Asset Liability Management

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

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:
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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.

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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

Balance Sheet
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.


Others and investments abroad. Advances: Bills Purchased and Discounted. Overdrafts & Loans repayable on demand. Cash Credits. Stationery and Stamps. depending on maturity profile and interest rate sensitivity. Other Assets: This includes Interest accrued. 4. Subsidiaries and Sponsored Institutions. Term Loans. Fixed Assets: This includes premises. 5.Asset Liability Management Assets 1. furniture & fixtures. Cash & Bank Balances: This includes cash in hand including foreign notes. Secured by tangible assets. etc.e. Government Securities. As per Reserve Bank of India guidelines issued for ALM implementation in bank in 1999. Non-banking assets acquired in satisfaction of claims. Covered by Bank/ Government Guarantees. Other approved Securities. balances with Reserve Bank of India in current and other accounts 2. Investments: This includes investments in India i. land. 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 . Deferred Tax Asset (Net) and Others. Debentures and Bonds. 3. Tax paid in advance/tax deducted at source. Shares. For ALM these assets and liabilities are classified into different time periods called maturity buckets.

Profit and Loss Account Profit and Loss Account includes: Income 1. Interest Earned: This includes Interest/Discount on Advances / Bills. Profit/(Loss) on Revaluation of Investments. Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. Exchange and Brokerage. Income on Investments. buildings and other assets.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.Asset Liability Management Assets . Profit on sale of Investments. Interest on balances with Reserve Bank of India and other inter-bank funds 2. Miscellaneous Income 6 . Other Income: This includes Commission. 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 . Guarantees. Profit on exchange transactions.

Interest on Reserve Bank of India / Inter-Bank borrowings and others. Operating Expense: This includes Payments to and Provisions for employees. 7 . Printing and Stationery. 2. Interest Expense: This includes Interest on Deposits.Asset Liability Management Expenses 1. Rent. Taxes and Lighting. etc. Advertisement and Publicity.

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). It is very important to note that the critical factor in the classification of time horizon chosen. the rate of rate sensitive to non rate sensitive assets and liabilities falls. The table below shows the classification of the assets and liabilities of the bank according to their interest rate sensitivity. 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 . As the time horizon is shortened. virtually all assets and liabilities are interest rate sensitive. over a significantly long time horizon. An asset or liability that is time sensitive in a certain time horizon may not be sensitive in shorter time horizon and vice versa. However. 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).

Design an appropriate risk management strategy to arrest risk mitigation. 1. It is the risk a company faces that it may lose value on 9 . Delays and loopholes in the legal system significantly affect the ability of the lender to enforce the contract. operations risk and foreign exchange risks.    2. Access the capability of the risk mitigates to hedge/insure risks. Evaluate the impact of exposure on bank‟s financial statements. 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. It reflects the profitability. since financial institutions like banks do have complexities and rapid changes in their operating environments. market risk. liquidity and reduced Non Performing Assets. Legal reforms are very critical in order to have timely contract enforcement. Credit Risk: The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk. 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. Credit risk plays a vital role in the way banks perform. both at individual transaction and portfolio level. 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. In the case of banks these include credit risk.Asset Liability Management RISK ASSOCIATED WITH ASSET LIABILITY MANAGEMENT Risk can be defined as the chance or the probability of loss or damage. capital risk. interest rate risk. liquidity risk. The other important issue is contract enforcement. These categories of financial risk require focus.

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. factories and liquid securities. In measuring its interest rate risk. Likewise. or violent fluctuations in the rate structure. Market Risk: Market risk refers to the risk to an institution resulting from movements in market prices. banks are in a position to realign their portfolios between more risky and less risky assets. which results from adverse movement in market prices. it becomes important for banks to equip themselves with some of these techniques. an institution should incorporate re- 10 . This risk cannot be diversified. changes in interest rates. one finds substantial erosion of the value of the securities held. and equity and commodity prices. foreign exchange rates. 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.Asset Liability Management its capital. namely moving away from administered interest rate structure to market determined rates. Interest risk is the change in prices of bonds that could occur as a result of change: n interest rates. in particular. in order to immunize banks against interest rate risk. Market risk is also referred to as “systematic risk”. Capital adequacy focuses on the weighted average risk of lending and to that extent. Market risk is related to the financial condition. But in the changed situation. 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. For example. The capital of a company can include equipment. Market risk is often propagated by other forms of financial risk such as credit and market-liquidity risks. 3. When there is a significant increase in the term structure of interest rates. a major sale of a relatively illiquid security by another holder of the same security could depress the price of the security. 4.

Longer maturity bonds are generally subject to more interest rate risk than shorter maturity bonds. with weights being the present values of cash flows. 5. bond prices increase at an increasing rate. market liquidity and funding liquidity. There are two types of liquidity i. 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).e. With each successive basis point movement downward. it is an outcome of the mismatch in the maturity patterns of assets and liabilities. It represents the percentage change in value in response to changes in interest rates.  Convexity: Because of a change in market rates and because of passage of time. These include:  Maturity: Since it takes into account only the timing of the final principal payment. Duration can again be used to determine the sensitivity of prices to changes in interest rates. the rate of decline of bond prices declines.  Duration: Is the weighted average time of all cash flows. This property is called convexity.Asset Liability Management pricing risk (arising from changing rate relationships across the spectrum of maturities). Similarly if rates increase. To a large extent.  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. It arises from the potential inability of the Bank to generate adequate cash to cope with a decline in deposits or increase in assets. Liquidity risk broadly comprises three sub-types: 11 . maturity is considered as an approximate measure of risk and in a sense does not quantify risk. There are certain measures available to measure interest rate risk. duration may not remain constant. 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. It is usually reflected in a wide bid-ask spread or large price movements.

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.  Time Risk: The need to compensate for non-receipt of expected inflows of funds. 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. when a borrower fails to meet his repayment commitments. 12 . e.g.

The gap is then assessed identify the future financing requirements. However. liquidity is ensured by grouping the assets/liabilities based on their maturing profiles. ALM leads to the formulation of critical business policies.Asset Liability Management Purpose of Asset Liability Mismatch ALM is no longer a standalone analytical function. At micro level. the objective functions of the ALM are two-fold. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. This ensures liquidity. The following tables explain the process involved in price matching and maturity matching. efficient allocation of capital and designing of products with appropriate pricing strategies. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. There are micro and macro level objectives of ALM. Similarly. 13 . At macro-level. maintaining profitability by matching prices and ensuring liquidity by matching the maturity levels is not an easy task.

are divided into „core and non-core’ balances. 1-2 year. 2-3 years. 14 . as most deposits and loans of a bank matures next day (call. 3-6 months. the core balance can be put into over 1 year bucket whereas non-core can be in 2-7 days or 3 months bucket. over 5 year) maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket.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. and noncore to be less stable. The distribution of core and non-core is determined through historical trend. statistical forecasts and managerial judgment. However. next day. banks prepare a forecasted balance sheet where the assets and liabilities of the nature of current. 3-4 years. a bucket-wise (e.). 4-5 years. overdraft etc. As a result. bucket-wise assets and liabilities based on actual maturity reflects huge mismatch. 1-3 months. 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. A typical strategy of a bank to generate revenue is to run mismatch. overdraft etc. customer behavior. 6 months1 year. i. current. 7 days-1 month. To address this risk and to make sure a bank does not expose itself in excessive mismatch.e. borrow short term and lend longer term. 2-7 days.g. savings. However. although all of the shorter tenor assets and liabilities will not come in or go out of the bank‟s balance sheet.

250 -350 250 400 -1.400 300 250 550 1.750 -1.000 2D-7D 0 100 100 1Y-5Y 500 1.200 Call 2D-7D 8D-1M 1M-3M 3M-1Y 300 250 250 250 1.500 -500 -250 -6.000 500 6.800 1Y-5Y -800 -400 -1.650 550 250 2D-7D -1.000 -4.450 -100 -300 8D-1M 1M-3M 3M-1Y -150 -1.200 1Y-5Y 0 5Y+ 500 500 5Y+ 0 5Y+ 0 8D-1M 1M-3M 3M-1Y -250 -1.000 750 4.250 Total -2.200 -250 -2.000 -1.200 -100 -200 -100 -1.000 300 1.850 Net Mismatch -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 1.750 Call 200 250 300 200 950 Call -750 -1.850 50 100 50 -50 -1.000 250 -1.900 600 500 15 .250 Total -1.

Analytical framework: Analytical methods in ALM require consistency. sub–committees. ALM activities should be supported by the top management with proper resource allocation and personnel committee. should have clearly defined roles and responsibilities. Various analytical components like Gap. 4. etc. They have to decide how much risk they are willing to take in quantifiable terms. Strategic framework: The Board of Directors are responsible for setting the limits for risk at global as well as domestic levels. Information reporting framework: The information – reporting framework decides who receives information. Technology framework: An integrated technological framework is required to ensure all potential risks are captured and measured on a timely basis. Also it is necessary to determine who is in chare of controlling risk in the organization and their responsibilities.Asset Liability Management Elements of Asset Liability Management There are nine elements related to ALM and they are as follows: 1. 16 .. how timely. planning and measurement of all facets of the ALM function. Duration. 2. The policy statement should be well articulated providing a clear direction for ALM function. 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. 3. which includes periodic review of the models used to measure risk to avoid miscalculation and verifying their accuracy. 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. Operational framework: There should be a proper direction for risk management with detailed guidelines on all aspects of ALM. 6. Stimulation and Value-at-Risk should be used to obtain appropriate insights. 5. Organizational framework: All elements of the organization like the ALM Committee.

Performance reporting framework: The performance of the traders and business units can easily be measured using valid risk measurement measures. analysis and reporting. Regulatory compliance framework: The objective of regulatory compliance element is to ensure that there is compliance with the requirements. Liabilities and their efficient management. This can be ensured through regular internal / external reviews of the function. Control framework: The control framework covers the control over all processes and systems. The emphasis should be on setting up a system of checks and balances to ensure the integrity of data.Asset Liability Management 7. 17 . The performance measurement considers approaches and ways to adjust performance measurement for the risks taken. expectations and guidelines for risk – based capital and liquidity ratios. The profitability of an institution comes from three sources: Asset. 9. 8.

The responsibility of ALM is on the treasury department of the banks.e. 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. The spread of computerization will also help banks in accessing data. A good information system gives the bank management a complete picture of the bank's balance sheet. 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 problem of ALM needs to be addressed by following an ABC approach i. ALM Process Pillar 1: ALM Information System It includes Management Information System. 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. ALM Information Systems 2. investment portfolio and money market operations. adequacy and expediency.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. it would be much easier to collect reliable information. in view of the centralized nature of the functions. ALM Organization 3. foreign exchange and equity price risk. 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. accuracy.

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.The RBI in its guidelines has asked Indian banks to use traditional techniques like Gap Analysis for monitoring interest rate and liquidity risk. measurement and management of risk parameter . However RBI is expecting Indian banks to move towards sophisticated techniques like Duration. but are gradually moving towards duration analysis. foreign exchange exposure and capital adequacy. Simulation. liquidity constraints. The size of ALCO varies from organization to organization. The Alco committee comprising of the senior management of bank is responsible for Balance Sheet risk management. Most of the foreign banks use duration analysis and are expected to move towards advanced methods. CEO heads the committee. Pillar3: ALM Process The basic ALM processes involving identification. VaR in the future. 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. 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. For the accrued portfolio. 19 . most Indian Private Sector banks use Gap analysis.

desired maturity profile of the incremental assets and liabilities.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. 20 . for instance. The ALM desk consisting of operating staff should be responsible for analyzing. domestic vs foreign currency funding. 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. In respect of the funding policy. The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. etc. wholesale vs retail deposits. the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. its responsibility as also the decisions to be taken by it. inter alia. 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. its responsibility would be to decide on source and mix of liabilities or sale of assets. money market vs capital market funding. The business and risk management strategy of the bank should ensure that the bank operates within the limits/parameters set by the Board. will include product pricing for both deposits and advances. etc. 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. Towards this end. Individual banks will have to decide the frequency for holding their ALCO meetings. 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.

limiting the possible risk level. Control over the state of the current liquidity ratio and resources of the Bank. Determination of the Bank‟s liquidity management policy. business mix and organizational complexity. Credit. The Chiefs of Investment.      Control over the capital adequacy and risk diversification. Formation of the Bank‟s capital markets policy. The size (number of members) of ALCO would depend on the size of each institution. Some banks may even have sub-committees. 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. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerization. 21 . Funds Management/Treasury (forex and domestic).Asset Liability Management Top Management. the CEO/CMD or ED should head the Committee. International banking and Economic Research can be members of the Committee. Execution of the uniform interest policy.

) as prescribed in the Bank's policy. Process of ALCO 22 .Asset Liability Management  Control over dynamics of size and yield of trading transactions (purchase/sale of currency. ROA. etc. derivatives for such instruments) as well as extent of diversification thereof.  Control over dynamics of the basic performance indicators (ROE. shares. state and corporate securities.

Asset Liability Management Organization Structure of ALCO 23 .

For measuring and managing net funding requirement. Experience shows that assets commonly considered being liquid. Therefore. By assuring the Company‟s ability to meet its liabilities as they become due. 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. Funds management represents the core of sound bank planning and financial management. such as govt.Asset Liability Management ALM APPROACH ALM in its most apparent sense is based on funds management. as liquidity shortfall in one institution can have repercussions on the entire system. it is not a new concept. could also become illiquid when the market and players are unidirectional. techniques. which have been discussed briefly. securities and other money market instruments. Although funding practices. and norms have been revised substantially in recent years. existing commitments. 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. Therefore. New loan demands. 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. Liquidity Tracking Measuring and managing liquidity needs are vital for effective operation of the Company. liquidity has to be tracked through maturity or cash flow mismatches. 24 . The importance of liquidity transcends individual institutions. and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. 1. liquidity management can reduce the probability of an adverse situation.

Over 6 months and up to 1 year 25 . a bank must perform one or a combination of the following: a. 29 days and up to 3 months d. 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. Increase liability of a term nature e. Decrease holding of less liquid assets d. Present and planned capital position To satisfy funding needs. Present and anticipated asset quality g. Dispose off liquid assets b. Present and future earning capacity and h. Historical Funding requirement b. It shows the structure as of a particular date. Anticipated future funding needs d. Increase short term borrowings c. Sources of funds e. Maturity Liabilities are cash outflow and Maturity Assets are cash inflows. The mismatches in the first two buckets cannot exceed 20% of outflows. Banks can fix the tolerance level for other maturity buckets. 1 to 14 days b. Over 3 months and up to 6 months e. Assets and Liabilities to be reported as per their maturity profile into 8 maturity buckets: a. 15 to 28 days c. Options for reducing funding needs f.Asset Liability Management Analysis of following factors throws light on a bank‟s adequacy of liquidity position: a.

57 0. excess liquidity can be deployed in money market instruments.67 -7. Over 1 year and up to 3 years g. creating new assets & investment swaps etc. h. 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 .69 28.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 -14.18 -4.29 -15. Repos & deployment of foreign currency converted into rupee. Strategies 26 .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.64 6.76 -13.Asset Liability Management f.38 18. Bills rediscounting. it can be financed from market borrowings (Call/Term).  For negative mismatch.

2. Income derived from higher yielding assets may be offset if a forced sale.Asset Liability Management  To meet the mismatch in any maturity bucket. Furthermore. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand. 27 . management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. concentrate on adjusting the price and availability of credit and the level of liquid assets. cyclical. To maximize profitability. The decision whether or not to use liability sources should be based on a complete analysis of seasonal. which exceeds available deposit funds. Asset liquidity. Seasonal. assets that are often assumed to be liquid are sometimes difficult to liquidate. and the costs involved. is necessary because of adverse balance sheet fluctuations. In addition to supplementing asset liquidity. But banks. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. cyclical.  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. or may be heavily depreciated because of interest rate changes. and other factors. or how "salable" the bank's assets are in terms of both time and cost. investment securities may be pledged against public deposits or repurchase agreements. which rely solely on asset management. ASSET MANAGEMENT Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. For example. liability sources of liquidity may serve as an alternative even when asset sources are available. However. at less than book value. is of primary importance in asset management. the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.

Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. liability management is not riskless. which will maintain a positive yield spread. LIABILITY MANAGEMENT Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition.Asset Liability Management 3. The obvious difficulty in estimating the latter is that. as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions. it cannot determine with complete certainty that funds will be available and/or at a price. the availability of asset and liability options should result in a lower liquidity maintenance cost. misuse or improper implementation of liability management can have severe consequences. This is because concentrations in funding sources increase liquidity risk. larger banks have a wider variety of options from which to select the least costly method of generating funds. This does not preclude the option of selling assets to meet funding needs. In this context. at a reasonable cost vis-à-vis asset yield. 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. When funds are required. Further. 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. The ability to obtain additional liabilities represents liquidity potential. a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U. until the bank goes to the market to borrow. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities. banks or the economy.S. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. and conceptually. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. For example. liquidity represents the ability to attract funds in the market when needed.

management must constantly be aware of the composition. and result in a large concentration of short-term liabilities supporting assets of longer maturity. without considering maturity distribution. Also if rate competition develops in the money market. Preoccupation with obtaining funds at the lowest possible cost. That is why banks that particularly rely on wholesale funding sources. relax asset liquidity standards.Asset Liability Management source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities. which are already on its books. greatly intensifies a bank's exposure to the risk of interest rate fluctuations. this could cause an earnings squeeze and an illiquid condition. and diversification of its funding sources. characteristics. 29 . the higher cost of purchased funds may result in a negative yield spread. During times of tight money. If a bank is purchasing liabilities to support assets. a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities.

Ratio of loans to deposits.       Ratio of Non Performing Assets to Total Assets.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. Ratio of contingent liabilities for loans to total loans. Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits). Ratio of short-term demand deposits to total deposits. 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. 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 long-term loans to short term demand deposits. funds management and financial ratio analysis. Ratio of pledged securities to total securities. Below a step-by-step approach of ALM examination in case of a bank has been outlined.

with focus on funding and liquidity management aspects have to be looked into.   Reviewing the bank's budget projections for a certain period of time in the future. This entails:  Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis. 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.  Determining whether the bank has included sensitivity to interest rate risk in the development of its long term funding strategy. 31 .  Assessing the bank's ability to meet liquidity needs. Step 3 The banks future development and expansion plans. Determining whether the bank really needs to expand its activities. 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.

5. Are internal management reports concerning liquidity needs prepared regularly and reviewed as appropriate by senior management and the board of directors. A mechanism to coordinate asset and liability management decisions. Does the planning and budgeting function consider liquidity requirements? 3.Asset Liability Management  Determining the alternative sources of funding liquidity and/or assets subject to necessity. A method to identify liquidity needs and the means to meet those needs. 2.  Determining the impact of the bank's liquidity management on net earnings position. Whether the board of directors has been consistent with its duties and responsibilities and included:     A line of authority for liquidity management decisions. Step 6 Preparing an Asset/Liability Management Internal Control Questionnaire which should include the following: 1. 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. 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. Guidelines for the level of liquid assets and other sources of funds in relationship to needs. 6. 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 . Are the internal management reports for liquidity management adequate in terms of effective decision making and monitoring of decisions.

This is again mainly due to lack of data on the other businesses of the bank.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. 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. Discussions in most ALCOs that do meet regularly are oriented towards treasury activity rather than taking a view of the entire balance sheet. 2. However. 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. 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. As a measure of liquidity management. It is therefore likely that the RBI would introduce more detailed guidelines for ALM. 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. these guidelines have been reviewed and it has been decided that : 33 . The RBI has already come out with guidelines governing market risk including the need for banks to constitute an ALCO. given the state of data availability most bank ALCOs are not able to hold meaningful discussions on balance sheet risks. Having regard to the international practices. As per the guidelines.

The format of the Statement of Short-term Dynamic Liquidity may also be amended on the above lines. (c) The net cumulative negative mismatches during the Next day. Banks may. (d) Banks may undertake dynamic liquidity management and should prepare the Statement of Structural Liquidity on daily basis. 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. make concerted and requisite efforts to ensure coverage of 100 per cent data in a timely manner. may. however. 15 % and 20 % of the cumulative cash outflows in the respective time buckets in order to recognize the cumulative impact on liquidity. 2-7 days and 8-14 days. the revised norms as well as the supervisory reporting as per the revised format would commence with effect from the period beginning January 1. in due consideration of non-availability of a fully networked environment. To enable the banks to fine tune their existing MIS as per the modified guidelines. The Statement of Structural Liquidity. 8-14 days and 15-28 days buckets should not exceed 5 %. the frequency of supervisory reporting of the Structural Liquidity position shall be fortnightly. However. as on the third Wednesday of every month.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. however. with effect from the fortnight beginning April 1. 2008 and the reporting frequency would continue to be monthly for the present. The format of Statement of Structural Liquidity has been revised suitably and is furnished at Annex I. 4. once a month. 10%. 34 . 2008. 2-7 days. (b) The Statement of Structural Liquidity may be compiled on best available data coverage. be reported to RBI. Next day. 3.

The argument is that for all other purposes. Proper revisions to this document. Data and Models: Data may not be available at all times in requisite format. Risk organization in banks generally land up reporting to treasury. it is required to follow policy implicitly in both letter and spirit. 2.Asset Liability Management ISSUES IN IMPLEMENTATION OF ALM 1. documented and practical policy is a big hindrance to ALM implementation. as they are people who come closest to understanding complex financial instruments. assumptions are being made. However. especially at a top level. Openness and transparency are essential to a proper risk organization. 3. 4. in charge of „risk taking‟ is overlooked. As data may not be obtained from this branch for 6 months. 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. The fact that they are a business unit. ALCO membership itself may not be aware of implications of risks being measured and impact. Policies should address all issues concerning the bank. it is mapping of models to zero coupon bonds that are an issue. a quarterly review needs to be organized as well as parameters may be changing due to change in situations. in modern banking. „Risk Taking‟ and „Risk management‟ are generally two distinct parts of any organization and both must report to a board completely independently. Most often. Most organizations react badly to some positions going wrong by taking more risks and enter vicious cycle of risks. Once again. Organization and culture: ALM function needs to be separated clearly from operations as it involves control and strategy functions. will be helpful as it would help in decision –making. Sensible options need to be chosen and manual branch without computer was an example. appropriate assumptions have to be made in any event. Policy: Lack of a coherent. 35 . Formalization of understanding. Understanding of complexities: Many people in a bank need to understand risk measurements and risk mitigation procedures. all policies should be clearly explained to all members of board. It must be remembered that many data items are assumptions and gaps must be measured in perspective. Measurement of risk is a fairly simple phenomenon and does go on regardless. Thus. apart from ALCO and these must be documented.

Unrealistic goals: An ALCO secretary was seen desperately trying to tweak with parameters to „show‟ less gaps in liquidity reports. multiple models may be used to validate this conversion.Asset Liability Management arguments are that this should exist within the bank. Based on sophistication required. ALCO‟s job is to correctly determine positions and put in place appropriate remedial measures using appropriate risks. A zero gap is not practical. This is strictly outside ALM framework but integrates into ALM framework. Returns are expected for taking risks. Banks assume market and credit risk and hence they make returns. It is not to show things as good when they are not. 5. 36 .

whichever is earlier. 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. Since the objective is to maximize the NII. If the rate sensitive assets equal the rate sensitive liabilities. 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. If the rate sensitive assets are more than the rate sensitive liabilities. 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. The decision to hold a positive gap or a negative will depend on the expectation on the movement of interest rates.Asset Liability Management TECHNIQUES OF ASEET LIABILITY MANAGEMENT GAP Analysis Model: Under the Gap analysis method. Then the gap between the assets and liabilities under each time bucket is worked out. it is known as negative gap position. The effect of an upward movement or a downward movement in the interest rate on the NII will also depend on the position taken.

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. Advantages    Simple to analyze Easy to implement Helps in future analysis of Interest Rate Risk 38 . These periods are known as maturity buckets which vary across banks. both short-term and long-term interest rate change by the same amount.e.e. 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. 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. NII also decrease Assumptions    Contractual Repayment Schedule i. depending on the operating strategy. there is no early repayments or defaults Parallel Shift in Yield Curve i.e. NII also increase liabilities If interest rate increase. It is computed for assets and liabilities of differing maturities and is calculated for a set time horizon. 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. no early repayment or option like feature On Schedule Payments i.

55 15D-28D 405. 376.00 2.50 5Y+ 6.55 Cr in the deposit liability of deposits means that as on December 31 st.113.70 Total 25.12 1.00 8.35 12.27 16.00 44.37 3Y-5Y 3.33 121.10 0.05 4. Rs.81 5.014.03 104.54 12.85 563.75 6M-1Y 3.12 1. 705.085. It in not take time value of money or initial net worth into account.757.  It does not provide a single reliable index of interest rate.674.05 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.463.543.16 23.14 3. Similarly.00 1.89 2.87 0. 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.681.14D 705.806.00 132.95 29D-3M 1.66 376.38 52.43 0.36 9.74 3M-6M 1.00 4.27 1.26 0.62 44. 31st December 2009 ABC Bank Maturity Pattern of Assets and Liabilities as on 31.92 25.52 17.60 Here.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.00 43.73 61.254.40 132.2009 Rate Sensitive Liabilities Rate Sensitive Assets Maturity Buckets Foreign Borrow Currency ings Liabilities 0. The periods used in the analysis are arbitrary and repricing is assumed to occur at the midpoint of the period.48 20.36 0.59 0.33 5.00 2.64 777.08 147.807.371. Example of GAP ABC bank for which maturity Pattern of assets and liabilities as on a particular date i.69 Loans & Advances Foreign Investment Currency in Securities Assets 88.e.955.379.375. 39 .00 0. Rs.00 12.39 Deposits 1D .82 1Y-3Y 7.

shorten the maturities of loan and convert term loans to floating rate loans. 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 0.92 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.87 15.25%.52 6.22 3.14 0.62 -316.22 0.14D 15D-28D 29D-3M 3M-6M 6M-1Y 1Y-3Y 3Y-5Y 5Y+ RSL = Total Outflows RSA = Total Inflows GAP = RSA RSL Cumulative GAP -233.454. lengthen the maturities of loan and convert floating rate loans to term loans.50 7.98 6.843.30 -2.573.38 1.Asset Liability Management Results Maturity Buckets 1D .746.52 -5.085.10 1.96 3.809.96 -591.53 943.3 0.141. which means ABC bank can be grouped as liability sensitive.92 16.24 1.708.40 624.58 0.91 1.26 Observations From the results GAP amount is negative till 3-5 year period and positive for the last period.15 -489. Cumulative GAP amount is also negative for all time periods.26 6.02 -6.31 -881. GAP ratio is between 0.98 -6.03 153.69 0.3 and 0.058.93 0.80 525.492.09 5.60 -2. 40 .25% RSA/RSL decrease) 0.96 1. To reduce Rate Sensitivity Buy long-term securities.65 -233.70 11.49 -1.48 758.70 ΔNII = GAP GAP Ratio ΔI (for ΔI = = 0.824. To increase Asset Sensitivity Buy short-term securities.39 -1.15 410.31 13 0.434.60 3.79 -256.928.984.37 3.30 -916.117.

To increase Liability Sensitivity Pay premium to attract short-term deposits and borrow more non-core purchased liability. c. a. By using appropriate discounting factor. Timing and the magnitude of the cash flows is ascertained and calculated. 41 . 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. the present value of each of the cash flows needs to be worked out. asset-liability structure. . 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. b. d.  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. Under the duration method.e. Duration Analysis: The Gap method ignores time value of money.Asset Liability Management To reduce Liability Sensitivity Pay premium to attract long-term deposits and issue ling-term subordinated debt. The time weighted value of the present value of the cash flows is calculates. Duration analysis is useful in assessing the impact of the interest rate changes on the market value of equity i.

These pertain to accuracy of data and reliability of the assumptions made.. Simulation Analysis: It analyzes the interest-rate risk arising from both current and planned business. etc. 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. There are certain criteria for the simulation model to succeed. 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. one should be in a position to look at alternatives pertaining to prices.  Accurate evaluation of current exposures of asset and liability portfolios to interest rate risk.g.  Changes in multiple target variables such as NII. In other words. growth rates.Asset Liability Management   It offers flexibility in spread management. Limitations  It requires extensive data on specific characteristics and current market pricing schedules of financial instruments. Instead of changing the maturity structure of assets and liabilities. 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. reinvestments. under various 42 .  It requires high degree of analytical expertise regarding issues such as term structure of interest rates and yield curve dynamics. Capital adequacy and liquidity.

but also from slippage in credit quality.Asset Liability Management interest rate scenarios. Any risk assessment model shall normally predict relative risk than absolute risk. 43 . Hence. In general. The objective of any risk assessment model is to initiate risk mitigating actions. This is due to credit risk. 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. Thus. banks review financial statements of borrowers once a year and allot credit ratings. 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. This could be difficult and sometimes contentious. the volatility of value due to changes in the quality of the credit needs to be estimated to calculate VAR. 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. 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. which emanates not only from counter party default.

may result in distorted results.Asset Liability Management Hence.   This model does not take already defaulted customers into account. 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. Limitations  This study is useful only for normal operative accounts to predict their probability of default. changes in government policies. any risk measurement model can be tailored to suit different time horizons based on actual need.. Macro level changes in an industry. etc. the risk assessment is more accurate.  In this methodology if the VAR measurement is for shorter duration. 44 .

86% GAP = 500 – 600 = -100 45 .06 x 220) NII = 78.2 = 41.5 .3 NIM = 41. if there is a mismatch between amount of assets and liabilities it causes interest rate risk and affects NII.37. Even though maturity dates are same.11 x 350) . It builds up Assets and Liabilities of the bank based on the concept of Net Interest Income (NII) or Net Interest Margin (NIM).Asset Liability Management GAP AND NII ALM is heavily dependent on the movements of interest rates in the market. 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 = (0.04 x 600 + 0.(0.3/850 = 4.08 x 500 + 0.

05 x 600 + 0.600 = -100 With a negative gap.11 x 350) .11 x 350) .06 x 220) NII = 83.(0.06 x 220) NII = 81 .8 NIM = 34.09 x 500 + 0.2 = 40.5% 600 5. hence NII & NIM fall 1% decrease in spreads 1% decrease in spread Particulars Assets Yield Libilities Cost Rate Sensitive 500 8.2 = 34.3 NIM = 40.3 / 850 = 4.43.600 = -100 46 .5 .5% Fixed Rate 350 11% 220 6% Non Earning 150 100 Equity 80 Total 1000 1000 NII = (0.09% GAP = 500 .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 = (0.74% GAP = 500 .055 x 600 + 0.8 / 850 = 4.085 x 500 + 0.46.(0. more liabilities than assets reprice higher.

62% 47 .06 x 440) NII = 157 . 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 = (0.08 x 540 + 0.04 x 560 + 0.86% GAP = 1000 .74. Net interest income varies directly with the changes in the volume of earning assets and interest bearing liabilities.06 x 260) NII = 77. 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 = (0.4 = 82.04 x 1200 + 0. regardless of the level of interest rates.11 x 310) .6 / 1700 = 4.3 . This is because.1200 = -200 NII & GAP doubled.11 x 700) . fixed assets decrease and RSL decrease.(0.38 = 39. if liabilities are short-term and assets are long-term.3 / 850 = 4.6 NIM = 82.(0. If RSA increase.08 x 1000 + 0. the spread will widen as the yield curve increases in slope and narrow when the yield curve decreases in slope and/or inverts. but NIM remains the same.3 NIM = 39.Asset Liability Management NII & NIM fall (rise) with a decrease (increase) in the spread.

Changes in portfolio composition and risk  To reduce risk. 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.Asset Liability Management GAP = 540 .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.     www.Asset Liability Management BIBLIOGRAPY  Asset Liability Management in Banks – ICFAI Bank Financial Management – Indian Institute of Banking and Finance  49  www.