Asset Liability Management in

Banks
Components of a Bank Balance Sheet

Liabilities Assets
1. Capital 1. Cash & Balances with RBI
2. Reserve & Surplus 2. Bal. With Banks & Money
3. Deposits at Call and Short Notices
4. Borrowings 3. Investments
5. Other Liabilities 4. Advances
5. Fixed Assets
6. Other Assets
Banks profit and loss account

A bank’s profit & Loss Account has the following

components:

I. Income: This includes Interest Income and Other

Income.
II. Expenses: This includes Interest Expended,
Operating Expenses and Provisions &
contingencies.
Evolution
 In the 1940s and the 1950s, there was an abundance of funds in banks in
the form of demand and savings deposits. Hence, the focus then was mainly
on asset management

 But as the availability of low cost funds started to decline, liability

management became the focus of bank management efforts

 In the 1980s, volatility of interest rates in USA and Europe caused the focus
to broaden to include the issue of interest rate risk. ALM began to extend
beyond the bank treasury to cover the loan and deposit functions

 Banks started to concentrate more on the management of both sides of

the balance sheet
What is Asset Liability Management??

 The process by which an institution manages its balance sheet

in order to allow for alternative interest rate and liquidity
scenarios

 Banks and other financial institutions provide services which

expose them to various kinds of risks like credit risk, interest
risk, and liquidity risk

 Asset-liability management models enable institutions to

measure and monitor risk, and provide suitable strategies for
their management.
 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

 It is aimed to stabilize short-term profits, long-term earnings and long-term

substance of the bank. The parameters for stabilizing ALM system are:
1. Net Interest Income (NII)
2. Net Interest Margin (NIM)
3. Economic Equity Ratio
3 tools used by banks for ALM

ALM information systems

ALM Organization

ALM Process
ALM Information Systems
 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

accessing data.
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

Risk Policies and Tolerance Level

 Categories of Risk
 Risk is the chance or probability of loss or damage

Credit Risk Market Risk Operational Risk

Transaction Risk /default Commodity risk Process risk

risk /counterparty risk
Portfolio risk Interest Rate risk Infrastructure risk
/Concentration risk
Settlement risk Forex rate risk Model risk

Equity price risk Human risk

Liquidity risk
But under ALM risks that are typically
managed are….

Liquidity Risk
Currency Risk

Interest
Rate Risk

Will now be discussed in detail

Liquidity Risk
 Liquidity risk arises from funding of long term assets by short term
liabilities, thus making the liabilities subject to refinancing

Funding • Arises due to unanticipated withdrawals of

risk the deposits from wholesale or retail clients

• It arises when an asset turns into a NPA. So,

Time risk the expected cash flows are no longer
available to the bank.

• Due to crystallisation of contingent liabilities

Call Risk and unable to undertake profitable business
opportunities when available.
Liquidity Risk Management
 Bank’s liquidity management is the process of generating funds to
meet contractual or relationship obligations at reasonable prices at
all times

 Liquidity Management is the ability of bank to ensure that its

liabilities are met as they become due

 Liquidity positions of bank should be measured on an ongoing basis

 A standard tool for measuring and managing net funding

requirements, is the use of maturity ladder and calculation of
cumulative surplus or deficit of funds as selected maturity dates is
adopted
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
 Statement of structural liquidity
 Places all cash inflows and outflows in the maturity ladder as per
residual maturity

 Maturing Liability: cash outflow

 Maturing Assets : Cash Inflow

 Classified in to 8 time buckets

 Mismatches in the first two buckets not to exceed 20% of outflows

 Shows the structure as of a particular date

 Banks can fix higher tolerance level for other maturity buckets.
 An Example of Structural Liquidity Statement
15-28 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5
1-14Days Days 3 Month 6 Mths 1Year Years 5 Years Years Total

Capital 200 200

Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total Outflow
-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
 Addressing the mismatches

 Mismatches can be positive or negative

 Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.

 In case of +ve mismatch, excess liquidity can be deployed in money

market instruments, creating new assets & investment swaps etc.

 For –ve mismatch, it can be financed from market borrowings

(Call/Term), Bills rediscounting, Repos & deployment of foreign currency
converted into rupee.
Currency Risk
 The increased capital flows from different nations following deregulation
have contributed to increase in the volume of transactions

 Dealing in different currencies brings opportunities as well as risk

 To prevent this banks have been setting up overnight limits and

undertaking active day time trading

 Value at Risk approach to be used to measure the risk associated with

forward exposures. Value at Risk estimates probability of portfolio losses
based on the statistical analysis of historical price trends and volatilities.
 Interest Rate Risk

 Interest Rate risk is the exposure of a bank’s financial conditions to

adverse movements of interest rates

 Though this is normal part of banking business, excessive interest

rate risk can pose a significant threat to a bank’s earnings and
capital base

 Changes in interest rates also affect the underlying value of the

bank’s assets, liabilities and off-balance-sheet item

 Interest rate risk refers to volatility in Net Interest Income (NII) or

variations in Net Interest Margin(NIM)

 NIM = (Interest income – Interest expense) / Earning assets

Sources of Interest Rate Risk

Basis

Interest
Options Rate Re-pricing

Risk

Yield
 Re-pricing Risk: The assets and liabilities could re-price at different dates
and might be of different time period. For example, a loan on the asset side
could re-price at three-monthly intervals whereas the deposit could be at a
fixed interest rate or a variable rate, but re-pricing half-yearly

 Basis Risk: The assets could be based on LIBOR rates whereas the
liabilities could be based on Treasury rates or a Swap market rate

 Yield Curve Risk: The changes are not always parallel but it could be a
twist around a particular tenor and thereby affecting different maturities
differently

 Option Risk: Exercise of options impacts the financial institutions by giving

rise to premature release of funds that have to be deployed in unfavourable
market conditions and loss of profit on account of foreclosure of loans
that earned a good spread.
Risk Measurement Techniques
Various techniques for measuring exposure of banks to
interest rate risks

 Maturity Gap Analysis

 Duration
 Simulation
 Value at Risk
Maturity gap method (IRS)
THREE OPTIONS:
 A) Rate Sensitive Assets>Rate Sensitive Liabilities=
Positive Gap
 B) Rate Sensitive Assets<Rate Sensitive Liabilities =
Negative Gap
 C) Rate Sensitive Assets=Rate Sensitive Liabilities =
Zero Gap
 Gap Analysis
 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 hence
ignores their market value.
 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

 As per the above equation, the bank will be immunized from

interest rate risk if the duration gap between assets and the
liabilities is zero.
Simulation
 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 method and

improves the quality of information available to the
management
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
Thank You!!!