Study of asset liability management in Indian banks.

Introduction
Asset Liability Management (ALM) defines management of all assets and liabilities (both off and on balance sheet items) of a bank. It requires assessment of various types of risks and altering the asset liability portfolio to manage risk. Till the early 1990s, the RBI did the real banking business and commercial banks were mere executors of what RBI decided. But now, BIS is standardizing the practices of banks across the globe and India is part of this process. The success of ALM, Risk Management and Basel Accord introduced by BIS depends on the efficiency of the management of assets and liabilities. Hence these days without proper management of assets and liabilities, the survival is at stake. A banks liabilities include deposits, borrowings and capital. On the other side pf the balance sheets are assets which are loans of various types which banks make to the customer for various purposes. To view the two sides of banks balance sheet as completely integrated units has an intuitive appeal. But the nature, profitability and risk of constituents of both sides should be similar. The structure of banks. balance sheet has direct implications on profitability of banks especially in terms of Net Interest Margin (NIM). So it is absolute necessary to maintain compatible asset-liability structure to maintain liquidity, improve profitability and manage risk under acceptable limits.

ALM MODELS

Analytical models are very important for ALM analysis and scientific decision making. The basic models are: 1. GAP Analysis Model 2. Duration GAP Analysis Model 3. Scenario Analysis Model 4. Value at Risk (VaR) model 5. Stochastic Programming Model Any of these models is being used by banks through their Asset Liability Management Committee (ALCO). The Executive Director and other vital departments heads head ALCO in banks. There are minimum four members and maximum eight members. It is responsible for Responsible for Setting business policies and strategies, Pricing assets and liabilities, Measuring risk, Periodic review, Discussing new products and Reporting.

OBJECTIVES OF THE STUDY

Though Basel Capital Accord and subsequent RBI guidelines have given a structure for ALM in banks, the Indian Banking system has not enforced the guidelines in total. The banks have formed ALCO as per the guidelines; but they rarely meet to take decisions. Public Sector banks are yet to collect 100% of ALM data because of lack of computerization in all branches. With this background, this research aims to find out the status of Asset Liability Management across all commercial banks in India with the help of multivariate technique of canonical correlation. The discussion paper has following objectives to explore: To study the Portfolio-Matching behavior of Indian Banks in terms of nature and strengths of relationship between Assets and Liability To find out the component of Assets explaining variance in Liability and viceversa To study the impact of ownership over Asset Liability management in Banks To study impact of ALM on the profitability of different bank-groups

METHODOLOGY
The study covers all scheduled commercial banks except the RRBs (Regional Rural Banks). The period of the study was from 1992 2004. The banks were grouped based on ownership structure. The groups were 1. Nationalized Banks except SBI & Associates ( 19 ) 2. SBI and Associates ( 8) 3. Private Banks( 30) 4. Foreign Banks(36)

RECLASSIFICATION OF ASSETS & LIABILITIES

The assets and liabilities of a Bank are divided into various sub heads. For the purpose of the study, the assets were regrouped under six major heads and the liabilities were regrouped under four major heads as shown in table below. This classification is guided by prior information on the liquidity-return profile of assets and the maturity-cost profile of liabilities. The reclassified assets and liabilities covered in the study exclude other assets on the asset side and other liabilities on the liabilities side. This is necessary to deal with the problem of singularity a situation that produces perfect correlation within sets and makes correlation between sets meaningless. The relevant data has been collected from the RBI website.

CANONICAL CORRELATION ANALYSIS

Multivariate statistical technique, canonical correlation has been used to access the nature and strength of relationship between the assets and liabilities. To explore the relationship between assets and liabilities, we could merely compute the correlation between each set of assets and each set of liabilities. Unfortunately, all of these correlations assess the same hypothesis - that assets influence liabilities. Hence, a Bonferroni adjustment needs to be applied. That is, we should divide the level of significance by the number of correlations. This Bonferroni adjustment, of course, reduces the power of each correlation and thus can obscure the findings. Canonical correlation provides a means to explore all of the correlations concurrently andthus obviates the need to incorporate a Bonferroni adjustment. The technique reduces the relationship into a few significant relationships.The essence of canonical correlation Measures the strength of relationship between two sets of variables (Assets (6) & Liabilities (4) in this case) by establishing linear combination of variables in one set and a linear combinations of variables in other set. It produces an output that shows the strength of relationship between two variates as well as individual variables accounting for variance in other set . A = A1 * (Liquid Assets) + A2 * (SLR Securities)+ A3 * (Investments) + A4 * (Term Loans) + A5 * (Short Term Loans) + A6 * (Fixed Assets) B = B1 * (Net Worth) + B2* (Borrowings) + B3 *(Short Term Deposits) + B4 * (Long Term Deposits) To begin with, A and B (called canonicalvariates) are unknown. The technique tries to compute the values of Ai and Bi such that the covariance between A & B is maximum.

Foreign Banks R square Canonical Loadings Assets LA SLR INV TL STL FA Liabilities NW BOR STD LTD Redundancy Asset Liability 0.948

Pvt Banks 0.997

Nationalised Banks 0.987

SBI & Associates 0.998

0.243 0.078 0.314 -0.469 0.268 -0.903 -0.664 0.171 0.498 -0.255 0.212 0.196

0.716 0.712 -0.467 -0.464 0.461 -0.945 -0.948 -0.523 0.972 -0.201 0.426 0.539

-0.046 -0.328 -0.662 0.188 0.747 -0.728 -0.885 0.593 0.126 0.007 0.279 0.288

0.237 0.744 0.858 0.568 -0.88 0.644 0.831 -0.83 -0.457 0.964 0.476 0.629

The first row (R2) is a measure of the significance of the correlation. In this case all the correlations are significant. The canonical loading is a measure of the strength of the association i.e. it is the percent of variance linearly shared by an original variable with one of the canonical variates. A loading greater that 40% is assumed to be significant. A negative loading indicates an inverse relationship. For example, for Foreign Banks, Fixed Assets (FA) under Assets has a loading of -0.903 and Net Worth (NW) under liabilities has a loading of -0.664. Since both are negative this means there is a strong correlation between FA and NW. Similarly for Foreign Banks, we can observe that there is a strong negative correlation betweenshort term deposit with both Term Loan and Fixed Asset.

OBSERVATIONS
As per the summary table above, the canonical co-relation coefficients of different set of banks indicate that different banks have different degree of association among constituents of assets and liabilities. Bank-Groups can be arranged in decreasing order of correlation: SBI & Associates Private Banks Nationalized Banks Foreign Banks Redundancy factors indicate how redundant oneset of variables is, given the other set of variable which gives an idea about independent anddependent sets. This also gives an idea aboutthe fact that whether the bank is assetmanaged or liability managed. Looking at the redundancy factors, the independent and dependent sets for different bank- groups can beidentified:

Other than foreign bank groups, all other three have asset as their independent set. This means during the study period (1992-2004), these banks were actively managing assets and liability was dependent upon how well the assets are managed. This is in perfect consonance with the macro indicators. The interest rates were coming down all these years and banks were busy in parking their assets in different avenues where they could get maximum return. Lately, the scenario has changed in terms of interest rates. Now as there is ample liquidity in the market, banks especially the bigger one is not concerned about the liability. They can always borrow from active money market to manage their liability.

Foreign Banks
The canonical function coefficient or the canonical weight of different constituents in case of foreign banks Term Loans and Fixed Assets form asset side and Net Worth and Short Term Deposit from liability side have significant presence with following interpretation: Very strong co-relation between Fixed Assetand Net Worth. Strong negative correlation between short term deposit with both Term Loan and Fixed Asset. This indicates Proper usage of short term deposit. Not used for long term assets or long term loans.

Private Banks
In case of private banks all constituents of asset side Liquid Assets, SLR Securities, Short Term Loans, Investments, Term Loans, and Fixed Asset are

significantly explaining the co-relation while on liability side only Net Worth and Short Term Deposit are contributing. This shows how actively these banks manage their asset to generate maximum return. This relationship can be interpreted in the following ways: Very strong co-relation between FA and NW. Short Term Deposits is used for Liquid Assets, SLR and Short Term Loans. As defined above LA, SLR and STL all are highly liquid section of assets. So it is very prudent to employ short term deposit. Borrowings are used for Investment and Term Loans. As defined, borrowings are near maturity liability while investment and term loans are of long term maturity. So the private banks are using risky strategy of deploying short term fund in long term investment which is clearly against right asset-liability management. Under normal circumstances long term investment gives better returns, so this strategy is to generate additional profitability at the cost of liquidity. However as the money market has become more matured, it is easy to manage liquidity without much of risk.

Nationalized Banks
In case of nationalized banks Investment, short term loan, fixed asset contribute significantly in explaining asset part while net worth and borrowings constituent of liability is major factor. The major interpretations are:

 Very strong co-relation between FA and NW. Nationalized banks use Borrowings for Short Term Loans. There is negative co-relation between Borrowings and investment. More concerned with liquidity than profitability Conservative strategy ( in comparison toPrivate Banks) Good short term maturity/liquidity management Nationalized banks use a borrowing (which is near term maturity) for short term a loan which is effective way of ALM. However nationalized banks deploy long term liability in short term assets. This is distinctly different from private banks strategy. The nationalized banks are more concerned about liquidity than profitability.

SBI & Associates

For SBI group all constituents of Liability namely Net worth, borrowings, short term deposits and long term deposits are significant while in assets side SLR investment, Investments, Term loans and fixed assets are significant. Following can be interpreted: Very strong correlation between FA and NW Strong correlation between Borrowings and STL.

 Correlation between Long term Deposits and Term Loans, Investment and SLR. Short Term Deposits and Short Term Liabilities are correlated. Most Conservative strategy Over concerned with liquidity Use Long term funds for Long as well as medium & short term loans Among all bank-groups, SBI & Associates seem to be most prudent asset liability management as short term liability is matched with short term asset and long term assets is matched with long term liability. But at the same time, this group deploy long term fund for medium and short term loans. This can be called over concerned with liquidity and that too by paying a price in terms of less profitability by foregoing the opportunity to deploy them in long term assets.

PROFITABILITY ANALYSIS OF BANKS

As discussed above, private banks are more aggressive in managing their portfolio for better profit realization. So let us look into the profitability of these banks and relate that to their ALM. For this all banks are divided into two groupsPublic and Private. Nationalized along with SBI are clubbed together as public banks while foreign and private banks are clubbed together as private banks. The profit figures can be compared in terms of Net Profit Margin, Return on Net Worth and Equity Multiplier. Following graph depicts the comparison The above comparison shows that till 2002, private banks were better in terms of profitability indicators. The aggressive strategy adopted by them in terms of deploying asset for long term is being reflected in the better profitability as compared to public

sector banks. Since 2002, the public banks have caught up with private banks. This can be due to second generation banking reforms, deregulation and more autonomy given to the banks in terms of directed credit and regulated interest rates. NET PROFIT MARGIN (%)
16 14 12 10 8 6 4 2 1997 2001 1995 1996 1998 1999 2000 2002 2003 2004 0 Public Private

RETURN ON NET WORTH (%)

30 25 20 15 10 5 0 Public Private

1997

2001

1995

1996

1998

1999

2000

2002

2003

2004