so as to ensure that the banks are sufficiently liquid. 3. An increasing proportions of investments by banks is being recorded on a market-to-market basis and as such large portion of the investment portfolio s exposed to market risks. Countering the adverse impact of these changes is possible only through efficient asset-liability management techniques. 4. As the focus on the net interest margin has increased over the years, there is an increasing possibility that the risk arising out of exposure to interest rate volatility will be built into the capital adequacy norms specified by the regulatory authorities. This, in turn, will require efficient asset-liability management practices. INFORMATION TECHNOLOGY AND ASSET-LIABILITY MANAGEMENT IN THE INDIAN CONTEXT: The boundaries of asset-liability management architecture itself is changing because of substantial changes brought about by information technology. 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 initiative of these institutions provide significant advantage to them in asset-liability management since it facilitates faster flow of information, which is accurate and reliable. Further, it helps in terms of quicker decision making from the

central office since branches are networked and accounts are considered as belonging to bank rather than a branch. WHERE THE ASSET-LIABILITY MANAGEMENT IS GOING: Changes in the availability of computers and the vast increase in their calculation power have led to ongoing refinements in the way risk is measured and managed. The biggest open issues on the risk measurement side are about the modeling of behavior-either the clients or the banks. The following are three key topics where the results can significantly affect the risk measure ad where quantification is still difficult. ) Prepayment: Much work has been done to describe the prepayment of mortgages. There is a wide range of methodologies in use, all the strength and shortcoming and all demonstrating room for improvement. ) Average life of non-maturity deposits: Again, a lot of work has been done to try to describe the balance behavior of savings and checking accounts. While there are several distinct methodologies, no clear favorite emerges. There is no definitive answer as to the average life of a deposit. ) Pricing strategies: The rates that banks pay on retail products still move at the discretion of the banks and in response to the factors other than moves in market rates. On the risk management side, understanding and quantifying performance remains an open issue. Funds transfer pricing systems allow some quantification of return from the interest rate but are not designed to describe how good that performance was. The next step in performance measurement will be to attempt to quantify returns in terms of the amount of risk taken. The ideas are out there, in various approaches to riskadjusted performance measurement systems, but they are still implemented by a minority of institutions. All of these issues are about refinements to the basic approaches of asset-liability management. They do not represent radical departures from the basic frameworks of risk-measurement and risk-management. The process of asset-liability management will continue to refine itself, but the framework is not going to change without a big push from somewhere else. CONCLUSION: It is important to note that the conglomerate approach to financial institutions, which is increasingly becoming popular in the developed markets, could be replicated in Indian situations. This implies that the distinction between commercial banks and the term lending institutions could become blurred. It is also possible that the same institution involves itself in short term and long term lending borrowing activities like mutual funds, insurance and pension funds. In such a situation, the strategy for the asset-liability management becomes more challenging because one has to adopt a modular approach in terms of meeting asset-liability management requirements of different decision and product lines. But it also provide opportunities of diversification across activities that could facilitate risk management on an enhanced footing.