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Asset Liability Management in

Banks and Financial Institutions


A case study of IDBI

Madhu Vij

Abstract
ALM as a concept is gradually gaining importance in the Indian conditions. It is the art of ensuring
that the maturity profiles of assets match that of liabilities and combines the techniques of asset
management, liability management and spread management into a cohesive process leading to an
integrated management of the total balance sheet. The process of ALM will differ from bank to bank
and the success of the technique depends upon how effectively banks are able to forecast and
manage the risks they carry and are exposed to. Efficient liquidity and interest rate management are
the two important activities of the banks and financial institutions in maximizing their income while
controlling the risk exposure. The objective of ALM at IDBI is to ensure adequate funding for each
product at the most attractive available cost and to manage the currency composition, maturity
profile and interest rate sensitivity characteristics of the portfolio of liabilities supporting each
product within the prescribed risk parameters.
Keywords: Asset-Liability Management, Net Interest Margin, GAP, Duration, Interest-rate Risk.

SECTION I management tool and banks and financial


institutions have now realized that the secret of
Introduction successful banking under deregulated and
The ongoing financial sector reforms and the competitive environment depends on matching
growing liberalization has made the concept of of assets and liabilities in terms of rate and
Asset Liability Management (ALM) important maturity so as to obtain an optimum yield.
in the Indian scenario. The simultaneous
ALM is the art of ensuring that the maturity
management of both assets and liabilities has
profile of assets match that of liabilities. It plays
come into being as a strategic response of banks
an important role, both as a risk management
and financial institutions to manage the high
tool and a profit generating engine. It combines
inflationary and volatile interest rates during the
the technique of asset management, liability
seventies and eighties coupled with severe
management and spread management into a
recessionary trends that prevailed during this
cohesive process leading to an integrated
period. ALM plays an important role as a risk-
management of the total balance sheet. The
importance of ALM lies not in eliminating risk
Dr. Madhu Vij
Associate Professor but in managing it in such a manner that an
Faculty of Management Studies acceptable balance exists between profitability,
University of Delhi, Delhi growth and risk.
As a result, ALM as a concept is gradually customers demand.
gaining importance in the Indian conditions.
But the situation has now changed beyond
This is the function which will help banks and
recognition. Capital adequacy norms,
financial institutions to keep their profit margins
deregulation of interest rates on deposits as well
intact. With growing competition and greater
as advances, liberalization and globalization in
volatility in the interest rate scenario, banks will
various sectors including partial convertibility of
have to adopt aggressive strategies to increase
the rupee, entry of foreign and domestic private
their incomes and at the same time keep their
banks and non-banking financial companies, and
risk level in manageable proportions. Any
the introduction of the new financial products
institution which is in a position to forecast the
are some of the developments that have
movement of interest rates to certain accuracy,
completely changed the outlook and
can plan its strategy according to the profit from
management of the Indian banks. As a result,
the changing business situation. Thus, in the
Indian banks have suddenly realized that risk
coming years, it will be the ability of banks and
management is an area of prime concern for
financial institutions to take risks based on the
them. Banks now face a whole array of risks,
extent of their risk bearing capacity, while not
important among them being credit risk,
severely reducing their incomes, that will
liquidity risk, interest rate and currency risk.
determine their profits.
Thus, these institutions have to bring their risk
In this scenario, the paper discusses the level in manageable proportions while not
rationale, importance and techniques of ALM. severely reducing their incomes. This can only
A case study of IDBI has also been attempted to be done by restructuring their balance sheets.
specifically highlight the importance of ALM. And as risk management (especially interest rate
The paper has been sub-divided into four risk) is the core activity of ALM, the technique
sections. Section I gives the introduction. has become extremely important and is of great
Section II discusses the interest rate risk significance to organizations in the financial
management through ALM. Gap, Duration, sector. The ALM framework specially discusses
Value at Risk and Simulation methods for the the interest rate risk and liquidity risk.
measurement of interest rate risk are discussed in
this section. Section III discusses the case study Interest Rate Risk Management through ALM
of IDBI, and finally Section IV gives the
concluding observations. Interest rate risk is the exposure of a bank’s
financial condition to adverse movements in
interest rates. Excessive interest rate risk can
SECTION II
pose a significant threat to a bank’s earnings and
Risk Relevant to Indian Banking capital base. The immediate impact of a change
in interest rate is on the bank’s net interest
A clear perception of risk within an integrated income or net interest margin and the level of
framework is essential for better asset-liability other interest sensitive assets and liabilities. A
management and survival of any bank. Risk, till long term impact of a change in interest rates is
recently, was a concept alien to Indian banks, on the bank’s market value of equity or net
particularly the public sector banks. The worth as the economic value of a bank’s assets,
financial markets were quite stable and bankers liabilities and off-balance sheet positions get
did not have to worry much about the risk affected due to variation in market interest rates.
management — at best, it was necessary to
protect against liquidity risk by ensuring that There are varied techniques for the
there were enough cash reserves to meet the measurement and management of interest rate

112 Journal of Management Research


risk. Gap, Duration, Simulation and Value at If ∆ rA = ∆ rl = ∆ r i.e. changes in interest rate
Risk are some of the popular techniques used by on RSAs and RSLs is the same for the time
banks to measure interest rate risk. We now period chosen then the change in net interest
discuss these techniques in brief. income can be written as
I GAP Method ∆ NII = (RSAs – RSLs) ∆ r
This approach is concerned with the rate Since GAP was earlier expressed as a difference
sensitivity of assets and liabilities and the between RSAs and RSLs a relationship can be
objective is to immunize a bank’s net interest expressed between a change in interest rates and
income (NII) or net interest margin (NIM). In a change in the bank’s net interest income.
every bank there are some assets and liabilities
that are sensitive to changes in interest rates ∆ NII = GAP x ∆ r
while others are not. The difficult task in Gap It is thus evident that a bank can immunize it’s
analysis is determining rate sensitivity. Rate net interest income over a given planning
sensitive instruments are those which can horizon by eliminating its funding Gap or when
mature or be priced upward and downward its RSAs are equal to its RSLs.
within a specified time frame. GAP is defined as
the difference between rate sensitive assets (RSA) Active Gap management requires the
and rate sensitive liabilities (RSL) in a particular monitoring of all markets within which the
accounting period. In symbols institution operates plus the willingness to use
interest rates forecasts as the basis for active
GAP = RSA – RSL asset/liability management. If the bank
RSA management wants to completely insulate the
Or as a ratio GAP = balance sheet from the changes in interest rates,
RSL the Gap would be set near to zero so that
GAP and the Net Interest Income changes in asset return would be
counterbalanced by changes in liability costs,
If the bank wants to keep its NII immune from irrespective of the direction of interest rates. If a
changes in interest rates it must closely monitor decline in interest rate is forecasted, the asset/
and manage its GAP carefully. Net interest liability strategy would try to narrow the Gap, so
income is the difference between interest income that the proportion of rate sensitive assets are
and interest expense. reduced. In case a rise in interest rate is
NII = Interest Income – Interest Expenses anticipated, the opposite strategy, increasing the
size of the Gap would be attempted. In addition
Changes in interest rates only affect the RSAs to the direction of interest rates, Gap
and RSLs over the planning horizon. The fixed management strategies also depend upon the
rate assets and fixed rate liabilities are not volatility of interest rates. In period of high
affected by changes in interest rate. interest rate volatility, aggressive positioning
with respect to the direction of interest rates is
Thus,
generally not advisable as the accuracy of interest
∆ NII = RSAs x ∆ rA – RSL x ∆ rl rate forecasts are subject to a high degree of
prediction error.
where
∆ rA = change in interest rate on RSAs NIM and GAP
∆ rl = change in interest rate on RSLs The GAP also affects a bank’s net interest
margin and is defined as follows:

Volume 1, Number 2 • January - April 2001 113


Net interest income (NII) maturities flows from an investment are
NIM = expected, where weights are the relative present
Interest earning assets (EA)
values of cash flows. Duration of a financial
Or instrument is governed by a complex interaction
NII of factors, viz., cash flows, their timings and
NIM =
EA current market yield. In the event of a change in
any of these factors the duration of the
Also, change in net interest income will result in instrument will also change. Further, as
a change in net interest margin, so that duration is denominated in number of periods,
symbolically we have the duration of several instruments can be
compared even if they have different yields, cash
∆ NII
∆ NIM = flows or contractual maturities.
EA
Substituting the value of ∆ NII in the above III Simulation Method
equation we get Simulation techniques involve detailed
assessments of the potential effects of changes in
GAP x ∆r
∆ NIM = interest rates by simulating the future path of
EA interest rates and their impact on cash flows.
Or This computer generated scenario then ascribes
probabilities on the basis of past behaviour and
EA x ∆ NIM helps the bank to choose the optimum models.
GAP = This method is generally used by banks using
∆r
complex financial instruments or having
Thus, as the above equations suggest, changes in complex risk profiles.
the bank’s net interest margin as a result of
interest rate changes will depend on the funding Simulation approach, though complicated, is
gap. RBI has advised each bank to set more dynamic as it typically involves a more
prudential limits on individual Gaps with the detailed breakdown of various categories of on
approval of the Board/ Management Committee. and off balance sheet position, so that specific
The prudential limits will have a bearing on assumptions about the interest and principal
total assets, earning assets or equity. payments and non-interest income and expense
arising from each type of position can be
incorporated. However, the applicability of
II Duration Method
simulation based interest rate risk measurement
This method takes into account the timing and techniques depends on the validity of the
the market value of cash flows. It is one of the underlying assumptions and the accuracy of the
most developed techniques of quantifying and basic methodology.
managing interest rate risk. It evaluates the
impact of interest rate changes on the market IV Value at Risk Method
value of assets and liabilities and takes into
account the fact that some assets or liabilities are Value at Risk (VaR) is an advanced tool to
more rate sensitive than others even if the measure interest rate risk. It takes into account
maturity is equal. The duration of an asset or the risk of individual assets and liabilities by
liability is calculated as the weighted average calculating the changes in the value of assets/
time over which the cash flows or contractual liabilities due to changes in the rates of interest.

114 Journal of Management Research


This helps the managers to evaluate the cost/ important area that development financial
benefits of carrying such assets/liabilities for a institution will need to handle in view of the
longer frame of time and also see the direct play of market forces. Efficient risk
impact of their decisions on the net worth of an management requires setting up exposure limits,
organization. The technique also helps the internal controls and risk management systems
managers to focus on the long term risk using a consistent approach.
implications of the decisions that have been
From the time of its inception in 1964, IDBI
taken by the management.
has had a separate department for risk
management. This department has ensured that
SECTION III IDBI’s lending risk is spread over approximately
Case Study on IDBI 20 industries, so that its lending becomes broad
base and is not concentrated in a few industries.
IDBI assumes various kinds of risks that arise For management of risks of asset-liability
from its business of being a development mismatch the bank has, as mentioned earlier, a
financial institution and the environment within full fledged Asset Liability Committee (ALCO)
which it operates. The increasing volatility in which meets regularly and frames strategies for
interest and exchange rates and financial containing such risks.
deregulation has led to a significant increase in
the risks being faced by IDBI and the bank has In assessing the overall quality of a banking
developed a comprehensive framework for organization, management and measurement of
defining, measuring and evaluating a wide array risks becomes an important part of ALM. IDBI
of risks to ensure that the level of risk it assumes has developed and is implementing various
is effectively managed. An in-house Asset guidelines for a prudent risk return
Liability Management Committee (ALCO) has optimization strategy. The objective of ALM at
been constituted to monitor liquidity risk, IDBI is to continuously monitor the interest
interest rate risk and foreign exchange risk in a rate/liquidity profile of maturing assets and
co-ordinated manner. liabilities.

The objective of ALM at IDBI is to ensure Some of the important indicators of measuring
adequate funding for each product at the most the quality of ALM at IDBI are discussed here.
attractive available cost and to manage the
interest rate/liquidity profile of maturing assets Capital Adequacy
and liabilities. Decisions regarding interest rate
In recent years, capital adequacy has become the
and maturity of incremental lending and
cornerstone of prudential regulatory framework
borrowing are managed in accordance with a
in India. The Narasimham Committee (1998)
view to achieve the desired interest rate and
had recommended enhancement of capital
liquidity profile of assets and liabilities. Further,
adequacy ratio from the present stipulation of 8
IDBI has appointed Arthur Andersen to
per cent to 10 per cent by 2002. Endorsing this
establish an effective ALM function. The bank
decision, the Union Budget 1998-98 has
has also initiated pro-active steps in 1998-99 to
announced raising of the minimum capital
formalize the ALM process in anticipation of
adequacy ratio to 9 per cent by March 31, 2000
RBI guidelines.
and to 10 per cent as early as possible thereafter.

Risk Management The assessment of capital adequacy should focus


on regulatory requirements in line with the
Risk management has recently emerged as an

Volume 1, Number 2 • January - April 2001 115


relevant guidelines issued by IDBI. In terms of solvency of an institution specially in terms of
regulatory hurdles the main ratios used should repaying the interest obligation. EPS assesses
include the capital adequacy ratio, the leverage the book value of the institution’s equity shares
ratio and risky asset outstanding ratio. Table 1 and is an important measure from the viewpoint
gives some of the important ratios to assess the of investors. The times interest earned ratio for
capital adequacy of IDBI. IDBI decreased from 1.38 times in 1998 to 1.23
times in 1999, while the EPS also declined from
Table 1: Important Ratios
22.3 to 18.71 for the same period.
1996-97 1997-98 1998-99
The decrease in the two ratios has been mainly
Capital adequacy ratio 14.70 13.70 12.70 due to a decrease in the overall profits and an
Risky Assets 05.51 06.26 07.24 increase in the expenditure of the bank in the
Outstanding
current year. The profitability of the bank has
Debt-equity ratio 05.80 06.10 06.50 been affected during the year due to lower
Times Interest Earned 01.36 01.38 01.23 growth in income and higher growth in
Ratio times times times
expenditure. Interest expenses have increased by
EPS 16.80 22.30 18.71 20.9% in 1999 mainly due to 16.4% increase in
outstanding borrowing.
IDBI’s capital adequacy ratio is well above the
regulatory requirement of 8.0%. The capital
adequacy ratio at end March 1999 was 12.7%. Asset Quality
(13.7% as at end March 1998). The entire Asset quality is one of the important parameters
capital is Tier 1 capital. of an efficient ALM system. With growing
competition profit margins of banks and
IDBI’s debt equity ratio is well within the
financial intermediaries are reducing. In an effort
prescribed norms. The debt to equity ratio
to increase the earnings and at the same time
increased from 6.1:1 in March 1998 to 6.5:1 in
keep their risk level in manageable proportions,
March 1999. A leverage ratio of more than 6
financial institutions are working hard on
per cent is considered well capitalized while a
improving their asset quality by adopting various
ratio of less than 2 per cent permits regulators to
methods for recovering their principal and
use early intervention and seizure powers. Still
interest dues.
another important measure of sound capital
adequacy requirement is the risky assets ratio In evaluating asset quality the focus should be
which has been calculated as risky assets divided on NPA levels, narrowing spreads and exposure
by net equity. Net equity here includes issued of these institutions to industries which are
and paid up capital plus reserves less investments going through a rough patch like steel, cement,
in shares of other financial institutions. Risky paper etc. Tables 2 and 3 give the asset
assets include direct loans outstanding and classification and spread management of IDBI
investment in shares and debentures of for the years 1998 and 1999.
industrial concerns. The risky assets ratio has
increased from 6.26% in 1998 to 7.24% in The net NPAs of IDBI have increased to 12.0%
1999 mainly because of the increase in risky during 1998-99 from 10.1% in the previous
assets outstanding in 1999. year. It must be kept in mind here that IDBI’s
NPAs are more due to compulsions from the
Two other ratios calculated here are times government to lend to a particular company or
interest earned ratio and earning per share industry. However, if the NPAs continue to rise
(EPS). The times interest earned ratio shows the this will in turn affect the profitability resulting

116 Journal of Management Research


Table 2: Asset Qualification
1997-98 1998-99
Gross Assets % of total Gross Assets % of total
(Rs. Crores) (Rs. Crores)

Standard 45,181.4 89.9 47,375.0 88.0


Sub-Standard 3,515.5 7.0 4,184.9 7.7
Doubtful 1,585.2 3.1 2,305.2 4.3
Loss 0 0 0.0 0.0
Total 50,282.1 100% 53,865.1 100%

in a higher risk profile for the institution. management and rehabilitation packages. These
Another important problem here is of spreads. steps would go a long way in improving the
Spreads are being increasingly squeezed and for quality of IDBI’s asset profile.
the IDBI it’s spread has come down from 3.9%
to 2.6% in the current year. IDBI is also aware Liquidity Risk
of the stress caused to its asset portfolio due to
prolonged weaknesses in certain sectors. Measuring and managing liquidity risk is an
important dimension of ALM. Mismatch in the
Table 3: NPAs and Spread Management maturity profile of assets and liabilities exposes
1997-98 1998-99 the balance sheet to liquidity risk. Liquidity risk
Net NPAs/ Total Assets 10.1% 12.0% is the potential inability of a bank/financial
institution to generate sufficient operating
Spread Management 3.9% 2.6% requirements. However, excess liquidity is also
costly for the financial institution because idle
As a result, it has already started working on cash is costly as the bank pays interest on its
improving its asset quality by lowering its deposits. Thus it should be the endeavour of
exposure to these critical industries. financial institutions to achieve a reasonable
trade-off between being overly liquid and
NPA Strategy relatively illiquid.
During the period under review IDBI has taken By ensuring that a bank is in a position to meet
up a time bound programme for containment of its liabilities as they become due, liquidity
NPAs with emphasis on identifying potential management can avert the probability of an
NPAs and taking up measures for their adverse situation from developing. The other
turnaround by way of financial and business important aspect of liquidity management arises
restructuring. Asset quality targets are today a from the fact that liquidity shortfalls in one
key parameter for employee performance institution can have repercussions on the entire
evaluation. IDBI has initiated more stringent system. Banks/financial institutions manage-
and control mechanism so as to improve ment should also examine how liquidity
recovery of dues and initiate timely remedial requirements are likely to evolve under crisis
action. A special rehabilitation committee scenarios.
comprising the zonal chief and a chief general
manager from the head office has been specially As per the RBI guidelines, while the mismatches
constituted to review the progress of NPA upto one year would be relevant since these

Volume 1, Number 2 • January - April 2001 117


provide early warning signals of impending Table 4: Maturity Pattern or
liquidity problem, the main focus should be on Assets and Liabilities (Rs. Crores)
the short-term mismatches i.e. 1-14 days and 15 Year Maturing Assets Maturing
to 28 days. Banks/financial institutions are Liabilities
expected to monitor their cumulative 1999-2000 14495 6970
mismatches across all time buckets by
establishing internal prudential limits with the 2000-01 8989 7006
approval of the Board/Management Committee. 2001-02 9566 7310
Development financial institutions are aware of 2002-03 8799 7864
the risk of being unable to fund its portfolio of
2003-04 6448 5371
assets at appropriate maturities and rates and the
risk of being unable to liquidate a position in a The table clearly shows that IDBI has a positive
timely manner and at a reasonable price. They Gap in all the years. IDBI should try and adjust
are hence, continuously trying to diversify and its portfolio of assets and liabilities as per the
expand their borrowing source to maximize directions in interest rate movements. Different
liquidity and reduce concentration risk. scenarios can be analyzed (i.e. an increase or a
As far as IDBI is concerned, it is comfortably decrease in interest rates) with the help of the
placed in the area of liquidity in the years to technique of sensitivity analysis. These different
come and has effectively managed its business options can help the management to take
and liability mix. Table 4 gives the maturity suitable action depending upon the expected
pattern of assets and liabilities over the next five movement in interest rates.
years.

Case I - Normal Case (Rs. Crores)

1999-2000 2000-01 2001-02 2002-03 2003-04

1. Maturing Assets 14495.00 8989.00 9566.00 8799.00 6448.00


2. Maturing liabilities 6970.00 7006.00 7310.00 7864.00 5371.00
3. Gap 7525.00 1983.00 2256.00 935.00 1077.00
4. Interest rate on assets 16.5% *
5. Interest rate on liabilities 12.5% **
6. Interest Income 2391.67 1483.18 1578.39 1451.83 1063.92
7. Interest expense 871.25 875.75 913.75 983.00 671.37
8. Net Interest Income 1520.42 607.43 664.64 468.83 392.55
9. Net Interest Margin 10.49 6.76 6.95 5.33 6.09
[(NIM) %]
* Assume IDBI's prime lending rate is 13.5%. With an interest rate band of 3% over the normal interest
rate charged to customers, comes out to be around 16.5%.
** This is the interest rate being given by IDBI on its flexibond 7th issue for 5-7 year bonds.

Analysis
There is a positive Gap in all the years and the NIM is also comfortable for the period under study.

118 Journal of Management Research


Case II - When Interest Rate increases by 1% only for Assets (Rs. Crores)

1999-2000 2000-01 2001-02 2002-03 2003-04

1. Maturing Assets 14495 8989 9566 8799 6448


2. Maturing liabilities 6970 7006 7310 7864 5371
3. Gap 7525 1983 2256 935 1077
4. Interest rate on assets 17.5%
5. Interest rate on liabilities 12.5%
6. Interest Income 2536.62 1573.07 1674.05 1539.82 1128.40
7. Interest expense 871.25 875.75 913.75 983.00 671.37
8. Net Interest Income 1665.37 697.32 760.3 556.82 457.03
9. NIM (%) 11.49% 7.76% 7.95 6.33 7.09

Analysis
When the interest rate on assets increases from 16.5% to 17.5%, the NIM improves for all the years as
the interest income rises while the interest expenses remain the same.

Case III - When Interest Rate decreases by 1% (Rs. Crores)

1999-2000 2000-01 2001-02 2002-03 2003-04

1. Maturing Assets 14495 8989 9566 8799 6448


2. Maturing liabilities 6970 7006 7310 7864 5371
3. Gap 7525 1983 2256 935 1077
4. Interest rate on assets 15.5%
5. Interest rate on liabilities 11.5%
6. Interest Income 2246.72 1393.29 1482.73 1363.84 999.44
7. Interest expense 801.55 805.69 840.65 904.36 617.66
8. Net Interest Income 1445.17 587.6 642.08 459.48 381.78
9. Net Interest Margin 9.97 6.54 6.71 5.22 5.92
[(NIM) %]

Analysis
With an overall decrease of 1% in the interest rates, the NIM also decreases in all the years. Also with
the spate of interest rate cuts announced by the RBI, this scenario could be more plausible. IDBI
needs to be concerned about its falling NIM in times to come.

SECTION IV down, the risk of assets/liabilities having


different maturities, the rising risk of certain
Conclusion industries, and are also facing a situation where
The deregulation of domestic interest rates, the protected industry margins are getting
volatility in the domestic debt and foreign eroded.
exchange markets and introduction of new
The ALM framework specifically focusses on the
financial instruments like derivatives, swaps etc.,
interest rate risk and liquidity risk and helps
have exposed the banking system to different
banks/financial institutions in strategic and
kinds of risks. Banks and financial institutions
business planning as well as in accessing risk in
are facing the risk of interest rates going up or

Volume 1, Number 2 • January - April 2001 119


advance. It helps banks to know exactly the IDBI did not make any fresh disbursals to steel
maturity profiles of assets and liabilities and and brought down its exposure in textiles
whether they match or not. (11.35% to 10.7%) and cement (6.91% to
4.7%).
IDBI has evolved a comprehensive framework
for managing and measuring risk and also has an Thus, in the context of the differing
in-house Asset Liability Management environment and the diverse nature of activities
Committee (ALCO). The business prospects of undertaken by different banks, the process of
IDBI have become difficult and the bank’s ALM will differ from bank to bank and the
spread show a declining trend. The lowering of success of the technique will depend upon how
interest spread is due to the increase in the cost effectively the banks are able to forecast and
of borrowings. Another problem area of IDBI manage the risks they carry and are exposed to.
and, in fact, of all development financial Efficient liquidity and interest rate management
institutions (DFIs) is asset quality. NPAs were would be the two important activities of the
higher by Rs. 800 crore for ICICI, Rs. 1,400 banks and the financial institutions in
crore for IDBI and Rs. 2000 crore for IFCI in maximising their income while controlling the
1998-99. DFIs are aware of their position and risk exposure.
have already started working on improving their
asset quality. As a first step, they have started In the emerging scenario the focus of ALM
lowering their exposure in some critical should be on bank profitability and long-term
industries. For example, IDBI has lent heavily operating viability in a scientific way. Once the
to the steel sector and its exposure to this sector Indian banking system has adopted the
is the highest compared to the other two DFIs sophistication in ALM, it would go a long way
(ICICI & IFCI). But for the year 1998-99 in strengthening the entire banking sector and
also have a positive impact on their profitability.
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120 Journal of Management Research


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