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Asset Liability Management in Banks

Presentation by Priyank Shah

“If there is any area of banking that has undergone drastic change, it is the whole subject of assets/liabilitiessmanagement.”
- Paul S. Nadler

Assets Liability Management
“ALM is an ongoing process of formulating, monitoring, revising and framing strategies related to assets and liabilities in an attempt to achieve the financial objective of maximizing interest spread or margins for a given set of risk level”.

Concept of ALM
• It is not only liquidity management tool but also portfolio management tool • System of matching inflow and outflow of cash. • It is also helpful in managing the credit risk, foreign exchange risk, operational risk, equity price risk. • It focus on day to day and week to week B/S management. • Asset/liability management focuses on the net interest income if the institutions. Net interest income is the difference between the amount of interest received from loans and investments and the amount of interest paid for deposits and other liabilities. • Net interest income = interest revenue – interest expense

Components of a Bank Balance sheet
Liabilities
1. 2. 3. 4. 5. Capital Reserve & Surplus Deposits Borrowings Other Liabilities

Assets
1. 2. Cash & Balances with RBI Bal. With Banks & Money at Call and Short Notices Investments Advances Fixed Assets Other Assets

3. 4. 5. 6.

Contingent Liabilities

ALM process rest on three pillars:
ALM information system • Management information system • Information availability, accuracy, adequacy  ALM organisation • Structure and responsibilities •Level of top management involvement  ALM process • Credit risk management • Management of market risk (including interest rate risk) • Liquidity risk management • Currency risk management

Credit risk management
• It reflects in The profitability Liquidity Reduced NPAs. • Ways for credit risk management  At micro level (focused on clients)  At macro level (capital adequacy)  Risk transfer

INTEREST RATE MANAGEMENT
• MEASURING INTEREST RATE SENSITIVITY

• GAP = RSA – RSL
THREE OPTIONS: – A) RSA>RSL= Positive Gap – B) RSL>RSA= Negative Gap – C) RSL=RSA= Zero Gap

• Relative GAP ratio • Interest rate sensitivity ratio

Effects of Changes in Interest Rates
Gap Changes in Interest Rates Increase Decrease Increase Decrease Increase Decrease Changes in Net Interest Rate Increase Decrease Decrease Increase Zero Zero

Positive Positive Negative Negative Zero Zero

CLASSIFICATION OF ASSETS AND LIABILITIES
ASSETS CLASSIFICATION LAIBILITIES & CAPITAL CLASSIFICATION

Vault cash Short term securities Long term securities Variable rate loans Short term loans Long term loans Other assets

NRSA RSA NRSA RSA RSA NRSA NRSA

Demands deposits Current accounts Money market deposits Short term deposits Long term saving Repo transaction Equity

NRSL NRSL RSL RSL NRSL RSL NRS

LIQUIDITY MANAGEMENT

Statement of Structural Liquidity
All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:
i. 1 to 14 days ii. 15 to 28 days iii. 29 days and up to 3 months iv. Over 3 months and up to 6 months v. Over 6 months and up to 1 year vi. Over 1 year and up to 3 years vii. Over 3 years and up to 5 years viii. Over 5 years

An Example of Structural LiquidityStatement
15-28 1-14Days Days 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5 3 Month 6 Mths 1Year Years 5 Years Years Total

300 200 350 400 50 50 700 650 200 150 50 50 200 150 Loans BPLR Linked 100 150 Others 50 50 Total Inflow 600 550 Gap -100 -100 Cumulative Gap -100 -200 -14.29 Gap % to Total Outflow -15.38

Capital Liab-fixed Int Liab-floating Int Others Total outflow Investments Loans-fixed Int Loans - floating

200 600 600 300 200 350 450 500 450 450 0 550 1050 1100 750 650 250 250 300 100 350 0 100 150 50 100 200 150 150 150 50 200 500 350 500 100 0 0 0 0 0 650 1000 950 800 600 100 -50 -150 50 -50 -100 -150 -300 -250 -300
18.18 -4.76 -13.64 6.67 -7.69

200 200 450 200 1050 900 100 50 100 200 1350 300 0
28.57

200 2600 3400 300 6500 2500 600 1100 2000 300 6500 0 0

LIQUIDITY MANAGEMENT IN FINANCIAL INSTITUTIONS Various tools used by financial institution:  Liquid assets  By setting a limit on maturity mismatches  A diversified source for liability raising  By availing funds from the wholesale market  Contingency plan

HYPOTHETICAL EXAMPLE OF MISMATCH BETWEEN ASSETS AND LIABILITIES A bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years. The bank is earning a 20 basis point spread. The bank earned USD 200,000 in the first year. Suppose, at the end of 1st year, an applicable 4-year interest rate is 6.00%. The bank is in serious trouble. It is going to be earning 3.20% on its loan and paying 6.00% on its financing.

Market value accounting recognizes the bank's predicament. The respective market values of the bank's asset and liability are: 100MM (1.032)5/(1.060)4=92.72MM 100MM(1.030) = 103.0MM The bank has lost USD 10.28MM

STRATEGIES FOR ASSET / LIABILITY MANAGEMENT Aggressive gap management Defensive gap management Future,option & swaps Duration gap management

Problems in Aggressive & Defensive Gap management
• Time horizon • Correlation between movement in general market interest rate and the interest revenue & cost are constant • Need to make interest rate forecast • Narrow focus on net interest income as opposed to shareholder wealth

Effect of interest rate changes on different type of Duration Gap
Duration Gap Net Interest Income Increase Decrease Increase Decrease Increase Decrease Changes in Market value of Equity Decrease Increase Increase Decrease Zero Decrease

Positive Positive Negative Negative Zero zero

PROBLEMS IN DURATION GAP MANAGEMENT
• Only effective when parallel shift in yield curve • Assets and liability duration are significantly different • Duration drift

Role of Reserve Bank of India
Developing a better understanding ALM concepts Introducing an ALM information system Setting up ALM decision making process

Role of financial Institutions

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