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Asset - Liability Management in Banks

Prepared bySk. Nazibul Islam Faculty member, BIBM

ALM: Conceptual Discussion Today banks are highly complex organizations- offering multiple services. Different groups of individuals inside the bank usually make the decisions on - What customers are to receive loans - What securities the bank should add to its investment portfolio - What terms should be quoted to the public on deposits and other services the bank offers - What sources of capital the bank should draw upon

In a well- managed bank all of these management decisions must be coordinated across the whole bank.
It must be ensured that they do not clash with each other, leading to inconsistent actions that damage the banks earnings and value. Today bankers have learned to look at their asset and liability portfolios as an integrated whole, considering how the banks total portfolio contributes to its broad goals of adequate profitability and acceptable risk.

This type of coordinated and integrated bank decision making is known as asset-liability management.

ALM represents management of the structure of a bank balance sheet in such a way that interest related earnings are maximized with in the overall risk preferences of a banks manager.

ALMBasically balance sheet management Sources and Uses of Funds management Cost and Revenue implication

Objectives of ALM - Maximize profitability - Maintain adequate liquidity - Manage B/S Risk ALM- Primary Responsibility of Treasury Department. Treasury analyzes B/S and places Results & Recommendations to ALCO (Asset liability committee)

ALCO Composition Chairman: CEO/MD + Head of treasury + Head of Finance + Head of Corporate banking + Head of Consumer Banking + Head of Credit + Head of Operation ALCO meets once in every month to set and review ALM strategies.

ALCO Paper- Coverage - Commentary on the last month status - Interest Rate Trend - Balance Sheet/Trend in A&L - Key Management Indicators Wholesale borrowing guidelines Commitments to customers Loan Deposit Ratio Medium Term Funding Ratio Maximum cumulative Outflow - Maturity Profile Mismatch - Interest Rate Profile - Local Regulatory Compliance etc.

A Bank Manager has three primary concerns: Liquidity Management: To keep enough cash on hand, to acquire sufficiently liquid assets to pay the depositors when there are Deposit Outflows. Asset Management: To minimize risks by acquiring assets that have a low rate of default risk by diversifying asset holdings. Strategies Involved: - Search borrowers to pay high interest rates / yet unlikely to default. - Purchasing securities with high returns and low risk. Risk Return Trade off. - Minimizing Risk by Diversifying both holdings of Loans and Securities. Not putting all eggs in one basket. - Managing the Liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs.

Liability Management: The main goal of Liability Management is to acquire Funds at low cost.
Earlier, a bank used to take its liability as fixed and spent their time trying to achieve an optimal mix of assets. But the things have changed now-a-days. A bank now can agree aggressively set target for asset growth and try to acquire funds as it needs. The higher interest cost of liabilities today has significantly affected banks profitability and their interest rate risk.

Composition of asset and liability of a bank Balance Sheet

Asset Cash & Liquid Reserve (Non-Earning Asset)

Liability Deposit Borrowing (Outside liability)

Loans/Advances/Invest- Capital (Inside liability) ment (Earning Asset)

Different Aspects of Fund Management of a Bank

Aspects
1.Outside Liability 2.Inside liability whichever 3.Non-Earning Asset 4.Earning Asset 5.Matching Strategy

Objectives
Minimization of Cost & Stability of fund. Regulatory Requirement: 10% of RWA or Tk. 400 crore is higher. Regulatory Requirement: 19% of TDTL, 6% CRR and 13% SLR Maximization of Return and Minimization of Risk Matching between Asset & Liability: Interest Risk Matching and Maturity Matching Based on Liability Cost: Cost of fund, risk premium Based on above all.

6.Pricing of Earning Asset 7.Profitability Management

Maturity Profile Mismatch A key issue that banks need to focus on is the maturity of its assets and liabilities in different tenors.
A typical strategy of a bank to generate revenue is to run mismatch. Banks make profits through the process of asset transformation: They borrow short term and lend longer term.

Mismatch is accompanied by liquidity risk and excessive longer tenor lending against shorterterm borrowing would put a banks balance sheet in a very critical and risky position. To address this risk and to make sure a bank does not expose itself in excessive mismatch, a bucket wise maturity profile of the assets and liabilities is prepared to understand mismatch in every bucket.

Bucket- wise means Next day 2 7 days 7 days 1 month 1 3 months 3 6 months 6 months 1 year 1 2 year 2 3 years 3 4 years 4 5 years Over 5 year

Banks prepare Forecasted Balance Sheet where the assets and liabilities of the nature of current, overdraft etc. are divided into Core and Non-Core balances.

Core

Non-Core

Stable and will stay with Less stable the bank


Can be put into over 1 year bucket Can be put in 2 7 days or 3 months bucket.