Asset Liability Management (ALM)

&
Liquidity Risk & Interest Rate Risk
Management

H S SHARMA

INDIAN INSTITUTE OF BANKING & FINANCE

MOST IMPORTANT ROLE OF BANK ??
Financial Intermediation?
Financial Intermediation?

WHICH TYPES OF IMBALANCES IT GENERATES?

 Financial Intermediation process
generates …..

Imbalance in
Imbalance in
the amount
the maturity
of funds
of asset and
collected and
liabilities
lent
These imbalances expose Earnings & Net
Worth of the Bank to which type of Risks?
These imbalances expose Earnings & Net Worth
of the Bank to various kinds of risks principally,

1. Interest rate risk and

2. liquidity risk.
If this downside risk is not managed
through structured asset and liability
management(ALM), it can lead to
insolvency of an institution or even
the banking industry
Define ALM?
 What is ALM ?

Asset Liability Management (ALM) involves total management of

Bank’s entire balance sheet on a continuous basis with a view to
ensure proper balance between fund mobilisation and fund
deployment .

It involves managing their maturity profile, rates and yields as well

as risk exposure so as to improve profitability and ensure
adequate liquidity as well as long term viability.
 The focus of ALM is………

1 2 3
Spread Maturity Managing Interest
Management Management Sensitive Assets
Controls interest Matching assets and &Liabilities
received on assets & liabilities over time To minimize impact of
paid on liabilities to bands so that risk interest rate risk & for
maximise spread remains within limit protection of long term
earning
Scope of ALM process includes…….

01 02 03 04 05 06
Interest Liquidity Manageme Funding & Capital Risk
Risk Risk nt of other profit planning & parameters
Manageme Manageme market risks planning growth & tolerance
nt nt projection limit, Policy
 Strategies adopted by ALCO ?

1. On-balance-sheet business strategies ?

2. On –balance –sheet Investment
strategies or funding ?
3. Off-balance-sheet strategies?
Strategies adopted by ALCO

• Changes in product mix

On-balance-sheet
• Pricing of deposits, loans
business strategies and other borrowings

On –balance –sheet • Changes in maturity mix

Investment strategies • Rate characteristics of
investment securities and
or funding wholesale funding

Off-balance-sheet • Derivatives/off balance

sheet tools to manage
strategies balance sheet risks
INTEREST RATE RISK IN BANKS
Let’s consider an asset for two year is funded by a deposit made for
1 year

Liabilities Rs 100 cr 1 Yr (Interest rate can 2yr

Interest rate 6% rise to 8% or 10%)

0 1yr 2yr
Assets Rs 100 cr
Interest rate = 8%

When Banks hold longer term assets relative to liabilities, it

potentially exposes itself to Refinancing risk i.e. cost of rolling
over or re-borrowing funds could be more than return on assets
Let’s now consider an asset for 1year which is covered by a
deposit made for 2 years

1 Yr 2yr

0 1yr 2yr
Liabilities Rs 100 cr
Interest rate = 6%

Assets Rs 100 cr (Interest rate can

Interest rate 8% come to 6% or 4%)
When Banks hold short term assets relative to liabilities, it
potentially exposes itself to Reinvestment risk i.e. uncertainty
about interest rate at which it can reinvest fund mobilized for a
longer period
 Interest rate risk is critical for a Bank
because it directly effects

Net Interest Income Market Value of Equity

(Earning Prospective) (Economic Value
prospective)
 Basis Risk

Interest Rate Risk

also includes

Yield curve Embedded

risk option risk
 Yield Curve Risk
The Risk from non-parallel changes in the yield curve:
Yield curve flattens:- Means short term rates rise faster
than long term rates reducing NII.
Period I Period II
Loan 5 years 6% 6.50%
1 Year deposit 1% 4%
Spread 5% 2.5%

Spread declines due to flattening of yield curve

Measurement of Interest Rate Risk
Traditional Gap Analysis
The GAP is defined as the difference between the
amount of rate sensitive assets and rate sensitive
liabilities maturing or repricing within a specified
time period

Rate sensitivity here means that the assets or

liability is repriced at the current market rate
within a certain time horizon i.e. maturity buckets

Repricing can be the result of a roll over of an

asset or liability or it can occur if the asset or
liability is a variable – rate instrument
Measurement of interest rate risk : Traditional GAP Analysis (TGP)

1st Step : Identify Risk Sensitive Assets and Liabilities

Liability Side Interest Sensitivity Asset Side Interest Sensitivity
Capital & Reserve NS Cash NS
Current Deposit NS Balance with RBI Intt Bearing portion only

SB Int bearing portion only Balance with other Current Deposit – NS

To be included in 3-6 bank Call money, TD Sensitive
months
TD Sensitive Repriced at Investment Sensitive
Maturity or otherwise
Borrowed Fund Sensitive Equity NS
Bill payable , NS Advance Sensitive
provision etc
Refinance Sensitive Office a/c NS
2nd Step :
GAP report is generated by grouping Assets and
Liabilities into buckets according to residual time to
maturity or the time until the first possible repricing
whichever is earlier.
The Gaps may be identified in the following time buckets:
i) 1-28 days
ii) 29 days and upto 3 months
iii) Over 3 months and upto 6 months
iv) Over 6 months and upto 1 year
v) Over 1 year and upto 3 years
vi) Over 3 years and upto 5 years
vii) Over 5 years
viii) Non-sensitive
 3rd Step: Preparation of Traditional GAP Analysis
Rs in crores
Time bucket RSA RSL GAP Cumulative Gap
1 to 28 days 15000 17000 (-) 2000 (-) 2000
>28 days up to 3 mths 11000 10000 (+)1000 (-) 1000
>3 mths up to 6 mths 9000 10000 (-)1000 (-) 2000
>6 mths up to 1 yr 15000 14000 (+)1000 (-)1000
>1yr upto 3 yrs 18000 13000 (+)5000 (+)4000
>3 yr upto 5 yrs 10000 15000 (-)5000 (-)1000
Over 5 yrs 15000 14000 (+)1000 Nil
Total 93000 93000 Nil

Positive gap within a specified time period or time bucket - When RSA > RSL (Bucket,2,4,5&7)
Negative gap within a specified time period or time bucket - When RSL > RSA(Bucket 1,3&6)
The cumulative gap over the whole balance sheet across the buckets must by definition be
zero.
4th Step: Interpretation of GAP analysis & Earning at Risk
Impact of change in interest using GAP model:
The advantage of the repricing model is that it shows the Net Interest Income
exposure(or profit) to interest rate change in different time buckets
△NIIi=(GAPi) △Ri
For example : 1st Bucket (1 to 28 days) GAP in the above table is (-)2000 cr.
If short term interest rate rise by 1% equally for RSA & RSL, the annualized
change in the Bank’s NII will be
△NIIi=(- 2000cr) x 0.01= - 20 cr
Banks can also estimate the Cumulative Gaps over various repricing category
or buckets.
In the above example, Cumulative Gap for one year period is (-)1000cr.
If △Ri is 3% both for RSA & RSL i.e. the average interest rate change affecting
assets and liabilities that can be repriced in one year, the cumulative impact
on Banks NII would be (-1000cr) x 0.03= -30 cr
5th Step Risk Management strategy : Relation between Change in
interest rate and change in Net Interest Income
Rule 1:In General, when CGAP is positive, the change in NII is positively
related to the change in rate of interest
Rule2: Conversely, if CGAP is negative, the change in NII is negatively related
to the change in rate of interest
Rule 3:The larger the absolute value of the CGAP, the larger the expected
change in NII
CGAP Gap Position Change in interest Change in Net
rate Interest Income
>0 Positive Increase Increase
>0 Positive Decrease Decrease
<0 Negative Increase Decrease
<0 Negative Decrease Increase
 Duration Gap Analysis
One of the major weaknesses of Traditional Gap analysis is that it uses book
value accounting . It takes into account the historic value of securities
purchased , loans made and liabilities sold

Duration Gap analysis, on the other hand, is based on market value

accounting as it takes in to account the market realities and the true value
of the assets and liabilities if the assets and liabilities are to be liquidated
today rather than at the price when they were purchased

Duration is a more complete measure of an asset or liability’s interest rate

sensitivity than its maturity because duration takes in to account the time
of arrival (or payment) of all cashflows as well as the assets(Liabilities)
maturity
 Consider a loan with 15% interest and required repayment of half of Rs 100 cr (principal)
plus interest at the end of six months and the other half at the end of the year. The loan is
financed with a one year CD paying 15% interest p.a
A. The promised cash flow received by the Bank would be
CF1/2=Rs 57.50cr CF1= Rs 53.75 cr

0 ½ yr 1yr

B. It is a intuitive truth that a rupee received at the end of one year is worth less than a
Rupee received at the end of six months and both of them would be less than a rupee
received today. Therefore, to make the sizes of the above cash flows comparable, we put
them in the same dimension i.e. to assess the present value of those cash flows taking in to
account the present rate of interest or yield.

C. Lets assume the current RI is 15%. Then the Present value of the Cash flows would be
CF1/2= Rs 57.50 cr PV1/2= Rs 57.50/(1+0.15/2)=Rs57.5/1.075=Rs 53.49 cr
CF1 = Rs 53.75 cr PV1= Rs 53.75/(1+0.15/2)2=Rs 53.75/1.0752=Rs 46.51cr
D. Technically, duration is the weighted average time to maturity on the asset using
the relative present value of the cash flows as weights. In the above example, Bank
received some cash flows at ½ yr and some at the end of 1 yr
E. If we weight the relative importance of timing of cash flows , which are ½ yr and 1yr
in the above cash by the present value of the cash flows we get

½ yr x 53.49 = 26. 745

1 yr x 46.51= 46.51
Total= 26.745+ 46.51= 73.255

F. To arrive at duration, the weighted value is divided by the sum total of present value of
the cash flows i.e 73.255/(53.49+46.51)=73.255/100.00=0.7326 yrs ( this is an at par
instrument)
G. It can be seen that while the maturity of the loan is 1 year, the duration of the loan has
been worked out to 0.7326 yrs. The duration is always less than maturity if there is
interim cash flow. The duration matches the maturity if there is no interim cashflow just
as in case of zero coupon bond or certificate of deposit ( CD)
H. Lets calculate the Duration of the Certificate Deposit which has funded the
loan. Since there is no interim cash flows, the Duration of the deposit will be
equal to the maturity i.e. 1 yr

I. Duration Gap = Duration of assets - Duration of liabilities= 0.7326 – 1 =( -) 0.2674 yr

It is worth noting that while maturity gap is (1yr-1yr) = 0, the duration gap is ( -)0.2674
J. In
this case if current rate of interest goes up from 15% to 16%, the effect on
economic value of equity would be
△E= - (DG E)(△R/1+R)= - (- 0.2674 x (0.01/1.01) = - (- 0.2674x.0099)= 0.002647 =
0.2647%
Duration Gap & Change in the interest rate
The effect of change in the interest rate on economic Net Worth of a Bank is therefore
determined by
A. Duration Gap: Higher the DG higher will be the impact on the economic value of equity
B. The size of the balance sheet: the larger the size the higher the impact
C. The size of the interest rate shock, the more the shock, the more the impact
D. In general, positive duration gap is inversely related to the change in interest and negative
duration gap is positively related to the change in interest rate
E. There is a trade off between earning prospective and economic value prospective which is to
be kept in mind by ALCO while taking decision in response to an actual/ expected change in
interest rate
Duration Gap Change in interest Change in economic value of equities
Positive Increase Decrease
Positive Decrease Increase
Negative Increase Increase
Negative Decrease Decrease
Liquidity Risk in Banks
What is liquidity in Banks ?

to fund increase in assets and meet both

Liquidity is Bank’s ability
expected and unexpected cash and collateral obligations at
reasonable cost without incurring unacceptable losses.

Bank’s liquidity management is the process of generating funds to

meet contractual or relationship obligations at all times at reasonable
price.
Liquidity Risk
Liability side reason
• When Bank's liability holders
such as depositors chose to
cash in their claims
immediately
Asset side reason
• When the Bank is required to meet
its loan/off balance sheet
commitments
• In the investment portfolio, large
interest rate movements can cause
value of the investment securities
portfolio to fall and large loss in
investment portfolio can occur
triggering liquidity crisis in the
particular market
 • Need to replace net
Funding outflows due to
unanticipated
Risk withdrawal / non-
renewal

• Need to
Liquidity Risk Time compensate for
non receipt of
gets Risk expected inflow of
accentuated by funds

Call • Crystallization of
contingent liability
Risk like BG , LC
 Liquidity Management

Purchased Liquidity Management Stored Liquidity Management

 Approaches market for purchase of  Bank can liquidate some of its
funds
assets
 Avails RBI repo window against
excess SLR
 When the Bank uses the stored
liquidity management both sides
 Avails Refinance facilities of the balance sheet contracts
 Approaches Inter-bank market
 Liquidity in the market is of
 Explores domestic money market critical importance in such
 However, this type of operations operations
involve cost and has to be cost
effective
 However, it does not effect the size
of the balance sheet
Measurement of liquidity risk : Flow Approach -
Structural Liquidity Statement
• Uses Maturity Ladder Approach
• All cash inflows & outflows in the maturity ladder are placed in the Structural
Liquidity Statement based on their residual maturity or on the basis of their
behaviour pattern
• Maturing Liability: Cash outflow
• Maturing Assets : Cash Inflow
• The difference between excess cash inflows or outflows or the GAP captures
excess or deficit of liquidity within a specific future interval
• Arranged in to 10 time buckets
• Mismatches in the first four buckets not to exceed 20% of cumulative
outflows (upto30 days)
Buckets prescribed by RBI for Structural Liquidity Statement

I. Next day
II. 2 days to 7 days
III. 8 days to 14 days
IV. 15 to 28 days
V. 29 days and upto 3 months
VI. Over 3 months and upto 6 months
VII.Over 6 months and upto 1 year
VIII.Over 1 year and upto 3 years
IX. Over 3 years and upto 5 years
X. Over 5 years
Outflow
Capital, Reserves and Surplus Over 5 years
Demand Deposit SB 10% Volatile
CD 15% Volatile
Volatile 1-14 days Buck
Core 1-3 yrs Buck
TD Residual Maturity Buck
Behavioural maturity
Certificate of Deposit, Bonds, Respective maturity buck
Borrowing
Bill Payable Volatile 1-14 days Buck
Core 1-3 yrs Buck
Inter office adj 1-14 days
Export Refinance Respective maturity buck of
underlying assets
Inflows
Cash 1-14 days
Balance with RBI Excess over CRR/SLR=1-14 days Buck
CRR/SLR as per maturity profile of DTL
Money at call/short notice Respective maturity bucket
Approved securities Respective maturity bucket
Corporate bonds,PSU Respective maturity bucket
Bonds,CDs,CPs,Redeemable
preferential share
Shares/ Units of Mutual Over 5 years
Funds
Securities in trading book 1-14,15,28,29-90 as per the defeasance
period
BD Respective maturity period
CC/OD/Working capital As per behavioural pattern
Term Loan Interim cash flows under respective mat
bucket
NPA
Sub standard 3-5 yrs
Doubtful& Loss Over 5 years
Fixed Assets Over 5 years
 01 day 02 to 07 08 15 To 31 ds >2m& >3m& >6m& >1yr >3yr >5yr & TOTAL
day to 14 day 30 day &upt upto 3 upto upto &upto & upto upto7y
2m m 6m 1yr 3yr 5yr r
Capital 500 500

Fixed Term Liability 200 200 100 50 50 50 200 300 1200 1300 1600 5250

Floating Tem Liability 250 100 350 100 200 100 300 400 1700 1500 1800 6800
Others 100 50 100 400 650
Total Outflow 550 350 450 150 250 150 500 800 2900 2800 4300 13200

Cumulative Outflow 550 900 1350 1500 1750 1900 2400 3200 6100 8900 13200

Investment 350 250 250 100 200 100 150 250 1000 200 900 3750

Fixed Loan 100 150 500 1200 1900 3850

Floating loan 500 600 1500 1100 2800 6500

Others 150 250 400

Total Inflow 500 250 250 100 200 100 750 1000 3000 2500 5850 14500

Gap -50 -100 -200 -50 -50 -50 250 200 100 -300 1550 1300

Cumulative Gap -50 -150 -350 -400 -450 -500 -250 -50 50 -250 1300

Cu Gap as % of -9.1% -16.7% -25.92% -26.% -25.% -26.% -10.% -1.56% 0.8% -2.8% -2.8%
Cumulative Outflow
Tolerance Limit 5% 10% 15% 20%
Mismatches

•Mismatches can be positive or negative

•Positive Mismatch if Matured assets >Matured liabilities and Negative Mismatch if Matured
Liabilities>Matured Assets.
•In case of Positive Mismatch, excess liquidity require to be deployed in money market
instruments, creating new assets & investment swaps etc.
•For Negative Mismatch, deficit liquidity can be financed from market borrowings (Call/Term),
Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

•To meet the mismatch in any maturity bucket, the bank may look into taking deposit
and invest it suitably so as to mature in time bucket with negative mismatch.
Flow Approach : Short- term Dynamic Liquidity Statement

• While Structural Liquidity Statement for the Bank shows its

liquidity position on a static basis, it ignores ongoing outflows and
inflows
• In order to monitor their short term liquidity on dynamic basis
along a time horizon of 1-90 days, Banks are required to prepare
their Dynamic Liquidity Statement
• They are prepared on the basis of (i) Business projection and (ii)
Historical trend taking in to account seasonal trend& potential
liquidity need
Measurement of Liquidity Risk –Stock Approach

Volatile Liabilities- • Extent of volatile money supported by Banks earning ability

• Volatile Dep=Dep + Borrowing up to 1yr+Otg LC &CCF of oth contingent credit
Temporary
• Earning Assets= Total Assets –(Fixed Assets +Other Assets + balance in CA of
Assets/Earning Assets- other banks)
Temporary Assets • 40%

• Extent of assets funded by stable deposit

Core Deposit/Total • Core Deposit= All deposits above 1 yr + Net Worth
Assets • 50%

Loan + Mandatory CRR • Extent of illiquid assets embedded in BS

& SLR + Fixed
Assets/Total Assets • 80%
Loans + Mandatory CRR
• Extent of illiquid assets funded out of core deposit
& SLR +Fixed • 150%
Assets/Core Deposit

Temporary Assets/Total • Measure of available liquid assets

Assets • 40%

Temporary Assets/ • Liquid investment relative to volatile liability

Volatile Liability • 60%

Volatile Liability/Total • Extent to which volatile liabilities fund the

Assets Balance Sheet
• 60%
 Stress Testing for liquidity risk management
• Stress Testing is an evaluation of a Bank’ financial
position under a severe but plausible scenario
• Alerts Bank management to adverse
unexpected outcome
• Stress test should be carried out regularly for a
short term and protracted, bank specific and
market wide stress scenario
• Banks choice of scenario and related
assumption should be conservative, clearly thought
of and documented
• Stress outcome should be used to identify
potential liquid strain and impact on Banks cash flow, liquidity position, profitability
& solvency
Contingency Funding Plan (CFP)
• Banks should formulate a CFP for
responding to severe disruption in its
activities in a timely manner and at a
reasonable cost PLAN A
• CFP should contain details of
available/potential contingency funding
sources and amount which can be drawn PLAN B
from these sources,
• Clear procedure details and when and how
PLANC
each of these action should be activated
should be codified
• Bank may also enter CFP agreement with
other Banks
Thanks