Asset Liability Management

Prof. Ashok Thampy

Indian Institute of Management Bangalore
 Introduction
• Risk faced by banks:
– Credit risk
– Funding risk or liquidity risk
– Foreign exchange risk
– Interest rate risk
– Operational risk
• This lecture focuses on interest rate risk and
liquidity risk
 Introduction - ALM
• Objective: Achieve the objectives of profit and
shareholder wealth within acceptable levels of
risk
• How?
• Management of asset and liability
composition so that profit objectives are met
without subjecting the bank to undue risk.
 Bank Balance Sheet

Loans 40% Deposits 80%

Investments 50% Borrowings 10%
Cash 10% Equity 10%
Assets 100% Liabilities 100%
 Bank Balance Sheet
• Value of bank balance sheet items such
as deposits, borrowings, loans and
investments are sensitive to interest rate
changes.
• Therefore banks income and value of
equity are also sensitive to interest rate
changes.
Profit and Loss Account for Bank X Rupees Percentage
Income
Interest income 853 81%
Other income 194 19%
Total income 1047 100%
Expenditure
Interest expended 667 63%
Operating expenses 153 15%
Provisions and contingencies 121 12%
Total expenses 941 90%
Net profit/loss 106 10%

Biggest source of income: interest income

Biggest expense: interest expense
Biggest source of profit: interest spread
 Objectives of ALM:
• Manage Interest Rate Spread and Risk
• Preserve Networth from eroding due to
interest rate risk
• Ensuring adequate liquidity
• In case of banks with foreign operations:
– Managing return and risk arising from mismatched
foreign currency assets and liabilities.
 Why is everyone talking of ALM now?
• The financial sector has recently been
liberalised. As a result, of late, there is much
more volatility in:
– interest rates
– foreign exchange rates
• The Global Financial Crisis starting in 2008
brought to the fore the importance of liquidity
management for financial institutions.
 Rate
19

10.00
12.00
14.00
16.00
18.00
20.00

0.00
2.00
4.00
6.00
8.00
70
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19 71
71
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72
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73
-7
19 4
74
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19 75
75
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76
-7
19 7
77
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19 78
78
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19 79
79
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19 80
80
-8
19 1
81
-
19 82
82
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19 83
83
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19 84
84
-8
19 5
85
-
19 86

Time
86
-
19 87
87
-
19 88
88
-8
19 9
89
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19 90
90
SBI Prime Lending Rate

-
19 91
91
-9
19 2
92
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19 93
93
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19 94
94
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19 95
95
-9
19 6
96
-
19 97
97
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19 98
98
-
19 99
99
-0
0
 Interest Rate Risk - Refinancing risk
0 Liability 1
0 Asset 2

Liability has 1 year maturity and asset has 2 year maturity.

Refinancing risk occurs when the maturity of assets
is greater than that of the liability.

Risk is that when the liability is refinanced, the

interest rates could rise, resulting in the decrease in
interest spread of the bank.
 Interest Rate Risk - Reinvestment risk
0 Asset 1
0 Liability 2

Asset is of 1 year maturity and liability is of 2 year maturity.

Re-investment risk occurs when the maturity of assets
is less than that of the liability.

Risk is that when the asset, say loan, is repaid, the

funds would have to be invested in a new asset.
If interest rates decline at this time, the interest income
will decrease while interest expense remains the
same, thus decreasing interest spread.
INTEREST RATE RISK ON PROFITS

INTEREST
INCOME

INTEREST
INTEREST ALM RATE
EXPENSES RISK

NET INTEREST
INCOME
INTEREST RATE RISK ON
MARKET VALUE OF EQUITY
VALUE
OF
ASSETS

VALUE INTEREST
OF ALM RATE
LIABILITIES RISK

NETWORTH
 Example: Risk and Return Tradeoff

Lending and Borrowing Term Structure

Year 1 Year 2 Year 3
Borrowing 8% 9% 10%
Lending 9% 10% 11%

One year forward rates:

8% 10% 11.5%
 Ex: Bank A takes Rs. 1000 in 3 year
deposit and lends for 3 years
• Profits: 10
– Year 1:Income= 110 9
8
– Expenses= 100 7
Net Income=10 6
– Year 2:Income = 110 5
Net
– Expenses = 100 4 Income
3
– Net Income= 10 2
– Year 3:Income=110 1
0
– Expenses =100 Year Year
– Net Income =10 1 3
 Ex: Bank B takes 1 year deposit and
lends for 3 years
• Profits: 30
– Year 1:Income= 110 25
– Expenses= 80 20
Net Income=30
15
– Year 2:Income = 110 Net
10
– Expenses = 100 Income
5
– Net Income= 10
0
– Year 3:Income=110
-5
– Expenses =115 Year Year
– Net Income =-5 1 3
 Major ALM models
• Maturity matching models
– the maturity of assets are matched with the
maturity of the liabilities.
• Duration matching models
– the duration of the assets are matched with the
duration of the liabilities
• Repricing models
– the gap in different repricing periods are
considered in managing interest rate risk
Maturity matching: Example of Bank A - asset
and liability has same maturity

• Bank A takes Rs. 1000 10

in 3 year deposit and 9
8
lends for 3 years 7
– Profits: 6
5
• Year 1: 10 4
Net
Income
• Year 2: 10 3
• Year 3: 10 2
1
0
Year Year
1 3
 Maturity matching:
the inadequacies
• Securities with the same maturity may not
have the same sensitivity to interest rates
– Ex: Security A is a two year zero coupon bond with
face value of Rs. 1000 and coupon rate of 10%.
Security B is a two year regular bond with face
value of Rs. 1000 and coupon rate of 10%.
– With an x % increase in interest rates, value of
security A falls more than the value of security B.
 Duration Model

• Duration is the average life of the cash flows

of a security and measures the sensitivity of
the value of the asset to interest rates.
 Basics of Interest Rate Risk

• Price of bond = discounted present value of

future cash flows from the
bond.
 Bond valuation

Example: Present value of a bond with a face value of

Rs. 1000, and a coupon payment of 10% annually, and
a maturity of 3 years is given by the following formula:
100 100 1100
Value = + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

If the discount rate, r = 10%, then

100 100 1100
Value = + 2
+ 3
(1.10 ) (1.10 ) (1.10 )
Value = 90 .91 + 82 .64 + 826 .45 = 1000
 Bond valuation

If the discount rate, r = 8%, then

100 100 1100
Value = + 2
+ 3
(1.08) (1.08) (1.08)
Value = 92 .59 + 85 .73 + 873 .22 = 1051 .5
 Bond valuation

If the discount rate, r = 12%, then

100 100 1100
Value = + 2
+ 3
(1.12 ) (1.12 ) (1.12 )
Value = 89 .29 + 79 .72 + 782 .96 = 951 .97
 Bond price and interest rates
• When r=8%, bond price = Rs. 1051.51
• when r = 10%, bond price = Rs. 1000.00
• when r = 12%, bond price = Rs. 951.97
Bond price and interest rates are inversely
related.
When interest rates fall, bond prices rise
and when interest rates rise, bond prices
fall.
Bond Prices and Interest Rates
Face Value = Rs. 1000
Annual Coupon payment = Rs. 100
Maturity of 1 year 2 years 3 years
bond
Interest(%) % change % change % change
8 1.85 3.57 5.15
9 0.92 1.76 2.53
10 0 0 0
11 -0.91 -1.71 -2.44
12 -1.79 -3.38 -4.80
 Bond Prices and Interest Rates
• Bond prices move inversely with interest
rates.
• Greater the maturity of the bond, greater
would be the change in the price of the bond
for a given change in interest rates.
• Bond price changes with respect to interest
rate changes exhibit convexity-
– fall in price of bond for an increase in r would
be less than the increase in bond price for the
same decrease in r.
 Duration Model
• Overcomes the weakness of the Maturity
Model by taking into account the interest
rate sensitivity of assets and liabilities.
• Measures interest rate sensitivity by
calculating duration.
•
 Duration Introduction
• Duration is a measure of the effective (or
average) time to maturity of a series of FIXED
cash flows.
• KEY POINT: Interest rate induced changes in a
security’s market value is directly proportional
to its duration.
 Duration concepts
• Maturity refers to the term, or the time
period, when the final cash flow from a
security is to be received.
• Price sensitivity of a security depends on its
maturity (term).
• Maturity is not a direct measure of price
sensitivity.
• Periodic cash flows influence price
sensitivity.
 Duration Concepts continued
• Maturity of a investment does not represent
maturity of all its payments when there are
periodic fixed payments over the life.
• Duration is a measure of the average maturity
of a security.
 Example
Calculate the duration of a Rs. 1,00,000 fixed interest loan.
Annual interest is 12%. Interest is paid semi-annually.
The term of the loan is 2 years. Current market yield is 8%.
(1) (2) (3) (4)=(2) x (3) (5) = (1) x (4)
Time Cash flow Discount PV of cash Time weighted
Factor flow PV
0.5 6,000 0.9615 5769 2885
1 6,000 0.9246 5547 5547
1.5 6,000 0.8890 5334 8001
2 106,000 0.8548 90609 181218
Sum 107260 197651
1.84
Duration = sum of column (5)/ sum of column (4)=1.84 yrs
Disount factor = 1/(1.04)^t
 Duration and Price Sensitivity
• Duration measures price sensitivity
• Duration is approximate because it assumes a
linear relationship between price change and
interest rates
• Price and interest rates have a non-linear
relationship - convexity.
Convexity-Bond Prices and Interest Rates
Face Value = Rs. 1000
Annual Coupon payment = Rs. 100
Maturity of 1 year 2 years 3 years
bond
Interest(%) % change % change % change
8 1.85 3.57 5.15
9 0.92 1.76 2.53
10 0 0 0
11 -0.91 -1.71 -2.44
12 -1.79 -3.38 -4.80
Four steps in Duration Gap Analysis
• Management develops an interest rate
forecast.
• Management estimates the market value of
banks assets, liabilities and stockholder’s
equity
• Management estimates the weighted
average duration of assets and liabilities.
• Measures the Duration GAP.
• Forecasts changes in equity value for
different interest rate scenarios.
 Duration GAP
•  Equity= -(DA- (MVL/MVA).DL).A.R/(1+R)
• DGAP = (DA- (MVL/MVA).DL).
• Risk to equity (everything remaining the
same)
– increases with increase in DGAP
– increases with asset size of the bank
– increases with interest rate shock
 Duration and ALM
Hypothetical Bank Balance Sheet
Market Duration Liabilities and Market Duration
Assets Value Rate Years equity value Rate Years
Cash $100 1 yr time deposit $620 5% 1
3 yr commercial paper 700 12% 2.69 3 yr CD 300 7% 2.81
6 yr treasury bond 200 8% 4.99 Total liabilities 920 1.59
2.88 Equity 80
Total assets $1,000 Total liabilities+equity
$1,000
Weighted average duration of assets = 2.88 years
Weighted average duration of liabilities = 1.59 years
Expected Net Interest Income=$48
DGAP= -(2.88 - (920/1000)*1.59) = 1.42 years
Duration GAP and Equity value
MVE = - DGAP . [R/(1+R)].MVA
= - (1.42).(0.01/1.1).1000
= - $12.70.

This approximates the actual decrease ($12).

 Sensitivity of Equity value to interest
rate shock
Equity value sensitivity
Interest rate shock change in EVE
-300 25
30 -200 13.6
20
Equity value

-100 8.2
10
0 0 0
Series1
-10 -300 -200100
-100 0 100 -8.2
200 300
-20 200 -20.4
-30
-40 300 -30.6

Interest rate shock

 Interest Rate Risk in the Duration Model

• Value of Equity is negatively impacted by: -

Leverage adjusted duration gap,
• (DA-DLk)   E
– The size of the financial intermediary,   E
– The size of the interest rate shock,   E
• Immunization of the equity value requires that
DA= DLk, where k = L/A
• Captures market value changes due to interest
rate changes
 Repricing Model
• This is a book value model that looks at the repricing
gaps for assets and liabilities with different maturities
– Repricing Gap Assets Liabilities Gap
• 1day-14 days 20 30 -10
• 15day-29 days 30 40 -10
• 30days-6mths 70 85 -15
• 6mths-1year 90 70 20
• 1yr - 5 yrs 40 30 10
• Over 5 years 10 5 5
• Total 260 260 0
 Repricing model: interest rate risk
• NIIi = (GAPi). Ri = (RSAi - RSLi).Ri

• Captures change in interest cost and interest

income due to change in interest. It does not
capture market value changes.
 Simple Balance Sheet Example
• One year Rate Sensitive Assets (RSA):
– Short term consumer loans (Rs. 50 m)
– 6 month T-bills (Rs. 65 m)
– 30 year floating rate mortgages (Rs. 40 m)
• One year Rate Sensitive Liabilities (RSL):
– 3 month CDs (Rs. 40 m)
– 3 month deposits (Rs.80 m)
– 1 year time deposit (Rs. 20 m)
– 1 year RSA = Rs. 155m / RSL = Rs.140m
 Simple Balance Sheet Example
(continued)
• Cumulative 1 year repricing gap
• = CGAP = 1 year RSA - 1 year RSL

• NIIi= CGAP x R
• = (1 year RSA - 1 year RSL) x R
• = (Rs. 1 5 m) x 0.01
• = Rs. 150,000
 GAP Risk
GAP  in  in  in  in
(RSA-RSL) int. rate int. inc. int. exp. NII
Positive   >  
Positive   >  
Negative   <  
Negative   <  
Zero   =  None
Zero   =  None
Weaknesses of the Repricing Model
• Market value effects - not taken into
account.
• Over aggregation- does not capture
mismatch in assets and liabilities within the
bucket (especially if the periods are long.)
This problem can be overcome.
• Runoffs- some assets and liabilities of the
bank may be taken off the books earlier
than the contracted period resulting in
runoff cash flows.
 Runoffs (RO) of Different Assets
• Example:
• Item Assets
• RO< 1yr RO>1yr
• ST Consumer loan Rs.50 _
• LT Consumer loan 5 20
• 3 month T bills 30 _
• 10 year mortgages 2 18
• GAP ANALYSIS SHOULD TAKE INTO
ACCOUNT THE RUNOFFS.
 Equal Rate Changes on RSAs, RSLs
• Example: Suppose rates rise 1% for RSAs and
RSLs. Expected annual change in NII,
NII = CGAP ×  R
= $15 million × .01
= $150,000
• With positive CGAP, rates and NII move in the
same direction
• Change proportional to CGAP

8-48
 Unequal Changes in Rates
• If changes in rates on RSAs and RSLs are not
equal, the spread changes; In this case,
NII = (RSA ×  RRSA ) - (RSL ×  RRSL )

8-49
 Unequal Rate Change Example

• Spread effect example:

RSA rate rises by 1.2% and RSL rate rises by
1.0%

NII =  interest revenue -  interest expense

= ($155 million × 1.2%) - ($155 million × 1.0%)
= $310,000

8-50
 *Unbiased Expectations Theory

• Yield curve reflects market’s expectations of

future short-term rates
• Long-term rates are geometric average of
current and expected short-term rates
• (1 +1RN)N = (1+ 1R1)[1+E(2r1)]…[1+E(Nr1)]

8-51
 *Liquidity Premium Theory

• Allows for future uncertainty

• Premium required to hold long-term

8-52
 *Market Segmentation Theory

• Investors have specific needs in terms of

maturity
• Yield curve reflects intersection of demand
and supply of individual maturities

8-53
Unbiased Expectations Theory and
Forward Rates
• 1R2 = {(1+1R1)[1+(2f1)]}1/2 -1
Where 1R2 is the 2 year rate
1R1 is the 1 year rate

2f1 is the expected 1 year rate for year 2,

or the implied forward one-year rate for year 2.
If 1R1 = 0.45%, 1R2 = 0.935%, 1R3 = 1.481% and 1R4
= 1.924% , what is 2f1 , 3f1 and 4f1 ?
Negative Gap and the S&L Fiasco in
the United States
• Hypothetical S&L Balance Sheet
– RSA 20 RSL 80
– Mortgages(fixed) 80 Other 20
» 100 100

»GAP=RSA-RSL = 20 - 80 = -60
»S&L exposed to risk from rising interest
rates.
 Swaps
• In a swap transaction, there is a restructuring
of asset or liability cash flows in a preferred
direction by the transacting parties.
• Swaps exist in interest rates, currencys, and
commodities. Of these, interest rate swaps
form the biggest group.
 Fixed floating rate swap
Bank Housing Finance Co

Long term
Floating rate fixed rate
loans loans
(LIBOR+3)

Short term
Long term liabilities
liabilities (1 year
(4 year, 13%) deposits)

RSA>RSL RSA < RSL

Risk of interest rates Risk of interest rates
 Interest Rate Swap
• Bank faced the risk of • HFC faced the risk of
lower interest rates higher interest rates
• By going for a swap, • By going for a swap, the
bank reduces interest HFC reduces interest
rate risk by changing its rate risk by changing its
long term fixed fixed rate cash inflows
liabilities to short term to a floating rate cash
floating rate liability. inflow.
 Fixed floating rate swap
Bank Housing Finance Co

Long term
Floating rate fixed rate
loans loans
(LIBOR+3)

Short term
Long term liabilities
liabilities (1 year
(4 year, 13%) deposits)
 Interest Rate Swap
• Expected interest rate at end of year:
– Year LIBOR
• 1 12%
• 2 12%
• 3 10%
• 4 9%

Nominal value of swap is Rs. 100 million.

In interest rate swap, only the interest payments are
exchanged and not the principal or notional value.
 Realized cash flows on the swap agreement with nominal
value of swap of Rs. 100m.
Cash Cash payment Net
One year LIBOR payment by housing payment
End of year LIBOR + 2% by bank finance co. by bank
1 12% 14% Rs. 14m Rs. 13m +1
2 12% 14% Rs. 14m Rs. 13m +1
3 10% 12% Rs. 12m Rs. 13m -1
4 9% 11% Rs. 11m Rs. 13m -2

A FI with a positive repricing gap, by being the paying

floating party to an IRS and receiving fixed, reduces its
GAP by increasing its rate sensitive liability.
 ALM guidelines
• A bank should have an ALCO headed by
CEO/CMD or the ED.
• Banks can first adopt repricing gap analysis,
then move on to Duration Gap Analysis,
Simulation.
• There should be regular reporting of
Statement of Structural Liquidity to ALCO.
 RBI guidelines
• Maximum mismatch tolerance levels should
be fixed by ALCO.
• Example: 1-14 day buckets and 15-28 day
buckets, the mismatch (negative gap) should
not exceed 20% of the cash flows.
 Liquidity Risk Management
• Maturity buckets:
– 1-14 days
– 15-28 days
– 29days to 3 months
– Over 3 months and upto 6 months
– Over 6 months and upto 1 year
– Over 1 year and upto 3 years
– Over 3 years and upto 5 years
– Over 5 years
 Interest Rate Risk
• Buckets for Gap analysis (RSA-RSL)
– 1-28 days
– 29 days and upto 3 months
– Over 3 months and upto 6 months
– Over 6 months and upto 1 year
– Over 1 year and upto 3 years
– Over 3 years and upto 5 years
– Over 5 years
– Non-sensitive
 In what repricing gap should
savings deposits be?
• Banks should undertake studies to understand
the behavior of assets and liabilities
• Estimate what is the core deposits
 Basel III

• Liquidity Rules
– Liquidity Coverage Ratio (LCR)
• sometimes known as the "Bear Stearns rule." The LCR requires banks to
maintain a stock of "high-quality liquid assets" that is sufficient to cover net
cash outflows for a 30-day period under a stress scenario. The formula is:

Stock of high quality liquid assets ≥ 100%

Net cash outflows over a 30-day time period

– Net cash outflows, in turn, is calculated by applying run-off rates to different

sources of funding (e.g., repos, unsecured wholesale, etc.). So the action here is in
(1) the definition of "high quality liquid assets," and, more importantly, (2) the run-
off rates used to calculate "net cash outflows."

Prof. Ashok Thampy, IIMB

 Summary
• Asset Liability Management is an integral
part of the management of a financial
intermediary - particularly the interest rate
risk. This requires good MIS.
• Since the deregulation of interest rates, a
good ALM system is essential to create
value of shareholders
State Bank’s balance sheet is listed below. Market
yields and durations (in years) are in parenthesis, and
amounts are in millions.
Assets Liabilities and Equity
Cash $20 Demand deposits $250
Fed funds (5.05%, 0.02) 150 MMDAs (4.5%, 0.50) 360
T-bills (5.25%, 0.22) 300 (no minimum balance requirement)
T-bonds (7.50%, 7.55) 200 CDs (4.3%, 0.48) 715
Consumer loans (6%, 2.50) 900 CDs (6%, 4.45) 1,105
C&I loans (5.8%, 6.58) 475 Fed funds (5%, 0.02) 515
Fixed-rate mortgages (7.85%, 19.50)1,200 Commercial paper (5.05%, 0.45) 400
Variable-rate mortgages, Subordinated debt:
repriced @ quarter (6.3%, 0.25) 580 Fixed-rate (7.25%, 6.65) 200
Premises and equipment 120 Total liabilities $3,545
Equity 400
Total assets $3,945 Total liabilities and equity $3,945

a. What is State Bank’s duration gap?

b. Use these duration values to calculate the expected change in the value of the assets and
liabilities of State Bank for the predicted increase of 1.5 percent in interest rates.
c. What is the change in equity value forecasted from the duration values for the predicted
increase in interest rates of 1.5 percent?