ASSET LIABILITY

MANAGEMENT
MODULE A
C.S.BALAKRISHNAN
FACULTY MEMBER,SPBT
COLLEGE

COMPONENTS OF ASSETS &

LIABILITIES IN BANKS BALANCE
SHEET AND THEIR MANAGEMENT
Banks Liabilities
-The sources of funds for the lending
and investment activities constitute
liabilities side of balance sheet.
Capital
Reserves and Surplus
Deposits
Borrowings
Other Liabilities and Provisions
Contingent Liabilities.

 Banks Assets are the funds mobilised by

bank through various sources.
-Cash and Bank balances with Reserve
Bank
Of India.
-Balances with banks and money at call
and
short notice.
-Investments
-Advances
-Fixed Assets
-Other Assets.

 Business of banking involves the

identifying,measuring,accepting and
managing the risk,the heart of bank
financial management is risk
management.One of the most
important risk-managemnet functions
in bank is Asset Liability Management.
Traditionally,administered interest
rates were used to price the assets and
liabilities of banks.However,in the
deregulated environment,competition
has narrowed the spreads of banks.

 Asset Liability Management is

concerned with strategic balance sheet
management involving risks caused by
changes in interest rates,exchange
rate,credit risk and the liquidity
position of bank.With profit becoming a
key-factor,it has now become
imperative for banks to move towards
integrated balance sheet management
where components of balance sheet
and its different maturity mix will be
looked at profit angle of the bank.

 ALM is about management of Net Interest

Margin(NIM) to ensure that its level and
riskiness are compatible with risk/return
objectives of the bank.It is more than just
managing individual assets and
liabilities.It is an integrated approach to
bank financial management requiring
simultaneous decision about types and
amount of financial assets and liabilities it
holds or its mix and volume.In addition
ALM requires an understanding of the
market area in which the bank operates.

 If 50% of the liabilities are maturing

within 1 year but only 10% of the
assets are maturing within the same
period.Though the financial institution
has enough assets,it may become
temporarily insolvent due to a severe
liquidity crisis.
Thus,ALM is required to match assets
& liabilities and minimise liquidity as
well as market risk.

 Reasons for growing significance of ALM

-Volatility
-Product Innovation
-Regulatory Framework
-Management Recognition
An effective Asset Liability Management
technique aims to manage the volume
mix,maturity,rate sensitivity,quality and
liquidity of assets and liabilities as a
whole
so as to attain a predetermined
acceptable
risk/reward ratio.

Purpose and objectives of asset liability

management
Review the interest rate structure and
compare the same to the interest/product
pricing of both assets and liabilities.
Examine the loan and investment portfolios
in the light of the foreign exchange risk and
liquidity risk that might arise.
Examine the credit risk and contingency risk
that may originate either due to rate
fluctuations or otherwise and assess the
quality of assets.

 Review,the actual performance against

the projections made and analyse the
reasons for any effect on spreads.
Aim is to stabilise the short-term
profits,long-term earnings and longterm substance of the bank.The
parameters that are selected for the
purpose of stabilising asset liability
management of banks are:
-Net Interest Income(NII)
-Net Interest Margin(NIM)
-Economic Equity Ratio

Net Interest IncomeInterest Income-Interest Expenses.

Net Interest MarginNet InterestIncome/Average Total Assets
Economic Equity RatioThe ratio of the shareholders funds to the
total
assets measures the shifts in the ratio of
owned
funds to total funds.The fact assesses the
sustenance capacity of the bank.

 ALM is required to match assets and

liabilities
to ---------liquidity risk as well as
market risk.
The ratio of shareholders funds to the
total assets is called-------.
Net Interest Margin is defined as net
interest income divided by ---------.
Liquidity is ensured by grouping the
assets/liabilities based on their ------.
The institution is in a position to
benefit from rising interest rates when
assets are ------ than liabilities

State True or False

Assets represent source of funds
whereas liabilities denote the use of
funds in a balance sheet.
Deregulated environment has
narrowed spreads of the banks.
Asset liability management is only
management of maturity mismatch
and has no bearing on profit
augmentation.
Net Interest Margin is known as
Spread

LIQUIDITY MANAGEMENT
Banks need liquidity to meet deposit
withdrawal and to fund loan demands.
The variability of loan demands and
variability of deposits determine banks
liquidity needs.It represents the ability
to accommodate decreases in liability
and to fund increases in assets.
It demonstrates the market place that
the bank is safe and therefore capable
of repaying its borrowings.

 It enables bank to meet its prior loan

commitments,whether formal or
informal.
It enables bank to avoid the
unprofitable sale of assets.
It lowers the size of the default risk
premium the bank must pay for funds.
Types of liquidity risk:
-Funding Risk
-Time Risk
-Call Risk.

 Funding Risk:
Need to replace net outflows due to
unanticipated withdrawal/non-renewal
of deposits arises due to :
-Fraud causing substantial loss
-Systemic Risk
-Loss of confidence
-Liabilities in foreign currencies

 Time Risk:
Need to compensate for non-receipt
of expected inflow of funds,arises due
to,
-Severe deterioration in the asset
quality
-Standard assets turning into nonperforming
assets
-Temporary problems in recovery
-Time involved in managing liquidity.

 Call Risk:Crystallisation of contingent

liabilities and inability to undertake
profitable business oppurtunities
when desirable,arises due to,
-Conversion of non-fund based limit
into fund
based.
-Swaps and options.

Measuring and Managing Liquidity

Risk
Developing a structure for managing
liquidity risk.
Setting tolerance level and limit for
liquidity risk.
Measuring and managing liquidity
risk.

 Setting tolerance level for a bank:

To manage the mismatch levels so as to
avert wide liquidity gaps-The residual
maturity profile of assets and liabilities will
be such that mismatch level for time
bucket of 1-14 days and 15-28 days
remain around 20% of cash outflows in
each time bucket.

To manage liquidity and remain solvent by

maintaining short-term cumulative gap up
to one year(short term liabilities-short term
assets at 15% of total outflow of funds.

 Measuring and Managing Liquidity Risk

Stock Approach
Flow Approach
Stock Approach is based on the level of
assets and liabilities as well as off balance
sheet exposures on a particular date.The
following ratios are calculated to assess the
liquidity position of the bank:
Ratio of core deposits to total assets
Net loans to total deposits ratio
Ratio of time deposits to total deposits
Ratio of volatile liabilities to total assets

 Ratio of short term liabilities to liquid

assets
Ratio of liquid assets to total assets
Ratio of short term liabilities to total
assets
Ratio of prime assets to total assets
Ratio of market liabilities to total assets.
Flow Approach
-Measuring and managing net funding
requirements.
-Managing Market Access
-Contingency Planning

Measuring and Managing net funding

Requirements:
Flow method is the basic approach followed by
Indian Banks.It is called as gap method of
measuring and managing liquidity.It requires
the
preparation of structural liquidity gap report.In
this method net funding requirement is
calculated on the basis of residual maturiries of
assets & liabilities.These residual maturities
represent net cash flows ie.difference between
cash
outflow & cash inflow in future time buckets

 These calculations are based on the

past behaviour pattern of assets and
liabilities as well as off balance
sheetexposures.Cumulative gap is
calculated at various time buckets.In
case gap is negative bank has to
manage the shortfall.
The analysis of net funding
requirements involves the construction
of a maturity ladder and the calculation
of a cumulative net excess or deficit of
funds at selected maturity dates.

 Objective of liquidity management is

to
a)Ensure profitability
b)Ensure liquidity
c)Either of two
d)Both
Banks need liquidity to
a) Meet deposit withdrawal
b) Fund loan demands
c) Both of them
d) None of them.

 Adequacy of a banks liquidity

position depends upon:
a)Sources of funds
b)Anticipated future funding needs
c)Present and Future earnings
capacity
d)All the above

 The need to replace net outflows due

to unanticipated withdrawal of
deposits is known as ---------risk.
The need to compensate for nonreceipt of expected inflows of funds
is classified as -----risk.
Call risk arises due to crystallisation
of ------.
Maturity ladders enables the bank to
estimate the difference between----and------in predetermined periods.

 Liquidity management methodology

of evaluating whether a bank has
sufficient liquid funds based on the
behaviour of cash flows under
different what if scenarios is known
as -------.
The capability of bank to withstand a
net funding requirement in a bank
specific or general market liquidity
crisis is denoted as----

INTEREST RATE RISK

MANAGEMENT

 Interest rate risk is the volatility in net

interest income(NII) or in variations in net
interest margin(NIM).
Gap:The gap is the difference between the
amount of assets and liabilities on which
the interest rates are reset during a given
period.
Basis risk:The risk that the interest rate of
different assets and liabilities may change
in different magnitudes is called basis risk.
Embedded option:Prepayment of loans and
bonds and/or premature withdrawal of
deposits before their stated maturity
dates.

 Yield curve:It is a line on a graph plotting the

yield of all maturities of a particular
instrument.
Changes in interest rates also affect the
underlying value of the banks-------Rise in interest rates-----the market value of
that
asset and fall in interest rate ----the market
value
of assets or liabilities.
The gap is the difference between the amount
of assets and liabilities on which interest rates
are------during a given period

 Mismatch occurs when assets and

liabilities fall due for -----in different periods
The economic value of a bank can be
viewed
as the present value of the banks
expected
-------.
Estimates derived from a standard
duration generally focus on just one form
of interest rate risk exposure ie.----The adverse impact on NII due to
mismatches can be minimised by fixing
appropriate ----on interest rate sensitivity
gaps.

Management of Exchange
Rate Risk

 Foreign exchange risk-Risk arising out of

adverse exchange rate movementsduring
a period in which it has open position in
an individual foreign currency.
Transaction exposure:Change in the
foreign exchange rate between the time
the transaction is executed and the time
it is settled.
Forwards-Agreement to buy or sell forex
for a predetermined amount,at a
predetermined rate on a predetermined
date.

 Open position:The extent to which

outstanding contracts to purchase a
currency exceed liabilities plus
outstanding contractsto sell the currency
& vice versa.
Overnight position-A limit on the
maximum open position left overnight,in
all major currencies.
Day-light position-A limit on maximum
open position in all major currencies at
any point of time during day.Such limits
are generally larger than overnight
positions.

 Options:It is a contract for future delivery of

a currency in exchange for another,where
the holder of the option has the
right,without obligation to buy or sell the
currency at an agreed price,the strike price
or exercise price,on a specified future date.
Call option;The right to buy under an option
Put option:The right to sell under an option.
Futures are forward contracts with
standardized size,standardised maturity
date governed by a set of guidelines
stipulated by exchange concerned for
settlements and payments.

An appreciation in domestic currency

will---value of assets and liabilities.
In a forward contract actual cash flow
occurs on
the date of----Swaps can be of two types----and------

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