Asset Liability Management in

Banks
Components of a Bank Balance Sheet

Liabilities Assets
1. Capital 1. Cash & Balances with
2. Reserve & Surplus RBI
3. Deposits 2. Bal. With Banks &
4. Borrowings Money at Call
and Short
5. Other Liabilities Notices
3. Investments
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
 Riskis the chance or probability of loss or
damage
Credit Risk Market Risk Operational Risk

Transaction Risk Commodity risk Process risk

/default 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
Currency Risk
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.

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

• Due to crystallisation of contingent

liabilities and unable to undertake
Call Risk 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
-50 - 50 -50 300 0
Cumulative Gap 100 150
-100 -200 -100 -150 -300 -250 -300 0
0
Gap % to Total O -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
market instruments, creating new assets & investment swaps
money
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
Liabilities
Sensitive = 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