Chapter -7

Assets and Liabilities management

Contents:-
Meaning and concept of assets liabilities management,
maturity mismatch, interest sensitive assets and liability,
interest rate risk, determination of interest rate, interest
spread, Gap analysis, Assets liability management
committee(ALCO),roles and responsibility of ALCO
 Meaning and Concept of Asset Liability Management

• Assets liabilities management is the process of making such decision

about the composition of assets and liabilities and the risk assessment
• The decisions are usually made by asset liability committee(ALCO) that
is responsible for the overall financial direction of the bank
• Asset management refers to a banking strategy where management has
control over the allocation of bank assets .liability management is a
strategy of control over bank liabilities by varying interest rates offered
on borrowed funds
• Funds management combines both assets and liability management
approaches into a balanced liquidity management strategy.
• It is a risk management technique designed to earn an adequate return
while maintaining a comfortable surplus of assets beyond liabilities
• It takes into consideration interest rates, earning power and degree of
willingness to take on debt
• It is also called surplus management.
Defensive Management
•Defensive strategy attempts to prevent interest rate movement
from reducing the profitability of the financial institution, and also
attempts to reduce the volatility of the net interest income.
•A defensive strategy attempts to keep the rupee amount of rate
sensitive assets in balance with the amount of the rate sensitive
liabilities over a given period, so the rupee gap will be near zero. If
the increase in the interest rate will produce equal increase in the
interest revenue and interest expense, that lead the net interest
income and the interest margin will not change. But falling in the
interest revenue and interest expense by the same amount and
leave net interest income and net margin unchanged if the amounts
of the rate sensitive assets and liabilities are balanced.
•The focus of the defensive strategy is to insulate (protect) the
portfolio from interest rate change
 Aggressive Management
• The management of a bank may choose to focus on the
rupee gap in controlling the interest rate risk of its
portfolio.
• An aggressive interest rate risk management program,
such a strategy would involve two steps: first, the direction
of future interest rate must be predicted. Second,
adjustments must be made in the interest sensitive of the
asset and he liability in order to take the advantage of the
projected interest rate changes. Rising interest rates: if
interest rates were expected to increase, a financial
institution with a positive gap would increase interest
return more than the liabilities would increase their costs.
 Maturity Mismatch
• In banking institutions, asset and liability management is the practice of managing
various risks that arise due to mismatches between the assets and liabilities (loans
and advances) of the bank.
•Banks face several risks such as the risks associated with assets, interest, currency
exchange risks. Asset Liability management (ALM) is at tool to manage interest rate
risk and liquidity risk faced by various banks, other financial services companies.
•Banks manage the risks of ALM mismatch by matching various assets and liabilities
according to the maturity pattern or the matching the duration, by hedging and by
securities.
•Increasing integrated risks is done on a full mark to market basis rather than the
accounting basis that was at the heart of the first interest rate sensitivity gap and
duration calculations.
•It is an attempt to match: Assets and Liabilities In terms of: Maturities and Interest
Rates Sensitivities. To minimize: Interest Rate Risk and Liquidity Risk.
 Interest Sensitive Assets and liability
•The main purpose of asset /liability management is to control the net
interest income. This control can be achieved through defensive or
aggressive asset/liability management.
•The goal of defensive asset/liability management is to prevent the net
interest income from decreasing or increasing the net interest income. On
the other hand, aggressive asset/liability management focuses on
increasing the net interest income through altering the portfolio of the
institution.
• The success of aggressive asset/liability management depends on the
ability to forecast future interest rate changes.
•A bank may be asset or liability sensitive at a given period of time. If
the bank were asset sensitive, it would have a positive gap, a positive
relative gap ratio and interest sensitive ratio greater than one.
Conversely, a bank that was liability sensitive would have a negative
gap, a negative relative gap ratio, and an interest sensitivity ratio less
than one.
 Determination of interest Rate
Interest rates are the price of credit demanded by lenders as compensation for the use of borrowed
funds. In simplest terms the interest rate is a ratio of the fees we must pay to obtain credit divided by
the amount of credit obtained.
•INTEREST SPREAD
The spread is the difference between the average rates on interest earning assets minus the average
rate paid on interest paying liabilities. The spread also measure the profitability and it is calculated as
follows:
•GAP ANALYSIS
A very popular hedging strategy among the banks and financial institutions is known as GAP
management or interest sensitivity analysis (ISA) or funding gap. Funding GAP is the duration based
technique for managing interest rate risk. Banking institutions can also immunize other financial
variables by using funding GAP or simply GAP analysis. With the GAP technique, the objective is to
immunize the institution’s net interest income or net interest margin. The basic strategy is to set
•Interest sensitive assets holdings = Interest sensitive liabilities
•A bank holding deposits whose interest rates rise along with increases in market rates could hold an
equal volume of floating rate loans. When the bank’s deposit interest costs increase in a rising rate
period, interest revenues from floating rate loans will increase by a similar amount, protecting the
bank’s net interest margin (or gap) between the revenues and expenses.
•GAP = Variable rate asset1 (VRA) – Variable rate liabilities2 (VRL)
Assets and liability management Committee(ALCO)

• An assets- liability committee(ALCO) also known as

surplus management is a supervisory group a company
employs for coordinating the management of assets and
liability with a goal of earning and adequate returns.
• An ALCO at a board or management level provides
important management information systems(MIS) and
oversight for effectively evaluating on and off-balance –
sheet risk for an institution.
• ALCO is a senior management level committee
responsible for supervision/management of market risk
• ALCO meeting should be conducted at least quarterly
 Roles and Responsibilities of ALCO
• Monitoring the structure/composition of bank’s assets and liabilities
• Identifying balance sheet management issues like balance sheet
gaps, interest rate gap
•Developing maturity profile and mix of incremental assets and
liabilities
• Determining interest rates the bank and deciding on the future
business strategy
• Deciding the transfer pricing policy of the bank
•Evaluating market risk involved in launching of new products
•Reviewing deposit pricing strategy for the local market
•Receiving and reviewing reports on liquidity risk, market risk and
capital management
•Reviewing liquidity contingency plan for the bank