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Asset Liability Management is the most important aspect for the Banks to manage Balance Sheet Risk, especially for managing of liquidity risk and interest rate risk. Failure to identify the risks associated with business and failure to take timely measures in giving a sense of direction threatens the very existence of the institution. Implementing Asset Liability Management (ALM) function in banks is not only a regulatory requirement in India but also an imperative for strategic bank management. With profit becoming the a key-factor, it has now become imperative for banks to move towards integrated balance sheet management where components of balance sheet and its different maturity mix will be looked at profit angle of the bank. Asset Liability Management is based on three pillars and they are ALM Information System, ALM Organization and ALM Process. ALM brings to bear a holistic and futuristic perspective to the balance sheet management. Banks provide services that exposes them to various risks like credit risk, liquidity risk, interest rate risk to name a few. It is therefore appropriate for banks to focus on ALM when they face different types of risks. There are different techniques used by banks for Asset Liability Management and they are GAP analysis Model, Duration Gap analysis Model, Simulation Model and Value at Risk.
Asset Liability Management
ASSET LIABILITY MANAGEMENT
As financial intermediaries banks are known to accept deposit to lend money to entrepreneurs to make profit. They essentially intermediate between the opposing liquidity needs of depositors and borrowers. In the process, they function with an embedded mismatch between highly liquid liabilities on the one side and less liquid and long term assets on the other side of their balance sheets. Over and above this balance sheet conflict, they also stand exposed to a wide array of risk such as market risk, transformation risk, credit risk, liquidity risk, forex risk, legal risk, operation risk, reputational risk, interest rate risk, etc. The recognition of three main risk i.e. Interest Rate Risk, Liquidity Risk and Credit Risk gave rise to the concept 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. Banks are exposed to several risks which are multi-dimensional. The main direct financial risks are interest rate risk, liquidity risk, credit risk and market risk. The initial focus of the ALM function would be to enforce the risk management discipline viz. managing business after assessing the risks involved. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management. The asset-liability management function would involve planning, directing and controlling the flow, level, mix, cost and yield of the consolidated funds of the Bank. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management. It enables banks to sustain their required growth rate by systematically managing market risk, liquidity risk, capital risk, etc. The objective of ALM is to manage risk and not eliminate it. Risks and rewards go hand in hand. One cannot expect to make huge profits without taking a huge amount of risk. The objectives do not limit the scope of the ALM functionality to mere risk assessment, but
Asset Liability Management
expanded the process to the taking on of risks that might conceivably result in an increase in economic value of the balance sheet. Apart from managing the risks ALM should enhance the net worth of the institution through opportunistic positioning of the balance sheet. The more leveraged an institution, the more critical is the ALM function with enterprise. The objectives of Asset-Liability Management are as follows:
To protect and enhance the net worth of the institution. Formulation of critical business policies and efficient allocation of Capital. To increase the Net Interest Income (NII) It is a quantification of the various risks in the balance sheet and optimizing of profit by ensuring acceptable balance between profitability, growth and risks.
ALM should provide liquidity management within the institution and choose a model that yields a stable net interest income consistently while ensuring liquidity.
To actively and judiciously leverage the balance sheet to stream line the management of regulatory capital.
Funding of banks operation through capital planning. Product pricing and introduction of new products. To control volatility of market value of capital from market risk. Working out estimates of return and risk that might result from pursuing alternative programs.
Asset Liability Management
COMPONENTS OF FINANCIAL STATEMENT
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 owner‟s 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 bank‟s 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.
etc. 3. Advances: Bills Purchased and Discounted. Covered by Bank/ Government Guarantees. Term Loans. Shares. Non-banking assets acquired in satisfaction of claims. Overdrafts & Loans repayable on demand. Cash & Bank Balances: This includes cash in hand including foreign notes. As per Reserve Bank of India guidelines issued for ALM implementation in bank in 1999. Others and investments abroad. depending on maturity profile and interest rate sensitivity. Stationery and Stamps. land. Subsidiaries and Sponsored Institutions. 4. furniture & fixtures.e. balances with Reserve Bank of India in current and other accounts 2. For ALM these assets and liabilities are classified into different time periods called maturity buckets. Other Assets: This includes Interest accrued. Secured by tangible assets. Fixed Assets: This includes premises. Cash Credits. Deferred Tax Asset (Net) and Others. Investments: This includes investments in India i. 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 5 . Government Securities. 5. Other approved Securities. Tax paid in advance/tax deducted at source. Debentures and Bonds.Asset Liability Management Assets 1.
Profit and Loss Account Profit and Loss Account includes: Income 1. Interest on balances with Reserve Bank of India and other inter-bank funds 2. Profit on sale of Investments. buildings and other assets. Income on Investments. Profit on sale of land.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 . Interest Earned: This includes Interest/Discount on Advances / Bills. Profit on exchange transactions. Other Income: This includes Commission. Miscellaneous Income 6 .Asset Liability Management Assets . Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.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 Bank‟s obligations under Letter of Credits. Profit/(Loss) on Revaluation of Investments. Guarantees. Exchange and Brokerage.
etc. 7 . Interest Expense: This includes Interest on Deposits. Advertisement and Publicity. Rent. Printing and Stationery.Asset Liability Management Expenses 1. Operating Expense: This includes Payments to and Provisions for employees. 2. Taxes and Lighting. Interest on Reserve Bank of India / Inter-Bank borrowings and others.
As the time horizon is shortened. the rate of rate sensitive to non rate sensitive assets and liabilities falls. virtually all assets and liabilities are interest rate sensitive. It is very important to note that the critical factor in the classification of time horizon chosen. However.Asset 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). An asset or liability that is time sensitive in a certain time horizon may not be sensitive in shorter time horizon and vice versa. The table below shows the classification of the assets and liabilities of the bank according to their interest rate sensitivity. over a significantly long time horizon. 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). 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 8 .
Credit risk plays a vital role in the way banks perform. 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. 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. 2. It is the risk a company faces that it may lose value on 9 . Access the capability of the risk mitigates to hedge/insure risks. both at individual transaction and portfolio level. Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. capital risk. Credit Risk: The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk. interest rate risk. 1. liquidity risk. In the case of banks these include credit risk. Capital Risk: Capital risk is the risk an investor faces that he or she may lose all or part of the principal amount invested. It reflects the profitability. Legal reforms are very critical in order to have timely contract enforcement. liquidity and reduced Non Performing Assets. The other important issue is contract enforcement. market risk. Design an appropriate risk management strategy to arrest risk mitigation. operations risk and foreign exchange risks. Credit risk management is an important challenge for financial institutions and failure on this front may lead to failure of banks.Asset Liability Management RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT Risk can be defined as the chance or the probability of loss or damage. These categories of financial risk require focus. Evaluate the impact of exposure on bank‟s financial statements. since financial institutions like banks do have complexities and rapid changes in their operating environments.
a major sale of a relatively illiquid security by another holder of the same security could depress the price of the security. Interest Rate Risk: 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. and equity and commodity prices. Market risk is related to the financial condition. one finds substantial erosion of the value of the securities held. The problem is accentuated because many financial institutions acquire bonds and hold it till maturity. Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. an institution should incorporate re- 10 . 3. foreign exchange rates. Likewise. In measuring its interest rate risk. But in the changed situation. For example. which results from adverse movement in market prices. Market risk is also referred to as “systematic risk”. or violent fluctuations in the rate structure. in particular. factories and liquid securities. 4. When there is a significant increase in the term structure of interest rates. The capital of a company can include equipment. This risk cannot be diversified. Capital adequacy focuses on the weighted average risk of lending and to that extent. in order to immunize banks against interest rate risk. changes in interest rates. namely moving away from administered interest rate structure to market determined rates. Market Risk: Market risk refers to the risk to an institution resulting from movements 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. Market risk is often propagated by other forms of financial risk such as credit and market-liquidity risks. a downgrading of the credit standing of an issuer could lead to a drop in the market value of securities issued by that issuer. banks are in a position to realign their portfolios between more risky and less risky assets.Asset Liability Management its capital. it becomes important for banks to equip themselves with some of these techniques.
With each successive basis point movement downward. Similarly if rates increase. It is usually reflected in a wide bid-ask spread or large price movements. bond prices increase at an increasing rate. it is an outcome of the mismatch in the maturity patterns of assets and liabilities. 5. Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds.Asset Liability Management pricing risk (arising from changing rate relationships across the spectrum of maturities). the rate of decline of bond prices declines. It arises from the potential inability of the Bank to generate adequate cash to cope with a decline in deposits or increase in assets. with weights being the present values of cash flows. Convexity: Because of a change in market rates and because of passage of time. Liquidity risk broadly comprises three sub-types: 11 . market liquidity and funding liquidity. 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. These include: Maturity: Since it takes into account only the timing of the final principal payment. 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. basis risk (arising from changing rate relationships among yield curves that affect the institution‟s activities) and optionality risks (arising from interest rate related options embedded in the institution‟s products). Duration can again be used to determine the sensitivity of prices to changes in interest rates.e. duration may not remain constant. To a large extent. It represents the percentage change in value in response to changes in interest rates. Duration: Is the weighted average time of all cash flows. There are certain measures available to measure interest rate risk. This property is called convexity. There are two types of liquidity i. maturity is considered as an approximate measure of risk and in a sense does not quantify risk.
Call risk also includes the need to be able to undertake new transactions when desirable. Call Risk: The need to find fresh funds when contingent liabilities become due.Asset Liability Management Funding Risk: The need to replace net outflows of funds whether due to withdrawal of retail deposits or non-renewal of wholesale funds.g. 12 . e. Time Risk: The need to compensate for non-receipt of expected inflows of funds. when a borrower fails to meet his repayment commitments.
Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. ALM leads to the formulation of critical business policies. the objective functions of the ALM are two-fold. There are micro and macro level objectives of ALM. The gap is then assessed identify the future financing requirements. Similarly. efficient allocation of capital and designing of products with appropriate pricing strategies.Asset Liability Management Purpose of Asset Liability Mismatch ALM is no longer a standalone analytical function. This ensures liquidity. 13 . At macro-level. maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not an easy task. At micro level. liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. However. The following tables explain the process involved in price matching and maturity matching.
bucket-wise assets and liabilities based on actual maturity reflects huge mismatch. However. mismatch is accompanied by liquidity risk and excessive longer tenor lending against shorter-term borrowing would put a bank‟s balance sheet in a very critical and risky position. 1-2 year. i. customer behavior. over 5 year) maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket. are divided into „core and non-core’ balances. borrow short term and lend longer term. banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current. 7 days-1 month. The distribution of core and non-core is determined through historical trend. 4-5 years. 2-7 days. and noncore to be less stable. savings. To address this risk and to make sure a bank does not expose itself in excessive mismatch. 2-3 years. However.Asset Liability Management ADDRESSING THE MISMATCHES A key issue that banks need to focus on is the maturity of its assets and liabilities in different tenors. As a result. next day. overdraft etc. current. 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. 6 months1 year. 3-6 months.). as most deposits and loans of a bank matures next day (call. 1-3 months.e. a bucket-wise (e. where core is defined as the portion that is expected to be stable and will stay with the bank. A typical strategy of a bank to generate revenue is to run mismatch. 14 . although all of the shorter tenor assets and liabilities will not come in or go out of the bank‟s balance sheet. 3-4 years.g. overdraft etc.
450 -100 -300 8D-1M 1M-3M 3M-1Y -150 -1.000 250 -1.000 -1.500 -500 -250 -6.750 Call 200 250 300 200 950 Call -750 -1.000 750 4.250 Total -2.650 550 250 2D-7D -1.250 -350 250 400 -1.200 Call 2D-7D 8D-1M 1M-3M 3M-1Y 300 250 250 250 1.Asset Liability Management An example of Forecasted balance can be as follows: Assets Reserve Assets Interbank Placing Assets Other Assets Total Assets Liabilities Interbank Deposits Other Deposits Capital & Reserves Other Liabilities Total Liabilities Off Balance Sheet Commitments Forward Contracts Total Off Balance Sheet Total 1.200 -100 -200 -100 -1.750 -1.800 1Y-5Y -800 -400 -1.900 600 500 15 .850 Net Mismatch -1.200 -250 -2.250 Total -1.400 300 250 550 1.000 -4.000 300 1.850 50 100 50 -50 -1.200 1Y-5Y 0 5Y+ 500 500 5Y+ 0 5Y+ 0 8D-1M 1M-3M 3M-1Y -250 -1.000 2D-7D 0 100 100 1Y-5Y 500 1.000 500 6.
2. Analytical framework: Analytical methods in ALM require consistency. Organizational framework: All elements of the organization like the ALM Committee. ALM activities should be supported by the top management with proper resource allocation and personnel committee.Asset Liability Management Elements of Asset Liability Management There are nine elements related to ALM and they are as follows: 1. how timely. 3. sub–committees. 4. 6. 16 .. should have clearly defined roles and responsibilities. which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. 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. Technology framework: An integrated technological framework is required to ensure all potential risks are captured and measured on a timely basis. how often and in how much detail and whether the amount and type of information received is appropriate and necessary for the recipient‟s task. Various analytical components like Gap. 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. Stimulation and Value-at-Risk should be used to obtain appropriate insights. planning and measurement of all facets of the ALM function. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. Also it is necessary to determine who is in chare of controlling risk in the organization and their responsibilities. Information reporting framework: The information – reporting framework decides who receives information. 5. Duration. etc. The policy statement should be well articulated providing a clear direction for ALM function.
This can be ensured through regular internal / external reviews of the function. The emphasis should be on setting up a system of checks and balances to ensure the integrity of data. Control framework: The control framework covers the control over all processes and systems. 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. Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements. analysis and reporting. expectations and guidelines for risk – based capital and liquidity ratios. The profitability of an institution comes from three sources: Asset.Asset Liability Management 7. 8. 17 . 9. Liabilities and their efficient management.
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. interest rate. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. adequacy and expediency. The responsibility of ALM is on the treasury department of the banks. it would be much easier to collect reliable information.Asset Liability Management THREE PILLARS OF ALM The three pillars of Asset-Liability Management are as follows: 1. The results of balance sheet analysis along with recommendations 18 . In respect of foreign exchange. Information availability. A good information system gives the bank management a complete picture of the bank's balance sheet. accuracy.e. investment portfolio and money market operations. The spread of computerization will also help banks in accessing data. ALM Process Pillar 1: ALM Information System It includes Management Information System. ALM Organization 3. The problem of ALM needs to be addressed by following an ABC approach i. ALM Information Systems 2. 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. 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. foreign exchange and equity price risk. in view of the centralized nature of the functions.
However RBI is expecting Indian banks to move towards sophisticated techniques like Duration. The size of ALCO varies from organization to organization.Asset Liability Management is place in Asset Liability Committee (ALCO) meeting by the treasurer where important decisions are made are made to minimize risk and maximize returns. Most of the foreign banks use duration analysis and are expected to move towards advanced methods. CEO heads the committee. measurement and management of risk parameter . most Indian Private Sector banks use Gap analysis. For the accrued portfolio. liquidity constraints. foreign exchange exposure and capital adequacy. but are gradually moving towards duration analysis. The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. 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.The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. VaR in the future. Pillar3: ALM Process The basic ALM processes involving identification. Simulation. 19 . It is the responsibility of the committee to ensure all strategies conform to the bank‟s risk appetite and levels of exposure as determined by the Board Risk Committee.
etc. 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. etc. domestic vs foreign currency funding. 20 . 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. The ALCO would also articulate the current interest rate 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. In respect of the funding policy. its responsibility as also the decisions to be taken by it. will include product pricing for both deposits and advances. the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. Individual banks will have to decide the frequency for holding their ALCO meetings. desired maturity profile of the incremental assets and liabilities. The business issues that an ALCO would consider.Asset Liability Management ASSET LIABILITY COMMITTEE – ALCO The Asset-Liability Committee (ALCO) consisting of the bank's senior management including CEO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank (on the assets and liabilities sides) in line with the bank's budget and decided risk management objectives. monitoring and reporting the risk profiles to the ALCO. its responsibility would be to decide on source and mix of liabilities or sale of assets. Towards this end. 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. money market vs capital market funding. wholesale vs retail deposits. In addition to monitoring the risk levels of the bank. The business and risk management strategy of the bank should ensure that the bank operates within the limits/parameters set by the Board. inter alia. for instance.
Control over the capital adequacy and risk diversification. Some banks may even have sub-committees. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerization. business mix and organizational complexity. limiting the possible risk level. 21 . Formation of the Bank‟s capital markets policy. The size (number of members) of ALCO would depend on the size of each institution. 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 Bank‟s balance sheet to provide the maximum profitability. Execution of the uniform interest policy. Control over the state of the current liquidity ratio and resources of the Bank. Credit.Asset Liability Management Top Management. Determination of the Bank‟s liquidity management policy. the CEO/CMD or ED should head the Committee. Funds Management/Treasury (forex and domestic). The Chiefs of Investment. International banking and Economic Research can be members of the Committee.
Asset Liability Management Control over dynamics of size and yield of trading transactions (purchase/sale of currency. Control over dynamics of the basic performance indicators (ROE. etc.) as prescribed in the Bank's policy. derivatives for such instruments) as well as extent of diversification thereof. Process of ALCO 22 . state and corporate securities. ROA. shares.
Asset Liability Management Organization Structure of ALCO 23 .
Liquidity Tracking Measuring and managing liquidity needs are vital for effective operation of the Company. securities and other money market instruments. liquidity management can reduce the probability of an adverse situation. Although funding practices. 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. 24 . For measuring and managing net funding requirement. Therefore. and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet. By assuring the Company‟s ability to meet its liabilities as they become due. could also become illiquid when the market and players are unidirectional. 1. Funds management represents the core of sound bank planning and financial management. and norms have been revised substantially in recent years. funds management has following three components. Therefore. 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. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. liquidity has to be tracked through maturity or cash flow mismatches. as liquidity shortfall in one institution can have repercussions on the entire system. The importance of liquidity transcends individual institutions.Asset Liability Management ALM APPROACH ALM in its most apparent sense is based on funds management. such as govt. LIQUIDITY RISK MANAGEMENT Bank‟s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times. it is not a new concept. techniques. New loan demands. existing commitments. Experience shows that assets commonly considered being liquid. which have been discussed briefly.
Asset Liability Management Analysis of following factors throws light on a bank‟s adequacy of liquidity position: a. Present and future earning capacity and h. Assets and Liabilities to be reported as per their maturity profile into 8 maturity buckets: a. The mismatches in the first two buckets cannot exceed 20% of outflows. Present and anticipated asset quality g. Sources of funds e. Over 6 months and up to 1 year 25 . a bank must perform one or a combination of the following: a. 1 to 14 days b. Decrease holding of less liquid assets d. It shows the structure as of a particular date. Increase short term borrowings c. 29 days and up to 3 months d. Increase Capital funds Statement of Structural Liquidity It Places all cash inflows and outflows in the maturity ladder as per residual maturity. Anticipated future funding needs d. 15 to 28 days c. Over 3 months and up to 6 months e. Increase liability of a term nature e. Current liquidity position c. Banks can fix the tolerance level for other maturity buckets. Dispose off liquid assets b. Maturity Liabilities are cash outflow and Maturity Assets are cash inflows. Present and planned capital position To satisfy funding needs. Historical Funding requirement b. Options for reducing funding needs f.
h.Asset Liability Management f.57 0.67 -7.00 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.69 28. Repos & deployment of foreign currency converted into rupee. creating new assets & investment swaps etc. it can be financed from market borrowings (Call/Term). Strategies 26 .18 -4. Over 3 years and up to 5 years Over 5 years 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 . excess liquidity can be deployed in money market instruments. For negative mismatch.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 Gap Cumulative Gap Gap % to Total Outflow 1D-14D 15D-28D 30D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ Total -100 -100 100 -50 -150 50 -50 300 0 -100 -200 -100 -150 -300 -250 -300 0 0 -14. Over 1 year and up to 3 years g. Bills rediscounting.38 18.29 -15.64 6.76 -13.
The decision whether or not to use liability sources should be based on a complete analysis of seasonal.Asset Liability Management To meet the mismatch in any maturity bucket. For example. or may be heavily depreciated because of interest rate changes. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. assets that are often assumed to be liquid are sometimes difficult to liquidate. which rely solely on asset management. at less than book value. or how "salable" the bank's assets are in terms of both time and cost. or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand. 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. cyclical. But banks. Asset liquidity. Income derived from higher yielding assets may be offset if a forced sale. 2. investment securities may be pledged against public deposits or repurchase agreements. However. liability sources of liquidity may serve as an alternative even when asset sources are available. Furthermore. concentrate on adjusting the price and availability of credit and the level of liquid assets. and other factors. the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. Seasonal. In addition to supplementing asset liquidity. is of primary importance in asset management. and the costs involved. To maximize profitability. 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. is necessary because of adverse balance sheet fluctuations. which exceeds available deposit funds. the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. 27 . cyclical. management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets.
In this context. Further. misuse or improper implementation of liability management can have severe consequences.Asset Liability Management 3. a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U. which will maintain a positive yield spread. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities. 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. as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions. until the bank goes to the market to borrow. This is because concentrations in funding sources increase liquidity risk. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand. larger banks have a wider variety of options from which to select the least costly method of generating funds. banks or the economy. This does not preclude the option of selling assets to meet funding needs. The obvious difficulty in estimating the latter is that. and conceptually. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. liquidity represents the ability to attract funds in the market when needed. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. it cannot determine with complete certainty that funds will be available and/or at a price. liability management is not riskless. the availability of asset and liability options should result in a lower liquidity maintenance cost. at a reasonable cost vis-à-vis asset yield. The ability to obtain additional liabilities represents liquidity potential. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets. For example. Replacing foreign 28 .S. When funds are required. LIABILITY MANAGEMENT Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition.
That is why banks that particularly rely on wholesale funding sources. which are already on its books. characteristics. management must constantly be aware of the composition. Preoccupation with obtaining funds at the lowest possible cost. During times of tight money. the higher cost of purchased funds may result in a negative yield spread. a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities. relax asset liquidity standards. and result in a large concentration of short-term liabilities supporting assets of longer maturity. and diversification of its funding sources. without considering maturity distribution. greatly intensifies a bank's exposure to the risk of interest rate fluctuations. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities.Asset Liability Management source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. 29 . this could cause an earnings squeeze and an illiquid condition. Also if rate competition develops in the money market. If a bank is purchasing liabilities to support assets.
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. Ratio of long-term loans to short term demand deposits. Below a step-by-step approach of ALM examination in case of a bank has been outlined. Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits). funds management and financial ratio analysis. This should include: - 30 . Ratio of short-term demand deposits to total deposits. Ratio of loans to deposits. Ratio of Non Performing Assets to Total Assets. Ratio of contingent liabilities for loans to total loans.Asset Liability Management Procedure for examining 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. 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).
31 . 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.Asset Liability Management Review of internal management reports on liquidity needs and sources of satisfying these needs. Step 3 The banks future development and expansion plans. with focus on funding and liquidity management aspects have to be looked into. Assessing the bank's ability to meet liquidity needs. Determining whether the bank has included sensitivity to interest rate risk in the development of its long term funding strategy. This entails: Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis. Step 4 Examining the bank's internal audit report in regards to quality and effectiveness in terms of liquidity management. 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.
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. A method to identify liquidity needs and the means to meet those needs. 5. Whether the board of directors has been consistent with its duties and responsibilities and included: A line of authority for liquidity management decisions. 2. 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? 32 . Determining the impact of the bank's liquidity management on net earnings position.Asset Liability Management Determining the alternative sources of funding liquidity and/or assets subject to necessity. Are internal management reports concerning liquidity needs prepared regularly and reviewed as appropriate by senior management and the board of directors. 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. 6. Step 6 Preparing an Asset/Liability Management Internal Control Questionnaire which should include the following: 1. A mechanism to coordinate asset and liability management decisions. Guidelines for the level of liquid assets and other sources of funds in relationship to needs. 4. 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.
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. As per the guidelines. Discussions in most ALCOs that do meet regularly are oriented towards treasury activity rather than taking a view of the entire balance sheet. As a measure of liquidity management. However. 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. Having regard to the international practices.Asset Liability Management Regulatory Framework 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. It is therefore likely that the RBI would introduce more detailed guidelines for ALM. However. This is again mainly due to lack of data on the other businesses of the bank. these guidelines have been reviewed and it has been decided that : 33 . 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. 1. 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. given the state of data availability most bank ALCOs are not able to hold meaningful discussions on balance sheet risks. given the increasing volatility in interest and exchange rates it is becoming critical for banks to manage their market risks. the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management. 2.
The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines. be reported to RBI. 2008. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. as on the third Wednesday of every month. 4. (c) The net cumulative negative mismatches during the Next day. Banks may. 2-7 days. 2-7 days and 8-14 days.Asset Liability Management (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. make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner. 2008 and the reporting frequency would continue to be monthly for the present. (d) Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. 10%. once a month. 34 . However. the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly. may. 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. Next day. To enable the banks to fine tune their existing MIS as per the modified guidelines. however. with effect from the fortnight beginning April 1. the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1. however. The Statement of Structural Liquidity. 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognize the cumulative impact on liquidity. 8-14 days and 15-28 days buckets should not exceed 5 %. (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. 3.
Proper revisions to this document. Formalization of understanding. Policies should address all issues concerning the bank. Organization and culture: ALM function needs to be separated clearly from operations as it involves control and strategy functions. Most often. Sensible options need to be chosen and manual branch without computer was an example. Policy: Lack of a coherent. documented and practical policy is a big hindrance to ALM implementation. Data and Models: Data may not be available at all times in requisite format. Once again. ALCO membership itself may not be aware of implications of risks being measured and impact. „Risk Taking‟ and „Risk management‟ are generally two distinct parts of any organization and both must report to a board completely independently. 35 . 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. apart from ALCO and these must be documented. 4. appropriate assumptions have to be made in any event. in charge of „risk taking‟ is overlooked. all policies should be clearly explained to all members of board. will be helpful as it would help in decision –making. Thus.Asset Liability Management ISSUES IN IMPLEMENTATION OF ALM 1. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. The argument is that for all other purposes. in modern banking. especially at a top level. The fact that they are a business unit. Measurement of risk is a fairly simple phenomenon and does go on regardless. a quarterly review needs to be organized as well as parameters may be changing due to change in situations. It must be remembered that many data items are assumptions and gaps must be measured in perspective. it is required to follow policy implicitly in both letter and spirit. 2. However. Openness and transparency are essential to a proper risk organization. as they are people who come closest to understanding complex financial instruments. Risk organization in banks generally land up reporting to treasury. 3. As data may not be obtained from this branch for 6 months. assumptions are being made. it is mapping of models to zero coupon bonds that are an issue. Understanding of complexities: Many people in a bank need to understand risk measurements and risk mitigation procedures.
36 . 5. ALCO‟s 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. This is strictly outside ALM framework but integrates into ALM framework. A zero gap is not practical. Based on sophistication required. multiple models may be used to validate this conversion.Asset Liability Management arguments are that this should exist within the bank. Banks assume market and credit risk and hence they make returns. Unrealistic goals: An ALCO secretary was seen desperately trying to tweak with parameters to „show‟ less gaps in liquidity reports. Returns are expected for taking risks.
Then the gap between the assets and liabilities under each time bucket is worked out. Since the objective is to maximize the NII. the various assets and liabilities are grouped under various time buckets based on the residual maturity of each item or the next repricing date. it is known as negative gap position. it will be sufficient if this is done only with respect to rate sensitive assets and liabilities. it is referred to as positive gap position and if the rate sensitive assets are less than the rate sensitive liabilities. If the rate sensitive assets equal the rate sensitive liabilities.Asset Liability Management TECHNIQUES OF ASEET LIABILITY MANAGEMENT GAP Analysis Model: Under the Gap analysis method. If the rate sensitive assets are more than the rate sensitive liabilities. whichever is earlier. These effects are given in the table below: 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 GAP Position Positive Positive Negative Negative Zero Zero 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) 37 . if on floating rate. 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. it is known as the Zero Gap or matched book position.
It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. 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.e. NII also increase liabilities If interest rate increase.e. there is no early repayments or defaults Parallel Shift in Yield Curve i. no early repayment or option like feature On Schedule Payments i.e.Asset Liability Management 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. both short-term and long-term interest rate change by the same amount. 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. depending on the operating strategy. Advantages Simple to analyze Easy to implement Helps in future analysis of Interest Rate Risk 38 . Positive Gap Negative Gap Rate Sensitive Assets are more than Rate Rate Sensitive Liabilities are more than Sensitive Liabilities Assets mature before Liabilities Rate Sensitive Assets Liabilities mature before Assets Short-term assets funded with long-term Long-term assets funded with short-term liabilities If interest rate increase. These periods are known as maturity buckets which vary across banks. NII also decrease Assumptions Contractual Repayment Schedule i.
26 0.10 0.371.807.14D 705.27 16.75 6M-1Y 3.36 0.92 25. It does not provide a single reliable index of interest rate.00 1.33 121.85 563.27 1.757.463.43 0. Example of GAP ABC bank for which maturity Pattern of assets and liabilities as on a particular date i.543.014.55 Cr in the deposit liability of deposits means that as on December 31 st.2009 Rate Sensitive Liabilities Rate Sensitive Assets Maturity Buckets Foreign Borrow Currency ings Liabilities 0.54 12. Similarly.37 3Y-5Y 3. 31st December 2009 ABC Bank Maturity Pattern of Assets and Liabilities as on 31.375.59 0.33 5.60 Here.95 29D-3M 1.64 777.00 44.70 Total 25.113.681.12 1.66 376.35 12.38 52.39 Deposits 1D . Rs.e.16 23.89 2. The periods used in the analysis are arbitrary and repricing is assumed to occur at the midpoint of the period.12 1.Asset Liability Management Helps in projecting the NII for further analysis Limitations It does not incorporate future growth or changes in the mix of assets and liabilities.36 9.254.55 15D-28D 405.00 43.62 44.81 5. 705.00 8.82 1Y-3Y 7.00 4. 39 .12.69 Loans & Advances Foreign Investment Currency in Securities Assets 88.03 104.379.87 0.806.955.50 5Y+ 6.00 132.14 3.48 20. 376.52 17.05 Cr in the loans and advances indicates as on 31st December 2009 the bank was expected to get back this amount during the next 14 days of the loans and advances it has given till date.674. Rs.00 2.00 0.085.40 132.73 61.00 2.133.05 4.74 3M-6M 1. It in not take time value of money or initial net worth into account.00 8.08 147. 2009 the bank was liable to repay this amount including the interest during the next 14 days on account of the deposits received by the bank till date.56 12.
15 410.79 -256.92 up to 3-5 year period indicating that inflows are always less than outflows and for the last time period inflows are double the outflows. which means ABC bank can be grouped as liability sensitive.26 Observations From the results GAP amount is negative till 3-5 year period and positive for the last period.39 -1.809.201.49 -1.3 0.14 0.746.085. lengthen the maturities of loan and convert floating rate loans to term loans.98 6.984.96 5.31 13 0.02 -6.53 943.91 1.96 1.15 -489.50 7.09 1.573.434.40 624.58 0.3 and 0. Cumulative GAP amount is also negative for all time periods.69 0.10 1.117.70 ΔNII = GAP GAP Ratio ΔI (for ΔI = = 0.60 -2.708.058.48 758.60 3.492. To reduce Rate Sensitivity Buy long-term securities.87 15.26 6.928. Long-term assets are funded with short-term liabilities and the bank will benefit as NII increases with decrease in interest rates a shown in the above table for a decrease in the rate of interest of 0.80 525.22 0. 40 . To increase Asset Sensitivity Buy short-term securities.824.93 0.22 3.454.31 -881.65 -233.03 153.38 1.92 16.62 -316.24 1.237.14D 15D-28D 29D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ RSL = Total Outflows RSA = Total Inflows GAP = RSA RSL Cumulative GAP -233.Asset Liability Management Results Maturity Buckets 1D .52 6.25%.70 11. GAP ratio is between 0.083.96 -591.98 -6.52 -5.141.37 3.30 -2.96 3.843.30 -916.25% RSA/RSL decrease) 0. shorten the maturities of loan and convert term loans to floating rate loans.
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. Timing and the magnitude of the cash flows is ascertained and calculated. the present value of each of the cash flows needs to be worked out. To increase Liability Sensitivity Pay premium to attract short-term deposits and borrow more non-core purchased liability. By using appropriate discounting factor. The time weighted value of the present value of the cash flows is calculates. a. DGAP Position Positive Positive Negative Negative Zero Zero Changes in Change in Market value Interest Assets Liabilities Equity Rates Increase Decrease Decrease Decrease Decrease Increase Increase Increase Increase Decrease Decrease Increase Decrease Increase Increase Decrease Increase Decrease Decrease None Decrease Increase Increase None Advantages Duration Gap analysis serves as a strategic tool for evaluating and controlling interest rate risk. . It improves the maturity gap and cumulative gap models by taking into account the timing and market value of cash flows rather them time maturity. Duration Analysis: The Gap method ignores time value of money. asset-liability structure. 41 . Duration analysis is useful in assessing the impact of the interest rate changes on the market value of equity i. b. 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. Under the duration method. d.Asset Liability Management To reduce Liability Sensitivity Pay premium to attract long-term deposits and issue ling-term subordinated debt.e. c.
Instead of changing the maturity structure of assets and liabilities. under various 42 . Simulation Analysis: It analyzes the interest-rate risk arising from both current and planned business.. Gap analysis and duration analysis as stand-alone tool for asset-liability management suffer from their inability to move beyond the static analysis of current interest rate risk exposures. an increasing reliance on short-term funds for balance sheet growth. In other words. growth rates. These pertain to accuracy of data and reliability of the assumptions made. Capital adequacy and liquidity.Asset Liability Management It offers flexibility in spread management. Accurate evaluation of current exposures of asset and liability portfolios to interest rate risk.g. etc. It requires high degree of analytical expertise regarding issues such as term structure of interest rates and yield curve dynamics. reinvestments. What if: The absolute level of interest rate shift There are non parallel yield curve changes Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad Debts and prepayment levels change in the different interest rate scenarios There are changes in the funding mix e. Limitations It requires extensive data on specific characteristics and current market pricing schedules of financial instruments. Basically simulation models utilize computer power to provide what if scenarios. Duration Gap analysis puts emphasis on change of mix of assets or liabilities whichever is feasible. Changes in multiple target variables such as NII. one should be in a position to look at alternatives pertaining to prices. There are certain criteria for the simulation model to succeed.
The objective of any risk assessment model is to initiate risk mitigating actions. Hence. Thus. This is due to credit risk. but also from slippage in credit quality. simulation models need to be used with the caution. volume and mix of assets and liabilities Advantages It is easy to approximate very complex and discounted payoffs It is very flexible It can incorporate multiple time periods It captures majority of the option risk Limitations It is computationally intensive It requires maintenance of pricing models Value at Risk (VAR) Model: Under VAR credit rating is given to each of the borrowers and its migration over the years form a part of the calculation of the credit value at risk over a given time horizon.Asset Liability Management interest rate scenarios. which emanates not only from counter party default. Any risk assessment model shall normally predict relative risk than absolute risk. 43 . The use of simulation model calls for commitment of substantial amount of time and resources. But there is no explicit theory to guide time horizon on risk assessment. it is also to be noted that the managers might not want to document their assumptions and data is not easily available for differential impacts of interest rates on several variables. In general. the volatility of value due to changes in the quality of the credit needs to be estimated to calculate VAR. Assumptions Expected changes and the levels of interest rates and the shape of yield curve Pricing strategies for assets and liabilities The growth. irrespective of the time horizons. This could be difficult and sometimes contentious. banks review financial statements of borrowers once a year and allot credit ratings.
Advantages Translates portfolio exposures into potential profit and loss Aggregates and reports multi-product. multi-market exposures into one number Uses risk factors and correlations to create a risk weighted index Monitors VAR limits Meets external risk management disclosures and expectations.Asset Liability Management Hence.. changes in government policies. Macro level changes in an industry. may result in distorted results. This model does not take already defaulted customers into account. In this methodology if the VAR measurement is for shorter duration. etc. Limitations This study is useful only for normal operative accounts to predict their probability of default. any risk measurement model can be tailored to suit different time horizons based on actual need. the risk assessment is more accurate. 44 .
Factors affecting NII Changes in the level of interest rates Changes in the composition of assets and liabilities Changes in the volume of earning assets and interest-bearing liabilities outstanding Changes in the relationship between the yields on earning assets and rates paid on interest-bearing liabilities Example Hypothetical Balance Sheet Particulars Assets Yield Libilities Cost Rate Sensitive 500 8% 600 4% Fixed Rate 350 11% 220 6% Non Earning 150 100 Equity 80 Total 1000 1000 NII = (Yield x Assets) – (Cost x Liabilities) NII = (0.06 x 220) NII = 78.86% GAP = 500 – 600 = -100 45 . if there is a mismatch between amount of assets and liabilities it causes interest rate risk and affects NII.3 NIM = 41.08 x 500 + 0.5 .11 x 350) .(0.2 = 41.04 x 600 + 0. Even though maturity dates are same.Asset Liability Management GAP AND NII ALM is heavily dependent on the movements of interest rates in the market.37. It builds up Assets and Liabilities of the bank based on the concept of Net Interest Income (NII) or Net Interest Margin (NIM).3/850 = 4.
8 / 850 = 4. hence NII & NIM fall 1% decrease in spreads 1% decrease in spread Particulars Assets Yield Libilities Cost Rate Sensitive 500 8.5% 600 5.3 NIM = 40.11 x 350) .05 x 600 + 0.5% Fixed Rate 350 11% 220 6% Non Earning 150 100 Equity 80 Total 1000 1000 NII = (0.(0.43.74% GAP = 500 .11 x 350) .3 / 850 = 4.46.(0.Asset Liability Management Impact of changes 1% increase in short time rates 1% increase in short time rates Particulars Assets Yield Libilities Cost Rate Sensitive 500 9% 600 5% Fixed Rate 350 11% 220 6% Non Earning 150 100 Equity 80 Total 1000 1000 NII = (0.09% GAP = 500 .8 NIM = 34.06 x 220) NII = 81 .09 x 500 + 0.055 x 600 + 0.5 .600 = -100 46 .2 = 40. more liabilities than assets reprice higher.2 = 34.600 = -100 With a negative gap.085 x 500 + 0.06 x 220) NII = 83.
04 x 560 + 0. fixed liabilities increase Particulars Assets Yield Liabilities Cost Rate sensitive 540 8% 560 4% Fixed rate 310 11% 260 6% Non earning 150 100 Equity 80 Total 1000 1000 NII = (0.11 x 700) .3 .11 x 310) .04 x 1200 + 0.6 / 1700 = 4.08 x 540 + 0.3 NIM = 39.38 = 39. Net interest income varies directly with the changes in the volume of earning assets and interest bearing liabilities.74.62% 47 .Asset Liability Management NII & NIM fall (rise) with a decrease (increase) in the spread. regardless of the level of interest rates. If RSA increase. fixed assets decrease and RSL decrease.86% GAP = 1000 .3 / 850 = 4. if liabilities are short-term and assets are long-term.06 x 440) NII = 157 .6 NIM = 82. Proportionate doubling in size Doubling in size Particulars Assets Yield Libilities Cost Rate Sensitive 1000 8% 1200 4% Fixed Rate 700 11% 440 6% Non Earning 300 200 Equity 160 Total 2000 2000 NII = (0. the spread will widen as the yield curve increases in slope and narrow when the yield curve decreases in slope and/or inverts.4 = 82.(0. This is because.06 x 260) NII = 77.(0.08 x 1000 + 0.1200 = -200 NII & GAP doubled. but NIM remains the same.
a bank with a negative GAP would try to increase RSAs (variable rate loans or shorter maturities on loans and investments) and decrease RSLs (issue relatively longer . Changes in portfolio composition and risk To reduce risk.term CDs and fewer fed funds purchased). Changes in portfolio composition also raise or lower interest income and expense based on the type of change.Asset Liability Management GAP = 540 .560 = -20 Although the banks GAP is lower the banks NII is also lower. Summary of GAP and NII Interest Rate Change Increases Decreases Increases Decreases GAP Positive Positive Negative Negative Impact on NII Positive Negative Negative Positive 48 .
org.org www.iibf.rbi.Asset Liability Management BIBLIOGRAPY Asset Liability Management in Banks – ICFAI Bank Financial Management – Indian Institute of Banking and Finance www.allbankingsolutions.investopedia.org 49 .fimmda.in www.com www.com www.
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