Chapter 2

Asset-Liability Management in Banks

This chapter begins with the discussion on classification of bank's assets and habiHties into
Banking Book and Trading Book. It then describes the meaning of 'Asset-LiabiHty
Management' and its role in handhng liquidity risk and interest rate risk. Finally, it
describes in detail, the computer based ALM system that was developed and implemented
in banks during the study.

2.1 The Banking and the Trading Book

Banks broadly position their balance sheet into Banking book and Trading Book. The
'banking book' groups and records all commercial banking activities. It includes all
lending and commercial borrowing activities such as bank deposits, borrowings and loans
and advances. The trading book comprises of securities such as bonds, equity, various
currency positions and commodity positions that are identified as a part of the trading
book. 'Conceptually, a Financial Institution's trading portfolio can be distinguished from
its banking portfolio on the basis of time horizon and liquidity.' (Saunders, 2003:232) The
important points on which these two differ from each other are as follows:
Holding Period: The assets and liabilities in the banking book are held till maturity;
whereas in case of trading book, the holding period can be as short as few minutes/hours to
a maximum of 90 days. The term 'trading' implies frequent and active buying and selling
to take advantage of temporary differences in market prices. Unlike the traditional
activities like deposit accepting and lending, in trading activities, banks make profits by
earning commissions on trading volume and by investing primarily in debt or equity
securities for their short term profit potential.
Accounting Rules: In case of banking book, accounting is done on the basis of accrual
basis and it relies on book values of assets and liabilities. Trading book relies on market
values of transactions which consider price appreciation (or depreciation) due to changes in
market conditions. Trading book is "marked to market" on daily basis, i.e. its valuation is
based on daily market prices of financial assets as opposed to their historical or acquisition
values (which is done in the case of a banking book).

J6
One more important issue in the risk management in the banking book is that it is spread
over a long time-period as compared to the risk management in trading portfoHos. This is
because, at a bank level, volume of a banking book in Indian banks generally outweighs
volume of a trading book and typically positions in the banking book are generally held till
maturity.

All assets and liabilities in the banking book generate accrued revenues and costs, of which
a large fraction is driven by the interest rates. Any maturity mismatch between assets and
liabilities results in surplus or deficit of funds. Mismatch may also exist due to customer's
demands or bank's business policy, e.g. when lending activity increases there may be
deficit of funds or growth in deposits that may lead to excess funds. This requires
simultaneous planning of all assets and liability positions on the bank's balance sheet. As
described by Moynihan (2002), using ALM techniques bank can mitigate the risks arising
out of changes in interest rates, provides adequate liquidity and enhances the value of the
bank. Such attempts of measuring financial risks, particularly risks related to interest rates
and liquidity positions are classified under the broad subject - "Asset-Liability
Management" (ALM).

2.2 Asset Liability Management: Background and Definition

Internationally, the phenomenon of asset-liability management (ALM) began in 1970s
when the markets observed increasing volatility in the interest rates. However, at that time
the Indian banks were still operating in protected environment as interest rates were guided
by the regulators. Prior to interest rate deregulation, financial management of a bank was
mainly limited to asset management. However, with liberalization and growing integration
of domestic and external markets the risks associated with bank's operations increased.
Deregulation of interest rates coupled with increased competition in mid-90s started
putting pressure on management to maintain spread and profitability. The changing nature
of sources (liabilities) and uses (assets) of funds highlighted the need for prudent liquidity
management and hence it was necessary to study the maturities of assets and liabilities in
structured manner by adopting comprehensive ALM practices.

17
Asset and Liability Management is broadly defined as the "coordinated management of
bank's balance sheet (portfolio) to allow for alternative interest rates, liquidity and
prepayment scenarios." (Sinkey, 2002 : 661). It is the process of planning, organizing and
controlling asset and liability mixes, volumes, yields and rates in order to achieve targeted
interest margin. The primary goal is to control interest income and expenses and to increase
the net interest margin on a continuous basis.

The entire subject of ALM is about balance sheet and its management. The management of
a firm's balance sheet is one of the important functions in risk management for financial
institutions. Hence it is necessary to know the components of Balance-sheet. Typically,
Indian commercial banks include following 'rate earning assets' and 'rate paying
liabilities' in their balance sheets. (Other assets and liabilities which are not significant
from ALM point of view are excluded.)
Assets
• Advances
Term Loans and Demand Loans
Un-availed portion of Cash Credit/Overdraft
Bills purchased and Discounted
• Investments
Government & Other Securities

Liabilities
Demand Deposits - Current and Savings Bank Deposits :Demand deposits can be
withdrawn on demand and hence do not have any specific maturity
Term Deposits - They are contracted for a specific term. They include Cumulative,
Non-cumulative and Recurring Deposits. Significant portion of them is at fixed -
rate.
Borrowings
2.3 Scope of ALM

From the above discussion it may be stated that in the overall risk management framework
of a bank ALM addresses the following important risks,
1. Liquidity Risk: The risk arising out of unexpected fluctuation in cash outflows and
cash inflows.
2. Interest Rate Risk: The risk arising due to changes in interest rates on assets and
liabilities.
These risks and may be explained as follows:

2.3.1 Liquidity Risk in the Banking Book

Liquidity risk is the potential inability to meet the bank's liabilities as they become due. It
arises when the banks are not able to generate enough cash to cope up with a decline in
deposits or increase in assets. "Liquidity risk arises for two reasons: a liability-side reason
and an asset-side reason" (Saunders, 2003: 424). The liability side risk occurs when
depositors ask for their claims without prior notification. The asset side risk occurs when
the borrower demands his loan commitment and the bank does not have sufficient funds to
fulfill his request.
The liquidity risk in the banking book can also be called as funding liquidity which arises
from mismatches in the maturity pattern of assets and liabilities. "Net funding
requirements are determined by analyzing the bank's future cash flows based on
assumptions of the future behaviour of assets and liabilities that are classified into
specified time buckets and then calculating the cumulative net flows over the time frame
for liquidity assessment." (RBI, 2002). An example of funding liquidity can be stated as
follows: Let us consider a single asset and single liability in the balance sheet. Let us
assume that the asset is a five-year old loan and the liability is 6-months term deposit. The
bank would face funding liquidity risk after one year when the 6-months old deposit
matures for payment, since the liability would require a cash out flow while the asset
would not have earned any cash flow (except the possible interest on the loan). This is a
typical case of funding mismatch that the bank can manage either when a customer renews
the matured deposit (rolling over) or gets fresh deposit or a combination of both. The
standard tools used to measure liquidity risk are: Liquidity Gap and Structural balance
sheet ratios.
2.3.1.1 The Liquidity Gap
One important approach to measuring liquidity risk at balance sheet level is to find out the
'liquidity gap'. "Liquidity gaps are the differences, at all future dates, between assets and
liabilities of the banking portfolio". (Bessis, 2002: 137) They are differences between
outstanding balances of assets and liabilities, or between their changes over time. Such
gaps cause the risk of not being able to generate funds without incurring excess costs.
Thus, the liquidity gap report is prepared by placing assets and liabilities into various time
buckets on the basis of timing of cash inflows from the assets and timings of cash outflows
from the liabilities on the basis of their residual maturities. The cash flow includes both
principal and interest cash flow. For regulatory purposes the RBI has suggested the
following format of liquidity report. (RBL 1999a)

Liquidity Gap Summary (Amount in Rs. Crores)

Particulars 1-14D 15-28D 29D-3M 3-6M 6M-1Y 1-3Y 3-5Y Over 5Y Total

A. Total
Outflows
B. Total
Inflows

C. Net Gap
(B-A)
D. Cumulative
Gap

( D: Day, M: Month, Y: Year)

Table 2.1
The advantage of the liquidity gap approach is that it is extremely simple to understand and
use. However, while using this approach some important issues need to be considered
through appropriate analysis. These issues are as follows,

20
1. Non maturity items in the balance sheet: A significant portion around 38% in
nationalized banks in the year 2004-05 (IBA,2005) of deposits in the banking
industry is in the form of current and savings deposits which do not have specific
maturity period. Similarly, advances in the form of cash credit, over-draft also do
not have any specific maturity. Such items which are of the 'non-maturity' variety
can result in cash flow at any time and hence it is difficult to place them in a
definite time period (bucket). For such items it is necessary to study their
behavioural maturity on the basis of statistical analysis and then place them in
appropriate time bucket.
2. Renewal assumptions in case of maturing deposits: Though the term deposits
result in cash outflow on maturity, the general practice is that a significant amount
of such deposits is actually renewed by the customers. Such renewals do not result
in cash outflow thereby reducing the net gap. It is difficult to predict the percentage
of renewal of deposits as it may vary from dme to time depending on various
factors such as prevailing interest rates, customer's need for cash, etc. If the
renewal percentage assumed for the preparation of gap report is more than the
actual renewal, it would create an unexpected deficit of liquidity. In the reverse
situation, surplus liquidity would result into less return as bank may not be able to
deploy the unexpected surplus. Considering this, it is necessary to have a detailed
roll-in / roll-out analysis of deposits. This analysis, if done over a reasonable
period, would enable the comparison of the actual renewals with the expected /
projected renewal.
3. Un-availed portion of Cash Credit Over-draft: In the advances portfolio of
Indian commercial banks, around 40% in the year 2004-05 (IBA,2005) advances
are in the form of cash credit and over-draft. In case of such loans, a limit is
sanctioned for the borrower, but how much and when to borrow is left to his/her
discretion. This causes a lot of uncertainty to the bank as they can neither keep
unutilized portions idle as returns may suffer, nor can they deploy them in other
assets as borrower may demand funds unexpectedly. Hence it is necessary to study
the behavioural pattern over a time period for proper handling of the same.
4. Off-balance sheet items: Items like letter of credit, bank guarantee, etc arc non-
funded commitments till the time they are invoked by the borrower to whom they
were issued by the bank. Hence, analysis of timing and the magnitude of invoking
is extremely important in order to know the impact on liquidity position.
5. Embedded options: Many items in the balance sheet that are offered to the
customers have embedded options in them. An option is a buyer's right to buy (call
option) or right to sell (put option) an item at a price determined at the time of
entering into options contract, e.g. a term deposit holder has a right to prematurely
terminate his deposit at any time (particularly when the interest rates are rising).
This causes an impact on liquidity position of the bank. Similarly a borrower may
exercise a 'call' option by pre-paying his term loan fully or partially when rates are
falling. If a customer exercises an option either on the liability side or on the asset
side with the same bank at new rates, it may not have an impact on the existing
liquidity of the bank. However, if he uses options and enters into a contract with
other bank it affects liquidity position of the bank. This calls for careful analysis of
options both on asset and liability side and their impact on liquidity position of a
bank.
6. Static and dynamic nature of the gap report: It is important for a bank to process
the liquidity report without any time delay. If there is a delay, then the few early
buckets of information would be useless as the period for which they are calculated
would have elapsed. Also, the dynamic nature of business where lot of assets and
liabilities are contracted on continuous basis make the gap report less relevant even
if taken on time. Hence it is necessary to study the potential new business and
behavioural pattern of customers.

2.3.1.2 Structural Ratios

The Structural balance sheet ratios are also used to assess the liquidity position. Some of
them are given below:
• The ratio of core deposits to core assets: It indicates the extent to which retail
deposits arc used to fund core assets such as loans and approved secunties
• The ratio of liquid assets to total assets: It is used to determine asset liquidity
 • The ratio of liquid assets to deposits: It indicates the extent of Hquid assets available
to meet cash outflows of deposits in abnormal situation
• The ratio of liquid securities to total investments: It is used to determine the extent
of liquid securities in the investment portfolio which is otherwise illiquid.

From the above discussion it is evident that the bank must have proper information system
to carry out liquidity analysis. "A bank must have adequate information systems for
measuring, monitoring, controlling and reporting liquidity risk. Reports should be
provided on a timely basis to the bank's board of directors, senior management and other
appropriate personnel." (BCBS, 2000a). It is also important for a bank to analyse liquidity
under "what i f scenarios so as to assess any significant positive/negative liquidity swings
that could occur under bank-specific and market-affected scenario.

2.3.2 Interest Rate Risk Management in the Banking Book

"Interest Rate Risk is the risk of loss to the Institution in the event of changes in interest
rates, aggregated across all on-balance-sheet and off-balance sheet positions, but excluding
any positions subject to market risk" (Quemard, Golitin, 2005). In practice, banks
distinguish clearly between interest rate risk (IRR) in the trading book and IRR in the
banking book. Interest rate risk in the banking book is traditionally managed by the Asset-
Liability Management function of the bank.
As indicated before, with the deregulation of interest rates, volatility of interest rate has
increased considerably. This calls for careful planning and choosing assets and liabilities
for achieving targets of profitability.
Let us consider a situation where a bank is funding five year fixed rate loan with a one-year
fixed-rate deposit. It is exposed to IRR as the timing of re-pricing of assets and liabilities
are different. To expand the concept further, if the interest rate goes up in one year, the
bank will suffer due to decrease in interest margin. This is because the asset rate in above
example is fixed for next 5 years whereas^siTl^ the liability is maturing at the end of one
year, hence the bank will have to look for new liability at a higher rate. The concept of re-
pricing is extremely important in IRR management which indicates the time remainmg for
interest rate to change on assets or liabilities.
The second situation of IRR arises when variable-rate assets and liabilities are indexed on
two different market rates, or on same market rate but at different re-pricing dates (basis
risk as discussed below).
The third source of IRR would be when the holder (customer) exercises an option. An
option gives its holder the right (but not the obligation) to buy or sell a financial contract
which will modify the cash flow it generates.
Thus, it is necessary to analyze the IRR in the banking book and assess the challenges
faced by the banks in this regard.

2.3.2.1 The Approaches to IRR Management

IRR in banking book covers all the assets and liabilities except the trading portfolio. The
management of IRR aims at capturing the risks arising from the maturity and re-pricing
mismatches and is measured using two approaches,
A. Earning approach or accounting approach
B. Economic value or market value approach

A. The Earning Approach (Accounting Approach)

The main focus of this approach is on the impact of interest rate changes on assets and
liabilities on the net interest income (Nil) and it is one of the top order performance
indicators of a bank. Nil can be expressed as,
Net Interest Income = Interest Earnings - Interest Expenses
where interest income includes income from advances and investment portfolios excluding
any fee-based income, commission, brokerage, etc. The interest expenses include interest
paid on deposits, borrowings and debt capital of banks.
In monetary terms. Nil can be expressed as a percentage in the form of Net Interest Margin
(NIM) where,

MM = Nil / Total Assets, or,

NIM = Nil / Eammg Assets
The earnings approach has a short-term focus because the analysis of interest rate impact is
restricted to a maximum period of one year (due to one year accounting cycle). In reality,
the impact is analyzed for a quarter or a month or a shorter period depending on the
penodicity of the updation of data at the bank level.
The important tool to implement earning approach of IRR is again the gap analysis as in
the case of liquidity report. The main difference between the two, is in the gap report of
interest rate sensitivity, the assets and liabilities are placed in the re-pricing buckets on the
basis of expected change in the interest rates for the assets and liabilities and not on the
basis of cash inflows and outflows as in the case of liquidity gap report (convention
followed in this context is 'maturity date or re-pricing date whichever is earlier'). As per
the RBI guideline following buckets are prescribed for regulatory reporting,

1-28D 29D-3M 3-6M 6M-1Y 1-3Y 3-5Y Over 5Y Non-Sensitive

( D: Day, M: Month, Y: Year)

As it can be seen, the first two buckets (in the earlier liquidity gap statement) have been
clubbed and a column for 'Non-sensitive' has been added. Cash in hand can be a non-
sensitive component as it does not earn any interest and hence any change in rate would not
have any impact on cash. On the liability side the equity capital falls under non-sensitive
item as equity itself is not directly sensitive to interest rate changes, its sensitivity is
reflected through assets and liabilities.
Let us consider the following example of gap summary. As it can be seen the gap is
positive in the first re-pricing bucket and it is negative everywhere else except in the last
bucket. To carry out Nil impact analysis following formula is used,

Impact on Nil = Gap * Interest Rate Change

Rate Sensitive Gap Summary (Rs. In Crores)
1-28D 29D-3M 3-6M 6M-1Y 1-3Y 3-5Y Over 5Y Non-Sensitive
Net Gap 50 -1000 -300 -1500 -2500 -4000 5000 -2000

Table 2.2

25
The formula assumes that the impact is for one year period and the rate of change is per
annum. Impact for shorter period can be computed by suitably adjusting both the period of
the impact and the rate to reflect the period, .e.g. if rate changes by 1% what will be the
annual impact of the positive gap in the first re-pricing bucket? For this, we need to assume
that the timing of rate change takes place at the mid-point of the bucket, i.e. 15 days from
today. (0.5 month in this case). Thus, the impact would be calculated as follows,
Annual impact would be for the period for (12-0.5) = 11.5 months
Gap in the first bucket = 50 Crores
Nil Impact for the first bucket = Gap * periodicity of annual impact * rate change
= 50*11.5*(1%/12) = .4792

Hence, the annual impact of the rate going up by 1% on the first re-pricing bucket is Rs.
0.4792 Crores. Going by the same method, the impact of 1% rate change on the second
bucket would be, (-1000*10months*l%/12) = -8.33 crores. These figures lead to a
conclusion that Nil would suffer if the rate increases and the gap is negative (in the second
bucket) whereas the positive gap would produce positive impact on Nil (in the first
bucket). All such possible scenarios can be summarized in the following table:

Nil Impact Analysis

Re-pricing Gap Change in Rate Impact on Nil
+ve (RSA >RSL) Up Positive
+ve(RSA>RSL) Down Negative
-ve(RSA<RSL) Up Negative
-ve(RSA<RSL) Down Positive
Zero (RSA=RSL) Up or Down Zero
Table 2.3
Thus, the Nil sensitivity analysis as discussed above is done on the basis of rate sensitive
gap report to assess the impact of rate changes on the Nil for various periods. Analyst,
however, has to keep in mind some of the basic assumptions in the above computation
process such as,
i) Simultaneity in the pricing of assets and liabilities
ii) Mid-point assumption
iii) Equal change in the rates both for assets and liabilities
iv) Mispriced maturing assets and liabilities

The main advantage of this approach described by Saunders (2001) is its information value
and its simplicity in arriving at bank's net interest income exposure to interest rate changes
in different maturity periods. However, the important limitation to this approach is that, it
ignores market value effects. This is because, in this approach asset and liability values are
reported at their historical values or costs. Thus change in interest rate affects only current
interest income or expenses. As observed by Hudson (2000), this approach only shows
how interest rates will affect the assets and liabilities but not by how much. A number of
banks (particularly small banks) in India have so far limited their IRR management to
earning approach, but it has a short-term focus and covers only initial part of the life of
assets and liabilities in the balance sheet. However, RBI has also advised the banks to
move ahead and adopt 'Duration' based approach. (RBI, 1999b)

One more limitation to the earnings approach is though higher earnings indicate higher
profit they are not adjusted to risk. Higher profits may not mean better performance unless
the risk taken for attaining the performance is taken into consideration.

B. Economic Value or Market Value Approach

A better approach than Earnings approach is Economic Value Approach (EVA) that covers
long-term implications of changes in interest rates by covering the entire lifespan of assets
and liabilities. The need to graduate to EVE approach has recently been amply highlighted
in a research study (Saha, Subramanian, 2004) in which the researchers have reported the
potential net worth exposures of major banks in the country due to volatilities in the
interest rates during the recent years. Following table shows the EVE impact where the
authors have generated 1000 simulated interest rate changes to calculate the impact on
EVE of 11 public sector banks in the country.

27
 EVE impact as % of Market Value
of Rate Sensitive Assets
Year 2002 2003 2004
Bank
Banki -5.301 -7.216 -7.242
Bank2 -8.454 -9.504 -10.192
Bank3 -6.704 -7.349 -8.749
Bank4 -3.149 -4.24 -8.749
Banks -3.941 -4.24 -4.664
Banks -7.585 -11.289 -11.575
Bank? -5.495 -8.359 -9.577
Banks -9.074 -10.701 -13.023
Bank9 -21.344 -24.124 n.a.
Banki0 n.a. n.a. -7.076
Banki1 n.a. n.a. -14.069
(source: Salia, Subramanian. 2004)
Table 2.4

Under this approach, the impact of rate changes are studied on an important variable called
Economic Value of Equity (EVE), where,

EVE = Economic Value of Assets - Economic Value of Liabilities (except equity)

EVE reflects the future earning potential of a bank (Saha, Subramanian, 2004). EVE
approach considers the fact that changes in interest rates not only change the Net Interest
Income, but also economic value of assets and liabilities, which in turn is reflected in the
value of equity.
This approach is based on the valuation of each rate sensitive asset and liability which is
known as 'present value of future cash flows' in the subject of finance. Here the basic
principle is when the interest rate increases, the value of an asset would fall and vice versa.
This applies to liabilities also; however, when the value of an asset goes up, it has a
positive impact on EVE while if value of liability goes up, it has a negative impact on
EVE.

One more reason because of which this approach has gained prominence is that for a given
change in interest rate the change in Nil and the change in EVE need not be in the same
direction. It is possible that when the rate goes up, bank significantly gains in terms of Nil,
but it faces the reduction in EVE and vice versa. Thus, it is a challenging situation for
bank management to manage both Nil & EVE simultaneously. They are required to set-up
limits for both Nil & EVE and ensure that the actual impact is within prescribed limits.

2.3.2.2 Duration: A Measure of an Asset or Liability's Rate Sensitivity

Duration is a more complete tool to calculate an asset or liability's sensitivity than the gap
model discussed earlier. According to Hempel and Simonson (1999) the matching gap
attempts to stabilize earnings, while matching duration attempts to stabilize Net-worth
value of the portfolio.
Duration Computation
Principal 50000
Open_date 01/01/2004
Current Date 01/01/2005
Maturity Date 31/12/2009
Interest Rate at contract 9%
Freq of interest 1
Payment
Current Rate of Interest 8%
Residual Maturity 5
(Years)

Time Period (t) in years Cash PVCF Duration

Flow Segment
1 4500 4166.67 0.0801
2 4500 3858.02 0.1484
3 4500 3572.25 0.2061
4 4500 3307.63 0.2545
5 54500 37091.78 3.5668
_^51996.4 4.2559 Duration
Value of Deposit -*—

3.9406 Modified Duration

<—
Table 2.5

The concept of duration analysis is based on Macaulay's concept of 'duration'. Let us

consider the example in Table 2.5 to understand how duration is computed. The valuation
in the table is carried out for term deposits which states that the economic value of the
deposit is Rs.51996.4 whereas the book value of the same is Rs.50000. A higher economic

29
value than the book value for a liability in this case is a negative impact on EVE. This
indicates possible deterioration in the future earning potential of the bank. Though the
market rate has fallen to 8%, the bank cannot reduce it as the deposit carries a fixed rate.

Hence the reduction in EVE for Rs. 1996.4 (i.e. 50000-51996.4) indicates the present value
of future losses. The bank will suffer from this for 5 years of life of deposit as it is forced
to pay 1% more than the present interest rate. Also, in this situation it is unlikely that the
depositor will exercise the 'put' option to prematurely withdraw his deposit as he would
lose the benefit of higher rate.

Both the duration and modified duration are interpreted to assess the volatility of the value
of deposit for a change in interest rate. Traditionally duration is the pay-back period by
which the investor would get back the original amount invested along with the expected
return. The duration number 4.25 for the deposit is the pay-back period in years for the
depositor. In the IRR context, duration is a measure of interest rate sensitivity applicable
in the continuous compounded form of interest rate. Technically, duration is the time-
weighted present value of a financial institute's cash flows. (Sinkey, 2002 : 664) The
higher the duration value, the more sensitive is the price of an asset or liability to changes
(or shocks) in interest rates. The modified duration gives the percentage change in the
price of asset (or liability) for a 1% change in its rate. e.g. modified duration of number
3.94 suggests that with 1% change in the interest rate of deposit, the value of the deposit
would change in the opposite direction by 3.94%.

In the above manner, the duration is found out for each asset and liability in the balance
sheet to arrive at the aggregate level duration. The aggregated duration of assets (or
liabilities) is nothing but the weighted average of individual asset (or liability) durations
where the weights used are market value of each asset (or liability) to the total value of the
assets portfolio. Once the assets and liability durations are estimated, they need to be
compared with each other to find out the net sensitivity which would impact the equity.
Consider this example,

30
Duration of assets = 4.5 Value of asset = 100
Duration of liabilities = 3 Value of liabilities = 85
Duration Gap = (4.5-3) = 1.5
Economic value of equity = (100-85) = 15

When the duration of assets exceeds the duration of liabilities the duration gap is positive.
A positive duration gap means greater exposure to rising interest rates; if interest rates go
up then the price of assets fall more than the price of liabilities and as a result EVE would
fall from its present value of Rs.l5. (Conversely, when the duration gap is negative; if
interest rates fall then the price of assets goes up less than the price of liabilities.)

One more factor that needs to be considered here is that, some portion of the assets is
funded by outside liability which is an adjustment for leverage, where

Leverage = 80/100 = 0.8 and,

Leverage adjusted duration gap = 4.5 - (3*0.85) = 1.95

Since the gap is positive, if interest rate goes up, there will be reduction in EVE and if it
falls, EVE would increase. The impact analysis of rate change on EVE is summarized in
following table:

Impact of rate change on EVE

Duration Gap Interest Rate Change EVE Impact

Positive Goes Up Negative

Positive Comes Down Positive

Negative Goes Up Positive

Negative Comes Down Negative

Zero Up or Down Zero

Table 2.6

To compute the impact on EVE following method is used:

Impact on EVE = -Duration gap * Economic value of asset * interest rate shock

where shock= change in rate/(l+new rate)

If the cun'ent rate is 9% and it increases by 1% in the above case, EVE impact would be,

-1.95*I00*(1%/(1+10%)) = -1.7727

Hence, EVE after shock = 15 - 1.7727= 13.227

Thus 1% increase in rate has caused negative impact on the EVE. Opposite would be the
case if the rate goes down by 1%.

To conclude IRR management under EVA approach, it can be stated that there are three
major components in IRR management viz., (Leverage Adjusted) Duration Gap, Market
Value of Assets and Interest Rate Shocks. Out of these three, the third component is
beyond the control of a bank. However, by adopting suitable policy, banks can sustain the
impact of adverse changes in interest rate by controlling market value of assets and
duration gap. Increase in duration gap is possible by either increasing asset duration or
decreasing liability duration or reverse actions would reduce the maturity structure of
assets and liabilities and consequently the duration gap.

2.3.2.3 Special Issues in IRR

For duration analysis, it is assumed that the interest rate for all maturities are same or in
other words, the yield curve* is assumed to be flat. However, in reality slope of the yield
curve may fluctuate with change in interest rates. Hence following additional risks also
need to
be considered.
Yield Curve Risk : Yield curve risk arises from variations in the movement of interest
rates across the maturity spectrum. It involves changes in the relationship between interest
rates of different maturities of the same index or market. (E.g. 5-year deposit rate may go
up by 1% whereas 3-year deposit rate may go up by 0.5%.) These relationships change
*Yield Curve is a graphic line chart that shows interest rates at specific point for all securities having equal
risk but different maturity dates.

32
when the slope of the yield curve steepens, or become inverted. Yield curve variation
highlights the risk of a bank's position by magnifying the effect of re-pricing mismatches.
The extent to which a bank is mismatched along the term structure will increase its
exposure to yield curve risks.
Basis Risk; Basis risk deals with the correlation between two different rates. It arises from
the non-parallel responses in the adjustment of interest rates among two or more rate
indices or "bases" i.e. when changes in asset rate and liability rate are not happening by
same magnitude. Basis risk also includes changes in the relationship between administered
rates, or rates established by the banks, and external rates. E.g. it may occur when there is a
difference in prime rate and bank's offered rate
Options Risk; Options risk arises when a bank's customer has the right (not the
obligation) to alter the level and timing of cash flows of an asset or a liability. An option
gives the owner the right to buy (call option) or to sell (put option) a financial instrument at
a specified price (strike price) over a specified time period. For the seller of an option, (e.g.
a bank) there is an obligation to perform if the owner exercises his option. Generally owner
will exercise his/her right when it is beneficial to him/her. Thus, the owner faces limited
downside risk and theoretically unlimited upside reward. For the other party (i.e. a bank)
the situation is exactly opposite. All the banks have some degree of option exposure. For
instance, on the assets side a common problem is of prepayments when interest rate
decreases. Actually, in this situation, the bank would prefer the borrowers maintain their
outstanding balance and pay at higher contracted rates. However, higher cash-inflows due
to prepayments force the bank to reinvest the funds at lower rates. This is known as
'reinvestment risk\ Conversely, when interest rate increases customers would like to delay
payments and bank consequently would lose the opportunity of investing the principal in
new higher yielding assets. This slowdown in prepayment is also known as extension risk.
On the deposit side, the most common option given to the customer is a right to withdraw
prematurely. When the rate increases and the market value of the customer's deposit
decreases he/she has a right to exercise 'put' option and re-invest elsewhere yielding higher
returns.

:^3
2.4 Role of IT in ALM

Recognizing the need for a strong and sound information system for ALM, the Reserve
Bank of India has issued the ALM guidelines in February 1999. The guidehnes have
emphasized that each bank must have an Asset-Liabihty Management Committee
consisting of senior management which is responsible for balance sheet planning from a
risk return perspective including management of interest rate risk and liquidity risk. Also,
the RBI has expressed the need to have sound information system for ALM. "The central
element for the entire ALM exercise is the availability of adequate and accurate
information with expedience." (RBI, 1999a) However, many Indian banks are not in a
position to generate the required information on ALM. The biggest problem faced by them
is collecting accurate data in timely manner due to wide geographic spread of branches and
lack of computerization. In many banks in computerized branches the software vendors
have provided the facility to generate ALM information mandated by the regulators.
However, mostly this information is limited to Liquidity Gap statement or Rate sensitivity
Statement. Given this background, it was decided to develop a comprehensive information
system on Asset-Liability Management that would address the issues discussed above.

2.5 Computer based ALM System

The information system for ALM can be divided into two subsystems,
Part I: The first system that operates at Regional or Zonal Offices of the bank which
mainly focuses on liquidity gap and interest rate sensitivity reports. The output of such
systems working at all Regional Offices (ROs) /Zonal Offices (ZOs) will be
consolidated at Head Office to take a final view.
Part II : The second system which works only at the Head Office and which mainly
handles techniques of Interest Rate Risk Management.

2.5,1 Part I: Liquidity Gap Analysis

The main purpose of having this system is to generate liquidity gap report and for
measuring short-term liquidity risk by placing assets and liabilities into various timc-

34
buckets on the basis of their respective maturities. A significant portion of data that is
needed to generate this kind of information needs to be captured from the bank's day-to-
day operational systems. Particularly, in case of term deposits and term loans, the bank is
required to capture account level information of each of the deposit and loan account.
Considering the volume of this data, processing it manually would not only be difficult for
banks but also prone to errors reflecting the wrong picture to the top management. One
more issue is that, such data does not remain static (as the business keeps "rolling in and
out") with passing of time and banks are required to take a view at a certain frequency.
A computer-based information system would certainly help in this situation which can not
only help the banks in meeting their compliance requirements but also in generating other
useful information which would help them in product planning and related exercises.

2.5.1.1 Methodology
In order to develop the information system for asset-liability management the steps
described below were followed:

1. Finding sources of data: Those items in the balance sheet which have definite
contractual period were considered as the main source for the system. Such items
include term deposits (cumulative, non-cumulative, recurring) and term loans
(PLR* linked and non-PLR linked). As shown in the Figure 2.1, both term loans
and term deposits data originate at branch level. In a computerized branch it is
maintained by the branch automation software, whereas in a manual branch clerks
maintain it in manual ledgers.
2. Master and Incremental Data Creation: The next step was to collect the data at
one place for further processing. Many public sector banks in India have not yet
achieved 100% branch-computerization and hence the entire data are not available
in electronic format. For manual branches, it was decided that they would send the
data to Regional or Zonal Offices (RO/ZO) in a paper format. At this level, the data
entry facility was provided to the users so that the data from manual branches
would be added into the main system. For computerized branches it was decided
*PLR: Prime Lending Rate, the loan interest rate that bank uses as a base to calculate interest rates.

35
 ;Branch :RO/ZO HO

Submit A/c Receive A/c

level Data level Data

Processing and Consolidation of

A/c. level Data

Data Send Check Error

Correction Back

z,
Report
X
Send Aggre- Receive
Generation gate Data Data

Consolidate
all ZO/RO

Report
Generation

•®

Figure 2.1: An activity Diagram for Initial Data Consolidation of ALM Process

36
 that they would send the data in electronic format to RO/ZO. At RO/ZO level, a
facility was provided to import this data in the integrated ALM database.
Considering the volume of data, it was decided to use Oracle Relational Database
Management System. In this way master data was created in all the regions as one-
time exercise.
However, as indicated earlier in the discussion of liquidity gap analysis, it is
necessary for a bank to conduct detailed study of roll-in, and roll-outs. For carrying
out this analysis, it was necessary to capture details of transactions at a certain
frequency. Such transaction data would include, details of newly opened deposit
accounts, accounts closed, accounts prematurely closed, accounts prematurely
closed and renewed, accounts matured and renewed. In case of term loans, the
transaction data consists of newly opened accounts, accounts closed, accounts pre-
paid and closed, installments paid, interest applied and other charges applied, if
any. A unique transaction flag was identified for all such transactions using which
master data could be updated, (e.g. 'N': New account, ' C : Close account, etc.)
3. Updating Master Data: The next step was to develop the necessary software
programs to update the master data with transactions. As shown in the Figure 2.2,
using transaction data master data was updated. In case, if any error (such as
duplicate record) was found in the transaction, a report was generated for further
action.
4. Interest Provisioning: In case of non-cumulative deposits, interest is paid to the
customer on monthly/quarterly/half-yearly or yearly basis. For cumulative and
recurring deposits interest is paid only at the maturity of the same. However, for
such accounts banks need to do interest provisioning on half-yearly basis. Such
interest provisioning would update the outstanding balance of deposit accounts by
the respective interest amounts. Considering this, a program was developed to do
interest provisioning on deposit accounts.
5. Treatment of 'Non-Maturity' Items: As indicated earlier, the 'non-maturity'
items in the balance sheet can result in cash flow at any time and hence it is difficult
to place them in a definite bucket. Hence, after going through RBI guidehnes, it
was decided to study their behavioural maturity on the basis of statistical analysis

37
 Branch :RO/ZO

Submit trans- Receive

action Data Data

Uodate master data

Data
Send Check Error
Correction
Back

Consolidate
Updated Master

Report
Generation

Figure 2.2: An activity diagram for updating the master data

with the incremental data

38
 and then place them in appropriate time buci<.et. This was done by developing a
small module on Trend Analysis. The module takes weekly (or fortnightly or
monthly) data of non-maturity assets and liabilities. All such assets would include
demand loan, CC/OD BP/BD and other advances and the liabilities would mainly
include current and savings deposit. Based on historical data it performs trend
analysis to forecast the future values based on the concept of i) simple polynomial
regression up to degree 15 or ii) moving averages up to 25 periods.
6. Report Generation: More than 25 reports were generated from the system
including the reports required for compliance purposes. Some of them are discussed
in detail subsequently. A facility was given also to export these reports so that the
same would get imported at the Head Office level.

2.5.1.2 Issues Faced during the Implementation

Similar to any other software development project, in this work also many practical
difficulties were faced. The major implemented issues are described below:

1. Data consolidation of manual branches: In case of manual branches, the biggest

problem was how to minimize time-delays in sending and receiving the data. To
start on an experimental basis, few manual branches (with higher business volumes)
were short-listed for the whole exercise. A Foxpro-based data-entry module was
provided to some branches, which were having a personal computer. The bank
decided to extend the same facility to the remaining manual branches over a period
of time.
2. Ddata consolidation of computerized branches: The public sector banks where
the system was implemented had the following problems as far as their
computerized branches were concerned:
i) Heterogeneity in the platforms: The banks were using different branch
automation software supplied by more than 6-7 vendors. Typically,
these vendors used varied platforms such as Oracle/Unix,
COBOL/Btrieve/Novell Netware,etc.

39
 ii) Non-availability of data in required format: Particularly, getting
incremental data in required format (with 'flags' as described above)
from computerized branches was difficult.
In order to overcome this problem, all the three parties including the bank and the
vendors held the discussions and came to the agreement that the vendors would
provide a small data extraction utility which would extract the necessary data in
'text format'. Each vendor's data structure was stored in the ALM system.
Subsequently, the 'import' utility was added in the system to add the text data to
Oracle based ALM database repository. After reading the data in text format this
utility would identify the 'branch code' of data to be imported, find out the
respective vendor code and accordingly map the data to required format. This
facilitated import of branch data irrespective of the platform on which branch
software would use. " T n " 'jjO'l *§ 3
3. The issues in incremental data: Similar problem was faced in case of incremental
data which was resolved as in the case of master data. The vendors were also asked
to include transaction 'flags' in the data extraction utility of transaction data.
4. Integrating new products: Next major concern was how to integrate new products
with the existing system, i.e. if bank adds new deposit scheme, it should be possible
to define the same in the system. The database was designed in such a way that all
product definitions were maintained in a separate table. This table stored the
characteristics of products such as type of deposit (Cumulative, non-cumulative,
recurring), details of interest computation, interest payment frequency, etc. Due to
this, it was possible to add new product scheme whenever bank launched the same.
5. Processing time: The main purpose of the system was to generate reports. The
entire data processing that was needed for report preparation was done at the time
of data import, e.g. when the new records are added, the system would generate
report related information like, bucket_index, sizejndex, contract_period_index,
overdue_index, etc. and the same would be stored in the deposit table along with
each record. The necessary logic to generate this information was written in the
back-end PL/SQL (procedural language of Oracle) which would be executed only
when data is imported or processing date is altered by the user. This improved the

40
 speed of report generation to a great extent as against those systems which use
front-end logic for generating reports.
6, Additional Queries: As indicated earlier the system was installed at RO/ZO of the
bank. However, sometimes branches need some information. Particularly manual
branches may want to know about interest provisioning held in their accounts, etc.
Considering this, a facility was given to build additional queries using a query
builder.

2.5.1.3 Important Output Reports of the system*

1. Schemewise Overdue Deposits

As per RBI guidelines entire amount of overdue deposits should appear in the first
bucket of liquidity and rate sensitivity reports. However, if the deposits remain overdue
for long time, the bank may like to distribute this amount over a number of buckets.
This report shows the distribution of overdue deposits in various time- buckets based
on the past dates. This will explain the managers how long deposit amount has been
overdue with the bank.
2. Scheme wise Remaining Term to Maturity (Outstanding Amount) for Term
Deposits

This report reflects the contribution of term deposits (scheme wise) to overall liquidity
and rate sensitivity of the bank's balance sheet. By looking at this report, the quantum
of deposits maturing in various time buckets can be understood.
This will help the bank in formulating a policy on funding medium to long term assets
using these deposits.
3. Draw Down Profile of Deposits
In this report residual maturity is shown as against contractual period of deposits. These
reports reflect the draw down profile of the term deposits of the bank. The tenure
structure of maturing deposits can be viewed from these reports. For example, out of
Rs.500 crores of deposits maturity in the first bucket, deposits to the tune of Rs.251

* Sample Output reports are enclosed in Annexure B

41
 crores are from 1 - 3 year deposits. This will help the bank in planning its deposit
profile.

4. Interest-provision Held
The scheme wise interest provision held in the cumulative/recurring deposit accounts is
reflected in this report. This report helps the bank to understand the magnitude of rate
sensitivity as a result of provision of interest to cumulative deposit accounts (of the two
rate sensitivity components, interest on principal and interest on interest, the second
part can be analysed through this report).

5. Interest-provision to be Made
This report reflects the interest provisions to be made schemewise in future on the basis
of existing balances and rates. This will help the bank in profit planning exercise. The
amount of interest provision to be made will also be reflected in the dynamic liquidity
statement.
6. Interest-Rate wise / Rate Range wise Remaining Term to Maturity
These reports help the bank in analysing the rate range of deposits. This along with the
maturity composition of the deposits enables the bank to take a view on alignment of
the deposit rates vis-a-vis existing market rate on deposits. Any misalignment in
favour of the bank may trigger the depositors' exercising their option to prematurely
close and extend the deposits. The bank has to analyse very carefully the report to get
valuable information on the impact on the optionality and on the profitability in various
rate scenarios.
Any bunching of a particular (favourable or unfavourable) rate range can also be
analyzed through these reports.

7. Deposit-Size wise Distribution of Deposits

The rate range wise contribution of deposits of various sizes to total deposits can be
analyzed through the report. This will enable the bank to study the composition of
retail and wholesale deposits and its conditioning.

42
8. Premature Closing and Renewal of Deposits

i) A two-way table showing deposits' old rate of interest before renewal

and new rate after renewal.
ii) A two-way table showing deposits' old contract period before renewal
and new contract period after renewal.

The rate wise transition report is significant in highlighting the rate responsiveness of
the depositors of the bank to interest rate changes. Studying these reports over a period
of time will enable the bank to fine-tune its deposit rate decisions. This will also
enable the bank to study region-wise (or zone-wise) rate sensitivity and exploit the
same to its advantage. For example, in a low rate sensitive region (zone), the bank may
target higher volume of deposit mobilisation.
The period wise transition report can indicate the structural shifts in the liability
compositions in the balance sheet.

9. Remaining Term to Maturity for Term Loans

i) Scheme wise Remaining Term to Maturity (Principal Amount) of PLR
Linked Loan
ii) Scheme wise Remaining Term to Maturity (Principal Amount) of Fixed
Rate Loans
iii) Scheme wise Remaining Term to Maturity (Outstanding Amount) of Term
Loans
The scheme wise contribution of term loans to liquidity and rate sensitivity of the bank
is reflected in these reports. In case of Liquidity Report, the amounts in various
buckets in the third report needs to be considered on the basis of remaining term to
maturity. But for Rate Sensitivity Report, while the fixed rate term loans will be
reflected on the basis of remaining term to maturity, the PLR linked loans will appear
on the basis of expected re-pricing date or term to maturity whichever is earlier.

43
10. Rate Range wise Remaining Term to Maturity for Term Loans

These reports help the bank in analyzing the rate range of term loans. This along with
the maturity composition of the loans will enable the bank to take a view on alignment
of the loans vis-a-vis existing market rate. Any misalignment in favour of the bank may
trigger the borrowers' exercising their option to prematurely close and renegotiate the
loans. The bank has to very carefully analyze the report to get valuable information on
the impact on optionality on profitability in various rate scenarios.

11. Roll-in / Roll-out of Deposits / Loans

These two reports give the summarized picture of overall business related to term
deposits and term loans. Using these reports bank can see in a given time-period the
extent of closure, premature closures, renewals, premature renewals and new business
added.

12. Contractual Maturity of Term Deposits and Term Loans

This report when consolidated for bank-level, will help the bank in formulating their
Fund Transfer Pricing policy.

Thus, the above approach of 'Liquidity Gap Analysis' helps the banks to see the
mismatches of their cash outflows and inflows. While the mismatches up to 1 year are
relevant since they provide early warning signals of impending liquidity problems, the
main focus should be on short term mismatches viz. 1-14 days, 15-28 days.

44
2.5.2 Part II : Managing Interest Rate Risk
Although IRR and hquidity risk occur at branches of a bank in the process of their
intermediation between depositors and borrowers, these risks need to be brought together
at the highest level and managed. The reason is "these risks arising at a branch is not
relevant as they can be offset by exactly opposite positions in some other branch of the
same bank" (Subramanian, 2004:3). Hence, the analysis of IRR needs to be carried out at
the bank level as a whole.

Keeping this in mind, a separate module was developed to handle IRR management which
mainly handles following activities.

1) Impact Analysis (Earning Approach)

2) Computation of Duration, Yield-curve risk, basis risk and options risk (EVE
Approach)
The module would function at the head office levels. The following write-up discusses the
methodology followed in the development of this module.

2.5.2.1 Methodology for Earnings Approach

1. As shown in the Figure 2.3, the bucketed data for term deposits and term loans
would be sent to the Head Office. (The alternative approach is to generate bucket-
wise cash-flows at the HO level. However, this approach is feasible only if, the HO
is equipped to process the data in terms of hardware/memory requirements.) For
other items which are of non-maturity variety, the head office would create its
bucketed information based on the behavioural method discussed earlier.
2. Based on the above data, the system would first compute the gap statement and
cumulative gap statement.

45
 ;RO/ZO :HO

^ >
Submit Receive
bucketed data Data
for Term
Deposit/Loan
• "

Consolidate for all RO/ZO

^f

Add Bucketed
data for non-
maturity items

Generate Gap
statement

Nil impact Duration &

Analysis EVE Analysis
J ^ )
1 r 1 r
C -N
/ >
Report Report
Gen ;ration Genertition

Figure 2.3: An Activity Diagram for Nil Impact and Duration Analysis

46
 3. A facility to study an impact on Net Interest Income (Nil) in case of interest rale
change is given to the user. It includes following options:

(i) Asset rate goes up /down by how many basis points*

(ii) Liability rate goes up /down by how many basis points

These two possibilities can be studied for the following scenarios,

(i) Rate changes at the midpoint of the bucket
(ii) Rate changes at the beginning of the bucket
(iii) Rate changes at the end of the bucket
(iv) Rate changes at the end of the bucket
(v) Asset Rate changes at the beginning and Liability rate at the end of the
bucket
(vi) Asset Rate changes at the end and Liability rate at the beginning of the
bucket.

2.5,2.2 Methodology for EVE Approach

In order to implement this approach also, the head office would use bucketed data for term
deposits and term loans. Additionally, HO would need to provide interest rates for assets
and liabilities for various buckets,

For a given reporting date the following analysis can be carried out at HO level,

1. Computation of Market value of assets and liabilities in each bucket and the totals.
2. Duration Gap and EVE Sensitivity Analysis : This report will give durations of
assets and liabilities in each bucket, the duration gap and for a given change in
interest rate, it will compute effect on the EVE i.e. for a given rate change how
much value will go up or down.

"Basis Point : One hundredth of one percent, i.e. 100 basis points = 1 percent

47
 3. Basis Risk : This report will accept from user the change in asset rate and change in
liability rate and it will compute impact on assets, liabilities and net impact
4. Yield Curve and Basis Risk: This report expects that there will be non-uniform
changes in each bucket and hence user will be asked to enter the same for either
assets or liabilities, e.g. if the user enters such rates for liabilities, the same would
be treated as independent variable. From this, to find out the asset rate (dependent
variable), it is necessary to find the slope of the yield curve. The same can be found
out by studying the historical movements of rate changes. Once the user enters
independent rate and the slope coefficient, user can see the net impact on EVE.
5. Options Risk: This requires the % of premature closures and renewals (in case of
term deposits) which can be obtained from one of the reports discussed earlier. The
above four reports can be re-done incorporating this percentage.

2,6 Advantages of Computer Based ALM System

The advantages of the said system are as follows:

1. Data Accuracy: Data accuracy begins with data input. The said system requires
least amount of manual entry as data is extracted from branch level automation
system in a text format and then it is imported using a conversion module. Also,
required data entry module for manual branches includes stringent field level and
record level validation checks to avoid data entry errors.
2. Data Integrity: The integrity of data is ensured through exceptional error
reporting. Particularly, for transaction data, exception reports can throw the
information on duplicate accounts, missing master account, etc. Also, when the
master data is updated at a certain periodicity, system ensures that updates are
taking place in chronological order of dates.
3. Reporting and Analysis: The computer based information systems for ALM can
not only produce the reports discussed above, but it also provides a facility to user
to perform ad-hoc analysis by writing his own queries through a query builder. The
system includes more than 20 pre-defined queries and a query builder.

48
2.7 CONCLUSION

Asset-Liability Management is concerned with the strategic management of balance sheet.

It is an attempt to match the assets and liabilities in terms of their maturities and interest
rate sensitivities so that risks arising from such mismatches - mainly interest rate risk and
liquidity risk - can be controlled within desired limits. The central element to the entire
exercise is the availability of adequate, accurate and timely information which demands
extensive technology support. However, most of the Public Sector Indian banks are finding
it difficult to generate this information due to wide geographic spread of branches and
heterogeneous platforms of branch computerization where the necessary data resides.
Given this background, an attempt is made to deploy technology based solution in the area
of ALM. The real merit of the system lies in the fact that it goes beyond regulatory
compliance and provides competitive advantage to banks by providing the reports that can
be used in the decision-making process of construction and modification in the balance
sheet structure in accordance with the risk appetite of individual bank on a continuous
basis.

49