Asset-Liability and Risk Management in

Banking

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Concept

• Banks are highly complex organizations

• Lending decisions are totally shaped by the bank’s ability to collect financial
resources (deposit, capital….)
• Overall bank’s goal/objective is the key driver to shape Assets and Liability
Management (ALM) and inherent risk.
• Proper balance between financial resource collection and deployment is
essential for overall growth.
• Trade off between inherent risk and profitability is reflected through adopted
strategies

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Profitability

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What is Asset Liability Management??
• Banks and other financial institutions provide services which expose them to
various kinds of risks like; credit risk, interest risk, and liquidity risk
• Asset-liability management models enable institutions to measure and monitor
risk, and provide suitable strategies for their management.
• ALM is the coordinated and integrated decision making among various function of
bank
• The purpose of asset-liability management is to control a Bank’s Sensitivity to
Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity

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Asset-Liability Management Strategies
Fund Management Strategies
Objectives:
• Maximize returns and minimize costs: Revenues and costs arise from both sides of
the bank’s balance sheet.
• Exercise control over the volume, mix, and return or cost of both assets and
liabilities in order to achieve the bank’s short-run and long-run goals.
• Effective coordination in managing assets and liabilities to maximize the spread
between bank’s revenues from earning assets and the cost of liabilities and
control risk exposure.

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 Asset-Liability Management Strategies

Many financial firms carry out daily asset-liability management (ALM) activities through an asset-
liability committee (ALCO), usually composed of key officers representing different departments of the
firm.
RBI’s Guideline
• The ALM process rests on three pillars:
• ALM Information System
• Management Information System
• Information availability, accuracy, adequacy and expediency
• ALM Organization
• Structure and responsibilities
• Level of top management involvement
• · ALM Process
• Risk parameters
• Risk identification
• Risk measurement
• Risk management
• Risk policies and tolerance levels.
 ALCO
• The ALCO is a decision-making unit, consisting of the FI's senior
management including CEO, responsible for integrated balance sheet
management from risk-return perspective including the strategic
management of interest rate and liquidity risks.
Assets Liabilities Committee (ALCO)
• A well-run ALCO meets regularly (quarterly, monthly, or even more frequently) to
manage the financial firm’s interest rate risk (IRR) and other risk exposures as well.
• Works on a specific numerical targets (e.g., an ROA of 1.5 percent and an equity-to-
assets ratio of at least 10 percent).
• The AOL regularly conveys to the board of directors the firm’s financial condition plus
suggestions for correcting identified weaknesses.
• The committee lays out a plan for how the firm should be funded, the quality of loans
that it should take on, and the proper limits to its off-balance-sheet risk exposure.
• ALCO estimates the firm’s risk exposure to its net interest margin and net worth
ratios, develops strategies to keep that risk exposure within well-defined limits, and
may employ simulation analysis to test alternative management strategies.
Responsibility of ALCO
• Monitoring the market risk levels of the FI by ensuring adherence to the
various risk-limits set by the Board;
• Articulating the current interest rate view and a view on future direction
of interest rate movements
• Base its decisions for future business strategy on this view as also on
other parameters considered relevant.
• Deciding the business strategy of the FI, both - on the assets and
liabilities sides, consistent with the FI’s interest rate view, budget and
pre-determined risk management objectives.
Responsibility of ALCO
• Determining the desired maturity profile and mix of the assets and
liabilities;
• Product pricing for both - assets as well as liabilities side;
• Deciding the funding strategy i.e. the source and mix of liabilities or
sale of assets; the proportion of fixed vs floating rate funds,
wholesale vs retail funds, money market vs capital market funding ,
domestic vs foreign currency funding, etc.
Liquidity
• Measuring and managing liquidity needs are vital for effective operation of
FIs.
• Assured a FI's ability to meet its liabilities as they become due
• Reduced the probability of an adverse situation developing.
• The importance of liquidity transcends individual institutions, as liquidity
shortfall in one institution can have repercussions on the entire system.
• Banks should measure not only the liquidity positions of FIs on an ongoing
basis but also examine how liquidity requirements are likely to evolve
under different assumptions
Liquidity Risk
• The Maturity Profile, is used for measuring the future cash flows of FIs in
different time buckets. The time buckets, may be distributed as under:
i) 1 to 14 days
ii) 15 to 28 days
iii) 29 days and upto 3 months
iv) Over 3 months and upto 6 months
v) Over 6 months and upto 1 year
vi) Over 1 year and upto 3 years
vii) Over 3 years and upto 5 years
viii) Over 5 years and upto 7 years
ix) Over 7 years andupto 10 years
x) Over 10 years.
 Determination of Interest Rate:

• Fig. Determination of the rate of interest

• Banks are price takers, not price makers

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Interest Rate Risk: Greatest challenges in ALM
• It can not be completely avoided
• Changing interest rate impact both bank’s balance sheet and its income
statement.
Forces determining Interest Rates:
• Determined by the financial market place where suppliers of loanable funds
(deposit) interacts with demanders of funds (credit) and interest rate (price of
credit) tends to settle at that point where the quantities of loanable funds
demanded and supplied are equal.

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Interest Rate Gap
• All investments, advances, deposits, borrowings, purchased funds,
etc. that mature/re-price within a specified timeframe are interest
rate sensitive.
• Any principal repayment of loan is also rate sensitive if the FI expects
to receive it within the time horizon.
• This includes final principal repayment and interim instalments.
• Certain assets and liabilities carry floating rates of interest that vary
with a reference rate and hence, these items get re-priced at pre-
determined inte
Interest Rate Gap
The interest rate 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 and upto 7 years
viii) Over 7 years and upto 10 years
ix) Over 10 years
x) Non-sensitive
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