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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.
Debentures and Bonds. Cash & Bank Balances: This includes cash in hand including foreign notes. Advances: Bills Purchased and Discounted. balances with Reserve Bank of India in current and other accounts 2. Term Loans. Shares. depending on maturity profile and interest rate sensitivity. Other approved Securities. Secured by tangible assets. 4. Cash Credits. Overdrafts & Loans repayable on demand. Subsidiaries and Sponsored Institutions. land. As per Reserve Bank of India guidelines issued for ALM implementation in bank in 1999. Deferred Tax Asset (Net) and Others. For ALM these assets and liabilities are classified into different time periods called maturity buckets. Stationery and Stamps.Asset Liability Management Assets 1. etc. 3. 5. Non-banking assets acquired in satisfaction of claims. furniture & fixtures. Covered by Bank/ Government Guarantees. Other Assets: This includes Interest accrued. 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 . Others and investments abroad. Tax paid in advance/tax deducted at source. Investments: This includes investments in India i. Fixed Assets: This includes premises. Government Securities.e.
buildings and other assets. Profit on exchange transactions.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. Interest on balances with Reserve Bank of India and other inter-bank funds 2. Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. Interest Earned: This includes Interest/Discount on Advances / Bills. Exchange and Brokerage. Profit/(Loss) on Revaluation of Investments.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 .Asset Liability Management Assets . Other Income: This includes Commission. Profit and Loss Account Profit and Loss Account includes: Income 1. Miscellaneous Income 6 . Income on Investments. Profit on sale of Investments. Guarantees. Profit on sale of land.
Printing and Stationery. 7 . Interest on Reserve Bank of India / Inter-Bank borrowings and others. Interest Expense: This includes Interest on Deposits. Operating Expense: This includes Payments to and Provisions for employees. etc. Rent.Asset Liability Management Expenses 1. 2. Taxes and Lighting. Advertisement and Publicity.
It is very important to note that the critical factor in the classification of time horizon chosen. An asset or liability that is time sensitive in a certain time horizon may not be sensitive in shorter time horizon and vice versa.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). 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 . However. the rate of rate sensitive to non rate sensitive assets and liabilities falls. 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). over a significantly long time horizon. As the time horizon is shortened. virtually all assets and liabilities are interest rate sensitive. The table below shows the classification of the assets and liabilities of the bank according to their interest rate sensitivity.
Credit risk management is an important challenge for financial institutions and failure on this front may lead to failure of banks. Capital Risk: Capital risk is the risk an investor faces that he or she may lose all or part of the principal amount invested. since financial institutions like banks do have complexities and rapid changes in their operating environments. In the case of banks these include credit risk. 1. Legal reforms are very critical in order to have timely contract enforcement. Credit Risk Management is the process that puts in place systems and procedures enabling banks to: Identify and measure the risk involved in credit proposition. both at individual transaction and portfolio level. 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. Evaluate the impact of exposure on bank‟s financial statements. Credit Risk: The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk. These categories of financial risk require focus. interest rate risk.Asset Liability Management RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT Risk can be defined as the chance or the probability of loss or damage. operations risk and foreign exchange risks. 2. market risk. It is the risk a company faces that it may lose value on 9 . liquidity risk. The other important issue is contract enforcement. capital risk. liquidity and reduced Non Performing Assets. Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. Access the capability of the risk mitigates to hedge/insure risks. Credit risk plays a vital role in the way banks perform. It reflects the profitability. Design an appropriate risk management strategy to arrest risk mitigation.
namely moving away from administered interest rate structure to market determined rates. 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. 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. 4. Likewise. The capital of a company can include equipment. banks are in a position to realign their portfolios between more risky and less risky assets. Market risk is also referred to as “systematic risk”. Market risk is often propagated by other forms of financial risk such as credit and market-liquidity risks. changes in interest rates. Market Risk: Market risk refers to the risk to an institution resulting from movements in market prices. and equity and commodity prices. But in the changed situation. Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. or violent fluctuations in the rate structure. in particular. which results from adverse movement in market prices. This risk cannot be diversified. factories and liquid securities. a downgrading of the credit standing of an issuer could lead to a drop in the market value of securities issued by that issuer. The problem is accentuated because many financial institutions acquire bonds and hold it till maturity. a major sale of a relatively illiquid security by another holder of the same security could depress the price of the security.Asset Liability Management its capital. Market risk is related to the financial condition. foreign exchange rates. Capital adequacy focuses on the weighted average risk of lending and to that extent. When there is a significant increase in the term structure of interest rates. In measuring its interest rate risk. 3. For example. one finds substantial erosion of the value of the securities held. in order to immunize banks against interest rate risk. an institution should incorporate re- 10 . it becomes important for banks to equip themselves with some of these techniques.
Duration can again be used to determine the sensitivity of prices to changes in interest rates. Dollar duration: Represents the actual dollar change in the market value of a holding of the bond in response to a percentage change in rates. There are certain measures available to measure interest rate risk. it is an outcome of the mismatch in the maturity patterns of assets and liabilities. Duration: Is the weighted average time of all cash flows. 5. bond prices increase at an increasing rate. Liquidity risk broadly comprises three sub-types: 11 .e. There are two types of liquidity i.Asset Liability Management pricing risk (arising from changing rate relationships across the spectrum of maturities). Convexity: Because of a change in market rates and because of passage of time. maturity is considered as an approximate measure of risk and in a sense does not quantify risk. with weights being the present values of cash flows. the rate of decline of bond prices declines. Similarly if rates increase. With each successive basis point movement downward. 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. To a large extent. It is usually reflected in a wide bid-ask spread or large price movements. It arises from the potential inability of the Bank to generate adequate cash to cope with a decline in deposits or increase in assets. duration may not remain constant. This property is called convexity. These include: Maturity: Since it takes into account only the timing of the final principal payment. Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds. market liquidity and funding liquidity. 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). It represents the percentage change in value in response to changes in interest rates.
Call risk also includes the need to be able to undertake new transactions when desirable. e. 12 .g.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. Call Risk: The need to find fresh funds when contingent liabilities become due. when a borrower fails to meet his repayment commitments. Time Risk: The need to compensate for non-receipt of expected inflows of funds.
Asset Liability Management Purpose of Asset Liability Mismatch ALM is no longer a standalone analytical function. maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not an easy task. The following tables explain the process involved in price matching and maturity matching. However. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. The gap is then assessed identify the future financing requirements. ALM leads to the formulation of critical business policies. Similarly. At macro-level. the objective functions of the ALM are two-fold. efficient allocation of capital and designing of products with appropriate pricing strategies. This ensures liquidity. There are micro and macro level objectives of ALM. liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. 13 . At micro level.
1-2 year. although all of the shorter tenor assets and liabilities will not come in or go out of the bank‟s balance sheet. 2-3 years. 14 . overdraft etc. borrow short term and lend longer term. as most deposits and loans of a bank matures next day (call. statistical forecasts and managerial judgment. 4-5 years.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. the core balance can be put into over 1 year bucket whereas non-core can be in 2-7 days or 3 months bucket. However. where core is defined as the portion that is expected to be stable and will stay with the bank. 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.). To address this risk and to make sure a bank does not expose itself in excessive mismatch. 6 months1 year. 2-7 days. 3-6 months. 7 days-1 month. 1-3 months. a bucket-wise (e. next day. overdraft etc. bucket-wise assets and liabilities based on actual maturity reflects huge mismatch. A typical strategy of a bank to generate revenue is to run mismatch. However. customer behavior. are divided into „core and non-core’ balances. over 5 year) maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket. The distribution of core and non-core is determined through historical trend. and noncore to be less stable. current.e. banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current. savings. 3-4 years. As a result.g. i.
900 600 500 15 .450 -100 -300 8D-1M 1M-3M 3M-1Y -150 -1.400 300 250 550 1.750 Call 200 250 300 200 950 Call -750 -1.250 -350 250 400 -1.750 -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 -1.800 1Y-5Y -800 -400 -1.000 -1.650 550 250 2D-7D -1.200 -250 -2.250 Total -2.000 500 6.000 2D-7D 0 100 100 1Y-5Y 500 1.000 300 1.000 250 -1.000 750 4.000 -4.200 Call 2D-7D 8D-1M 1M-3M 3M-1Y 300 250 250 250 1.250 Total -1.500 -500 -250 -6.850 50 100 50 -50 -1.850 Net Mismatch -1.200 1Y-5Y 0 5Y+ 500 500 5Y+ 0 5Y+ 0 8D-1M 1M-3M 3M-1Y -250 -1.
should have clearly defined roles and responsibilities.. The policy statement should be well articulated providing a clear direction for ALM function. 4. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. Organizational framework: All elements of the organization like the ALM Committee. how timely. Also it is necessary to determine who is in chare of controlling risk in the organization and their responsibilities. 6. They have to decide how much risk they are willing to take in quantifiable terms. 16 . 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. 2. Information reporting framework: The information – reporting framework decides who receives information. ALM activities should be supported by the top management with proper resource allocation and personnel committee. Various analytical components like Gap. which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. 5. planning and measurement of all facets of the ALM function. 3. Strategic framework: The Board of Directors are responsible for setting the limits for risk at global as well as domestic levels. 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. etc. Stimulation and Value-at-Risk should be used to obtain appropriate insights.Asset Liability Management Elements of Asset Liability Management There are nine elements related to ALM and they are as follows: 1. sub–committees. Analytical framework: Analytical methods in ALM require consistency. Duration.
Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements. 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. Liabilities and their efficient management. expectations and guidelines for risk – based capital and liquidity ratios. 8. The profitability of an institution comes from three sources: Asset. 9.Asset Liability Management 7. Control framework: The control framework covers the control over all processes and systems. analysis and reporting. Performance reporting framework: The performance of the traders and business units can easily be measured using valid risk measurement measures. 17 . The performance measurement considers approaches and ways to adjust performance measurement for the risks taken.
The problem of ALM needs to be addressed by following an ABC approach i. it would be much easier to collect reliable information. The responsibility of ALM is on the treasury department of the banks. A good information system gives the bank management a complete picture of the bank's balance sheet. ALM Information Systems 2. interest rate. 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. adequacy and expediency. 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. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. Information availability.e. foreign exchange and equity price risk. In respect of foreign exchange. The results of balance sheet analysis along with recommendations 18 . ALM Organization 3. in view of the centralized nature of the functions. The spread of computerization will also help banks in accessing data. accuracy. 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.Asset Liability Management THREE PILLARS OF ALM The three pillars of Asset-Liability Management are as follows: 1. ALM Process Pillar 1: ALM Information System It includes Management Information System. investment portfolio and money market operations.
For the accrued portfolio.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. However RBI is expecting Indian banks to move towards sophisticated techniques like Duration. measurement and management of risk parameter . 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. Most of the foreign banks use duration analysis and are expected to move towards advanced methods. most Indian Private Sector banks use Gap analysis. Pillar3: ALM Process The basic ALM processes involving identification. The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. 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. but are gradually moving towards duration analysis. foreign exchange exposure and capital adequacy. Simulation. 19 .The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. The size of ALCO varies from organization to organization. CEO heads the committee. VaR in the future. liquidity constraints.
inter alia. The business and risk management strategy of the bank should ensure that the bank operates within the limits/parameters set by the Board. its responsibility as also the decisions to be taken by it. etc. 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. for instance. domestic vs foreign currency funding. Towards this end. will include product pricing for both deposits and advances. 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. 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. the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. The ALM desk consisting of operating staff should be responsible for analyzing. wholesale vs retail deposits. etc. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. 20 . In addition to monitoring the risk levels of the bank. The business issues that an ALCO would consider. Each bank will have to decide on the role of its ALCO. desired maturity profile of the incremental assets and liabilities. its responsibility would be to decide on source and mix of liabilities or sale of assets. In respect of the funding policy. monitoring and reporting the risk profiles to the ALCO. money market vs capital market funding.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. Individual banks will have to decide the frequency for holding their ALCO meetings.
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. 21 . The Chiefs of Investment. The size (number of members) of ALCO would depend on the size of each institution. the CEO/CMD or ED should head the Committee. Determination of the Bank‟s liquidity management policy. Execution of the uniform interest policy. Formation of the Bank‟s capital markets policy. Control over the state of the current liquidity ratio and resources of the Bank. Credit. 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. Control over the capital adequacy and risk diversification.Asset Liability Management Top Management. Some banks may even have sub-committees. Funds Management/Treasury (forex and domestic). International banking and Economic Research can be members of the Committee.
Process of ALCO 22 . shares.) as prescribed in the Bank's policy.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. derivatives for such instruments) as well as extent of diversification thereof. ROA. state and corporate securities.
Asset Liability Management Organization Structure of ALCO 23 .
Experience shows that assets commonly considered being liquid. Although funding practices. could also become illiquid when the market and players are unidirectional. which have been discussed briefly. For measuring and managing net funding requirement. Therefore. such as govt. Liquidity Tracking Measuring and managing liquidity needs are vital for effective operation of the Company. The importance of liquidity transcends individual institutions. securities and other money market instruments. liquidity has to be tracked through maturity or cash flow mismatches. Funds management represents the core of sound bank planning and financial management. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. existing commitments. 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. it is not a new concept.Asset Liability Management ALM APPROACH ALM in its most apparent sense is based on funds management. Therefore. as liquidity shortfall in one institution can have repercussions on the entire system. 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 has following three components. and norms have been revised substantially in recent years. 24 . 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. and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet. techniques. 1. liquidity management can reduce the probability of an adverse situation. New loan demands. By assuring the Company‟s ability to meet its liabilities as they become due.
Asset Liability Management Analysis of following factors throws light on a bank‟s adequacy of liquidity position: a. a bank must perform one or a combination of the following: a. Banks can fix the tolerance level for other maturity buckets. Current liquidity position c. Increase Capital funds Statement of Structural Liquidity It Places all cash inflows and outflows in the maturity ladder as per residual maturity. Over 3 months and up to 6 months e. Decrease holding of less liquid assets d. Present and future earning capacity and h. Assets and Liabilities to be reported as per their maturity profile into 8 maturity buckets: a. 1 to 14 days b. Present and anticipated asset quality g. Increase liability of a term nature e. 29 days and up to 3 months d. It shows the structure as of a particular date. Dispose off liquid assets b. Sources of funds e. 15 to 28 days c. Anticipated future funding needs d. Increase short term borrowings c. Maturity Liabilities are cash outflow and Maturity Assets are cash inflows. Options for reducing funding needs f. Historical Funding requirement b. Present and planned capital position To satisfy funding needs. The mismatches in the first two buckets cannot exceed 20% of outflows. Over 6 months and up to 1 year 25 .
Over 1 year and up to 3 years g. 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 .38 18.76 -13. creating new assets & investment swaps etc.67 -7. Bills rediscounting.64 6.69 28. excess liquidity can be deployed in money market instruments. it can be financed from market borrowings (Call/Term).18 -4. Repos & deployment of foreign currency converted into rupee.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 -14.57 0.Asset Liability Management f. Strategies 26 . h.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.29 -15. For negative mismatch.
The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows. Income derived from higher yielding assets may be offset if a forced sale. the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. or how "salable" the bank's assets are in terms of both time and cost. which rely solely on asset management. To maximize profitability. management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. Seasonal. is of primary importance in asset management. 27 .Asset Liability Management To meet the mismatch in any maturity bucket. investment securities may be pledged against public deposits or repurchase agreements. cyclical. liability sources of liquidity may serve as an alternative even when asset sources are available. For example. Furthermore. assets that are often assumed to be liquid are sometimes difficult to liquidate. and other factors. The decision whether or not to use liability sources should be based on a complete analysis of seasonal. at less than book value. But banks. Asset liquidity. and the costs involved. 2. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand. cyclical. or may be heavily depreciated because of interest rate changes. In addition to supplementing asset liquidity. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. concentrate on adjusting the price and availability of credit and the level of liquid assets. However. is necessary because of adverse balance sheet fluctuations. ASSET MANAGEMENT Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch. which exceeds available deposit funds.
as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions.Asset Liability Management 3. For example. When funds are required. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity.S. until the bank goes to the market to borrow. Further. at a reasonable cost vis-à-vis asset yield. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand. This does not preclude the option of selling assets to meet funding needs. which will maintain a positive yield spread. liquidity represents the ability to attract funds in the market when needed. it cannot determine with complete certainty that funds will be available and/or at a price. The obvious difficulty in estimating the latter is that. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. the availability of asset and liability options should result in a lower liquidity maintenance cost. Replacing foreign 28 . The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets. In this context. liability management is not riskless. banks or the economy. larger banks have a wider variety of options from which to select the least costly method of generating funds. 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. and conceptually. misuse or improper implementation of liability management can have severe consequences. The ability to obtain additional liabilities represents liquidity potential. LIABILITY MANAGEMENT Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. This is because concentrations in funding sources increase liquidity risk.
management must constantly be aware of the composition. this could cause an earnings squeeze and an illiquid condition.Asset Liability Management source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. That is why banks that particularly rely on wholesale funding sources. greatly intensifies a bank's exposure to the risk of interest rate fluctuations. characteristics. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities. a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities. Also if rate competition develops in the money market. During times of tight money. the higher cost of purchased funds may result in a negative yield spread. which are already on its books. If a bank is purchasing liabilities to support assets. relax asset liquidity standards. and result in a large concentration of short-term liabilities supporting assets of longer maturity. Preoccupation with obtaining funds at the lowest possible cost. without considering maturity distribution. 29 . and diversification of its funding sources.
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). This should include: - 30 . Ratio of contingent liabilities for loans to total loans. 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 short-term demand deposits to total deposits.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. funds management and financial ratio analysis. Below a step-by-step approach of ALM examination in case of a bank has been outlined. Ratio of pledged securities to total securities. Ratio of loans to deposits. Ratio of Non Performing Assets to Total Assets. Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits). Ratio of long-term loans to short term demand deposits.
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. Determining whether the bank has included sensitivity to interest rate risk in the development of its long term funding strategy. Reviewing the bank's budget projections for a certain period of time in the future. Step 3 The banks future development and expansion plans. This entails: Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis. with focus on funding and liquidity management aspects have to be looked into. Determining whether the bank really needs to expand its activities.Asset Liability Management Review of internal management reports on liquidity needs and sources of satisfying these needs. Assessing the bank's ability to meet liquidity needs. 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. Step 4 Examining the bank's internal audit report in regards to quality and effectiveness in terms of liquidity management.
Are internal management reports concerning liquidity needs prepared regularly and reviewed as appropriate by senior management and the board of directors. Guidelines for the level of liquid assets and other sources of funds in relationship to needs. Whether the board of directors has been consistent with its duties and responsibilities and included: A line of authority for liquidity management decisions. 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. 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. Are the internal management reports for liquidity management adequate in terms of effective decision making and monitoring of decisions. 4. 2.Asset Liability Management Determining the alternative sources of funding liquidity and/or assets subject to necessity. Does the planning and budgeting function consider liquidity requirements? 3. Does the bank's policy of asset and liability management provide for an adequate control over the position of contingent liabilities of the bank? 7. Is the foregoing information considered an adequate basis for evaluating internal control in that there are no significant deficiencies in areas not covered in this questionnaire that impair any controls? 32 . 6. 5. A method to identify liquidity needs and the means to meet those needs. Determining the impact of the bank's liquidity management on net earnings position.
As per the guidelines. these guidelines have been reviewed and it has been decided that : 33 . given the state of data availability most bank ALCOs are not able to hold meaningful discussions on balance sheet risks. However. given the increasing volatility in interest and exchange rates it is becoming critical for banks to manage their market risks. It is therefore likely that the RBI would introduce more detailed guidelines for ALM. 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. However. the level of sophistication of banks in India and the need for a sharper assessment of the efficacy of liquidity management. 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. This is again mainly due to lack of data on the other businesses of the bank. 1. 2. The RBI has already come out with guidelines governing market risk including the need for banks to constitute an ALCO.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. 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. 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. Having regard to the international practices. 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.
10%. Next day. 2-7 days. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. with effect from the fortnight beginning April 1. in due consideration of non-availability of a fully networked environment. be reported to RBI. however. To enable the banks to fine tune their existing MIS as per the modified guidelines. 8-14 days and 15-28 days buckets should not exceed 5 %. the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1. 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.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. (c) The net cumulative negative mismatches during the Next day. once a month. the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly. 3. However. 4. however. make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner. (b) The Statement of Structural Liquidity may be compiled on best available data coverage. 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognize the cumulative impact on liquidity. 34 . 2-7 days and 8-14 days. as on the third Wednesday of every month. 2008 and the reporting frequency would continue to be monthly for the present. 2008. Banks may. The Statement of Structural Liquidity. (d) Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines. may.
Openness and transparency are essential to a proper risk organization. assumptions are being made. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. Proper revisions to this document. 3. 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. Most often. Policy: Lack of a coherent. Formalization of understanding. 35 . Understanding of complexities: Many people in a bank need to understand risk measurements and risk mitigation procedures. apart from ALCO and these must be documented. documented and practical policy is a big hindrance to ALM implementation. Organization and culture: ALM function needs to be separated clearly from operations as it involves control and strategy functions. in charge of „risk taking‟ is overlooked. Policies should address all issues concerning the bank. appropriate assumptions have to be made in any event. Thus. all policies should be clearly explained to all members of board. it is mapping of models to zero coupon bonds that are an issue. 4. ALCO membership itself may not be aware of implications of risks being measured and impact. in modern banking. The argument is that for all other purposes. 2. As data may not be obtained from this branch for 6 months. will be helpful as it would help in decision –making. Risk organization in banks generally land up reporting to treasury. as they are people who come closest to understanding complex financial instruments. „Risk Taking‟ and „Risk management‟ are generally two distinct parts of any organization and both must report to a board completely independently. 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.Asset Liability Management ISSUES IN IMPLEMENTATION OF ALM 1. However. it is required to follow policy implicitly in both letter and spirit. a quarterly review needs to be organized as well as parameters may be changing due to change in situations. Sensible options need to be chosen and manual branch without computer was an example. Data and Models: Data may not be available at all times in requisite format. It must be remembered that many data items are assumptions and gaps must be measured in perspective. Once again.
A zero gap is not practical. This is strictly outside ALM framework but integrates into ALM framework. It is not to show things as good when they are not. Unrealistic goals: An ALCO secretary was seen desperately trying to tweak with parameters to „show‟ less gaps in liquidity reports. 36 . Returns are expected for taking risks. 5. Banks assume market and credit risk and hence they make returns. Based on sophistication required.Asset Liability Management arguments are that this should exist within the bank. multiple models may be used to validate this conversion. ALCO‟s job is to correctly determine positions and put in place appropriate remedial measures using appropriate risks.
if on floating rate. Since the objective is to maximize the NII. Then the gap between the assets and liabilities under each time bucket is worked out. The effect of an upward movement or a downward movement in the interest rate on the NII will also depend on the position taken. If the rate sensitive assets are more than the rate sensitive liabilities. it is known as negative gap position.Asset Liability Management TECHNIQUES OF ASEET LIABILITY MANAGEMENT GAP Analysis Model: Under the Gap analysis method. If the rate sensitive assets equal the rate sensitive liabilities. The decision to hold a positive gap or a negative will depend on the expectation on the movement of interest rates. it is referred to as positive gap position and if the rate sensitive assets are less than the rate sensitive liabilities. whichever is earlier. it will be sufficient if this is done only with respect to rate sensitive assets and liabilities. it is known as the Zero Gap or matched book position. the various assets and liabilities are grouped under various time buckets based on the residual maturity of each item or the next repricing date. 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 .
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. no early repayment or option like feature On Schedule Payments i. there is no early repayments or defaults Parallel Shift in Yield Curve i. These periods are known as maturity buckets which vary across banks.e. NII also increase liabilities If interest rate increase. both short-term and long-term interest rate change by the same amount. Advantages Simple to analyze Easy to implement Helps in future analysis of Interest Rate Risk 38 . It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. This model looks at the repricing gap that exists between the interest revenue earned and the bank's assets and the interest paid on its liabilities over a particular period of time. depending on the operating strategy. 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. 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.e. NII also decrease Assumptions Contractual Repayment Schedule i.
113. It does not provide a single reliable index of interest rate.38 52.75 6M-1Y 3.62 44.12 1.92 25. 39 .26 0.85 563.16 23.27 1.05 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.05 4. The periods used in the analysis are arbitrary and repricing is assumed to occur at the midpoint of the period.73 61. 376.56 12.e.89 2.014.674.00 2.085.371.955.757.463.00 132.00 44.50 5Y+ 6.543.00 1.33 121. It in not take time value of money or initial net worth into account.807.00 2.00 8.52 17.12.00 4.81 5. 705.14D 705.08 147.254.66 376.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.55 15D-28D 405.64 777.74 3M-6M 1.12 1.82 1Y-3Y 7.95 29D-3M 1.375.27 16.14 3. Rs.133.39 Deposits 1D .60 Here. 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. Similarly.2009 Rate Sensitive Liabilities Rate Sensitive Assets Maturity Buckets Foreign Borrow Currency ings Liabilities 0.36 9.55 Cr in the deposit liability of deposits means that as on December 31 st.48 20.69 Loans & Advances Foreign Investment Currency in Securities Assets 88.87 0.59 0.00 0.54 12. Example of GAP ABC bank for which maturity Pattern of assets and liabilities as on a particular date i.00 43.806. 31st December 2009 ABC Bank Maturity Pattern of Assets and Liabilities as on 31.35 12. Rs.379.681.37 3Y-5Y 3.33 5.43 0.03 104.00 8.10 0.70 Total 25.40 132.36 0.
37 3.58 0.70 ΔNII = GAP GAP Ratio ΔI (for ΔI = = 0.96 1. 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 0.91 1.62 -316.87 15.60 3.141.Asset Liability Management Results Maturity Buckets 1D .80 525.25% RSA/RSL decrease) 0.984.69 0.98 6.085.49 -1.434.454.083.14D 15D-28D 29D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ RSL = Total Outflows RSA = Total Inflows GAP = RSA RSL Cumulative GAP -233.10 1.70 11.237.98 -6.92 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. GAP ratio is between 0.48 758.03 153.60 -2.30 -2.96 -591.38 1.058.708.22 3.52 6. To increase Asset Sensitivity Buy short-term securities.39 -1.26 Observations From the results GAP amount is negative till 3-5 year period and positive for the last period.30 -916.96 5.25%.14 0.928. which means ABC bank can be grouped as liability sensitive.79 -256.93 0.843.22 0.40 624.65 -233.15 410.02 -6.50 7. 40 .09 1. Cumulative GAP amount is also negative for all time periods.26 6.573.824.809.31 -881.492.746.92 16.15 -489. lengthen the maturities of loan and convert floating rate loans to term loans.3 0.3 and 0.117.96 3. To reduce Rate Sensitivity Buy long-term securities.24 1.52 -5.31 13 0.53 943. shorten the maturities of loan and convert term loans to floating rate loans.201.
the present value of each of the cash flows needs to be worked out. 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. 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. 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.e. 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. Duration analysis is useful in assessing the impact of the interest rate changes on the market value of equity i. Duration Analysis: The Gap method ignores time value of money. Under the duration method. 41 . The time weighted value of the present value of the cash flows is calculates. asset-liability structure. To increase Liability Sensitivity Pay premium to attract short-term deposits and borrow more non-core purchased liability. Timing and the magnitude of the cash flows is ascertained and calculated. By using appropriate discounting factor. b. .Asset Liability Management To reduce Liability Sensitivity Pay premium to attract long-term deposits and issue ling-term subordinated debt. d. a. c.
In other words. etc. Simulation Analysis: It analyzes the interest-rate risk arising from both current and planned business.g.. Capital adequacy and liquidity. under various 42 . 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.Asset Liability Management It offers flexibility in spread management. Accurate evaluation of current exposures of asset and liability portfolios to interest rate risk. Limitations It requires extensive data on specific characteristics and current market pricing schedules of financial instruments. These pertain to accuracy of data and reliability of the assumptions made. Instead of changing the maturity structure of assets and liabilities. 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. Changes in multiple target variables such as NII. an increasing reliance on short-term funds for balance sheet growth. growth rates. Duration Gap analysis puts emphasis on change of mix of assets or liabilities whichever is feasible. one should be in a position to look at alternatives pertaining to prices. reinvestments. Basically simulation models utilize computer power to provide what if scenarios. There are certain criteria for the simulation model to succeed. It requires high degree of analytical expertise regarding issues such as term structure of interest rates and yield curve dynamics.
Thus. This is due to credit risk. the volatility of value due to changes in the quality of the credit needs to be estimated to calculate VAR. Any risk assessment model shall normally predict relative risk than absolute risk. 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. The objective of any risk assessment model is to initiate risk mitigating actions. but also from slippage in credit quality. In general. which emanates not only from counter party default. The use of simulation model calls for commitment of substantial amount of time and resources. banks review financial statements of borrowers once a year and allot credit ratings. irrespective of the time horizons. 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.Asset Liability Management interest rate scenarios. Assumptions Expected changes and the levels of interest rates and the shape of yield curve Pricing strategies for assets and liabilities The growth. Hence. 43 . This could be difficult and sometimes contentious. But there is no explicit theory to guide time horizon on risk assessment. simulation models need to be used with the caution.
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. 44 . This model does not take already defaulted customers into account. etc. Limitations This study is useful only for normal operative accounts to predict their probability of default.Asset Liability Management Hence. may result in distorted results. Advantages Translates portfolio exposures into potential profit and loss Aggregates and reports multi-product. the risk assessment is more accurate.. any risk measurement model can be tailored to suit different time horizons based on actual need. Macro level changes in an industry. changes in government policies. In this methodology if the VAR measurement is for shorter duration.
3/850 = 4.11 x 350) .(0.3 NIM = 41. 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 = (0.5 .06 x 220) NII = 78. if there is a mismatch between amount of assets and liabilities it causes interest rate risk and affects NII.2 = 41.37. Even though maturity dates are same.86% GAP = 500 – 600 = -100 45 . It builds up Assets and Liabilities of the bank based on the concept of Net Interest Income (NII) or Net Interest Margin (NIM).04 x 600 + 0.08 x 500 + 0.Asset Liability Management GAP AND NII ALM is heavily dependent on the movements of interest rates in the market.
2 = 40.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 = (0.600 = -100 46 .5 .5% Fixed Rate 350 11% 220 6% Non Earning 150 100 Equity 80 Total 1000 1000 NII = (0.(0.43.8 NIM = 34.(0.085 x 500 + 0.2 = 34.09 x 500 + 0.11 x 350) .06 x 220) NII = 81 .055 x 600 + 0. more liabilities than assets reprice higher.74% GAP = 500 .3 / 850 = 4.8 / 850 = 4.5% 600 5.46.600 = -100 With a negative gap.3 NIM = 40. hence NII & NIM fall 1% decrease in spreads 1% decrease in spread Particulars Assets Yield Libilities Cost Rate Sensitive 500 8.06 x 220) NII = 83.09% GAP = 500 .11 x 350) .05 x 600 + 0.
if liabilities are short-term and assets are long-term. fixed assets decrease and RSL decrease.08 x 540 + 0.3 / 850 = 4. If RSA increase. the spread will widen as the yield curve increases in slope and narrow when the yield curve decreases in slope and/or inverts.06 x 260) NII = 77.(0.6 / 1700 = 4. but NIM remains the same.11 x 310) .62% 47 .86% GAP = 1000 .1200 = -200 NII & GAP doubled. Net interest income varies directly with the changes in the volume of earning assets and interest bearing liabilities.6 NIM = 82.38 = 39. 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 = (0.3 .04 x 1200 + 0.3 NIM = 39. 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.(0.08 x 1000 + 0.04 x 560 + 0.06 x 440) NII = 157 .74. regardless of the level of interest rates.11 x 700) .Asset Liability Management NII & NIM fall (rise) with a decrease (increase) in the spread.4 = 82. This is because.
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 . 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 . 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 .560 = -20 Although the banks GAP is lower the banks NII is also lower.
org www.in www.fimmda.Asset Liability Management BIBLIOGRAPY Asset Liability Management in Banks – ICFAI Bank Financial Management – Indian Institute of Banking and Finance www.com www.org 49 .com www.allbankingsolutions.investopedia.org.rbi.iibf.
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