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ASSET LIABILITY MANAGEMENT IN BANKS

Components of a Bank Balance Sheet


Liabilities
1. 2. 3. 4. 5. Capital Reserve & Surplus Deposits Borrowings Other Liabilities

Assets
1. Cash & Balances with RBI 2. Investments 3. Advances 4. Fixed Assets 5. Other Assets

Banks profit and loss account


A banks profit & Loss Account has the following components:

Income: This includes Interest Income and Other Income. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

What is Asset Liability Management??


Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. The asset-liability management function would involve planning, directing and controlling the flow, level, mix, cost and yield of the consolidated funds of the Bank.

Objectives of ALM

To protect and enhance the net worth of the institution. Formulation of critical business policies and efficient allocation of Capital. To increase the Net Interest Income (NII) It is a quantification of the various risks in the balance sheet and optimizing of profit by ensuring acceptable balance between profitability, growth and risks. ALM should provide liquidity management within the institution and choose a model that yields a stable net interest income consistently while ensuring liquidity. To actively and judiciously leverage the balance sheet to stream line the management of regulatory capital. Funding of banks operation through capital planning. Product pricing and introduction of new products. To control volatility of market value of capital from market risk. Working out estimates of return and risk that might result from pursuing alternative programs.

Risk associated with ALM


Credit risk: The risk of counter party failure in meeting the payment obligation on the specific date is known as credit risk Capital risk: Capital risk is the risk an investor faces that he or she may lose all or part of the principal amount invested. It is the risk a company faces that it may lose value on its capital. Market risk: Market risk refers to the risk to an institution resulting from movements in market prices, in particular, changes in interest rates, foreign exchange rates, and equity and commodity prices.

Interest rate risk: Interest risk is the change in prices of bonds that could occur as a result of change in interest rates. Liquidity risk: Liquidity Risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Liquidity risk broadly comprises three sub-types: Funding risk Time risk Call risk

Elements of ALM
Strategic framework Organisational framework Operational framework Analytical framework Technology framework Information reporting framework Performance reporting framework Regulatory compliance framework Control framework

Three pillars of ALM


1.

ALM Information System:


Usage of Real Time information system to gather the information about the maturity and behavior of loans and advances made by all other branches of a bank ABC Approach :

analysing the behaviour of asset and liability products in the top branches as they account for significant business then making rational assumptions about the way in which assets and liabilities would behave in other branches The data and assumptions can then be refined over time as the bank management gain experience

The spread of computerisation will also help banks in

ALM Organization

The board should have overall responsibilities and should set the limit for liquidity, interest rate, foreign exchange and equity price risk

The Asset - Liability Committee (ALCO)


ALCO, consisting of the bank's senior management (including CEO) should be responsible for ensuring adherence to the limits set by the Board Is responsible for balance sheet planning from risk return perspective including the strategic management of interest rate and liquidity risks The role of ALCO includes product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, It will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs foreign currency funding It should review the results of and progress in implementation of the decisions made in the previous meetings

ALM Process
Risk Parameters Risk Identification Risk Measurement Risk Management

ASSET LIABILITY COMMITTEE ALCO


The ALCO is a decision making unit responsible for balance sheet planning from risk-return perspective including the strategic management of interest rate and liquidity risks. The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity. Committee composition

Permanent members: Chairman Managing Director/CEO Financial Director Risk Manager Treasury Manager ALCO officer Divisional Managers By invitation: Economist Risk Consultants

Techniques of ALM
Maturity Gap Analysis Duration Simulation Value at Risk

GAP Analysis model

Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates - If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII - conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII

The basic weakness with this model is that this method takes into account only the book value of assets and liabilities and

Duration analysis

It basically refers to the average life of the asset or the liability

It is the weighted average time to maturity of all the preset values of cash flows

The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero.

As

Simulation analysis

Basically simulation models utilize computer power to provide what if scenarios, for example: What if:
The absolute level of interest rates shift Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad debt and prepayment levels change in different interest rate scenarios There are changes in the funding mix e.g.: an increasing reliance on short-term funds for balance sheet growth

This dynamic capability adds value to this

Value at Risk (VAR)

Refers to the maximum expected loss that a bank can suffer in market value or income: Over a given time horizon, Under normal market conditions, At a given level or certainty It enables the calculation of market risk of a portfolio for which no historical data exists. VAR serves as Information Reporting to stakeholders It enables one to calculate the net worth of the organization at any particular point of time so that it is possible to focus on long-term risk implications of decisions that have already been taken or that are going to be taken