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5, Money, Banking and Finance (Feb. 2-8, 2002), pp. 378-379 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4411679 . Accessed: 06/04/2011 12:41
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For close-ended schemes. When interest rates were deregulated in the US.) But turningback to the savings and loan industry.the so-called FederalFunds Rate. To avoid making losses.000 crore. Take the case of US 64 which. more so. Traditionally(and even now) it has targeted the overnight interbankrate. their principal activity. and go to play golf at 3 PM!). i e. banks in India have not paid much attention to the topic of management of the interest rate mainly because all interest rates were regulated by the central bank. The latter became a matter of crucial importance only after the deregulation of bank interest rates in the US in the late 1970s. assured returns would be possible only if the entire money is invested in fixed income securities.While no capitaladequacy have so far been made applicable to the non-trading activitiesof the banking system (such as normaldepositsand advances).fordecades. This apart. the losses were much more than what they otherwise would have been because. in a dramatic terms concerns. the cost of funds went up sharply. on which obviously there are no assured returns! Quite apartfrom US 64. greater is the impact of interest rate changes on the bottom line. and pay on deposits.the interestthey could charge on housing loans. securities soldin auctions are government and banks are also. Historically.financialinstitutions. the author knows of many banks having lost substantialamountson theirFCNR(B) portfolios through a lack of appreciation.Thefullreport available September on the web site of the Bank for InternationalSettlements(www.interest rates. charge interest at 6 per cent on loans. supervisory concerns were more focused on credit risk than on interest rate risk.Inarecent UK case.Again. To my mind. have suffered losses totalling a few thousand crore in meeting their obligations.the Indianmutualfundsindustry has also been a major victim of mismanaging assets and liabilities. housing finance. In 1979. for all practical purposes.and is unableto meet the obligationsin the rate ruling.clearly an evidence of the extremely capital-intensive nature of banking. Amongst all businesses. a large segmentof the savingsandloan industry wentinsolventandultimately theUS cost like taxpayer something $ 500 bn. In the US. To be sure.critically examine the maturitygap model. Indian Scenario In recent years in India. identification and management of the interest rate risk. Inasset of banksupervisoryis a rela fashion.bis. 2002 .However. free to determine the interest rates on deposits and advances. The industryhad to be bailed out at a huge cost to the taxpayerrunninginto hundreds of billions of dollars.in Asset Issues Liability Management Thesubjectof asset liability managementis of relativelyrecent origin both internationallyand.muchlower interest scenario. the Basle Committeehas come out with a report titled 'Principles the for Managementof InterestRate Risk' in is 1997. It has withinthe purviewof its alreadybrought normsthetopicof intercapitaladequacy est rate risk in the tradingactivities of norms banks. was perceived as an assured income scheme. With the changing scenario. resulting into very high and volatile . But the problem was that the asset investment policy was not such as to earn the assured returnon the liabilities. as trustees of assured returns on various schemes. ie. the topic assumes a great deal of importance as market determined interest rates inevitably lead to volatilityandhence interestraterisk. in a bid to curb inflation. through open market operations. over andabove the fluctuation in the net interest margin.This is of crucial to importance all thosefinancialintermediarieslike banks. the Fed startedtargetingmoney supply ratherthan interest rates.org). the problem arose primarily because of significant investment in equities. banks' bottom lines are vulnerable to changing interest rateson thisscoreas well. others canbehit. As faras banksareconcerned. their dependence on net interest margin for meeting their costs and 378 Economic and Political Weekly February 2. in the savings and loan industry US is a in casestudy what happen can wheninterest ratesarederegulated theindustry and does not take steps to managerisks properly. suggest alternatives. most such schemes were close-ended. Basle the Committeeon BankingSupervisionhas withthequestion interbeenconcerned of est rateriskfor severalyearsnow.Indeed. with a large partof the securities portfolio now subject to 'markto market' valuation for compiling accounts. the US FederalReserve changed the way it implementedmonetarypolicy. with a few exceptions. When major defaults occurred also of resultpartly because therecession ing from the high interestrates. A V RAJWADE liability management tively recent subject.it is proposedto focus on the former. we in India followed suit in the 1990s. with the cost runningto well in excess of Rs 10. and which is now in deep trouble. The impact on the far more complex rupee book is hardly likely to be significantly different. savings andloans increased theirexposure to risky assets likejunk bonds.look at the principles of pricing deposits and advances and deal with connectedsubjects. It is manifest that the greater the capital intensiveness of a business. most of the interest rates have been deregulated. (The other major segment hit by the sky-high USD interest rates were the thirdworld countries which had raised huge LIBOR based loans in the 1970s to pay for the galloping oil bill: the 1980s debt crisis was the result. industry. But focusing on banks and financial institutions. banking is perhaps the most capital intensive since the gross value added through intermediation(or the net interest income) as a proportion of the capital employed is perhapsthe lowest. in India. a centuries-old insurerhas life had to close down operations becauseit assured returns policy-holders to basedon the high interestratesof the 1970s. The subjectof asset liabilitymanagement covers both interestrate risk and liquidityrisk.whose prinis cipalsourceof earnings the net interest But too margin. Unlike US 64. and the duration of the portfolio is so kept as to coincide with the maturityof the scheme. an explosive mixture whose victims included the savings and loan industry. many banks. were regulated (wags used to refer to savings and loans bankersas 3-6-3 bankers:pay interest at 3 per cent on deposits. While rigorous data about the impact on the rupee book of Indian banks of interest rate changes are not available. NBFCsandprimary dealers. in 1979. the biggest impact of deregulated interest rates was felt by the savings and loan. This is the first of a series of articles which will discuss the differentissues involved. Historically.
ie. ALCO etc.The guidelinesalso suggest that a proper transfer within pricemechanism the bankis an important of component an effective and efficient ALM system.the principalsource guidelines recognisethatsomebanksmay of mismatchis their holdings of fixed have alreadyin place more sophisticated incomesecurities partof theirstatutory systems. therefore. financial dealers.NBFCs (June2001).(ii) 29 days to 3 months.7 Surplus is that gearing muchlowerthan of theother Source: Reporton Trend Progressof Banking financialintermediaries.while mostof the assetsarein the system.95 an extent.The objectivethereforeis that. (iii) over 3 monthsto 6 months. wouldconsider issues I the classificaarisingfromthe recommended tion of assetsand liabilitiesinto different buckets. All threeguidelines banks.in particular rate interest mix desired pricing.Again.2 income 0.of the assetsand in liabilitiesdueto be repriced eachband: (i) 1 to 28 days. ratesensitiveassets larger thanratesensitiveliabilities. While thekey to aneffectiveALMstrategy. offices shouldbe electronically collatedat As forthefinancial the institutions. while the portfolioof fixed to startwith. due course. 2002 379 . mismatch the would help increasethe net interestincome in a risinginterestratescenarioand vice versa.the financialinstitutions numberof branches(but which account haveanexactlyoppositemismatch that for a significantproportion the bank's to of Economic and Political Weekly February 2. RBI. While the guidelines take of Thismismatch leadtosubstantial can losses maturity gaps in differenttime bandsor on the fixed incomeportfoliowheninter. Again. for anytimebucket. shouldalso articulate bank'sviews on the theinterest movements devisethe rate and fundingmix. to prepare estimatesfor the bank as a whole.whichformsa signifi.06 4. at least 60 per cent of the incomesecurities.thedatafromall the such requests. and also decide the businessstrategyon the assets andliabilityside.B31 maturity the Clearly.transactions interestrate swaps. threefoundations asset liability manof On the liability side. simulation valueat risk cushionagainstthe interestraterisk.it is not as if The guidelines specify the following thatportfolio aloneis thesourceof therisk.andtheprimary rate risk arises from the mismatch in meaningful. with the average data evidence. the fixed deposit agement is portfolio alsoa sourceof risk.Theseguidelinescovernotonly the Asset Liability Structures rate of Different Entities topicof interest riskbutalso liquidity risk and a few otherpricerisks.52 1. The management anotherspecial) (or committee theboardshouldoverseethe of of implementation the ALM system and review its functioning with a view to refiningit.But analysis would be introduced. using data from a limited repayment way.primary dealersare in a better 1.RBI Guidelines terestmarginin a changinginterestrate scenario asset The Reserve Bank of India came out through appropriate liability is for with its guidelines on Asset Liability management important them. and (viii) not sensitive. total assets and liabilities).protecting/improving net in. of incremental assetsandliabilities. Management Systemin BanksinFebruary 1999. it canaffectboththenetinterest fora givenperiod.further The promptavailabilityof assets and adding to costs.often but 100percentcoverageis mandatory of in has a much longerduration maturity. Banksalso face a risk from the liabilities data.To start 'market') with.quiteapart fromthe riskof depositorsshiftingfrom (1) ALM Information System savings bank accountsto fixed deposits wheninterest ratesarehigh.in practicefew bankscan resist computerised. bulk a centralplace. maturities the assetsandthe liabilities.To Net Interest 6.theyalso est rates go up.earningprofitsis high as the following of the bankingsystem.the guidelinesadvocated ABC formof instalment i loans.assets and liabilitiesshould be covered. Since it will taketime for of their liabilities are bullet repayment many banks to put in place a suitable an bonds.RBI has As faras thefinancialintermediaries issuedseparate ALMguidelines finanin for Indiaareconcerned.0 expenses 2.64 Operating position to take the risk.(v) over 1 year to 3 (vi) years.5 income 2. alsotheeconomic(or as valueof a bank'sequity. The guidelinesalso prescribethe rules for classification of various liabilities andassetsin thedifferent timebuckets. particularly largerIndian mented publicsectorbanks.whileothersmaynothaveproper as The liquidity portfolio.84 1.datato cover 100 per cent assets and lities of thecommercial banksarerelatively abilities. (2) ALM Organisation At thetopof theALMorganisation the is boardof directors whichhas finalresponIt decidethe for sibility thefunction. of maturity the liabilitiesportfoliolonger (As Per Cent of TotalAssets) than that of the asset portfolio. ALCOwouldbe assistedby a support groupfromthe bank'streasury. ALCOwouldconsistof senior executives of the bank. including in particular options embeddedin the fixed deposit residual maturities. over3 yearsto 5 years. are for encashment.60 Other 1.the maturity gap is positive. In a approach. this is verynominal. and in India2000-01. This positors premature contractually nobodycan force a bankto wouldpresenta majorchallengeto banks make premature payment of the fixed in India which may not be optimally deposit. short term. 1999.Eachbankis required place to limits on the extent of gap in each time bucket.49 3.as also off-balance the like portfoliothrough freedomto the de. because their 1. e. bulkof the liabili. In thenext article. should riskmanagement andspecifylimits policy. TheReserve of Bank'sguidelines banks for As far as the commercialbanks are issuedin February 1999wereto be implethe witheffectfromApril1. interestrateriskis to be considered from the angle of the net interestincome by using maturitygaps in the following time bands(or buckets).(iv) over 6 monthsto 1 year.The concerned. dealersalso face a significant Primary Commercial Financial NBFCs of in amount riskas theyoftenborrow the Banks Institutions(1999(2000-2001)(2000-2001) 2000) interbank money marketfor investcall ment in datedgovernment securities. If. interest are similar and the differencesare not The tions.32 1. The Reserve Bank has envisage that in course of time more a normforthe sophisticatedmeasurement prescribed capital adequacy systems like and holding in governmentsecurities as a duration gap. for interestrate (andother)risks. (3) ALM Process As faras theinterest riskis concernrate income ed. principal the ones are cial institutions (December 1999) and thecommercial the institu. maturity profile. cantproportion theirtotalassets.timebuckets thestarting as point.(vii)over 5 years. The next tier of the ALM organisation is the Asset LiabilityCommittee (ALCO) which would be responsible ensuring for thatthepoliciesandlimitsset by theboard areimplemented.