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Assets liability management has today become the most topical subject of any financial
institution. It encompasses the analysis and development of goals and objectives, the
development of long term strategic plans, periodic profit plans and rate sensitivity
management. In one way or another it has always been the function or responsibility of
Treasury and other financial/ strategic department is being established and assets liability
management department are being formed within financial institution. These committees are
often given extraordinary powers regarding the mix and match of assets and liabilities and
have large influence in winding up activities which do not fit business strategy.
It is true that banks create both assets and liabilities in their day-to-day operations, but it is
also equally true that risk management in bank is keener to manage their assets rather than
their liabilities. In fact, for some time, bankers were happy to keep an eye on their assets
acquisition and treated the liability as granted.
Of late, the mindset has changed and banks increasingly shown equal, if not more, interest in
liability management. In fact, bank’s main business is to manage risk. Importantly, liquidity
and interest risk management constitutes the core business of banks.
To be more precise, banks are in the business of maturity transformation. They accept
deposits of different maturities and advance loan of different maturities. Balancing and
adjusting maturity period of deposits and loans from the core business activity of banks.
If this activity of a bank is analyzed, one may observe that banks also transfer the risk
appetite of customers to each other through market operation.
These activities of banks result in management of liquidity and interest risk in their
operations. In early day’s bank were mongering risks by having in-depth knowledge of
In day-to-day operation, it is inevitable for bank to face liquidity imbalance due to various

Traditionally, banks and insurance companies used accrual system of accounting for all their
assets and liabilities. They would take on liabilities - such as deposits, life insurance policies
or annuities. They would then invest the proceeds from these liabilities in assets such as
loans, bonds or real estate. All these assets and liabilities were held at book value. Doing so
disguised possible risks arising from how the assets and liabilities were structured.
Consider a bank that borrows 1 Core (100 Lakhs) at 6 % for a year and lends the same money
at 7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank
is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the
bank will have to find new financing for the loan, which will have 4 more years before it
matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the
new financing than the fixed 7 % it is earning on its loan.
Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious
trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its financing.
Accrual accounting does not recognize this problem. Based upon accrual accounting, the
bank would earn Rs 100,000 in the first year although in the preceding years it is going to
incur a loss.
The problem in this example was caused by a mismatch between assets and liabilities. Prior
to the 1970's, such mismatches tended not to be a significant problem. Interest rates in
developed countries experienced only modest fluctuations, so losses due to asset-liability
mismatches were small or trivial. Many firms intentionally mismatched their balance sheets
and as yield curves were generally upward sloping, banks could earn a spread by borrowing
short and lending long.
Things started to change in the 1970s, which ushered in a period of volatile interest rates that
continued till the early 1980s. US regulations which had capped the interest rates so that
banks could pay depositors, were abandoned which led to a migration of dollar deposit
overseas. Managers of many firms, who were accustomed to thinking in terms of accrual
accounting, were slow to recognize this emerging risk. Some firms suffered staggering losses.
Because the firms used accrual accounting, it resulted in more of crippled balance sheets than

bankruptcies. Firms had no options but to accrue the losses over a subsequent period of 5 to
10 years.
One example, which drew attention, was that of US mutual life insurance company "The
Equitable." During the early 1980s, as the USD yield curve was inverted with short-term
interest rates sky rocketing, the company sold a number of long-term Guaranteed Interest
Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. Equitable then
invested the assets short-term to earn the high interest rates guaranteed on the contracts. But
short-term interest rates soon came down. When the Equitable had to reinvest, it couldn't get
even close to the interest rates it was paying on the GICs. The firm was crippled. Eventually,
it had to demutualize and was acquired by the Axa Group.
Increasingly banks and asset management companies started to focus on Asset-Liability Risk.
The problem was not that the value of assets might fall or that the value of liabilities might
rise. It was that capital might be depleted by narrowing of the difference between assets and
liabilities and that the values of assets and liabilities might fail to move in tandem. Assetliability risk is predominantly a leveraged form of risk.
The capital of most financial institutions is small relative to the firm's assets or liabilities, and
so small percentage changes in assets or liabilities can translate into large percentage changes
in capital. Accrual accounting could disguise the problem by deferring losses into the future,
but it could not solve the problem. Firms responded by forming assets-liability management
( ALM ) department to assess these assets-liability risk.

An effective Asset Liability Management technique aims to manage the volume mix,
maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to
attain a predetermined acceptable risk/reward ratio.

Review the interest rate structure and compare the same to the interest/product pricing
of both assets and liabilities.


Examine the loan and investment portfolios in the light of the foreign exchange risk
and liquidity risk that might arise.


Examine the credit risk and contingency risk that may originate either due to rate
fluctuations or otherwise and assess the quality of assets.


Review, the actual performance against the projections made and analyse the reasons
for any effect on spreads.

The Assets Liability Management technique so designed to manage various risk primarily
aim to stabilize the short profits.
-Net Interest Income (NII)
-Net Interest Margin (NIM)
-Economic Equity Ratio

1. Net Interest Income (NII):

The impact of volatility on the short. 2. This fact assesses the sustenance capacity of the bank. 3. Net Interest Income = Interest Income – Interest Expenses. Economic Equity Ratio: The ratio of shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. The higher the spread the more will be the NIM. OBJECTIVE OF ASSETS LIABILITY MANAGEMENT . The net income of banks comes mostly from the spreads maintained between total interest income and total interest expense. Net Interest Margin can be viewed as the ‘spread’ on earning assets. Net Interest Margin (NIM): Net Interest Margin = Net Interested Income / Average Total Assets.term profit is measured by Net Interest Income.

The gap in then assessed to identify future financing Requirements. SIGNIFICANCE OF ALM . 2. 1. 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. This exercise would indicate whether the institution is in a position to benefit from rising interest rates by having a positive gap (assets > liabilities) or whether it is in a position to benefit from declining interest rates by a negative gap(liabilities > assets). there are often maturity mismatches. which may to a certain extent affect the expected result. However. Price Matching basically aims to maintain spreads by ensuring that deployment of liabilities will be at a rate higher than the costs.At micro – level the objectives of Assets Liability Management are two folds.

Central Bank in various countries (including Reserve Bank of India) has issued frameworks and guidelines for banks to develop Assets Liability Management policies. Bank for International Settlement (BIS) provides a framework for banks to tackle the market risks that may arise due to rate fluctuation and excessive credit risk. Assets Liability Management views the financial institution as a set of interrelationships that must be identified coordinated and managed as an integral system. Regulatory Environment At the international level.In simple terms. While there were some innovations that came as passing fads. Thus.a financial institution may have enough assets to pay off its liabilities. But what if 50% of liabilities are maturing within 1 year but only 10% of assets maturing within the same period. ALM is required to match the assets and liabilities and minimize liquidity as well as market risk. Some of reasons for growing significance ALM are: 1. The vagaries of such free economic environment are reflected in interest rate structures. 3. Management Recognition . the exchange rate and price level. 2. Though the financial institution has enough assets. Product Innovation The second reason for growing importance of ALM is rapid innovation take place in financial product of bank. Volatility Deregulation of financial system changed the dynamics of financial markets. others have received tremendous response. money supply and overall credit position of the market. 4. The primary management goal is the control of income and expenses and the resulting net interest margins on ongoing basis. it may become temporarily insolvent due to severe liquidity crisis.

And this calls for efficient Asset. There is increasing awareness in the top management that banking is now a different game altogether since all risks of the game have since changed.All the above – mentioned aspects forced bank management to give a serious thought to effective management of assets and liabilities. SCOPE OF ASSETS LIABILITY MANAGEMENT .Liability Management. A bank shoul be in a position to relate and link the asset side with liability side.

a. The Treasury Department undertakes operational tasks of executing the detailed strategies and actions. in such context.The scope of Asset Liability Management (ALM) must be clearly defined. neither ALM nor ALCO get associated. the goals are. COMPONENTS OF A BANK BALANCE SHEET . To maximize or at least to stabilize the net interest margin and b. directing actions an monitoring implementation thereof for shaping bank’s balance sheet that contributes to attainment of the bank’s goals. To maximize or at least to protect the value or stock price. in any way. It is recognized that ALM addresses to the managerial tasks of planning. Normally. at an acceptable level. It has the purpose of formulating strategies. Managing risk / return trade off with in the ALM framework provided by ALCO is the task of Treasury and not ALM / ALCO. with the operational aspects of funds management. directing and monitoring. In any case.

Revenue and Other Reserves V. Deposits 3. Other Liabilities 5. Other Assets COMPONENTS OF LIABILITIES 1.LIABILITIES ASSETS 1. Reserve & Surplus 1. Balance With Banks & Money at Call and Short Notices 3.  It is considered to be a long term sources for the bank. Capital: Capital represents owner’s contribution/stake in the bank. Advances 5. Balance in Profit and Loss Account 3. Cash & Balances with RBI 2. Investments 4. Fixed Assets 6. Borrowings 4. Statutory Reserve II.  It serves as a cushion for depositors and creditors. Investment Fluctuation Reserve IV. Capital Reserves III. Reserves & Surplus: Components under this head include: I. Capital 1. 2. Deposits: .

This is the main source of bank’s funds. Inter-bank & other institutions) I. Bills Payable Inter Office Adjustments (Net) Interest Accrued IV. Term Deposits 4. III. Borrowings in India i) Reserve Bank of India ii) Other Banks iii) Other Institutions & Agencies II . II.Borrowings outside India 5. Other Liabilities & Provisions: It is grouped as under: I. Demand Deposits II. Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) IV. Other (including provision) COMPONENTS OF ASSETS . The deposits are classified as deposits payable on ‘demand’ and ‘time’. Savings Bank Deposits III. They are reflected in balance sheet as under: I. Borrowings: (Borrowings include Refinance / Borrowings from RBI.

Balances With Banks And Money At Call & Short Notice I. Investments: .1. outside India a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice 2. Cash & Bank Balances with RBI I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts 2. In India i) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks b) With Other Institutions II.

COD & Mutual Fund Units etc. Investments in India in: i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bond v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares. Particulars of Advances: i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured .) II. Commercial Papers.A major asset item in the bank’s balance sheet. Investments outside India Subsidiaries and/or Associates abroad 4. Advances: The most important assets for a bank. i) Bills Purchased and Discounted ii) Cash Credits. Reflected under 6 buckets as under: I. Overdrafts & Loans repayable on demand iii) Term Loans B.

Fixed Asset: I. Stationery and Stamps IV. BANKS PROFIT & LOSS ACCOUNT A bank’s profit & Loss Account has the following components: I. and Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads. Guarantees. Interest accrued II. Premises II. Others CONTINGENT LIABILITY Bank’s obligations under LCs. Deferred Tax Asset (Net) VI. . Other Assets: I.5. Tax paid in advance/tax deducted at source (Net of Provisions) III. Income: This includes Interest Income and Other Income. Non-banking assets acquired in satisfaction of claims V. Other Fixed Assets (Including furniture and fixtures) 6.

Income earned by way of dividends etc.II. COMPONENTS OF INCOME 1. from subsidiaries and Associates abroad/in India VII. Income on Investments III. Other Income I. Interest/Discount on Advances / Bills II. Profit on exchange transactions (Net) VI. Interest Earned I. Profit on sale of Investments (Net) III. Operating Expenses and Provisions & contingencies. Exchange and Brokerage II. Interest on balances with Reserve Bank of India and other inter-bank funds IV. Miscellaneous Income COMPONENTS OF EXPENSES I. Profit/ (Loss) on Revaluation of Investments IV. . Expenses: This includes Interest Expended. Payments to and Provisions for employees. Profit on sale of land. Commission. buildings and other assets (Net) V. Others 2.

Insurance XII. Other Expenditure . Telegrams. Repairs and Maintenance XI. Law Charges.II. Telephones etc. IX. Taxes and Lighting III. Rent. Postages. V. VIII. Advertisement and Publicity. Directors' Fees. Depreciation on Bank's property. VII. Allowances and Expenses. V. Printing and Stationery IV. X. Auditors’ Fees and Expenses (including Branch Auditors).

To the extent that perfect matching is not possible. . ALM. therefore. Moreover. which leads to an unattractive level of contribution to assets. This interest rate risk management techniques can be extended beyond a simple duration-based approach to fairly general contexts. probably more important. disadvantages of the cash-flow matching technique are that is that represented by the positioning that is extreme and not necessary optimal for the investor in the risk/return space.TECHNIQUES OF ASSETS LIABILITY MANAGEMENT Asset liability management denotes the adaptation of the profit management process in order to handle the presence of various constraint relating to the commitments that figure in the liabilities of an institutional investor’s balance sheet (commitments to paying pensions. which lead to problem of reinvesting the coupons. insurance premium etc.type management techniques can be classified into several categories. for perfect risk management. as many types of liability constraints as there are types of institutional investor. that this technique is difficult to adapt to hedging non-linear risk related to the presence of options hidden in the liability structures. Including for example. or to simultaneous management of interest rate risk and inflation risk. nevertheless presents a number of limitations.). In fact. related to absence of risk premia. hedging non-parallel shifts in the yield curve. the lack of return. It should be noted. This technique. and thus as many types of approaches to Assets liability management. which allows the residual interest rate risk created by the imperfect match between the assets and liabilities to be managed in an optimal way. Another. we can say that the cash-flow matching approach in ALM is the framework. A first approach called cash-flow matching involves ensuring a perfect match between the cash flows from the portfolio of assets and commitments in the liabilities. most of those securities pay out coupons. it will generally be impossible to find inflation-linked securities whose maturity corresponds exactly to the liability commitments. There are. makes this approach very costly. there is a technique called immunization. which provides the advantage of simplicity and allow. First of all. in theory. however. However.

In a concern to improve the profitability of the assets. These can be financial risk (inflation. which makes the amount of liability cash flows. the excess value of the assets compared to the liabilities. stocks) or non financial risks (demographic ones in particular). dependent on interest rate risk. For example. i. an insured person cans (typically in exchange for penalties) Cancel his/her life assurance contract if the guaranteed contractual rate drops significantly below the interest rate level prevailing at date flowing the signature of the contract.e. In particular. . interest rate.. it is useful to turn to stochastic models that allow for a representation of the uncertainty relating to a set of risk factors that impact the liabilities. in a risk/return space. therefore to reduce the level of contributions. and not just their current value. it is necessary to introduce assets classes (stock. agent behavior models are then developed which allows the impact on decisions linked to the exerting of certain implicit options to be represented. It will then involve finding the best possible compromise between the risk (relative to the liability constraints ) there by taken on. When necessary. and the excess return that the investor can hope to obtain through the exposure to rewarded risk factor Different techniques are then used to the optimize the surplus. government bonds and corporate bonds) which are not perfectly correlated with the liabilities in to strategic allocation.

If liquidity needs are not met through liquid asset holdings. techniques. systemic or instrument-specific. regional. The price of liquidity is a function of market conditions and market perception of the risks. An organization has adequate liquidity when it can obtain sufficient funds. a bank may be forced to restructure or acquire additional liability under adverse market conditions. Funds management represents the core of sound bank planning and financial management. External liquidity risks can be geographic. Liquidity Management Liquidity represents the ability to accommodate decreases in liabilities and to fund increases in assets. Sound liquidity risk management should address both types of exposure. it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Although funding practices. Internal liquidity risk relates largely to the perception of an institution in its various markets: local.ASSET-LIABILITY MANAGEMENT APPROACH ALM in its most apparent sense is based on funds management. which have been discussed briefly. and norms have been revised substantially in recent years. Liquidity exposure can stem from both internally (institution-specific) and externally generated factors. A. Liquidity is essential in all organizations to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. funds management has following three components. both interest rate and credit risks. promptly and at a reasonable cost. reflected in the balance sheet and off-balance sheet activities in the case of a bank. Determination of the adequacy of a bank's liquidity position depends upon an analysis of it’s:  Historical funding requirements  Current liquidity position . Therefore. either by increasing liabilities or by converting assets. national or international.

or may be heavily depreciated because of interest rate changes. investment securities may be pledged against public deposits or repurchase agreements. . Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. The cost of maintaining liquidity is another important prerogative. management must consider the current ratings by regulatory and rating agencies when planning liquidity needs. The amount of liquid assets a bank should hold depends on the stability of its deposit structure and the potential for rapid expansion of its loan portfolio. But banks. Furthermore. If deposit accounts are composed primarily of small stable accounts. liability management or a combination of both. management must decide how to meet them through asset management. concentrate on adjusting the price and availability of credit and the level of liquid assets. a relatively low allowance for liquidity is necessary Additionally. Asset Management Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. Anticipated future funding needs  Sources of funds  Present and anticipated asset quality  Present and future earnings capacity  Present and planned capital position As all banks are affected by changes in the economic climate. However. B. assets that are often assumed to be liquid are sometimes difficult to liquidate. Once liquidity needs have been determined. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. For example. which rely solely on asset management. the monitoring of economic and money market trends is key to liquidity planning. Management must also have an effective contingency plan that identifies minimum and maximum liquidity needs and weighs alternative courses of action designed to meet those needs. the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads. An institution that maintains a strong liquidity position may do so at the opportunity cost of generating higher earnings.

and conceptually. is of primary importance in asset management. is necessary because of adverse balance sheet fluctuations. Liability Management Liquidity needs can be met through the discretionary acquisition of funds on the basis of interest rate competition. Consideration must be given to such factors as the frequency with which the banks must regularly refinance maturing purchased liabilities. The ability to obtain additional liabilities represents liquidity potential. To maximize profitability. C. and the costs involved. cyclical. management must carefully weigh the full return on liquid assets (yield plus liquidity value) against the higher return associated with less liquid assets. Seasonal. at less than book value. The decision whether or not to use liability sources should be based on a complete analysis of seasonal. it cannot determine with complete certainty that funds will be available and/or at a . Income derived from higher yielding assets may be offset if a forced sale. the availability of asset and liability options should result in a lower liquidity maintenance cost. liability sources of liquidity may serve as an alternative even when asset sources are available. A bank relying strictly on asset management would restrict loan growth to that which could be supported by available deposits. In addition to supplementing asset liquidity. The marginal cost of liquidity and the cost of incremental funds acquired are of paramount importance in evaluating liability sources of liquidity. as well as an evaluation of the bank's ongoing ability to obtain funds under normal market conditions.Asset liquidity. until the bank goes to the market to borrow. This does not preclude the option of selling assets to meet funding needs. 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. which exceeds available deposit funds. or how "salable" the bank's assets are in terms of both time and cost. The obvious difficulty in estimating the latter is that. and other factors. cyclical. The alternative costs of available discretionary liabilities can be compared to the opportunity cost of selling various assets. or other factors may cause aggregate outstanding loans and deposits to move in opposite directions and result in loan demand.

Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities. relax asset liquidity standards. which will maintain a positive yield spread. Further. a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. During times of tight money. misuse or improper implementation of liability management can have severe consequences. liability management is not risk less. this could cause an earnings squeeze and an illiquid condition. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money market Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand. Replacing foreign source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. and result in a large concentration of short-term liabilities supporting assets of longer maturity. That is why banks who particularly rely on wholesale funding sources. without considering maturity distribution. . the higher cost of purchased funds may result in a negative yield spread. characteristics. banks or the economy. management must constantly be aware of the composition. liquidity represents the ability to attract funds in the market when needed.price. Also if rate competition develops in the money market. For example. greatly intensifies a bank's exposure to the risk of interest rate fluctuations. and diversification of its funding sources. This is because concentrations in funding sources increase liquidity risk. 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. Preoccupation with obtaining funds at the lowest possible cost. In this context.S. at a reasonable cost vis-à-vis asset yield. which are already on its books.

3. . together with increasing volatility in the domestic interest rates as well as foreign exchange rates.RBI GUIDELINES 1. This note lays down broad guidelines in respect of interest rate and liquidity risks management systems in banks which form part of the Asset-Liability Management (ALM) function. foreign exchange risk. The ALM process rests on three pillars: 1. Over the last few years the Indian financial markets have witnessed wide ranging changes at fast pace. => Level of top management involvement. Intense competition for business involving both the assets and liabilities. accuracy. 2. These pressures call for structured and comprehensive measures and not just ad hoc action.ASSETS LIABILITYMANAGEMENT (ALM) SYSTEM IN BANK. Banks are exposed to several major risks in the course of their business credit risk. adequacy and expediency. ALM organization => Structure and responsibilities. driven by corporate strategy. has brought pressure on the management of banks to maintain a good balance among spreads. => Information availability. managing business after assessing the risks involved. liquidity risk and operational risks. equity / commodity price risk. ALM information systems. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process. The initial focus of the ALM function would be to enforce the risk management discipline viz. interest rate risk. profitability and long-term viability. 2. The objective of good risk management programmes should be that these programmes will evolve into a strategic tool for bank management. => Management Information System.

b) The Asset .e. in view of the centralized nature of the functions.3. In respect of foreign exchange. 4. 5. investment portfolio and money market operations. ALM process => Risk parameters => Risk identification => Risk measurement => Risk management => Risk policies and tolerance levels. The spread of computerization will also help banks in accessing data. The data and assumptions can then be refined over time as the bank management gain experience of conducting business within an ALM framework. . foreign exchange and equity price risks. The problem of ALM needs to be addressed by following an ABC approach i. it would be much easier to collect reliable information.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. 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. ALM information systems Information is the key to the ALM process. ALM Organization a) The Board should have overall responsibility for management of risks and should decide the risk management policy of the bank and set limits for liquidity. Considering the large network of branches and the lack of an adequate system to collect information required for ALM which analyses information on the basis of residual maturity and behavioural pattern it will take time for banks in the present state to get the requisite information. interest rate.

Individual banks will have to decide the frequency for holding their ALCO meetings. In respect of the funding policy. In addition to monitoring the risk levels of the bank. the CEO/CMD or ED should head the Committee. Each bank will have to decide on the role of its ALCO. Credit. 2) The ALCO is a decision making unit responsible for balance sheet planning from risk return perspective including the strategic management of interest rate and liquidity risks. Funds Management / Treasury (forex and domestic). business mix and organizational complexity. etc. 4) Committee of Directors . The ALCO would also articulate the current interest rate view of the bank and base its decisions for future business strategy on this view. The business issues that an ALCO would consider. wholesale vs. monitoring and reporting the risk profiles to the ALCO. its responsibility as also the decisions to be taken by it. its responsibility would be to decide on source and mix of liabilities or sale of assets. 3) Composition of ALCO The size (number of members) of ALCO would depend on the size of each institution. Towards this end. foreign currency funding. In addition the Head of the Information Technology Division should also be an invitee for building up of MIS and related computerization. for instance. retail deposits. floating rate funds. etc. the ALCO should review the results of and progress in implementation of the decisions made in the previous meetings. 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. will include product pricing for both deposits and advances. The Chiefs of Investment. it will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs.c) The ALM desk consisting of operating staff should be responsible for analyzing. desired maturity profile of the incremental assets and liabilities. domestic vs. money market vs capital market funding. inter alia. To ensure commitment of the Top Management. International Banking and Economic Research can be members of the Committee. The business and risk management strategy of the bank should ensure that the bank operates within the limits / parameters set by the Board. Some banks may even have sub-committees.

3. Liquidity Risk Management 1. liquidity management can reduce the probability of an adverse situation developing. as liquidity shortfall in one institution can have repercussions on the entire system. Experience shows that assets commonly considered as liquid like Government securities and other money market instruments could also become illiquid when the market and players are unidirectional.Banks should also constitute a professional Managerial and Supervisory Committee consisting of three to four directors which will oversee the implementation of the system and review its functioning periodically. ALM Process The scope of ALM function can be described as follows: a) Liquidity risk management b) Management of market risks (including Interest Rate Risk) c) Funding and capital planning d)Profit planning and growth projection e)Trading risk management The guidelines given in this note mainly address Liquidity and Interest Rate risks. 6. The importance of liquidity transcends individual institutions. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios. Therefore liquidity has to be tracked through maturity or cash flow mismatches. . Measuring and managing liquidity needs are vital activities of commercial banks. 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. By assuring a bank's ability to meet its liabilities as they become due. For measuring and managing net funding requirements.

2. The Statement of Structural Liquidity may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. The discretion to allow a higher tolerance level is intended for a temporary period. till the system stabilises and the bank is able to restructure its asset -liability pattern. If a bank in view of its asset -liability profile needs higher tolerance level. A copy of the note approved by Board / Management Committee may be forwarded to the Department of Banking Supervision. the main focus should be on the short-term mismatches viz. Within each time bucket there could be mismatches depending on cash inflows and outflows. are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Management Committee.. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. 4. The time buckets given the Statutory Reserve cycle of 14 days may be distributed as under: i) 1 to 14 days ii) 15 to 28 days iii) 29 days and up to 3 months iv) Over 3 months and up to 6 months v) Over 6 months and up to 12 months vi) Over 1 year and up to 2 years vii) Over 2 years and up to 5 years viii) Over 5 years. RBI. Banks. It would be . however. The Maturity Profile as given in Appendix I could be used for measuring the future cash flows of banks in different time buckets. The mismatch during 1-14 days and 15-28 days should not in any case exceed 20% of the cash outflows in each time bucket. 3. it could operate with higher limit sanctioned by its Board / Management Committee giving reasons on the need for such higher limit. 1-14 days and 15-28 days. While the mismatches up to one year would be relevant since these provide early warning signals of impending liquidity problems.

Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of banks' balance sheets. The simplest way to avoid currency risk is to ensure that mismatches. . etc) which can be deployed for augmenting rupee resources. then the currency mismatch can add value or erode value depending upon the currency movements. Besides. if any. 5. it may not be possible to eliminate currency mismatches altogether. Indian banks with large branch network can (on the stability of their deposit base as most deposits are renewed) afford to have larger tolerance levels in mismatches if their term deposit base is quite high. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. While determining the likely cash inflows / outflows. future strategy etc. banks have to make a number of assumptions according to their asset . nature of business. In order to enable the banks to monitor their short-term liquidity on a dynamic basis over a time horizon spanning from 1-90 days. Currency Risk 1. An indicative format for estimating Short-term Dynamic Liquidity is enclosed. If the liabilities in one currency exceed the level of assets in the same currency. Large cross border flows together with the volatility has rendered the banks' balance sheets vulnerable to exchange rate movements. For instance. Irrespective of the strategies adopted. Dealing in different currencies brings opportunities as also risks. making loans and advance and quoting prices for foreign exchange transactions.necessary to take into account the rupee inflows and outflows on account of forex operations including the readily available forex resources ( FCNR (B) funds. 2. some of the institutions may take proprietary trading positions as a conscious business strategy.liability profiles. While determining the to learn levels the banks may take into account all relevant factors based on their asset-liability base. banks may estimate their short-term liquidity profiles on the basis of business projections and other commitments. are reduced to zero or near zero. 6. Banks undertake operations in foreign exchange like accepting deposits.

7. maturity mismatches (gaps) are also subject to control. A. Managing Currency Risk is one more dimension of Asset. the banks are also free to set gap limits with RBI's approval but are required to adopt Value at Risk (VAR) approach to measure the risk associated with forward exposures. 4. Ever since the RBI (Exchange Control Department) introduced the concept of end of the day near square position in 1978. For monitoring such risks banks should follow the instructions contained in Circular A. Thus the open position limits together with the gap limits form the risk management approach to forex operations. Series) No. It is the intention of RBI to move over to modern techniques of Interest Rate Risk measurement like Duration Gap Analysis. Following the recommendations of Expert Group on Foreign Exchange Markets in India (Sodhani Committee) the calculation of exchange position has been redefined and banks have been given the discretion to set up overnight limits linked to maintenance of additional Tier I capital to the extent of 5 per cent of open position limit. Simulation and Value at Risk at a later date when banks acquire sufficient expertise and sophistication in MIS. 1997 issued by the Exchange Control Department. Presently. Mismatched currency position besides exposing the balance sheet to movements in exchange rate also exposes it to country risk and settlement risk. Gap analysis measures mismatches between rate . banks have been setting up overnight limits and selectively undertaking active day time trading. The phased deregulation of interest rates and the operational flexibility given to banks in pricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk. Changes in interest rates affect both the current earnings (earnings perspective) as also the net worth of the bank (economic value perspective). Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The risk from the earnings' perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest Margin (NIM). Following the introduction of "Guidelines for Internal Control over Foreign Exchange Business" in 1981. slow pace of computerisation in banks and the absence of total deregulation. Interest Rate Risk (IRR) 1.D (M.3.Liability Management. the traditional Gap analysis is considered as a suitable method to measure the Interest Rate Risk. The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. In the context of poor MIS.52 dated December 27.

ii) The interest rate resets/reprises contractually during the interval. An asset or liability is normally classified as rate sensitive if: i) Within the time interval under consideration. Certain assets and liabilities receive/pay rates that vary with a reference rate. Similarly. borrowings. etc. any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. Refinance CRR balance. corresponding to the changes in PLR. This includes final principal payment and interim installments. and iv) It is contractually pre-payable or withdrawal before the stated maturities. The interest rates on advances could be reprised any number of occasions. purchased funds etc. the advances portfolio of the banking system is basically floating. 2. These assets and liabilities are reprised at pre-determined intervals and are rate sensitive at the time of reprising.2 lakhs. advances up to Rs. While the interest rates on term deposits are fixed during their currency. The Gap Report should be generated by grouping rate sensitive liabilities. whichever is earlier. advances.e. DRI advances Export credit. All investments. deposits. The Gaps may be identified in the following time buckets: i) Up to 1 month ii) Over one month and up to 3 months iii) Over 3 months and up to 6 months iv) Over 6 months and up to 12 months .) In cases where Interest rates are administered.sensitive liabilities and rate sensitive assets (including off-balance sheet positions). iii) RBI changes the interest rates (i. The difficult task in Gap analysis is determining rate sensitivity. interest rates on Savings Bank Deposits. assets and off balance sheet positions into time buckets according to residual maturity or next reprising period. there is a cash flow. that mature/reprise within a specified timeframe are interest rate sensitive.

The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has more RSLs. . Term). The Gap can. Repos and deployment of foreign currency resources after conversion into rupees (unsnapped foreign currency funds) etc. The prudential limits should have a bearing on the total assets. The banks may work out earnings at risk. 4. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). RBI will also introduce capital adequacy for market risks in due course. be used as a measure of interest rate sensitivity. therefore. Refinance from RBI / others. 5. etc of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets.v) Over 1 year and up to 3 years vi) Over 3 years and up to 5 years vii) Over 5 years viii) Non-sensitive 3. based on their views on interest rate movements and fix a prudent level with the approval of the Board/Management Committee. Bills Rediscounting. subject to approval from the ALCO / Board. Banks which are better equipped to reasonably estimate the behavioral pattern. embedded options. Each bank should set prudential limits on individual Gaps with the approval of the Board/Management Committee. The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. rolls-in and rolls-out. 6. The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision. earning assets or equity.

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 pledged securities to total securities.  Ratio of contingent liabilities for loans to total loans. STEP 3 The banks future development and expansion plans. Assessing the bank’s ability to meet liquidity needs. This should include: Review of internal management reports on liquidity needs and sources of satisfying these needs. 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). 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 short-term demand deposits to total deposits.  Ratio of loans to deposits.  Ratio of Non Performing Assets to Total Assets.PROCEDURE FOR EXAMINATION OF 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.  Current liquidity position (Minimum ratio of highly liquid assets to demand liabilities/deposits). This entails: - .  Ratio of long-term loans to short term demand deposits. with focus on funding and liquidity management aspects have to be looked into.

 Determining the impact of the bank's liquidity management on net earnings position.  Reviewing the bank's budget projections for a certain period of time in the future. 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.  A method to identify liquidity needs and the means to meet those needs.  Determining whether the bank has included sensitivity to interest rate risk in the development of its long term funding strategy. Determining whether bank management has effectively addressed the issue of need for liquid assets to funding sources on a long-term basis.  Determining the alternative sources of funding liquidity and/or assets subject to necessity. STEP 6  Preparing an Asset/Liability Management Internal Control Questionnaire which should include the following: -  Whether the board of directors has been consistent with its duties and responsibilities and included: -  A line of authority for liquidity management decisions. 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 really needs to expand its activities.  A mechanism to coordinate asset and liability management decisions.

 Guidelines for the level of liquid assets and other sources of funds in relationship to needs. .

To view the two side of bank’s balance sheet as completely integrated units. The basic models are: 1. On the other side of the balance sheet are assets which are loans of various types which banks make to the customer for various purposes. Hence. BIS is standardizing the practices of banks across the globe and India is part of this process. Till the early 1990s. the survival is at stake. the RBI has done the real banking business and commercial banks were mere executors of what RBI decided. But now. Stochastic Programming Model . It requires assessment of various types of risks and alerting the assets liability portfolio to manage risk. without proper management of assets and liabilities. Value-at-risk models 5. GAP Analysis Model 2. The success of ALM.STUDY OF ASSETS LIABILITY MANAGEMENT IN INDIAN BANK: CANONICAL CORRELATION ANALYSIS ( PERIOD – 1992-2004) INTRODUCTION Assets liability management (ALM) defines management of all assets and liabilities of a bank. Duration GAP Analysis Models 3. borrowing and capital. Risk Management of Assets and Liabilities. Has an intuitive appeal. But the nature profitability of bank especially in terms of Net Interest Margin (NIM). A bank’s liabilities include deposits. these days. ALM MODELS Analytical models are very important for ALM analysis and scientific decision making. Scenario Analysis Model 4.

Measuring risk. Public Sector bank are yet to collect 100% of ALM data because of lack of computerization all branches. Nationalized bank except SBI & Associates (19) 2. METHODOLOGY The study covers all scheduled commercial except the RBIs. The period of the study was from 1992-2004. The executive Director and other vital department heads ALCO in banks. Private Banks (30) . Periodic review. o To find out the component of Assets explaining variance in liability and viceversa. It is responsible for Setting business policies and strategies. With this background. Discussing new products and Reporting. this research aims to find out the status of Asset Liability Management across all commercial bank in Indian with the help of multivariate technique of canonical correlation. OBJECTIVE OF THE STUDY Though Basel Capital Accord and subsequent RBI guidelines have given a structure for ALM in banks. Pricing assets and liabilities. SBI and Associate (8) 3. o To study the impact of ownership over Asset Liability Management in Bank o To study impact of ALM on the profitability of different back-groups. the Indian Banking system has not enforced the guidelines in total. The banks were grouped based on ownership structure the group were 1.Any of these models is being used by banks through their Asset Liability Management Committee (ALCO). The discussion paper has following objective to explore:  To study the Portfolio-Matching behavior of Indian Bank in terms of nature and strengths of relationship between Assets and Liability. There are minimum four members and maximum eight members.

4. For a purpose of the study. Bal With Banks. Foreign Banks (36) RECLASSIFICATION OF ASSETS AND LIABILITIES The assets and liabilities of a Bank are divided into various sub head. Money At Call And Short Notice.cost profile of liabilities. the assets were regrouped under six major heads and the liabilities were regrouped under four major heads as shown in table below. Overdrafts Loans And Loans Fixed Assets Fixed Assets TABLE 2: RECLASSIFICATION OF LIABILITIES Net Worth Capital. Bond Subsidiaries And Other. The reclassified assets and liabilities cover in the study exclude ‘other assets’ on the asset side and ‘other liabilities’ on the liabilities side. Other Fls From India And Abroad Short Term Deposits Demand Deposits And Savings Bank Deposits Long Term Deposits All Deposits Not Included In Short Term . Banks. Cash Credits. The relevant data has been collected from RBI website TABLE 1 : RECLASSIFICATION OF ASSETS Liquid Assets Cash In Hand. Securities And Other Approved Securities Investments Other Than SLR Such As Shares. Reserves And Surpluses Borrowings Borrowing From RBI. This is necessary to deal with the problem of singularity – a situation that produces perfect correlation with in sets and make correlation between sets meaningless. This classification is guided by prior information on the liquidity – return profile of assets and the maturity. SLR Securities Govt. Debentures. Term Loans Term Loan ShortTerm Advance Not In TL – Bill Purchased And Discounted.

canonical correlation has been used to access the nature and strength of relationship between the assets and liabilities.TABELE 3: LIQUIDITY-RETURN PROFILE OF ASSETS Assets .Liquidity High Liquid Assets Medium SLR Securities Short Term Loans Investment Term Loans Fixed Asset Low TABLE 4: MATURITY – COST PROFILE OF LIABILITIES Short Term Deposits Near Borrowing Liability Maturity Medium Far Term Deposits Net Worth CANONICAL CORRELATION ANALYSIS Multivariate statistical technique. To explore the relationship between assets and liabilities. we could merely compute the correlation between each set of assets and .

945 -0.469 -0.948 -0. The technique tries to compute the values of Ai and Bi such that the covariance between A & B is maximum.83 STD 0.831 Bor 0. all of these correlations assess the same hypothesis – that assets influence liabilities. It produces an output that shows the strength of relationship between two variates as well as individual variables accounting for variance in other set.523 0.Term Deposits) To begin with.328 0.461 0.568 STL 0. A &B (called canonical variates) are unknown.664 -0.593 -0.each set of liabilities.948 0.998 Assets 0.997 0.712 -0.662 0. The essence of canonical correlation Measures the strength of relationship between two sets of variables by establishing linear combination of variables in one set and a linear combinations of variables in other set.716 -0.744 SLR 0.858 Inv -0.88 FA -0.171 -0. A=A1* (Liquid Assets) + A2* (SLR Securities) + A3* (Investment) + A4* (Term Loan) + A5* (Short – Term Loans) + A6* (Fixed Assets) B= B1*(Net Worth) + B2* (Borrowings) + B3* (Short –Term Deposits) +B4* (Loan.644 NW -0.467 -0.885 0.126 -0.728 0.464 0.188 0.078 0.237 LA 0.747 -0.972 0.498 0.243 0.268 0. The technique reduces the relationship in to a few significant relationships.903 -0.987 0.314 -0.457 Banks R2 Canonical Loading Liabilities . TABLE 5: CANONICAL CORRELATION SUMMARY OF OUTPUT Foreign Private bank nationalized SBI & Associate 0. Unfortunately.046 0.

288 0. Bank-Groups can be arranged in decreasing order of correlation: o SBI and Associate o Private Banks o Nationalized Banks o Foreign Banks Redundancy factors indicate how redundant one set of variables which gives an idea about independent and dependent sets.196 0.LTD -0. Looking at the redundancy factors.539 0. we can observe that there is a strong negative correlation between short-term deposit with both Term Loan and Fixed Asset.201 0. The canonical loading is measure of the strength of the association which means it is a present of variance linearly shared by an original variable with one of the canonical varieties. In this case all the correlation is significant.255 -0.964 Asset 0. for foreign bank. Similarly for foreign banks.426 0.476 Liability 0. 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. the independent and dependent sets for different bank-group can be identified: . Fixed Assets (FA) under assets has a loading of -0. A negative loading indicates an inverse relationship. A loading greater than 40% is assumed to be significant. This also gives an idea about the fact whether the bank is asset-managed or liability-managed.903Net worth under liabilities has loading of -0. For example.664. Since both are negative. this means there is a strong correlation between FA and NW.629 Redundancy The first row (R2) is measure of the significance of the correlation.007 0.279 0. OBSERVATION As per the summary table above.212 0.

remaining three have assets as their independent set this means during the study period (1992-2004).term deposit. o Not use for long. This is in perfect consonance with the micro indicator. these banks were actively managing assets and liability was dependent upon how well the assets are managed. FOREIGN BANKS The canonical function coefficient or the canonical weight of different constituents in case of foreign banks Term Loans and Fixed Assets from asset side Net Worth Short – term Deposit from liability side have significant presence with following interpretation :  Very strong co-relation between Fixed Asset and Net Worth. PRIVATE BANKS .  Strong negative correlation between short-term deposit with both Term loan and Fixed Assets.TABLE 6: CAUSE EFFECT RELATIONSHIP Bank Independent Set Dependent Set Foreign Liability Asset Private Asset Liability Nationalized Asset Liability SBI & Associates Asset Liability Other than Foreign bank groups. This indicates – o Proper using of short.term assets or long term losses.

SLR and STL – all are highly liquid section of assets.term deposit is used for Liquid Assets. This relationship can be interpreted in the following ways:  Very strong co-relation between FA and NW. o Good short-term maturity/liquidity management. The major interpretations are:  Very strong co-relation between FA NW. NATIONALIZED BANKS In case of nationalized banks investment. fixed asset contribute significantly in explaining asset part while net worth and borrowings constituent of liability is major factor. Term Loans. SLR and Short –Term Loans As defines above LA. Investment.  There is negative co-relation between Borrowing and Investment. Term loans and Fixed Assets are significant. Borrowings short-term deposit and long term deposit are significant while in assets side SLR investment. and Fixed Assets and significantly explaining the corelation while on liability side only Net Worth and Short –Term Deposit are contributing.  Nationalized banks use borrowing for Short-term loans. So it is very prudent to employ short term deposits.  Short. Shortterm loans.In case of private bank all constituents’ of asset side Liquidate Assets. investment. o More concerned with liquidity than profitability. SBI & ASSOCIATES For SBI group all constitute of liability namely Net Worth. o Conservative strategy (in comparison to Private Banks). . Nationalized Banks use a borrowing (which is never term maturity) for Short. SLR Securities.term a loan which is effective way of ALM. short-term loan. This shows how actively these banks manage their assets to generate maximum return.

SBI & association have best Assets-Liability maturity pattern  Other than Foreign Bank. CONCLUSION Based on this decision above.  Use long-term funds for Long as well as medium &short-term loan. Investment and SLR’.all other banks can be called liability manage banks.  Over concerned with liquidity. The discussion paper concludes with following findings:  Among all groups. Fixed Assets and Net Worth are highly correlated.  Correlation between Long term Deposits and ‘Term Loan. .  Short –term Deposits and Short-term liabilities are correlated.  Most Conservative strategy.  Across all banks. it can be conclude that ownership and structure of the banks do affect their ALM procedure.  Strong correlation between Borrowing and SLR.Following can be interpreted:  Very strong correlation between FA and NW.  Private Banks are aggressive in profit generation.

. Nationalized Banks (including SBI &Associates) are excessively concerned about Liquidity.  The aggressive strategy adopted by private banks is being reflected in terms of better profitability.