INTRODUCTION

In a regulated economy, the interest spread is primarily a function

of central bank of the country because banks accept deposits of regulated
rate and lend at the regulated rate and earn the stipulated spread. In a
globalized environment, intense competition for business and increasing
fluctuation in both domestic interest rates as well as foreign exchange
rates put pressure on the management of banks of maintain spreads
profitability and long term viability without increasing market risk. There
are two major types of risks that commercial banks are exposed to in the
course of their operation i.e. credit risk and market risk. Banking business
itself is a credit risk. Market risk arising out of fluctuation in interest
rates, foreign exchange rates, equity price risk and commodity price risk
is virtually not existent in such a regime where market rates and prices
are stable for relatively long periods of time. Banks are exposed to market
risk in market driven and liberalized environment. Therefore, banks have
to manage not only credit risk but also market risk. They require a
managerial approach to control the viability of market risk.
Thus, Asset Liability Management is a strategic response of banks
to inflationary pressures, volatility in interest rates and severe
recessionary trends in the global economy. The commercial banks in
India began to face tremendous problems of Asset-liability mismatch
leading to deregulation of interest rates and free play of market forces,
entry of new players, emergence of new instruments and new products at
competitive rates and enhancement of risks. The banks witnessed the
vulnerability of mismatches during 1995-96. The banks which funded
term assets through short term loans with low interest rates were caught
napping when the call money rates increased to 80% to 90% or even
higher, with growing tendency of greater integration of money market

foreign exchange market and capital market and greater volatility in the
market condition with the emergence of an active debt market. Indian
commercial banks were under pressure to adopt the new approach of
asset liability management. Therefore, asset liability management has
recognized in India as strategic approach of making business decision in
more comprehensive and disciplined framework to control asset liabilities
mismatch with an eye on the risks that the banks are exposed to.
The actual concept of ALM is however much wider, and of greater
importance to banks' performance. Historically, ALM has evolved from
the early practice of managing liquidity on the bank's asset side, to a later
shift to the liability side, termed liability management, to a still later
realization of using both the assets as well as liabilities sides of the
balance sheet to achieve optimum resources management. But that was
till the 1970s.
In the 1980s, volatility of interest rates in USA and Europe caused the
focus to broaden to include the issue of interest rate risk. ALM began to
extend beyond the bank treasury to cover the loan and deposit
functions.The induction of credit risk into the issue of determining
adequacy of bank capital further enlarged the scope of ALM in later
1980s.
CONCEPT OF ASSET-LIABILITY MANAGEMENT
Asset liability management is an integrated strategic managerial
approach of total balance sheet dynamics having regard to its size and
quality in such a way that the net earnings from interest are maximized
with the overall risk preferences of bank. It is concerned with
management of net interest margin to ensure that its level and riskiness
are compatible with risk return objective of bank. This is done by

matching of liabilities and assets in terms of maturity cost, and yield

rates. The maturity mismatches and disproportionate changes in the level
of asset and liability can cause both liquidity and interest rate risk.
ALM is more than just managing asset-liability items of banks
balance sheet. However, it is an integrated approach to financial
management requiring simultaneous decisions about types of amounts of
financial assets and liabilities so as to insulate the spread from moving in
opposite direction.
ALM closely integrated with banks business strategy as it has
bearing upon the interest risk profile of the bank. The focus of ALM is
not on building up of deposits and loans in isolation but on net interest
income and recognizing interest rate and liquidity risk.
In banking, asset liability management is the practice of managing
risks that arise due to mismatches between the assets and liabilities (debts
and assets) of the bank...Banks face several risks such as :

Liquidity risk,

Interest rate risk,

Credit risk and

Operational risk.
Asset Liability management (ALM) is a strategic management tool

to manage interest rate risk and liquidity risk faced by banks, other
financial services companies and corporations.

Banks manage the risks of Asset liability mismatch by matching

the assets and liabilities according to the maturity pattern or the matching
the duration, by hedging and by securitization.
Asset Liability Management is the act of planning, acquiring, and
directing the flow of funds through organization. The ultimate objective
of this process is to generate adequate/stable earnings and to steadily
build an organizations equity overtime, while taking reasonable and
measured business risks.
Active management of a bank's Balance Sheet to maintain a mix of
loans and deposits consistent with its goals for long-term growth and risk
management. Banks, in the normal course of business, assume financial
risk by making loans at interest rates that differ from rates paid on
deposits. Deposits often have shorter maturities than loans and adjust to
current market rates faster than loans. The result is a balance sheet
mismatch between assets (loans) and liabilities (deposits).
Asset-liability management (ALM) is a term whose meaning has
evolved. It is used in slightly different ways in different contexts. ALM
was pioneered by financial institutions, but corporations now also apply
ALM techniques. This article describes ALM as a general concept,
starting with more traditional usage.
Traditionally, banks and insurance companies used accrual accounting for
essentially all their assets and liabilities. They would take on liabilities,
such as deposits, life insurance policies or annuities. They would invest
the proceeds from these liabilities in assets such as loans, bonds or real
estate. All assets and liabilities were held at book value. Doing so
disguised possible risks arising from how the assets and liabilities were

structured.The function of asset-liability management is to measure and

control three levels of financial risk:

Interest Rate Risk (the pricing difference between loans and

deposits),

Credit Risk (the probability of default), and

Liquidity Risk (occurring when loans and deposits have

different maturities). Interest Margin that is, the net

A primary objective in asset-liability management is managing Net

difference

between interest earning assets (loans) and interest paying

liabilities (deposits) to produce consistent growth in the loan portfolio

and shareholder earnings, regardless of short-term movement in interest
rates. The dollar difference between assets (loans) maturing or re-pricing
and liabilities (deposits) is known as the rate sensitivity Gap (or maturity
gap). Banks attempt to manage this asset-liability gap by pricing some of
their loans at variable interest rates.

COMPONANTS OF BANKS BALANCE SHEET

Like any balance sheet of any other firm, the banks balance sheet
also comprises of sources and uses of funds. Liabilities and net worth
form the sources of funds, where as asset represent uses of funds to
generate revenue for the bank.
Sources of funds

Uses of funds

Capital

Cash in hand and balance with RBI

Reserves and surplus

Balance with banks and money at

call and short notice

Deposits

Investments

Borrowings

Advances

Other liabilities and provisions

Fixed assets

Contingent liabilities

Other assets

The liabilities side of the banks balance sheet consists of sources if

funds for the lending and investment activities.

The assets side of banks balance sheet consist of the funds

mobilized by the bank through various sources.

A brief description of various balance sheet components under liabilities
and assets in narrated below:

Components of liabilities
Capital :
Capital represents the owners stake in the bank and it serves as a
cushion for depositor and creditor to fall back in case of losses. It is
considered to be a long term sources of funds. Minimum capital
requirement for the domestic and foreign bank is prescribed by Reserve
Bank of India.
Reserves and surplus

The components under this item include statutory reserve, capital

reserve, share premium, revenue and other reserve and balance in profit
and loss account.
Deposits
Main source of funds for banks is deposits. The deposits are
broadly classified as deposits payable on demand which includes current
deposits, overdue deposits, call deposits etc. Second category is saving
bank deposits and lastly the term deposits which are repayable after a
specified period, known as fixed deposits, short deposits and recurring
deposits.
Borrowings
Borrowings in India consist of Borrowings/refinance obtained from
the RBI ,other commercial banks and other institutions and agencies like
IDBI, EXIM Bank of India, NABARD, etc.

Other liabilities and provisions

The other liabilities of the bank are grouped in to the following
category:

Bills payable: This includes drafts, telegraphic transfers, travelers

cheques mail transfers payable, pay slips, bankers cheques and other
miscellaneous items.

Inter office adjustments: the credit balance of net inter office

adjustments.

Interest accrued: The interest accrued but not due on deposits an

borrowings.

Others: All other liability items like provision for income tax, tax

deducted at source, interest tax, provisions etc.

Components of Assets
Cash and balance with RBI
All cash assets of the banks are listed under this account and it
forms the most liquid account held by any bank. The cash assets consist
of the following:
Cash in hand:
this asset item includes cash in hand including foreign currency
notes and cash balances in the overseas branches of the bank.
Balances with RBI:
cash account also includes the balances held by each bank with
RBI in order to meet statutory cash reserve requirements (CRR).
Balances with banks and money at call and short notice:
The bank balances include the amount held by the bank in the
current accounts and term deposits accounts with other banks. Money at
short notice includes all loans made in the interbank call money market
that are repayable within 15 days notice.

Investments
A major asset item in the balance sheet of a bank is investments in
various kinds of securities. These include Government Securities,
Approved Securities, Shares, Debentures and Bonds, Subsidiaries and/or
Joint venture, other investments.
Advances
The most important of the asset items on the Banks balance sheet
are advances. These advances which represent the credit extended by the
Bank to its customers, forms a major part of the assets for all the banks.

Cash credits, overdrafts and loans repayable on demand:

Items under this category represent advances which are repayable on

demand though they may have a specific due date.

Term loans:

All term loans extended by the bank are included here. These advances
also have a specific due date, but they will not become payable on
demand.
Bills purchased and discounted:
This item includes the bills discounted/purchased by banks from
the client irrespective of whether they are clean/documentary or
domestic/foreign.
Secured/unsecured advances:
Based on the underlying security, advances are classified into the
following categories:

Secured by tangible assets:

All advances or part of advances, within/outside India, which are

secured by tangible assets, will be considered as secured assets.
Covered by bank/government guarantees:
Advances in India and Outside India to the extent they are covered
by guarantees of Indian and Foreign governments/banks and DICGC and
ECGC will be included here.
Unsecured advances:
All advances that do not have any security and which do not
appear in the above two categories will come under this category.
Fixed assets:
All the fixed assets of the ban, e.g. immovable properties,
premises, furniture and fixtures, hardware, motor vehicles are classified
into fixed assets.
Other assets: The remainder of the items on the asset side of the banks
balance sheet is categorized as other assets. The miscellaneous assets that
appear are:

Inter office adjustments: Debit balance of the net position or the

interoffice accounts, domestic as well as overseas.

Interest accrued: This will be the interest accrued, but not due on

investments and advances and interest due, but not collected on

investments.

Tax paid in advance/tax deducted at source: This includes amount

of tax deducted at source on securities and the advance tax paid to the
extent that they are not set-off against relative tax provisions.

Stationery and stamps: Stock on hand of stationery is considered

under this head of account.

Non-banking assets acquired on satisfaction of claims: Items under

this account include immovable properties/tangible assets which are

acquired by the bank in satisfaction of banks claims on others.

Others: Other items primarily include claims that are in the form of

clearing items, unadjusted debit balance representing additions to assets

and deductions from liabilities and advances provided to the employees
of the bank.
Contingent Liabilities
Banks obligations under issuance of letter of credit, guarantees ad
acceptances on behalf of constituents and bills accepted by the bank on
behalf of its customers are reflected under contingent liabilities. Other
contingent liabilities include claims against the bank not acknowledged as
debts, liability for partly paid-up investments, liability on account of
outstanding forward exchange contracts and other items like arrears of
cumulative dividends, bills rediscounted, underwriting, commitments,
estimated amount of contracts remaining to be executed on capital
account and not provided for, etc.
PURPOSE AND OBJECTIVES OF ASSET LIABILITY
MANAGEMENT
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. Thus, purpose of Asset Liability Management is to
enhance the asset quality; quantity risks associated with the assets and
liabilities and further manage them. Such a process will involve the
following steps:

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

analyses the reasons for any effect on the spreads.

The Asset Liability Management technique so designed to manage
various risks primarily aim to stabilize the short-term profits, long term
earnings and long term substance of the bank. The parameters that are
selected for the purpose of stabilizing Asset Liability Management of the
banks are:

Net Interest Income(NII)

Net Interest Margin(NIM)

Economic Equity Ratio

A brief description of these parameters is given below:

1.

Net Interest Income(NII)

The impact of volatility on the short-term profit is measured by Net

Interest Income.
Net Interest Income= Interest Income Interest Expenses. In order to
stabilize short-term profits; banks have to minimize fluctuation in the NII.
2.

Net Interest Margin(NIM)

Net Interest Margin is defined as net interest income divided by

average total assets.

Net Interest Margin (NIM) = Net Interest Income/ Average Total Assets.
Net Interest Margin can be viewed as the Spread on earning assets.

The net income of banks comes mostly from the spreads

maintained between total interest income and total interest expenses. The
higher the spread more will be the NIM. There exist a direct correlation
between risks and return. But since any business is conducted with the
objective of making profits and achieving higher profitability I the target,
it is the management of risks that holds key to success and not risk
elimination.
3.

Economic Equity Ratio

The ratio of shareholders funds to the total assets measures

the shifts in the ratio of owned funds to total funds. This fact assesses the
sustenance capacity of the bank.

Objectives of ALM
a)

To manage market risk by minimizing the fluctuations in interest

income and to protect the net economic value of the bank.

b)

To control volatility in targeted earnings by ensuring an acceptable

balance between profitability and growth.

c)

To control liquidity risks i.e. avoid technical insolvency by

ensuring adequate liquidity without sacrificing profitability.

d)

At micro level, the objectives of Asset Liability Management are

two folds. It aims at profitability through price matching while ensuring

liquidity by means of maturity matching.
FUNCTION OF ALM:
The basic function of ALM is to guide the management in
establishing optimal match between the assets and liabilities of the bank

in such a way as to maximize its net income and minimize the market
risk. This is to done by analyzing the current market risk profile of the
bank and its impact on the future risk profile. The manager has to choose
the best course of action depending on the risk preference of the
management.
(1)

Asset Management: The asset management includes the following:

(a)

Cash Management:
Cash management is a dynamic function that needs to

be dealt with effectively at various levels. Cash balances are the idle
assets of the bank; hence cash should be kept at a bare minimum level.
The banks need to manage their cash balances in order to meet their
customer requirements of their demand deposits.
(b)

Reserve and Investment Management:

Reserve requirements constitute the first charge on

any banks funds and the balance can be used for advances and other
income generating assets. The reduction in statutory liquidity ration helps
the banks to invest more resources in profitable avenues. The banks
should plan their requirements properly.
(c)

Credit Management:
A major portion of banks income is derived from

returns on advances and credit expansion. Managing credit is a critical

function of any bank. Effective credit management is necessary to ensure
that the advances remain performing and the income is maximized.
(d)

Management of other Assets:

The banks have to invest in other assets in order to

generate more income and not to keep idle assets. It can invest in real
estate, government securities, money market etc. However, the creation of
other assets should generate additional income to the bank.
(2)

Liability Management:
The liability management includes the following:
(a)

Owned Funds:
The banks owned fund are capital and reserve and

surplus. Capital is raised by offering equity to the public. It can also be

achieved through increasing reserves. Capital adequacy has to be
maintained by the banks. It is considered as a financial barometer for the
stability and soundness of a bank.
(b)

Deposits:
A major source of asset creation of a bank is

mobilization of deposits. It has become a challenging task for banks in

these days. Banks collect funds through different types of deposits having
different maturities. There are some demand deposits also. The banks
have to see that these deposits are repaid on time.
(c)

Borrowings:
Whenever there is a shortage of funds, banks can

borrow from RBI, financial institutions, and markets. It is also a major

source of raising funds. However, the banks have to consider the rate of
interest, maturity and other statutory requirements, while borrowing from
outside.
(d)

Floating Funds:

The banks have floating funds with them in the form

of bills payables, draft payables. These funds are available for short and
temporary period. These funds have no costs. However, proper
management of these funds requires network of branches, speed in
delivery of service and technological advancement.
PROCESS OF ALM:
Asset-liability management is a strategic approach to measure,
monitor and manage the market risk of a bank. The process of
ALM involves the following stages:
1)

Management of Risk:
The first step in ALM is to decide or measure the risk. The

appropriateness of risk measurement parameters depends upon the degree

of volatility in the operating environment, availability of supporting data
and expertise within the bank and the expected market and business
developments. Generally, the net interest income and market value of
portfolio equity are the two major parameters which banks employ to
measure their balance sheet risks. The short term as well as long term
balance sheet risks can be measured with the help of these parameter.
There are various methods used to measure interest rate risk, the
important methods are Gap method, Duration method, Simulation and
Value of Risk Method.
Gap analysis is the important technique used to analyze interest
rate risk. It measures the difference between a banks assets and liabilities
and off balance sheet positions which will be repriced or will mature
within a pre-determined period. This technique measures the difference
between the absolute value of rate sensitive assets and rate sensitive
liabilities over a gap period. It ignores the time when the assets and

liabilities would need to be repriced. The rate sensitivity gap can be

mathematically expressed as follows:
RSG =

RSA
RSL

Where

2)

RSG =

Rate Sensitive Gap

RSL =

Rate Sensitive Assets

RSL =

Rate Sensitive Liabilities

Enhancement of Long-term Profitability:

The next stage of ALM is identification of favourably priced

assets or liabilities and off balance sheet items so as to enhance long-term

profitability for a given level of risk. The branch managers should resist
the temptation of accession to easily found high priced liabilities. Every
effort should be made to find out low priced liabilities. The management
has to build up core business and create assets and liabilities for the bank.
The thrust of the management should be on client market and not on a
financial market. Mismatches are usually built in client market as assets
and liabilities are created sequential but not simultaneously and the same
are managed in financial markets.

3)

Management of Risk:
The third stage in the ALM is effective management of

market risk. The directors should formulate overall investment policy,

liquidity policy and the policy regarding financing. It should also
determine the acceptable level of risk in terms of the parameters chosen.
The bank should undertake strategic planning exercise for its assetliability. It involves management of CRR & SLR for the Bank as a whole
formulating schemes having refinance facilities to have better leverage in

managing the assets-liability and as a spin off earning better profit. The
management should also focus on products and services, that are made
available to branches which have special advantage. The policies and
strategies of the bank need to be reviewed from time to time keeping in
view the banks liquidity exercise and development in the business.

ALM AND COMMERCIAL BANKS IN INDIA

Emergence of new players ,new instruments and new products at
competetive rates in the market follwing the reform process in india
further increased the banks risks. These developments india faced the
commercial banks to take a re-look on the assets and liability. The
RBIvide its circular dated February 12,1998, advised commercial banks
to tighten their assets-liability management and put inplac n appropriate
system of asset liability management. The rbi has decided to test a model
on the few lending banks whereby banks have been asked to furnish data
in aformat outlined by it. The RBI guidelines add that:
(1)

20 to 25 percent of the demand deposits, including savings, should

be considered as withdrawable on the demand and shown under the 1-14

day time bucket.

(2)

Bank should study the behavariol pattern of deposits on the basis of

historical trends and based on this bank should classify the deposits into
volatile and core portions.
(3)

NPA, netof provision should be shown under the two to five ywar

bucket and subs standard assets in one to two year bucket.

(4)

Excess balance over the required CRR and SLR should be shown

under the 1-14 bucket.

(5)

Banks should study the behavarioul and seasional pattern of drawl

in credit, based on outstanding the core and volatile portion should be

identified.
(6)

For borrowimg on float rate, the amount should be distributed to

the appropriate bucket which, refers to the repricing date while for the
zero coupouns, it should be distributed to the maturity bucket relating to
matter of April and October, since the re-price is done only when RBI
changes rates.
Asset Liability Management in Indian Context
The post-reform banking scenario in India was marked by interest
rate deregulation, entry of new private banks, and gamut of new products
along with greater use of information technology. To cope with these
pressures banks were required to evolve strategies rather than ad hoc
solutions. Recognizing the need of Asset Liability management to
develop a strong and sound banking system, the RBI has come out with
ALM guidelines for banks and FIs in April 1999.

The Indian ALM framework rests on three pillars: ALM Organisation (ALCO)
The ALCO or the Asset Liability Management Committee
consisting of the banks senior management including the CEO should be
responsible for adhering to the limits set by the board as well as for
deciding the business strategy of the bank in line with the banks budget
and decided risk management objectives. ALCO is a decision-making
unit responsible for balance sheet planning from a risk return perspective
including strategic management of interest and liquidity risk. The banks
may also authorize their Asset-Liability Management Committee (ALCO)
to fix interest rates on Deposits and Advances, subject to their reporting
to the Board immediately thereafter. The banks should also fix maximum
spread over the PLR with the approval of the ALCO/Board for all
advances other than consumer credit.
ALM Information System
The ALM Information System is required for the collection of
information accurately, adequately and expeditiously. Information is the
key to the ALM process. A good information system gives the bank
management a complete picture of the bank's balance sheet.
ALM Process
The basic ALM processes involving identification, measurement
and management of risk parameter .The RBI in its guidelines has asked
Indian banks to use traditional techniques like Gap Analysis for
monitoring interest rate and liquidity risk. However RBI is expecting
Indian banks to move towards sophisticated techniques like Duration,

Simulation, and VaR in the future. For the accrued portfolio, most Indian
Private Sector banks use Gap analysis, but are gradually moving towards
duration analysis. Most of the foreign banks use duration analysis and are
expected to move towards advanced methods like Value at Risk for the
entire balance sheet. Some foreign banks are already using VaR for the
entire balance sheet.
Before proceeding to understand asset liability management and
its approaches, it is necessary to become familier with the components of
assets and liabiltities in a banks balance sheet. Understanding if such
components will enable a better understanding of various aspects of
Assets Liability Management detailed in this and the subsequent chapters.
Emerging issues in the Indian context
With the onset of liberalization, Indian banks are now more exposed to
uncertainty and to global competition. This makes it imperative to have
proper asset-liability management systems in place. The following points
bring out the reasons as to why asset-liability management is necessary in
the Indian context. In the context of a bank, asset-liability management
refers to the process of managing the net interest margin (NIM) within a
given level of risk.
NIM = Net Interest Income/Average Earning Assets = NII/AEA
Since NII equals interest income minus interest expenses,
Sin key (1992) suggests that NIM can be viewed as the spread on earning
assets and uses the term spread management. As the basic objective of
banks is to maximize income while reducing their exposure to risk,
efficient management of net interest margin becomes essential. . Several
banks have inadequate and inefficient management systems that have to
be altered so as to ensure that the banks are sufficiently liquid.

Indian banks are now more exposed to the vagaries of the international
markets, than ever before because of the removal of restrictions,
especially with respect to forex transactions.
Asset-liability management becomes essential as it enables the
bank to maintain its exposure to foreign currency fluctuations given the
level of risk it can handle. . An increasing proportion of investments by
banks is being recorded on a marked-to-market basis and as such large
portion of the investment portfolio is exposed to market risks. Countering
the adverse impact of these changes is possible only through efficient
asset-liability management techniques. . As the focus on net interest
margin has increased over the years, there is an increasing possibility that
the risk arising out of exposure to interest rate volatility will be built into
the capital adequacy norms specified by the regulatory authorities. This,
in turn will require efficient asset-liability management practices.
PRE-REQUISITES TO THE EFFECTIVENESS OF ALM:
ALM as on approach of managing assets-liability can help a bank
in achieving the desired result if the following conditions are fulfilled:
1)

ALM requires dedication to acting on the basis of the contemplated

future, a determination to plan regularly and systematically as an integral

part of management.
2)

The ALM presupposes the team approach in decision making and

action.
3)

Visualization of the banks vision and its articulation in terms of

purpose and mission is the hallmark of ALM.

4)

The top management should evolve a system to provide to all

levels of management a thorough understanding and awareness of risk

and all its parameters.

5)

Technological and infrastructure support system in the bank would

be an important prerequisite to implement the system effectively.

6)

ALM system must continually be reviewed and its results

appraised so as to conform that the standard set are being achieved.

7)

The bank must develop human resource and craft a well thought

out strategy for developing skills and competencies of its functionaries

for risk definition, risk quantification and risk analysis.

ALM AS CO-ORDINATED BALANCE SHEET MANAGEMENT

The asset liability management function can be viewed in terms
of two stages approach to balance sheet financial management.
Stage 1
Specific Balance Sheet Management Functions
Asset side management will include:

Reserve Position Management

Liquidity Management

Investment/Security Management

Loan Management

Fixed Asset Management

Liability Side Management Will Include:

Liability Management

Reserve Position Management

Long Term Management(Notes And Debentures)

Capital Management

Stage 2
Income-Expense Function
Profit= Interest Income- Interest Expense Provision For Loan
Loss + Noninterest Revenue-Non Interest Expense-Taxes. Banks are
required to formulate policies to achieve following objectives of Asset
Liability Management,

Spread management

Loan quality

Generating fee income and service charges

Control of non-interest operating expenses

Tax management

Capital adequacy

Asset-Liability Management Approach

ALM in its most apparent sense is based on funds management.
Funds management represents the core of sound bank planning and
financial management. Although funding practices, techniques, and
norms have been revised substantially in recent years, 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. Therefore, funds management has following three components,
which have been discussed briefly.
A. Liquidity Management:-

Liquidity represents the ability to accommodate decreases in

liabilities and to fund increases in assets. An organization has adequate
liquidity when it can obtain sufficient funds, either by increasing
liabilities or by converting assets, promptly and at a reasonable cost.
Liquidity is essential in all organizations to compensate for expected and
unexpected balance sheet fluctuations and to provide funds for growth.
The price of liquidity is a function of market conditions and market
perception of the risks, both interest rate and credit risks, reflected in the
balance sheet and off-balance sheet activities in the case of a bank.
If liquidity needs are not met through liquid asset holdings, a bank may
be forced to restructure or acquire additional liabilities under adverse
market conditions. Liquidity exposure can stem from both internally
(institution-specific) and externally generated factors. Sound liquidity risk
management should address both types of exposure. External liquidity
risks can be geographic, systemic or instrument-specific. Internal
liquidity risk relates largely to the perception of an institution in its
various markets: local, regional, national or international. Determination
of the adequacy of a bank's liquidity position depends upon an analysis of
its:

Historical funding requirements

Current liquidity position

Anticipated future funding needs

Sources of funds

Present and anticipated asset quality

Present and future earnings capacity

Present and planned capital position

The cost of maintaining liquidity is another important prerogative.

An institution that maintains a strong liquidity position may do so at the
opportunity cost of generating higher earnings. 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. If deposit
accounts are composed primarily of small stable accounts, a relatively
low allowance for liquidity is necessary.
Additionally, management must consider the current ratings by
regulatory and rating agencies when planning liquidity needs. Once
liquidity needs have been determined, management must decide how to
meet them through asset management, liability management, or a
combination of both.
B. Asset Management:Many banks (primarily the smaller ones) tend to have little
influence over the size of their total assets. Liquid assets enable a bank to
provide funds to satisfy increased demand for loans. But banks, which
rely solely on asset management, concentrate on adjusting the price and
availability of credit and the level of liquid assets. However, assets that
are often assumed to be liquid are sometimes difficult to liquidate. For
example, investment securities may be pledged against public deposits or
repurchase agreements, or may be heavily depreciated because of interest
rate changes.
Furthermore, the holding of liquid assets for liquidity purposes is less
attractive because of thin profit spreads. Asset liquidity, or how "salable"
the bank's assets are in terms of both time and cost, is of primary
importance in asset management. To maximize profitability, management

must carefully weigh the full return on liquid assets (yield plus liquidity
value) against the higher return associated with less liquid assets. Income
derived from higher yielding assets may be offset if a forced sale, at less
than book value, is necessary because of adverse balance sheet
fluctuations.
Seasonal, cyclical, or other factors may cause aggregate outstanding loans
and deposits to move in opposite directions and result in loan demand,
which exceeds available deposit funds. A bank relying strictly on asset
management would restrict loan growth to that which could be supported
by available deposits. The decision whether or not to use liability sources
should be based on a complete analysis of seasonal, cyclical, and other
factors, and the costs involved. In addition to supplementing asset
liquidity, liability sources of liquidity may serve as an alternative even
when asset sources are available.
C. Liability Management:Liquidity needs can be met through the discretionary acquisition of
funds on the basis of interest rate competition. This does not preclude the
option of selling assets to meet funding needs, and conceptually, the
availability of asset and liability options should result in a lower liquidity
maintenance cost. The alternative costs of available discretionary
liabilities can be compared to the opportunity cost of selling various
assets. 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, larger banks have a wider variety of
options from which to select the least costly method of generating funds.
The ability to obtain additional liabilities represents liquidity potential.

The marginal cost of liquidity and the cost of incremental funds acquired
are of paramount importance in evaluating liability sources of liquidity.
Consideration must be given to such factors as the frequency with which
the banks must regularly refinance maturing purchased liabilities, as well
as an evaluation of the bank's ongoing ability to obtain funds under
normal market conditions. The obvious difficulty in estimating the latter
is that, until the bank goes to the market to borrow, it cannot determine
with complete certainty that funds will be available and/or at a price,
which will maintain a positive yield spread.
Changes in money market conditions may cause a rapid
deterioration in a bank's capacity to borrow at a favorable rate. In this
context, liquidity represents the ability to attract funds in the market when
needed, at a reasonable cost vis--vis asset yield. The access to
discretionary funding sources for a bank is always a function of its
position and reputation in the money markets.
Although the acquisition of funds at a competitive cost has enabled many
banks to meet expanding customer loan demand, misuse or improper
implementation of liability management can have severe consequences.
Further, liability management is not riskless. This is because
concentrations in funding sources increase liquidity risk. For example, a
bank relying heavily on foreign interbank deposits will experience
funding problems if overseas markets perceive instability in U.S. banks
or the economy.
Also if rate competition develops in the money market, a bank may
incur a high cost of funds and may elect to lower credit standards to book
higher yielding loans and securities. If a bank is purchasing liabilities to

support assets, which are already on its books, the higher cost of
purchased funds may result in a negative yield spread.
Preoccupation with obtaining funds at the lowest possible cost,
without considering maturity distribution, greatly intensifies a bank's
exposure to the risk of interest rate fluctuations. That is why banks that
particularly rely on wholesale funding sources, management must
constantly be aware of the composition, characteristics, and
diversification of its funding sources.
Reasons for growing significance of ALM
1.

Volatility
Deregulation of financial system changed the dynamics of

financial markets. The vagaries of such free economic environment are

reflected in interest rate structures, money sipply and the overall credit
position of the market, the exchange rate and price level. For the
business, this involves trading in money, rate fluctuations invariably
affect the market value of the bank and its net interest income.
2.

Product innovation
The second reason for the growing importance of

ALM is the rapid innovations take place in the financial products of the
bank. While there were some innovations that came in passing fads,
others hae received tremendous response.
In several cases, the same product has been reapeted with certain
differences and offered by various banks. Whatever may be the features
of the products, most of them have an impact on the risk profile of the
bank thereby enhancing the need for ALM for e.g. Flexi-deposit facility.
3.

Regulatory Enviornment

At the international level, Bank for institutional

settlement provides a framework for banks to tackle the market risks that
may arise due to rate fluctuations and excessive credit risk, Central Bank
in various countries (including Reserve Bank of India) have issued
frameworks and guidelines for banks Asset Liability Management
Policies.
4.

Management Recognition
All the above-mentioned aspects forced bank

management to give a serious thought to effective management of assets

and liabilities, the management has realized that it is just not sufficient to
have a very good franchise for credit disbursement, nor is it enough to
have just a very good retail deposit base. In addition to these, a bank
should be in a position to relate and link the asset side with liability side.
And this calls for efficient asset liability management.
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.
Asset liability mismatch
In finance, an asset-liability mismatch occurs when the
financial terms of the assets and liabilities do not correspond. For
example, a bank that chose to borrow entirely in U.S. dollars and lend in
Russian rubles would have a significant (currency) mismatch: if the value
of the ruble were to fall dramatically, the bank would lose money. In
extreme cases, such movements in the value of the assets and liabilities
could lead to bankruptcy, liquidity problems and wealth transfer.
Asset-liability mismatches can occur in several different areas. A bank
could have substantial long-term assets (such as fixed rate mortgages) but
short-term liabilities (maturity mismatch), such as deposits. Alternatively,

a bank could have all of its liabilities as floating interest rate bonds, but
assets in fixed rate instruments.
Asset-liability mismatches are also important to insurance companies and
various pension plans, which may have long-term liabilities (promises to
pay the insured or pension plan participants) that must be backed by
assets. Choosing assets that are appropriately matched to their financial
obligations is therefore an important part of their long-term strategy.
Few companies or financial institutions have perfect matches between
their assets and liabilities. In particular, the mismatch between the
maturities of banks' deposits and loans has been offered as an explanation
of bank runs. On the other hand, 'controlled' mismatch, such as between
short-term deposits and somewhat longer-term, higher-interest loans to
customers is central to many financial institutions' business model.
Asset-liability mismatches can be controlled, mitigated or hedged by
entering into derivative contracts like swaps.
Risks involved in asset liability management
Risk in a way can be defined as the chance or the probability of
loss or damage. In the case of banks, these include credit risk, capital risk,
market risk, interest rate risk, and liquidity risk. These categories of
financial risk require focus, since financial institutions like banks do have
complexities and rapid changes in their operating environments.

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 an
important challenge for financial institutions and failure on this front may
lead to failure of banks. The recent failure of many Japanese banks and
failure of savings and loan associations in the 1980s in the USA are

important examples, which provide lessons for others. It may be noted

that the willingness to pay, which is measured by the character of the
counter party, and the ability to pay need not necessarily go
together.Credit risk is the risk of loss due to a debtor's non-payment of a
loan or other line of credit (either the principal or interest (coupon) or
both).

Capital risk:
One of the sound aspects of the banking practice is the maintenance of
adequate capital on a continuous basis. There are attempts to bring in
global norms in this field in order To bring in commonality and
standardization in international practices. Capital adequacy also focuses
on the weighted average risk of lending and to that extent; banks are in a
position to realign their portfolios between more risky and less risky
assets.

Market risk:
Market risk is related to the financial condition, which results from
adverse movement in market prices. This will be more pronounced when
financial information has to be provided on a marked-to-market basis
since significant fluctuations in asset holdings could adversely affect the
balance sheet of banks. In the Indian context, the problem is accentuated
because many financial institutions acquire bonds and hold it till maturity.
When there is a significant increase in the term structure of interest rates,
or violent fluctuations in the rate structure, one finds substantial erosion
of the value of the securities held.

Liquidity risk:
The final major category of financial risk is liquidity risk.the
liquidity risk arises from funding of long term assets by short term
liabilities or resources, thereby making the liabilities subject to rollover or
refinancing risk. Those banks that fud their domestic assets with foreign
country deposits with them may be particularly susceptible to liquidity
risk when sharp fluctuations in exchange rates and market turbulence
make it difficult to retain sources of financing.
Interest rate risk
Interest rate risk is the risk (variability in value) borne by an
interest-bearing asset, such as a loan or a bond, due to variability of
interest rates. In general, as rates rise, the price of a fixed rate bond will
fall, and vice versa. Interest rate risk is commonly measured by the bond's
duration.
A more precise measure of interest rate risk is Duration which
measures the impact of changes in interest rates on the expected
maturities of both assets and liabilities. In essence, duration takes the gap
report data and converts that information into present-value worth of
deposits and loans, which is more meaningful in estimating maturities
and the probability that either assets or liabilities will re-price during the
period under review. Besides financial institutions, nonfinancial
companies also employ asset-liability management, mainly through the
use of derivative contracts to minimize their exposures on the liability
side of the balance sheet.
Asset liability management is a common name for the complete set
of techniques used to manage risk within a general enterprise risk
management framework.

Calculating interest rate risk

Interest rate risk analysis is almost always based on simulating

movements in one or more yield curves using the Heath-Jarrow-Morton
framework to ensure that the yield curve movements are both consistent
with current market yield curves and such that no riskless arbitrage is
possible.
There are a number of standard calculations for measuring the impact of
changing interest rates on a portfolio consisting of various assets and
liabilities. The most common techniques include:

1. Marking to market, calculating the net market value of the assets

and liabilities, sometimes called the "market value of portfolio equity"

2. Stress testing this market value by shifting the yield curve in a

specific way. Duration is a stress test where the yield curve shift is
parallel

3. Calculating the Value at Risk of the portfolio

4. Calculating the multi-period cash flow or financial accrual

income and expense for N periods forward in a deterministic set of future

yield curves

5. Doing step 4 with random yield curve movements and

measuring the probability distribution of cash flows and financial accrual

income over time.

6. Measuring the mismatch of the interest sensitivity gap of assets

and liabilities, by classifying each asset and liability by the timing of

interest rate reset or maturity, whichever comes first?

Measurement of interest rate risk

The methods to measure of Interest Rate Risk in trading book are:

i) Duration Gap analysis: Duration is a value and time weighted measure

of maturity that considers the timing of all cash inflows from assets and

all cash outflows associated with liabilities. It measures the average

maturity of a promised stream of future cash payments. In effect, duration
measures the average time needed to recover the funds committed to an
investment.
ii) Convexity: Convexity is the rate of change of duration. Compared to
duration, it is a better measure of price sensitivity for larger change in
interest rates.
iii) Simulations: Simulations are computer-generated scenarios about the
future that permit banks to analyse interest rate risk and business
strategies in a dynamic framework. Given such information, banks may
evaluate the desirability of various courses of action. The scenarios are
based on assumptions, such as changes in interest rates, shape of yield
curve, pricing strategies, growth volume and mix of assets and liabilities
and hedging strategies.
iv) VAR based methodology: VaR is an estimate of potential loss in a
position or asset/liability or portfolio of assets/liabilities over a given
holding period at a given level of certainty.
The Bank of International Settlements has accepted VaR as a
measurement of market risks and provision for capital adequacy for
market risks.
VaR is used as a MIS tool in the trading portfolio to "slice and
dice" risk by levels/products/geographic/level of organisation etc.

Banks and interest rate risk

Banks face four types of interest rate risk:

1. Basis risk is the risk presented when yields on assets and costs on
liabilities are based on different bases, such as the London Interbank

Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances
different bases will move at different rates or in different directions,
which can cause erratic changes in revenues and expenses.
2. Yield curve risk is the risk presented by differences between short-term
and long-term interest rates. Short-term rates are normally lower than
long-term rates, and banks earn profits by borrowing short-term money
(at lower rates) and investing in long-term assets (at higher rates). But the
relationship between short-term and long-term rates can shift quickly and
dramatically, which can cause erratic changes in revenues and expenses.
3. Re-pricing risk is the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate
will generate more interest income when rates rise and less interest
income when rates fall. If the loan is funded with fixed rated deposits, the
bank's interest margin will fluctuate.
4. Option risk is presented by optionality that is embedded in some assets
and liabilities. For instance, mortgage loans present significant option risk
due to prepayment speeds that change dramatically when interest rates
rise and fall. Falling interest rates will cause many borrowers to refinance
and repay their loans, leaving the bank with un invested cash when
interest rates have declined. Alternately, rising interest rates cause
mortgage borrowers to repay slower, leaving the bank with relatively
more loans based on prior, lower interest rates. Option risk is difficult to
measure and control.

Hedging interest rate risk

Interest rate risks can be hedged using fixed income instruments or

interest rate swaps. Interest rate risk can be reduced by buying bonds with
shorter duration, or by entering into a fixed-for-floating interest rate
swap.
MANAGEMENT OF EXCHANGE RISK
Introduction
Foreign exchange risk is linked to unexpected fluctuations in the value of
currencies. A strong currency can very well be risky, while a weak
currency may not be risky. The risk level depends on whether the
fluctuations can be predicted. Short and longterm fluctuations have a
direct impact on the profitability and competitiveness of business.
The present chapter provides an overview of the foreign exchange risks
faced by MNCs. A very important dimension of international finance is
exposure management and their has been an increased interest by MNCs
in recent times in developing techniques and strategies for foreign
exchange exposure management. MNCs face three kinds of risk Translation, Transaction and Economic exposure. The chapter first
discusses the above-mentioned three kinds of exposure and then goes on
to discuss the tools and techniques of exposure management.
The Management of Foreign Exchange Risk
The foreign exchange market consists of the spot market and the
forward or futures market. The spot market deals with foreign exchange
delivered within 2 business days or less.

Transactions in the spot market quote rates of exchange prevalent at the

time the transactional took place. Typically, a bank will quote a rate at
which it is willing to buy the currency (bid rate) and a rate at which it will
sell a currency (offer rate) for delivery of the particular currency. The
forward market is for foreign exchange to be delivered in 3 days or more.
In quoting the forward rate of -currency; a bank will quote a bid
and offer rate for delivery typically one, two, three or six months after the
transaction date.
Exchange rates are considered by MNCs as a crucially important
factor affecting their profitability. This is because exchange rate
fluctuations directly impact the sales revenue of firms exporting goods
and services. Future payments in a foreign currency carry the risk that the
foreign currency will depreciate in value before the foreign currency
payment is received and is exchanged into Indian rupees.
Thus, exchange risk is the effect that unexpected exchange rate
changes have on the value of the firm. Foreign exchange risks therefore
pose one of the greatest challenges to MNCs. The present chapter deals
with the management of foreign exchange risk and based on the nature of
the exposure and the firms ability to forecast currencies, what hedging or
exchange risk management strategy should the firm employ.
What is Exchange Risk?
Foreign exchange risk is the possibility of a gain or loss to a firm that
occurs due to unanticipated changes in exchange rate.
For example, if an Indian firm imports goods and pays in foreign
currency (say dollars), its outflow is in dollars, thus it is exposed to
foreign exchange risk. If the value of the foreign currency rises (i.e., the

dollar appreciates), the Indian firm has to pay more domestic currency to
get the required amount of foreign currency.
The advent of the floating exchange rate regime, since the early
1970s, has heightened the interest of MNCs in developing techniques and
strategies for foreign exchange exposure management. The primary goal
is to protect corporate profits from the negative impact of exchange rate
fluctuations.
However, the goals and techniques of management vary depending on
whether the focus is on accounting exposure or economic exposure.
Foreign exchange risks, therefore, pose one of the greatest
challenges to a multinational company. These risks arise because
multinational corporations operate in multiple currencies.
Infact, many times firms who have a diversified portfolio find that the
negative effect of exchange rate changes on one currency are offset by
gains in others i.e. - exchange risk is diversifiable.
Types of Exposure
There are mainly three types of foreign exchange exposures:
1. Translation exposure
2. Transaction exposure
3. Economic Exposure
Translation Exposure
It is the degree to which a firms foreign currency denominated financial
statements are affected by exchange rate changes. All financial statements
of a foreign subsidiary have to be translated into the home currency for
the purpose of finalizing the accounts for any given period.
If a firm has subsidiaries in many countries, the fluctuations in
exchange rate will make the assets valuation different in different periods.

The changes in asset valuation due to fluctuations in exchange rate will

affect the groups asset, capital structure ratios, profitability ratios,
solvency rations, etc.FASB 52 specifies that US firms with foreign operations should
provide information disclosing effects of foreign exchange rate changes
on the enterprise consolidated financial statements and equity. The
following procedure has been followed:

Assets and liabilities are to be translated at the current rate that is

the rate prevailing at the time of preparation of consolidated statements.

All revenues and expenses are to be translated at the actual

exchange rates prevailing on the date of transactions. For items occurring

numerous times weighted averages for exchange rates can be used.

Translation adjustments (gains or losses) are not to be charged to

the net income of the reporting company. Instead these adjustments are
accumulated and reported in a separate account shown in the shareholders
equity section of the balance sheet, where they remain until the equity is
disposed off.
Measurement of Translation exposure
Translation exposure = (Exposed assets Exposed liabilities)
(change in the exchange rate)
The various steps involved in measuring translation exposure are:
First, Determine functional currency.
Second, Translate using temporal method recording gains/ losses in the
income statement as realized.

Third, Translate using current method recording gains/losses in the

balance sheet and as realized.
Finally, consolidate into parent company financial statements.
Transaction Exposure
This exposure refers to the extent to which the future value of
firms domestic cash flow is affected by exchange rate fluctuations.
It arises from the possibility of incurring foreign exchange gains or losses
on transaction already entered into and denominated in a foreign
currency.
The degree of transaction exposure depends on the extent to which a
firms transactions are in foreign currency: For example, the transaction
in exposure will be more if the firm has more transactions in foreign
currency.
According to FASB 52 all transaction gains and losses should be
accounted for and included in the equitys net income for the reporting
period. Unlike translation gains and loses which require only a
bookkeeping adjustment, transaction gains and losses are realized as soon
as exchange rate changes.
The exposure could be interpreted either from the standpoint of the
affiliate or the parent company. An entity cannot have an exposure in the
currency in which its transactions are measured.
Economic Exposure

Economic exposure refers to the degree to which a firms present

value of future cash flows can be influenced by exchange rate
fluctuations. Economic exposure is a more managerial concept than an
accounting concept. A company can have an economic exposure to say
Pound/Rupee rates even if it does not have any transaction or translation
exposure in the British currency. This situation would arise when the
companys competitors are using British imports. If the Pound weakens,
the company loses its competitiveness (or vice versa if the Pound
becomes strong).
Thus, economic exposure to an exchange rate is the risk that a variation in
the rate will affect the companys competitive position in the market and
hence its profits. Further, economic exposure affects the profitability of
the company over a longer time span than transaction or translation
exposure. Under the Indian exchange control, economic exposure cannot
be hedged while both transaction and translation exposure can be hedged.
Tools and Techniques of Foreign Exchange Risk
Management

Forward contract

Future contract

Option contract

Currency contract
The most frequently used financial instruments by companies in

India and abroad for hedging the exchange risk are discussed below.
These instruments are available at varying costs to the company. Two
criterions have been used to contrast the different tools. First, there are
different tools that serve practically the same purpose differing only in

details like default risk or transaction cost or some fundamental market

imperfection.
Second, different tools hedge different kinds of risk.
1. Forward Contracts:
A forward contract is one where a counterparty agrees to exchange
a specified currency at an agreed price for delivery on a fixed maturity
date. Forward contracts are one of the most common means of hedging
transactions in foreign currencies.
In a forward contract, while the amount of the transaction, the value data,
the payments procedure and the exchange rate are all determined in
advance, no exchange of money takes place until the actual settlement
date. For example, an Indian company having a liability in US dollars due
in December end may buy US dollars today for the ma (December end).
By doing so, the company has effectively locked itself into a rate. A
forward contract for a customer involves a spot and a swap transaction, as
the customer cannot cover the transaction outright for the forward data.
This is because the market quotes only spot transactions on an outright
basis: In the example given above, the customer, or the company) will
have to first buy US dollars in the spot market and then enter into a swap
where he sells spot and buys forward (December end).
The problem with forward contracts however, is that since they
require future performance, sometimes one party may be unable to
perform the contract. Also, many times forward rate contracts are
inaccessible for many small businesses.
Banks often tend to quote unfavorable rates for smaller business because
the bank bears the risk of the company - defaulting in the payments. In
such situations, futures may be more suitable.

2. Futures contracts:
Futures is the same as a forward contract except that it is
standardized in terms of contract size is traded on future exchanges and is
settled daily. In practice, futures differ from forwards in 3 important
ways.
First, forwards could be for any amount while futures are for
standard amount with each contract being much smaller than the average
forward transaction. Also, futures are also standardized in terms of
delivery dates while forwards are agreements that can specify any
delivery date that the parties choose. Second, forwards are traded by
phone and letters - while futures are traded in organized exchanges, such
as
SIMEX in Singapore, IMM in Chicago. Third, in a forward
contract, transfer of funds takes place only once - i.e. at maturity while in
a futures contract, cash transactions take place practically every day
-during the life or the contract.
Thus, the default risk is largely avoided in a futures contract.
Despite the above mentioned advantages, futures contract also entails
some limitations since the futures trade only in standardized amounts,
flexibility is missing and thus the hedges are not always perfect. Also,
many big companies tend to prefer futures because of their adaptability.

3. Option Contract:
An option contract is one where customer has the right but not the
obligation to contract on maturity date. Options have an advantage as

compared to forward contracts as the customer has no obligation to

exercise the option in case it is not in his favour.
An option can be a call or a put option. A call option is the right to buy
the underlying asset whereas a put is the right to sell the underlying asset
at the agreed strike price. For the purchase of an option, a customer will
have to pay a premium. Likewise, the seller of the option receives
premium. The option premium depends on the strike price, the maturity
date, current spot rate and the volatility.
4. Currency Swap:
A currency swap is defined as an agreement where two parties
exchange a series of cash flows in one currency for a series of cash flows
in another currency, at agreed intervals over an agreed period. Typically, a
corporate would want to do such a swap if it wants to convert its
liabilities in a particular currency to that of another currency.
For example, U.S. corporate needs German Marks to fund a
construction project in Germany. The company chooses to issue a fixed
rate bond in dollars and convert them to
German Marks. The company takes the dollars received from the issue of
the dollar denominated bond and pays them up front to a swap dealer who
pays a certain amount of Marks to the firm. Interest payments on the
dollar denominated bond are paid in dollars. At the same time, the firm
pays an agreed-upon amount of German Marks to the swap dealer and
receives dollars in exchange. The dollars received from the swap dealer
offset the payment of the dollar coupon interest. Upon maturity, the firm
pays its bondholders in dollars and receives an equivalent amount of
dollars from the swap dealer to which it paid an agreed-upon amount of
Marks. In effect, the company has converted its Dollar denominated loan
into a Mark denominated loan.

The most popular instrument used to hedge is forward exchange contracts

in India. Although in the more developed markets, options and derivatives
are used to a larger extent.
Forward contracts are more popular for the following reasons:
1. Forward exchange markets arc well established and transparent.
2. Forward contracts are accessible even by the smaller corporates. There
are few corporates in the country who have volumes, which are tradeable
in the option and derivative markets.
3. Many corporate policies do not allow them to trade in options and
derivatives. This is because these instruments are perceived to be risky
and expensive. Options are relatively new to the Indian market. There is
also a lack of product knowledge. Hence, many corporates are not too
comfortable while dealing with options.
Liquidity risk
Liquidity risk a definition
The risk that a bank or corporation, although balance sheet solvent,
cannot meet or generate sufficient cash resources to meet its payment
obligations in full as they fall due, or can only do so at materially
disadvantageous terms.
Asset liquidity an asset cannot be sold due to lack of liquidity in the
market - essentially a sub-set of market risk. Can be accounted for by:
o

Widening bid/offer spread

Making explicit liquidity reserves

Lengthening holding period for VaR calculations

Funding liquidity Risk that liabilities: (1) cannot be met when they

fall due (2) Can only be met at an uneconomic price (3) Can be namespecific or systemic.
o
Causes of Liquidity Risk
Liquidity risk' arises from situations in which a party interested in
trading an asset cannot do it because nobody in the market wants to trade
that asset. Liquidity risk becomes particularly important to parties who
are about to hold or currently hold an asset, since it affects their ability to
trade.
Manifestation of liquidity risk is very different from a drop of price to
zero. In case of a drop of an asset's price to zero, the market is saying that
the asset is worthless. However, if one party cannot find another party
interested in trading the asset, this can potentially be only a problem of
the market participants with finding each other. This is why liquidity risk
is usually found higher in emerging markets or low-volume markets.
Liquidity risk is financial risk due to uncertain liquidity. An institution
might lose liquidity if its credit rating falls, it experiences sudden
unexpected cash outflows, or some other event causes counterparties to
avoid trading with or lending to the institution. A firm is also exposed to
liquidity risk if markets on which it depends are subject to loss of
liquidity.
Liquidity risk tends to compound other risks. If a trading organization has
a position in an illiquid asset, its limited ability to liquidate that position
at short notice will compound its market risk. Suppose a firm has
offsetting cash flows with two different counterparties on a given day. If

the counterparty that owes it a payment defaults, the firm will have to
raise cash from other sources to make its payment. Should it be unable to
do so, it too will default. Here, liquidity risk is compounding credit risk.
A position can be hedged against market risk but still entail liquidity risk.
This is true in the above credit risk examplethe two payments are
offsetting, so they entail credit risk but not market risk.
Accordingly, liquidity risk has to be managed in addition to market, credit
and other risks. Because of its tendency to compound other risks, it is
difficult or impossible to isolate liquidity risk. In all but the most simple
of circumstances, comprehensive metrics of liquidity risk do not exist.
Certain techniques of asset-liability management can be applied to
assessing liquidity risk. A simple test for liquidity risk is to look at future
net cash flows on a day-by-day basis. Any day that has a sizeable
negative net cash flow is of concern. Such an analysis can be
supplemented with stress testing. Look at net cash flows on a day-to-day
basis assuming that an important counterparty defaults.
Analyses such as these cannot easily take into account contingent cash
flows, such as cash flows from derivatives or mortgage-backed securities.
If an organization's cash flows are largely contingent, liquidity risk may
be assessed using some form of scenario analysis.
A general approach using scenario analysis might entail the following
high-level steps:

Construct multiple scenarios for market movements and defaults

over a given period of time

Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to

the next, there is little standardization in how such analyses are
implemented.

Regulators are primarily concerned about systemic implications of

liquidity risk.
To manage and control liquidity risk, it is important for financial
institutions to understand the intraday flows associated with their
customers activity to gain an understanding of peak funding needs and
typical variations. To smooth a customers peak credit demands, a
depository institution might consider imposing overdraft limits on all or
some of its customers. Moreover, institutions must have a clear
understanding of all of their proprietary payment and settlement activity
in each of the payment and securities settlement systems in which they
participate.

Risk measurement technique

GAP ANALYSIS
Gap analysis is a technique of asset-liability management that can
be used to assess interest rate risk or liquidity risk. Implementations for
those two applications differ in minor ways, so people distinguish
between interest rate gaps and liquidity gaps.
Gap analysis was widely adopted by financial institutions during the
1980s. When used to manage interest rate risk, it was used in tandem with
duration analysis. Both techniques have their own strengths and
weaknesses.
Duration is appealing because it summarizes, with a single number,
exposure to parallel shifts in the term structure of interest rates. It does

not address exposure to other term structure movements, such as tilts or

bends.
Gap analysis is more cumbersome and less widely applicable, but it
assesses exposure to a greater variety of term structure movements.
The term structure of interest rates can move in many ways.
Duration analysis addresses exposure to parallel shifts only. Gap analysis
can warn of exposure to more complex movements, including tilts and
bends.
This is an effective, but largely impractical means of eliminating
interest rate risk. If a portfolio has a positive fixed cash flow at some
time, its market value will increase or decrease inversely with changes in
the spot interest rate for maturity. If the portfolio has a negative fixed
cash flow at time, its market value will increase or decrease in tandem
with changes in that spot rate. Simply, interest rate risk arises from either
positive or negative net future cash flows. The concept of cash matching
is to eliminate interest rate risk by eliminating all net future cash flows. A
portfolio is cash matched if :
Every future cash inflow is balanced with an offsetting cash
outflow on the same date, and
Every future cash outflow is balanced with an offsetting cash
inflow on the same date.
The net cash flow for every date in the future is then 0. Obviously,
this is an ideal that usually don't want to achieve, but it is a theoretically

useful concept. In its most basic form, gap analysis assesses how close a
portfolio is to being cash matched. Here is how it works.
Considering a portfolio with only fixed cash flowsthat is, the
timing and amount of all cash flows is known. The portfolio contains no
floaters, no options and no bond with embedded options. Gap analysis
doesnt consider credit risk, so assume all cash flows will occur.
Gap analysis comprises aggregating cash flows into maturity
buckets and checking if cash flows in each bucket net to 0. Different
bucketing schemes might be used. As a simple example, consider a
portfolio whose cash flows all mature in less than three years.
Bank aggregate maturities into five buckets:
0 - 3 months
3 - 6 months
6 - 12 months
12 - 24 months
24 - 36 months
An interest rate gap is simply a positive or negative net cash flow
for one of the buckets. Example 2 illustrates a gap analysis using our
buckets and some hypothetical cash flows.
Example:GapAnalysis

Bucketed cash flows in USD millions. A gap is any net cash flow for
a bucket, so there is a USD 100MM gap for the 3 - 6 month bucket. There
is a negative gap of USD 30MM for the 12 - 24 month bucket.
This portfolio is exposed to tilts in the term structure of interest
rates. If rates for the 3 - 6 month bucket rise and rates for the 12 - 24
month bucket decline, the portfolio will incur a mark-to-market loss on
both gaps. This exposure would not be identified by duration. If you
calculate the Macaulay duration of the portfolio, it is about 0.
Now let's add floating rate instruments to the portfolio. These
generally are not bucketed according to their maturity but according to
their next reset date. Consider a USD 100MM floating rate note (FRN)
that pays 3-month Libor flat. Its last reset was a month ago at 2.8%. It
will pay USD 0.7MM in two months, and then the rate will be reset
again.
From a market value standpoint, the FRN is equivalent to a fixed
cash payment of USD 100.7MM to be received in two months.
Accordingly, that is how we bucket itwe bucket the entire FRN as a
single USD 100.7MM cash flow in the 0 - 3 month bucket.
Because of how floaters are treated, buckets are often called repricing buckets as opposed to maturity bucketsinstruments are
bucketed according to their next re-pricing date as opposed to their
maturity date. We are moving away from cash matching and towards repricing date matching. From this standpoint, interest rate gaps are
sometimes called re-pricing gaps.

This is all about the use of gap analysis for assessing interest rate
risk. It can also be used to assess liquidity risk. Cash flows are bucketed
as above. The only difference is that cash flows from floaters are
bucketed according to their maturity.
The actual values of floating rate cash flows will not be known,
but estimated values may be used. The idea of liquidity gap analysis is to
anticipate periods when a portfolio will have large cash out-flow. Such
buckets are called liquidity gaps.
A shortcoming of gap analysisboth interest rate and liquidity gap
analysisis the fact that it does not identify mismatches within buckets.
An even more significant shortcoming is the fact that it cannot handle
options in a meaningful way. In today's markets, options proliferate.
Fixed income portfolios routinely hold caps, floors, swaptions, mortgagebacked securities, callable bonds, etc. Options have cash flows whose
magnitudesand sometimes timingis highly uncertain. Those
uncertain cash flows cannot be bucketed. For this reason, gap analysis has
largely fallen out of use. Today, gap analysis is most useful as a
theoretical tool for communicating issues related to interest rate and
liquidity risk.

RBI GUIDELINES
Asset - Liability Management (ALM) System in banks
Guidelines
1. Over the last few years the Indian financial markets have witnessed
wide ranging changes at fast Pace. Intense competition for business
involving both the assets and liabilities, together with increasing volatility
in the domestic interest rates as well as foreign exchange rates, has
brought Pressure on the management of banks to maintain a good balance
among spreads, profitability and Long-term viability. These pressures call
for structured and comprehensive measures and not just Ad hoc action.
The Management of banks has to base their business decisions on a
dynamic and Integrated risk management system and process, driven by
corporate strategy. Banks are exposed To several major risks in the course
of their business - credit risk, interest rate risk, foreign Exchange risk,
equity / commodity price risk, liquidity risk and operational risks.
2. 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. 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.
3. The ALM process rests on three pillars:

ALM information systems

=> Management Information System

=> Information availability, accuracy, adequacy and expediency

ALM organisation

=> Structure and responsibilities

=> Level of top management involvement

ALM process

=> Risk parameters

=> Risk identification
=> Risk measurement
=> Risk management
=> Risk policies and tolerance levels.
ALM Information Systems
1. ALM has to be supported by a management philosophy which
clearly specifies the risk policies and tolerance limits. This framework
needs to be built on sound methodology with necessary information
system as back up. Thus, information is the key to the ALM process. It is,
however, recognised that varied business profiles of banks in the public
and private sector as well as those of foreign banks do not make the
adoption of a uniform ALM System for all banks feasible. There are
various methods prevalent world-wide for measuring risks. These range
from the simple Gap Statement to extremely sophisticated and data
intensive Risk Adjusted Profitability Measurement methods. However,
the central element for the entire ALM exercise is the availability of
adequate and accurate information with expedience and the existing
systems in many Indian banks do not generate information in the manner
required for ALM.

2. Collecting accurate data in a timely manner will be the biggest

challenge before the banks, particularly those having wide network of
branches but lacking full scale computerisation. However, the
introduction of base information system for risk measurement and
monitoring has to be addressed urgently. As banks are aware,
internationally, regulators have prescribed or are in the process of
prescribing capital adequacy for market risks. A pre-requisite for this is
that banks must have in place an efficient information system.
3. Considering the large network of branches and the lack of (an
adequate) support 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. The problem of ALM needs to be addressed by following an
ABC approach i.e. analysing the behaviour of asset and liability products
in the sample branches accounting for significant business and then
making rational assumptions about the way in which assets and liabilities
would behave in other branches. In respect of foreign exchange,
investment portfolio and money market operations, in view of the
centralised nature of the functions, it would be much easier to collect
reliable information. The data and assumptions can then be refined over
time as the bank management gain experience of conducting business
within an ALM framework. The spread of computerisation will also help
banks in accessing data.
ALM Organisation
Successful implementation of the risk management process would
require strong commitment on the part of the senior management in the
bank, to integrate basic operations and strategic decision making with risk
management. 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, interest rate, foreign exchange and
equity price risks.
a.

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.
b.

The ALM Support Groups consisting of operating staff should be

responsible for analysing, monitoring and reporting the risk profiles to the
ALCO. 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.
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. Each bank will have to
decide on the role of its ALCO, its responsibility as also the decisions to
be taken by it. The business and risk management strategy of the bank
should ensure that the bank operates within the limits / parameters set by
the Board. The business issues that an ALCO would consider, inter alia,
will include product pricing for both deposits and advances, desired
maturity profile and mix of the incremental assets and liabilities, etc. In
addition to monitoring the risk levels of the bank, the ALCO should
review the results of and progress in implementation of the decisions
made in the previous meetings. The ALCO would also articulate the
current interest rate view of the bank and base its decisions for future
business strategy on this view. In respect of the funding policy, for
instance, its responsibility would be to decide on source and mix of

liabilities or sale of assets. Towards this end, it will have to develop a

view on future direction of interest rate movements and decide on
funding mixes between fixed vs floating rate funds, wholesale vs retail
deposits, money market vs capital market funding , domestic vs foreign
currency funding, etc. Individual banks will have to decide the frequency
for holding their ALCO meetings.
Composition of ALCO
The size (number of members) of ALCO would depend on the size of
each institution, business mix and organisational complexity. To ensure
commitment of the Top Management and timely response to market
dynamics, the CEO/CMD or the ED should head the Committee. The
Chiefs of Investment, Credit, Resources Management or Planning, Funds
Management / Treasury (forex and domestic), International Banking and
Economic Research can be members of the Committee. In addition, the
Head of the Technology Division should also be an invitee for building
up of MIS and related computerisation. Some banks may even have Subcommittees and Support Groups.
Committee of Directors
The Management Committee of the Board or any other Specific
Committee constituted by the Board should oversee the implementation
of the system and review its functioning periodically.
ALM Process:
The scope of ALM function can be described as follows:
i.

Liquidity risk management

ii.

Management of market risks

iii.

Trading risk management

iv.

Funding and capital planning

v.

Profit planning and growth projection

vi.

The guidelines given in this note mainly address Liquidity and

Interest Rate risks.

Liquidity Risk Management
Measuring and managing liquidity needs are vital for effective operation
of commercial banks. By assuring a bank's ability to meet its liabilities as
they become due, liquidity management can reduce the probability of an
adverse situation developing. The importance of liquidity transcends
individual institutions, as liquidity shortfall in one institution can have
repercussions on the entire system.
Banks 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 different assumptions. 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. Therefore liquidity has to
be tracked through maturity or cash flow mismatches. For measuring and
managing net funding requirements, 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. The format of the Statement of
Structural Liquidity is given in Annexure I.
The Maturity Profile as given in Appendix I could be used for measuring
the future cash flows of banks in different time buckets. 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 upto 3 months

iv.

Over 3 months and upto 6 months

v.

Over 6 months and upto 1 year

vi.

Over 1 year and upto 3 years

vii.

Over 3 years and upto 5 years

viii. Over 5 years

The investments in SLR securities and other investments are
assumed as illiquid due to lack of depth in the secondary market and are
therefore required to be shown under respective maturity buckets,
corresponding to the residual maturity. However, some of the banks may
be maintaining securities in the 'Trading Book', which are kept distinct
from other investments made for complying with the Statutory Reserve
requirements and for retaining relationship with customers. Securities
held in the 'Trading Book' are subject to certain preconditions like :

The composition and volume are clearly defined;

Maximum maturity/duration of the portfolio is restricted;

The holding period not to exceed 90 days;

Cut-loss limit prescribed;

Defeasance periods (product-wise) i.e. time taken to liquidate the

position on the basis of liquidity in the secondary market are prescribed;

Marking to market on a daily/weekly basis and the revaluation

gain/loss charged to the profit and loss account; etc.

Banks which maintain such 'Trading Books' and complying with the
above standards are permitted to show the trading securities under 1-14
days, 15-28 days and 29-90 days buckets on the basis of the defeasance
periods. The Board/ALCO of the banks should approve the volume,
composition, holding/defeasance period, cut loss, etc. of the 'Trading
Book' and copy of the policy note thereon should be forwarded to the
Department of Banking Supervision, RBI.

Within each time bucket there could be mismatches depending on

cash inflows and outflows. While the mismatches upto one year would be
relevant since these provide early warning signals of impending liquidity
problems, the main focus should be on the short-term mismatches viz., 114 days and 15-28 days. Banks, however, 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. The mismatches (negative gap) during 1-14
days and 15-28 days in normal course may not exceed 20% of the cash
outflows in each time bucket. If a bank in view of its current asset
-liability profile and the consequential structural mismatches needs higher
tolerance level, it could operate with higher limit sanctioned by its
Board / Management Committee giving specific reasons on the need for
such higher limit. The discretion to allow a higher tolerance level is
intended for a temporary period, i.e. till March 31, 2000.
The Statement of Structural Liquidity (Annexure I ) may be
prepared by placing all cash inflows and outflows in the maturity ladder
according to the expected timing of cash flows. A maturing liability will
be a cash outflow while a maturing asset will be a cash inflow. It would
also be necessary to take into account the rupee inflows and outflows on
account of forex operations. While determining the likely cash inflows /
outflows, banks have to make a number of assumptions according to their
asset - liability profiles. For instance, Indian banks with large branch
network can (on the stability of their deposit base as most deposits are
rolled-over) afford to have larger tolerance levels in mismatches in the
long-term if their term deposit base is quite high. While determining the
tolerance levels the banks may take into account all relevant factors based
on their asset-liability base, nature of business, future strategy, etc. 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.
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, banks may
estimate their short-term liquidity profiles on the basis of business
projections and other commitments for planning purposes. An indicative
format (Annexure III ) for estimating Short-term Dynamic Liquidity is
enclosed.
Currency Risk
Floating exchange rate arrangement has brought in its wake
pronounced volatility adding a new dimension to the risk profile of banks'
balance sheets. The increased capital flows across free economies
following deregulation have contributed to increase in the volume of
transactions. Large cross border flows together with the volatility has
rendered the banks' balance sheets vulnerable to exchange rate
movements.
Dealing in different currencies brings opportunities as also risks. If
the liabilities in one currency exceed the level of assets in the same
currency, then the currency mismatch can add value or erode value
depending upon the currency movements. The simplest way to avoid
currency risk is to ensure that mismatches, if any, are reduced to zero or
near zero. Banks undertake operations in foreign exchange like accepting
deposits, making loans and advances and quoting prices for foreign
exchange transactions. Irrespective of the strategies adopted, it may not
be possible to eliminate currency mismatches altogether. Besides, some
of the institutions may take proprietary trading positions as a conscious
business strategy.

Managing Currency Risk is one more dimension of Asset- Liability

Management. Mismatched currency position besides exposing the
balance sheet to movements in exchange rate also exposes it to country
risk and settlement risk. Ever since the RBI (Exchange Control
Department) introduced the concept of end of the day near square
position in 1978, banks have been setting up overnight limits and
selectively undertaking active day time trading. Following the
introduction of "Guidelines for Internal Control over Foreign Exchange
Business" in 1981, maturity mismatches (gaps) are also subject to control.
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 capital to Risk-Weighted
Assets Ratio of 8% of open position limit.
Presently, 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. Thus the open position limits together
with the gap limits form the risk management approach to forex
operations. For monitoring such risks banks should follow the
instructions contained in Circular A.D (M. A. Series) No.52 dated
December 27, 1997 issued by the Exchange Control Department.
Interest Rate Risk (IRR)
The phased deregulation of interest rates and the operational flexibility
given to banks in pricing most of the assets and liabilities imply the need
for the banking system to hedge the Interest Rate Risk. Interest rate risk is
the risk where changes in market interest rates might adversely affect a
bank's financial condition. The changes in interest rates affect banks in a
larger way. The immediate impact of changes in interest rates is on bank's

earnings (i.e. reported profits) by changing its Net Interest Income (NII).
A long-term impact of changing interest rates is on bank's Market Value
of Equity (MVE) or Net Worth as the economic value of bank's assets,
liabilities and off-balance sheet positions get affected due to variation in
market interest rates. The interest rate risk when viewed from these two
perspectives is known as 'earnings perspective' and 'economic value'
perspective, respectively. The risk from the earnings perspective can be
measured as changes in the Net Interest Income (NII) or Net Interest
Margin (NIM). There are many analytical techniques for measurement
and management of Interest Rate Risk. In the context of poor MIS, slow
pace of computerisation in banks and the absence of total deregulation,
the traditional Gap analysis is considered as a suitable method to measure
the Interest Rate Risk in the first place. It is the intention of RBI to move
over to the modern techniques of Interest Rate Risk measurement like
Duration Gap Analysis, Simulation and Value at Risk over time when
banks acquire sufficient expertise and sophistication in acquiring and
handling MIS.
The Gap or Mismatch risk can be measured by calculating Gaps
over different time intervals as at a given date. Gap analysis measures
mismatches between rate sensitive liabilities and rate sensitive assets
(including off-balance sheet positions). An asset or liability is normally
classified as rate sensitive if:

within the time interval under consideration, there is a cash flow;

the interest rate resets/reprices contractually during the interval;

RBI changes the interest rates (i.e. interest rates on Savings Bank

Deposits, DRI advances, Export credit, Refinance, CRR balance, etc.) in

cases where interest rates are administered ; and

it is contractually pre-payable or withdrawal before the stated

maturities.

The Gap Report should be generated by grouping rate sensitive

liabilities, assets and off-balance sheet positions into time buckets
according to residual maturity or next repricing period, whichever is
earlier. The difficult task in Gap analysis is determining rate sensitivity.
All investments, advances, deposits, borrowings, purchased funds, etc.
that mature/reprice within a specified timeframe are interest rate
sensitive. Similarly, any principal repayment of loan is also rate sensitive
if the bank expects to receive it within the time horizon. This includes
final principal payment and interim instalments. Certain assets and
liabilities receive/pay rates that vary with a reference rate. These assets
and liabilities are repriced at pre-determined intervals and are rate
sensitive at the time of repricing. While the interest rates on term deposits
are fixed during their currency, the advances portfolio of the banking
system is basically floating. The interest rates on advances could be
repriced any number of occasions, corresponding to the changes in PLR.
The Gaps may be identified in the following time buckets:
1.

1-28 days

2.

29 days and upto 3 months

3.

Over 3 months and upto 6 months

4.

Over 6 months and upto 1 year

5.

Over 1 year and upto 3 years

6.

Over 3 years and upto 5 years

7.

Over 5 years

8.

Non-sensitive
The various items of rate sensitive assets and liabilities and off-

balance sheet items may be classified as explained in Appendix - II and

the Reporting Format for interest rate sensitive assets and liabilities is
given in Annexure II
The Gap is the difference between Rate Sensitive Assets (RSA) and Rate
Sensitive Liabilities (RSL) for each time bucket. The positive Gap
indicates that it has more RSAs than RSLs whereas the negative Gap
indicates that it has more RSLs. 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). The Gap can,
therefore, be used as a measure of interest rate sensitivity.
Each bank should set prudential limits on individual Gaps with the
approval of the Board/Management Committee. The prudential limits
should have a bearing on the Total Assets, Earning Assets or Equity. The
banks may work out Earnings at Risk (EaR) or Net Interest Margin
(NIM) based on their views on interest rate movements and fix a prudent
level with the approval of the Board/Management Committee.
RBI will also introduce capital adequacy for market risks in due
course.