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Asset-Liability Management (ALM)

Asset-liability management (ALM) though a generic term, in this context it is used to refer to the
high level management of a banks assets and liabilities. ALM practice is concerned with the
management of interest rate risk and liquidity risk. There are two strands to interest rate risk:
first, the risk of changes in asset-liability value due to changes in interest rate as it impacts the
cash flows or net present value. The second strand is associated with optionality which arises
with products such as early redeemable loans. On the other hand, liquidity risk refers to first, the
funding liquidity of markets and the ease with which assets can be converted to cash. ALM is
conducted at an overview, aggregate or group level.
Broadly, the process of ALM rests on the following three important pillars:
i)
ALM information system: This comprises of availability of information accuracy and
its sufficiency.
ii)
ALM organization: Setting up of asset liability management committee (ALCO) and
organizational set up at different levels.
iii)
ALM process: Management of liquidity risk, interest rate risk, market risk, trading
risk, capital planning and profit planning.
The interest rate exposure arises because rates fluctuate from day to day and continuously over
time. The primary risk is that of interest rate reset for floating rate asset and liabilities. Whether
an asset carries a fixed or floating rate reset, will determine its exposure to interest rate
fluctuations. Where an asset is marked at a fixed rate, a rise in its rates will reduce its NPV as the
asset is now paying a below market rate of interest. Or it could be thought of as a loss due to
opportunity cost forgone, since the assets are earning below what they could earn if invested
elsewhere. The opposite applies if there is a fall in rate; this causes the NPV to rise. For assets
marked at a floating rate of interest, the risk exposure of fluctuating rates is lower, as the rate
receivable will reset at periodic intervals. This exposure must therefore aggregate the net risk of
all the banks operating business. The resulting net mismatch, known as the ALM gap, between
assets and liabilities will manifest itself in two ways:

The mismatch between the different terms of assets and liabilities across the term
structure; the liquidity gap
The mismatch between different interest rates that each asset and liability contract has
struck at; the interest rate gap.

The assets and liabilities are valued at their NPV. Hence, the overall sensitivity of the balance
sheet NPV to changes in interest rate can be measured.
The following figure shows the ALM profile of a securities and derivatives trading house. There
is a term mismatch as only a few assets are deemed to have overnight maturity whereas a

significant portion of funding is in the overnight term. Maturity of assets can be defined
following two alternative approaches:

The actual contractual maturity of the assets, and


The liquidity duration which is the estimated time it would take the firm to dispose of its
assets in an enforced or fire sale situation.

The method to adopt will depend on the nature of the business line and the type of assets in
question. There is also an element of judgment required.

Liquidity gap
The liquidity gap is created by the mismatch of maturity terms of assets and liabilities.
Alternatively, the amount of assets and liabilities maturing at any one time will also not match,
though overall assets must equal liabilities. As we know that liquidity risk is the risk that a bank
will not be able to refinance assets as liabilities become due. To manage this, banks may hold a
large portion of assets in very liquid form. A surplus of assets over liabilities at any specific tenor
point creates a funding requirement. On the other hand, if there is a surplus of liabilities, the bank
will need to find efficient uses of those funds. In either case bank has a liquidity gap. If this can
be projected over time then one can estimate the daily liquidity situation, based on net expiring
assets and liabilities.
The liquidity gap risk can be eliminated by matching assets and liabilities across each time
bucket. At an individual loan level this can be done by investing in an asset paying 5.5% for
three months while funding this with a 3-month loan costing 5%. However, such an approach is

not possible at an aggregate level without imposing severe restrictions on the business. Hence,
liquidity risk is an essential part of banking and a key consideration in ALM. Because for many
banks ALM concerns itself with a medium term management of risk, the maturity term will not
be beyond a 5-year horizon and in many cases it will be considerably less than this. In the above
figure also the time bucket in the ALM profile extended to only 12-month plus, so that all
liabilities longer than 1 year were grouped in one time bucket. For each point along the term
structure where a gap exists, there is a gap risk exposure that funds cannot be raised as required
or the rate payable in these funds is prohibitive. To manage this risk, a bank must

Dispersethe funding profile over more than just a short period of time by spreading the
profile across a number of time buckets.
Manage expectations or events so that large size funding requirements are diarized well
in advance; for instance, advance preparedness for low liquidity periods like festival
seasons.
Hold a significant portion of assets in the form of very liquid instruments such as very
short term risk free cash loans, T-bills and high-quality short term bank CDs.

The size of the liquidity gap at any one time is never more than snapshot in time since it is
constantly changing as new commitments are entered on both sides of the balance sheet. For this
reason, some differentiate between a static and a dynamic gap, but in practice there is only a
dynamic gap. Further, the difference between the change in assets and change in liabilities during
a specified time period is known as marginal gap or incremental gap. If change in assets is
greater than change in liabilities, the gap is positive, otherwise negative.
Liquidity risk
Liquidity risk exposures arises from normal banking operations, irrespective of the type of
funding gap; i.e. whether it is excess assets over liabilities or an excess liabilities over assets.
Liquidity risk itself generates interest rate risk because of the nature of interest rate reset.
Floating rate liabilities issued to fund fixed rate assets create forward rate exposure to rising
interest rates. Even for both floating rate assets and liabilities, the interest rate risk remains,
known as basis risk. For instance, if assets pay 6-month LIBOR and liabilities require 3-month
LIBOR, then there is an interest rate spread risk between the two terms. Liquidity riskcan be
managed by matching assets and liabilities or by setting a series of rolling term loans to fund a
long-dated asset.
The simplest way to manage liquidity and interest rate risk is the matched book approach, also
known as cash matching. In matched book, assets and liabilities and their time profiles are
matched as closely as possible. This includes allowing for amortization of assets. Further,
interest rate basis for both assets and liabilities are matched; i.e. fixed loans to fund fixed rate
assets and the same for floating rate assets and liabilities. Floating rate instruments will further

need to match the period of each interest rate reset to eliminate spread risk. However, this
approach is rarely used in practice because it would be very restrictive to the business.
So far we have described scenarios where the maturity dates of both assets and liabilities are
known with certainty. However, a large part of commercial and retail banking operations
revolves around assets that do not have an explicit or fixed maturity, like current account
overdrafts, drawn and undrawn lines of credit, credit card balances etc. Banks need to be familiar
with their clients behaviour and requirement over time to assess when and for how long these
assets will be utilised. Undated assets are balanced on the other side of the non-dated liabilities
such as current and savings bank account. Undated liabilities are treated in different ways by
banks. The most common is to place then in the shortest time bucket of overnight to 1-week.
This makes banks gap and liquidity profile highly volatile and unpredictable and puts greater
strain on ALM. For this reason some banks place these liabilities in the longest dated bucket of
12 months or more. This is logically tenable as the statistical behaviour of such liabilities is often
long dated in practice. A third approach is to split the undated liabilities into a core balance and
an unstable balance and place the first in the long dated bucket and the second in the shortest
dated bucket.
Techniques to measure ALM risk could be categorized as follows:

Traditional techniques
o Gap analysis
Sophisticated techniques
o Duration analysis
o Simulation exercises
o Value at risk method

Gap analysis
This model looks at reprising gap that exists between the interest revenueearned on the bank's
assets and the interest paid on its liabilities over a particular period oftime. The various steps
involved are:
Various assets and liabilities 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.
Assets and liabilities subject to repricing within a year are rate sensitive assets (RSA) and
rate sensitive liabilities (RSL)
Only RSAs and RSLs are considered. The gap is identified as:
o RSG = RSA RSL (rate sensitive assets minus rate sensitive liabilities).
o Positive gap occurs when RSA>RSL. If interest rates rise (fall), bank NIMs or
profit will rise (fall). The reverse happens in the case of a negative gap where
RSA<RSL.

o Based on this gap position, the required strategy is worked out to maximize the
NII.
To see the effect of interest rate change on NII, first calculate RSG and use this gap to maintain
or improve the NII. If RSG is positive, there is direct relation between NII and rate movements
and if RSG is negative, there is inverse relation between NII and rate movements. If RSG is zero,
no effect on NII. The following table exemplifies the same.
RSG,
position
Positive
Positive
Negative
Negative
Zero
Zero

Gap in interest rate in interest in interest in NII


income
expenses
Increase
Increase
Increase
Increase
Decrease
Decrease
Decrease
Decrease
Increase
Increase
Increase
Decrease
Decrease
Decrease
Decrease
Increase
Increase
Increase
Increase
None
Decrease
Decrease
Decrease
None

The impact of change in interest rate on NII is calculated as NII = gap r, where
Gap = [assets NIM]/r
Where NIM is acceptable change in net interest margin and r is expected change in interest
rate.
Price matching aims to maintain spread by ensuring that the deployment of liabilities will be at a
rate higher than the costs. For example:
Table 1
Liabilities
Amount ( Rate
crore)
15
0
25
5
30
12
30
13

100

Assets
Amount
crore)
10
20
50
20

8.75 100

Table 1 Rearranged
Liabilities
( Rate Amount ( Rate
crore)
0
10
0
12
5
0
15
15
5
18
10
5
30
12
10
13
20
13
13.5 100
8.75

Assets
Amount
crore)
10
5
15
10
30
10
20
100

( Rate Spreads
0
12
12
15
15
15
18
13.5

0
7
12
10
3
2
5
4.75

Maturity matching aims at maintaining liquidity by grouping assets/liabilities based on their


maturing profile. The gap is then used to identify future financing requirement.
Liabilities

Table 2
Maturing in Assets

Maturing in Liabilities

Table 2 Rearranged
Assets
Gap Cumulative

( crore)

(months)

10
5
8
4
45
20
8
100

1
3
6
12
24
36
> 36

(
crore)
15
10
5
10
30
10
20
100

(months)

( crore)

<1
3
6
12
24
36
> 36

10
5
8
4
45
20
8
100

(
crore)
15
10
5
10
30
10
20
100

gap
-5
-5
3
-6
15
10
-12

-5
-10
-7
-13
2
12
0

Managing liquidity
Liquidity management is the term used to describe the continuous process of raising and laying
off funds, depending on whether one is long or short on cash that day. The basic idea is that the
bank must be squared off by the end of each day; i.e. the net cash position is zero. Thus, liquidity
management is both very short term as well as projected over the long term because every
position put on today creates a funding requirement in the future on its maturity date. Let us take
two examples of funding the liquidity gap.
Example 1
Time
Assets
Liabilities
Gap

t1
970
380
-590

t2
840
410
-410

t3
1250
1120
-130

Borrow 1: tenor 3 periods


Borrow 2: tenor 2 periods
Borrow 3: tenor 1 period
Total funding
Squared off

130
280
180
590
0

130
280
410
0

130
130
0

Time
Assets
Liabilities
Gap

t1
970
720
-250

t2
840
200
-640

t3
1250
1200
-50

Borrow 1: tenor 3 periods


Borrow 2: tenor 2 periods
Borrow 3: tenor 1 period
Total funding

50
200
250

50
200
390
640

50
50

Example 2

Squared off

In the first example the longest gap is -130, so the bank puts on funding for +130 to match this
tenor of three periods. The gap at period t2 is -410 and this is matched with a two period tenor
funding position of +280. This leaves a gap of -180 at period t1, which is then funded with a 1period loan. The net position is zero at each period and the book has been funded with three
bullet fixed term loans. In the second example, the gap has increased from period 1 to period 2.
The first period is funded with a 3-period and 2-period borrowing of +50 and +200, respectively.
The gap at period t2 needs to be funded with a position that is not needed now. The bank can
cover this with a forward start loan of +390 at t1 or can wait and act at t2.
The Liquidity Ratio
The liquidity ratio is the ratio of assets to liabilities. It is a short term ratio, usually calculated
with the money market term only. Under most circumstances, and certainly under a positive
yield curve, it is expected to be above 1.00. However, this is less common at the very short end
of 1 to 3-month period, since the average tenor of assets is greater than the average tenor of
liabilities. A ratio less than one is inefficient from an ROE point of view. It represents and
opportunity cost of return forgone. To manage this, banks may invest more funds in the very
short term, but this has its own problem since returns on these investments may not be sufficient,
specifically in a positive yield curve environment. Here a matched book approach will be
prudent, since the bank should be able to lock-in a bid-offer spread in the very short end of the
yield curve.
ALM in the Indian Context
While most of the banks in other economies began with strategic planning for asset liability
management as early as 1970, the Indian banks remained unconcerned about the same. Till
eighties, the Indian banks continued to operate in a protected environment. In fact, the
deregulation that began in international markets during the 1970s almost coincided with the
nationalization of banks in India during 1969. Nationalization brought a structural change in the
Indian banking sector. Wholesale banking paved the way for retail banking and there has been an
all-round growth in branch network, deposit mobilization and credit disbursement. The Indian
banks did meet the objectives of nationalization, as there was overall growth in savings, deposits
and advances. But all this was at the cost of profitability of the banks. Quality was subjugated by
quantity, as loan sanctioning became a mechanical process rather than a serious credit
assessment decision. Political interference has been an additional malady.
The situation in pre liberalization era was that competition in the banks was negligible as the
major business was handled by public sector banks. The interest rates were by and large
controlled by the Central bank, the Reserve bank of India (RBI). The balance sheet management

did not pose many problems as the income was accounted for on accrual basis.1 Therefore
liabilities to the bank in terms of deposits did not pose many problems. Banks used to have major
focus on asset management. It was only after liberalization process implemented in 1991, the
banking sector had undergone the following major changes:
1. De-regulation of interest rates.
2. Non- recognition of Income on accrual basis.
3. Growth of forward contracts in foreign transactions and therefore higher off balance sheet
exposure.
4. Diversification of banking products.
5. Growth of a healthy competition in banking sector.
Reserve Bank of India has made mandatory for banks with effect from 2002 03
To form ALCO (Asset-Liabilities Committee) as a committee of the Board of Directors
To track, monitor and report ALM
The main reasons for the growing significance of ALM are volatility in operating environment,
product innovations, regulatory prescriptions, enhanced awareness of top management, high
percentage of the non-performing loans in India attributed to the stringent asset classification
norms, which the Indian banks follow. The following table gives an example of the assets and
liabilities profiles of Indian banks.
An analysis of the below table shows that,
i)
The composition of short term deposits is comparatively higher in the overall deposits
for both types of banks.
ii)
There is no much significant difference in maturity wise deployment of funds by way
of loans and advances during the period of study for both the banks.
iii)
It indicates that short term liabilities are utilized to finance long term assets. This
could result in the maturity mismatch and a bank may be at the liquidity exposure.
iv)
Though RBI has clear guidelines on the subject, the banks are implementing in the
phased manner

Bank Group-wise Maturity Profiles of Select Asset and Liability (As at End March)

Deposits

Assets/Liabilities Public Sector Banks


2005
2011
Up to 1 year
36.3
48.2

Private Sector Banks


2005
2011
53.9
46.4

Take an example. Bank A borrows 100 million from the market at a rate of 6% p.a. and lends to company B for 5
years at a rate of 6.20% p.a. Apparent gain is 20 bps. The inherent risk comes from an increase in the interest rate
over 6.20% when A has to borrow again at the end of 1 year to fund the loan which has 4 more years to expiry.
Under the accrual method of accounting asset = 106.2 million, liability = 106 million, earnings = 0.2 million.
Under market value method of accounting, asset = 100[(1.062) 5]/(1.070)4] = 103.06; earnings = - 2.94 million.
1

Over 1 year and


up to 3 years
Over 3 years
Borrowings Up to 1 year
Over 1 year and
up to 3 years
Over 3 years
Total
Up to 1 year
liabilities
Over 1 year and
up to 3 years
Over 3 years
Loans
& Up to 1 year
advances
Over 1 year and
up to 3 years
Over 3 years
Up to 1 year
Investment
Over 1 year and
up to 3 years
Over 3 years
Total assets Up to 1 year
Over 1 year and
up to 3 years
Over 3 years

35.3

28.6

43.1

37.9

28.4
41.8
20.2

23.2
40.1
12.5

3
51.2
34.1

15.6
41.7
16.4

38
78.1
55.5

47.4
88.3
41.1

14.6
105.1
77.2

41.9
88.1
54.3

66.4
36.7
34.6

70.6
36
36.2

17.6
39.7
32.2

57.5
36.3
35.8

28.6
13.4
12.7

27.7
18.1
12.7

28.1
47.6
27.5

27.8
39.7
25.3

73.9
50.1
47.3

69.2
54.1
48.9

25.0
87.3
59.7

35.0
76
61.1

102.5

96.9

53.1

62.8

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