Asset Liability

Management
(Interest Rate Risk &
Liquidity Risk)
Ms. P. Soumya
Faculty, IIBF
September 24, 2022
Basic function of a bank
Balance Sheet of a bank
Assets Liabilities

 Cash and Balance with RBI  Capital

 Balances with banks, Money at call and  Reserves and Surplus

Short notice

 Investments  Deposits

 Advances  Borrowings

 Fixed Assets  Other liabilities & Provisions

 Other Assets

 TOTAL
 TOTAL
 Rs. 1 lakh Rs. 1 lakh
Deposit Bank Loan
6 months 6 months
@ 5% @ 5%

Liabilities Assets

Amounts, maturity, interest rates are all same

Rs. 1 lakh Rs. 2 lakh

Deposit Bank Loan
6 months 1 year
@ 5% @ 7%

Liabilities Assets

Amounts, maturity, interest rates are different

 Asset
Liability
Mismatch

Change in
Amounts Maturity
earnings &
mismatch mismatch
Net Worth

Interest Liquidity
Rate Risk Risk
Definition of ALM
1 Continuous Process

2 Managing Bank’s entire balance sheet

3 Managing maturity profiles of assets & liabilities

4 Review interest rates, yields for improved profitability

5 Ensure adequate liquidity with long term viability

6 Balance fund mobilization & fund deployment

7 ALM is protection of net worth of the bank.

 Focus of ALM

Spread Maturity Managing Interest

Management Management Sensitive Assets
Controls interest received Matching assets and
&Liabilities
on assets & paid on liabilities over time bands Minimize impact of interest
liabilities to maximise so that risk remains within rate risk & protect long
spread limit term earning
Asset Liability Management
Committee (ALCO)
Head Treasury/Investments
Head Credit/Advances
Head Deposit
Head Research
Head Information Technology
Head Corporate Policy
Strategies adopted by ALCO
• Changes in product
mix
On-balance-sheet
• Pricing of deposits,
business strategies
loans and other
borrowings
On –balance –sheet • Changes in maturity mix
• Rate characteristics of
Investment investment securities
strategies or funding and wholesale funding

Off-balance-sheet • Derivatives/off balance

sheet tools to manage
strategies balance sheet risks
 Change in Interest
Interest Rate
income due to change
Risk rate
in interest

Earnings
perspective Measured using GAP
(change in NII & Analysis Method
Interest NIM)
Rate Risk Economic Value
Measured using
Perspective (change
Duration Analysis
in Market Value of
Method
Equity-MVE)

Net Interest Income Net Interest Margin (NIM) =

(NII) = Interest Income – (Net Interest Income-NII /
Interest Expense Rate Sensitive Assets-RSA ) x 100
Types of Interest Rate Risk

Gap Risk

Reinvest
Basis
ment
Risk
Risk

Interest
Rate
Risk
Yield
Refinanc
curve
e Risk
Risk

Embedde
d Option
Risk
Basis Risk Example - An asset (loan) of 2 years is funded by a
borrowing (liability) of 1 year with interest rate linked to
different benchmarks

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

0 Liabilities Rs 100 cr 1 Yr Benchmark – 2yr

Interest rate 6% MIFOR

Assets and Liabilities, though matched, when priced on

different benchmarks, is known as Basis Risk
 Yield curve – plotting interest rates of bonds having
same credit quality but different maturities

Positive curve/ Upward slope – short

term bonds with same quality have a
lower yield than long term bonds
Interest rates of all maturities are at
the same level – happens when the
curve moves from Normal to
Inverted or from Inverted to Normal

Negative curve / Downward slope –

can be observed during times of
recession

When shifts in yield curve have adverse effects on a bank’s

income is known as Yield Curve Risk
Refinancing Risk Example - An asset (loan) of 2 years is
funded by a borrowing (liability) of 1 year

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

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

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

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
Reinvestment Risk Example - An asset (loan) of 1 year is
covered by a borrowing (liability) of 2 years

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

0 Assets Rs 100 cr 1 Yr (Interest rate can 2yr

Interest rate 8% rise 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 generates from

There is a cash flow

Interest rate resets during the time period

RBI changes the interest rates

Prepaid or withdrawn before the slated maturity

dates
Traditional Gap Analysis (TGP)

Rate Assets and Liabilities repriced at current

Sensitivity market rate within a certain time horizon
i.e. maturity buckets

Difference between amount of Rate Sensitive

Assets (RSA) & Rate Sensitive Liabilities (RSL)
Gap maturing or repricing within a specified time
period
Measurement under TGP
1st Step : Identify Risk Sensitive Assets (RSA)
Asset Side Interest Sensitivity Time Bucket
Cash Non-sensitive -
Sensitive - Intt Bearing portion
Balance with RBI 3-6 months
only
Non-sensitive - balance amount -
Current Deposit – NS -
Balance with other bank
Call money, TD Sensitive Respective maturity
Investment - Fixed/Floating Sensitive Residual / Repricing
Equity Non-sensitive -
Advance Sensitive Residual maturity
NPAs Sub-standard Over 3 to 5 years
Doubtful & Loss Over 5 years
Fixed Assets Non-sensitive -
Other Assets Non-sensitive -
Reverse Repos, Swaps etc Sensitive Respective maturity
Other Products (IRS,
Sensitive Respective maturity
Derivatives)
Measurement under TGP
1st Step : Identify Risk Sensitive Liabilities (RSL)
Liability Side Interest Sensitivity Time Bucket
Capital & Reserve Non Sensitive -
Current Deposit Non Sensitive -
Sensitive - Int bearing portion only 3-6 months
SB Non-Sensitive - Non-interest bearing
portion
Sensitive Repriced at Maturity or
TD Residual maturity
otherwise
Borrowings - Fixed Sensitive Residual maturity
Borrowings - Floating Sensitive Repricing date
Borrowings - Zero
Sensitive As per maturity
Coupon
Borrowings - RBI 1 month
Bill payable , provision
Non-Sensitive -
etc
Residual / Repricing
Refinance Sensitive
as the case may be
Measurement under TGP
2nd Step : Place in the Time Buckets to identify Gaps
The Time Buckets, under which the RSA/RSL have to be
placed are :

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
Measurement under TGP
3rd Step - Gap Analysis – Options
Cause Gap
RSA > RSL Positive
RSA < RSL Negative
RSA = RSL NIL
By definition - The cumulative gap over the whole balance
sheet across the buckets must be zero.
4th Step – Gap in relation to Interest Rate
movement – analyse if benefit / loss from rising interest
rates with a positive / negative Gap or from declining
interest rates with a negative / positive Gap
3rd Step – Gap Analysis - Let us understand this better
with an example
Gap Analysis – Negative Mismatch
Time RSA RSL GAP C.Gap Inc @ Dec @
bucket 0.25% 0.50%
1 to 28 days 34915 41700 -6785 -6785 -16.96 33.93
>28 days up 52650 61250 -8600 -15385 -21.50 43.00
to 3 mths
>3 mths up 78000 80000 -2000 -17385 -5.00 10.00
to 6 mths
>6 mths up 93500 95000 -1500 -18885 -3.75 7.50
to 1 yr
>1yr upto 3 102000 105000 -3000 -21885 -7.50 15.00
yrs
>3 yr upto 5 118000 111000 7000 -14885 17.50 -35.00
yrs
Over 5 yrs 125000 115000 10000 -4885 25.00 -50.00
Total -4885 -12.21 24.43
Measurement under TGP
5th Step Risk Management strategy : Relation between
Change in interest rate and change in Net Interest Income

CGAP Gap Position Change in Change in Net

interest rate Interest Income
>0 Positive Increase Increase
>0 Positive Decrease Decrease
<0 Negative Increase Decrease
<0 Negative Decrease Increase

The larger the absolute value of the CGAP, the larger the
expected change in NII
Traditional Gap vs Duration Gap Analysis

Traditional Gap
Duration Gap Analysis
Analysis

Book Value of Accounting Market Value of Accounting

Historic Value True/Real value

Original period of cashflows Actual time of cashflows

 CF- 57.50 CF- 57.50

0 6m 1yr
Loan of Rs 100 cr
Interest rate = 15% (Semi-annual)

The loan is funded by 1 year CD paying 15% interest p.a.

Calculate the Present Value of the Loan assuming yield @ 14%

Present Value (PV) of the Loan is Rs. 103.96

Calculate Duration of the Loan

Duration of the Loan is 0.7415 year

Weighted Average PV of cashflows
Time to Maturity used as weights

Duration

Less than
Equal to maturity
maturity if
if no cashflows
interim cashflows
Duration Gap Analysis
Duration Gap = Duration of Assets – Duration of Liabilities
(DG) = 0.7415 – 1 = (-) 0.25845 yr

If yield increases from 15% to 16%, the effect on Economic

Value of Equity is
△E= - (DG E)(△R/1+R)
Where,
△E = % Change in market value of Net Worth
△R= Change in interest rate
DG = Duration Gap

Example: -(-0.25845) x (0.01/1+0.15) = 0.0022474 = 0.2247%

Conclusions

Duration Change in Change in economic value

Gap interest of equities

Positive Increase Decrease

Positive Decrease Increase

Negative Increase Increase

Negative Decrease Decrease

Liquidity Risk
in Banks
Definitions…..

Ability to fund Potential inability

increase in assets to generate cash Process of
and meet both to cope with generating funds
expected and decline in deposits to meet
unexpected cash
or increase in contractual or
and collateral
assets relationship
obligations at
reasonable cost obligations at all
without incurring times at
unacceptable losses. reasonable price
Liquidity Risk in Balance Sheet

Liability side Asset side

reason reason
• Depositors choose to • Loan/off balance sheet
cash in their claims commitments
immediately
• Investments - large
• Borrowings not available interest rate movements
in the market for the leading to fall in the
required amount value of the investment
triggering liquidity crisis
Types of Liquidity Risk

• Unable to meet the expected

Funding and unexpected current and
future cash flows and collateral
Liquidity needs
• Without affecting its daily
Risk operations or its financial
condition

Market • Unable to easily offset or eliminate

a position at the prevailing market
Liquidity price
• Due to inadequate market depth or
Risk market disruption
Measurement of Liquidity Risk

Flow Stock
Approach Approach
Structural Liquidity Statement
• Actual Cash inflows & outflows as per
maturity ladder on a date,
• Measures liquidity on a static basis
Liquidity
Ratios
Short Term Dynamic Liquidity
Statement
• Measures liquidity on an ongoing
basis, projected cash flows,
• Time horizon of 1-90 days
Buckets prescribed by RBI for Structural
Liquidity Statement
I. Next day
II. 2 days to 7 days
III. 8 days to 14 days Old
IV. 15 to 30 days 15-28 days
V. 31 days and upto 2 months
VI. Over 2 months and upto 3 months 29 days to 3
VII. Over 3 months and upto 6 months months
VIII. Over 6 months and upto 1 year
IX. Over 1 year and upto 3 years
X. Over 3 years and upto 5 years
XI. Over 5 years
Outflows / Liabilities Time Bucket
Capital, Reserves and Surplus Over 5 years

Demand Deposit SB 10% Volatile

CD 15% Volatile
Volatile 2-14 days Buck
Core 1-3 yrs Buck
TD Residual Maturity Buck
Behavioural maturity
Certificate of Deposit, Bonds, Respective maturity buck
Borrowing
Bill Payable Volatile 2-14 days Buck
Core 1-3 yrs Buck
Inter office adj 2-14 days
Export Refinance Respective maturity buck of underlying
assets
Inflows / Assets
Cash
Balance with RBI
Money at call/short notice
Approved securities
Corporate bonds,PSU
Bonds,CDs,CPs,Redeemable
preferential share
Shares/ Units of Mutual Funds
Securities in trading book
BD
CC/OD/Working capital
Term Loan
NPA
Sub standard
Doubtful& Loss
Fixed Assets
Time Bucket
2-14 days
Excess over CRR/SLR=1-14 days Buck
CRR/SLR as per maturity profile of DTL
Respective maturity bucket
Respective maturity bucket
Respective maturity bucket
Over 5 years
2-14,15,28,29-90 as per the defeasance period
Respective maturity period
As per behavioural pattern
Interim cash flows under respective mat bucket
3-5 yrs
Over 5 years
Over 5 years
Measurement of Liquidity Risk –Stock Approach
• Extent of volatile money supported by Banks earning ability
Volatile Liabilities- • Volatile Dep=Dep + Borrowing up to 1yr+Otg LC &CCF of oth
Temporary contingent credit
Assets/Earning Assets- • Earning Assets= Total Assets –(Fixed Assets +Other Assets + balance in
Temporary Assets CA of other banks)
• 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
• Extent of illiquid assets funded out of core deposit
CRR & SLR +Fixed • 150%
Assets/Core Deposit

Temporary • Measure of available liquid assets

Assets/Total Assets • 40%

Temporary Assets/ • Liquid investment relative to volatile liability

Volatile Liability • 60%

Volatile • Extent to which volatile liabilities fund the

Liability/Total Balance Sheet
Assets • 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

• CFP should contain details of available/potential

contingency funding sources and amount which can be
drawn from these sources,

• Clear procedure details and when and how each of these

action should be activated should be codified

• Bank may also enter CFP agreement with other Banks