Commercial Banking

Asset Liability Management

 Pre-Financial Sector Reforms (1991)
• Geographical spread of Bank branches
• Directed Investments / Credit Programs
• Administered Rates of Interest
• Accrual based accounting
• Problems of Recovery of Loans
• Deterioration in Quality of Assets /Loans
• Erosion of Profits
• No Computerisation
• Trade Union Issues

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 Banking Reforms 1993 onwards
• L-P-G Policy of GOI since 1991
• Technological Changes – ATMs / Internet
• New Products and Services : Competition
• Narasimham Committee - I / II on Financial /
Banking Sector Reforms (1991 & 1997)
• Capital Adequacy Ratio : IRAC Norms : NPAs
• Priority Sector Loans: Reduce from 40 to 10%?
• Reduce SLR (40%) and CRR (15%)
• Benchmark Prime Lending Rates
• Enactment / Amendments to various laws

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 Banking Sector Reforms …….
• Market determined Rates of Interest
• No directed lending or investments
• Organisational Changes : Transparency
• 4 way classification of Loan Accounts / Assets
• Provisioning for Losses o/a NPAs & Std Assets
• ALM (1999) and Risk Management, KYC in Banks
• Non Performing Assets definition revised from
4 quarters (1993) dues in Principal & Interest to
3 (1994) to 2 (1995) quarters and now from April
01, 2004 – just 90 days / 1 quarter !
• Basel II norms for Bank Supervision from 2008!
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 ALM - Introduction
Banks
Economic Factors Economic Policies

Balance Sheet of a Bank

Liabilities Assets

Capital Cash and Balances at RBI

Reserves and Surplus Balance with banks and money
Deposits at call and short notice
Borrowings Investments
Other Liabilities and Provisions Advances
Contingent Liabilities Fixed Assets
Other Assets
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 Risks

• Various Risks
– Interest Rate Risk

– Foreign Exchange Risk

– Liquidity Risk

– Credit Risk

– Contingency Risk

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 Liquidity Risk Profile of a Bank
(Rs in crores)

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 International Initiatives in
Managing Risks
• Till the 1980s, a professional risk manager was
unheard of
• Late 1980s, US Financial Firms started using VaR
• Basel I ;1988
• Risk Metrics, 1995
• Bank for International Settlement (BIS) - a series of
risk management guidelines for Banks worldwide
• Market Risk Guidelines of Basel, 1996
• Basel II process ( November 2005 Document)
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 Risk Management
• How to bring it (Risks)
down to manageable
levels?
– The 5-step process
1. Identification of risks
2. Quantification
3. Policy formulation
4. Strategy formulation
5. Monitoring

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 WHAT IS ALM?
• An attempt to match:
Assets and Liabilities

• In terms of:
Maturities and Interest Rates Sensitivities

• To minimize:
Interest Rate Risk and Liquidity Risk
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 Asset Liability Management

Asset Liability
Management Management

How Liquid are the How easily can

assets of the Bank the Bank generate
loans from market

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 Asset Liability Management
• ALM is an integral part of the financial
management process of any bank.
• ALM is concerned with strategic balance sheet
management involving risks caused by changes
in the interest rates, exchange rates and the
liquidity position of the bank.
• While managing these three risks forms the crux
of ALM, credit risk and contingency risk also
form a part of the ALM

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 Asset Liability Management
• ALM can be termed as 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 and hence is also known
as Surplus Management

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 ALM and NIM
• ALM is all about efficient management of
balance sheet dynamics with regard to its size,
constituents and quality.
• It is the process of managing the Net Interest
Margin (NIM) within the overall risk bearing
ability of a bank
• ALM process depends on the understanding of
the balance sheet; the availability, accuracy,
adequacy and expediency of the data and the
MIS system

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 GAP Analysis
• One way to measure the direction and
extent of asset-liability mismatch is by
using gap analysis. The analysis derives
its name from the “gap” which is the
difference between the amounts of Rate
Sensitive Asset (RSA) and Rate Sensitive
Liabilities (RSL).

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 HISTORY OF ALM
• Mid 1970s in the U.S.A.

Deregulation of Interest Rates

Interest Rate Risk

Liquidity Risk Credit Risk

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 Definition of ALM
• ALM is defined as, “the process of decision –
making to control risks of existence, stability and
growth of a system through the dynamic
balances of its assets and liabilities.”
• The text book definition of ALM 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”.
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 SUCCESS OF ALM PROCESS
The ALM process rests on Three Pillars:

1. ALM Information Systems

2. ALM Organisation

3. ALM Process

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 1. ALM INFORMATION SYSTEM
• Decision Support and Reporting Tool
• Comparison between different Branches
• Product Analysis
• Duration Gap Analysis
• Risk Planning and Management
• Flexible Design
• Strategic Planning of the Asset-Liability Mix
• Simulation Analysis
• Transfer- Pricing Mechanism

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 2. ALM ORGANISATION
• Strong Commitment of Senior Management

• ALCO should comprise the Senior Management

( including the CEO)

• A Support Group of Operational Staff

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 Board of Directors

Management Committee

Asset Liability Committee (ALCO)

Asset Liability Management Cell

Finance Planning Department

Credit Analysis Credit Risk Management Treasury

Department Department

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Investment and Loan Departments
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 3. ALM PROCESS
• The scope of ALM function can be described as
follows:
• Liquidity Risk Management
• Management of Market Risks
• Trading Risk Management
• Funding and Capital Planning
• Profit Planning and Growth Projection
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 Price Matching
(Rs. cr.)
* Average cost/return on liabilities/assets.
Table 1 Table 1 (Rearranged)
Liabilities Assets Liabilities Assets  
Amount Amount Amount Amount Spread
Rate Rate Rate Rate
(%) (%) (%) (%) (%)
15 0 10 0 10 0 10 0 0
25 5 20 12 5 0 5 12 12
30 12 50 15 15 5 15 12 7
30 13 20 18 10 5 10 15 10
        30 12 30 15 3
        10 13 10 15 2
        20 13 20 18 5
100 8.75* 100 13.5* 100 8.75* 100 13.5* 4.75*
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 Maturity Matching
Table II
(Rs. cr.)
Table II (Rearranged)
(period in
months)

Liabili Liabil Cumulati

ties Maturing Assets ities Assets Gap ve
within Maturing Gap
(months) within
(months)
10 1 15 <1 10 15 -5 -5
5 3 10 3 5 10 -5 -10
8 6 5 6 8 5 3 -7
4 12 10 12 4 10 -6 -13
45 24 30 24 45 30 15 2
20 36 10 36 20 10 10 12
8 >36
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20 >36ALM 2008 8 20 -12 0 29
100   100   100 100    
 Risks in ALM
• Interest Rate Risk: It is the risk of having a
negative impact on a bank’s future earnings and
on the market value of its equity due to changes
in interest rates.
• Liquidity Risk: It is the risk of having insufficient
liquid assets to meet the liabilities at a given
time.
• Forex Risk: It is the risk of having losses in
foreign exchange assets and liabilities due to
exchanges in exchange rates among multi-
currencies under consideration.

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 MANAGEMENT OF
LIQUIDITY RISK
• Availability of funds as & when liabilities
are due
• Liquidity through maturity & cash flow
matching
• Maturity ladder & calculation of cumulative
surplus/deficits at selected dates

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 MANAGEMENT OF
LIQUIDITY RISK
Construction of time buckets:
1 to 30/31 days
Over 1 month and upto 2 months
Over 2 months and upto 3 months
Over 3 months and upto 6 months
Over 6 months and upto 1 year
Over 1 year and upto 3 years
Over 3 years and upto 5 years
Over 5 years
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 MANAGEMENT OF
LIQUIDITY RISK
• Main focus on Short Term mismatches
• Mismatches during 1-30 days < 20 % of cash
outflows in the same bucket
• For higher limits, special sanction from the
Board
• Statement of Structural Liquidity (maturity
ladder)
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 MANAGEMENT OF
Interest Rate Risk
• Impact on Net Interest Income (NII)
• Long term impact on market value/ net
worth
• Techniques:
1. Gap Analysis
2. Duration Gap Analysis
3. Simulation
4. Value at Risk
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 1. GAP ANALYSIS
• Calculating Gap over different time intervals
at a given date
• Mismatches between RSL and RSA
• GAP = RSA( i) - RSL( i) = NII( i) for
each time bucket
• Positive GAP ( RSA > RSL )
– Increasing Interest Rates would be
beneficial for a Bank
• Negative GAP ( RSL > RSA )
– Falling Interest Rates would be
beneficial for a Bank
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 9. 1.
Control
Strategic
Framework
8. Framework
Regulatory 2.
Organizational
Compliance
Framework
Framework
ASSET AND
7. LIABILITY 3.
Performance MANAGEMENT Operational
Measurement
Framework
Framework
4.
6. Analytical
Information Framework
Reporting 5.
Framework Technology
Framework
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 Regulatory Environment –
Risk Management Guidelines in India
• ALM Guidelines - February,1999
• Operating Guidelines on Risk Management, October 7,
1999 covering broad contours for management of credit,
liquidity, interest rate, foreign exchange and operational
risks.
• December 2000 : Capital Adequacy Guidelines for Primary
Dealers covering Credit and Market Risk
• On September 20, 2001, two Working Groups were
constituted in Reserve Bank of India drawing experts from
select banks and FIs for preparing detailed Guidance Notes
on Credit Risk and Market Risk Management by banks.

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 Risk Regulation in India
• Identified further steps to be taken by banks for
improving their existing risk management
framework, suiting to Indian conditions

• 2005 – Detailed Capital Adequacy guidelines for Banks

to move towards Basel II, 2007- final guidelines

• 2006 – April 17, the ALM framework of 1999 updated.

• 2007- Pillar II guidelines being issued

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 RBI revised guidelines 2007-08
• Issued on Sept 05, 2007
• Feb 10, 1999 guidelines covered Interest
Rate and Liquidity Risk Management
• Cumulative mis-matches in first bucket to be
reported in Statement of Structural Liquidity
• -ve Gap in 1-14 and 15-28 days buckets not
to exceed 20 % of the cash flows
• Need for revising this position – Hence
revised the first bucket to 1, 2-7 & 8-14 days
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 RBI Revised ALM
• Cumulative negative mismatches / Gap in new
buckets – Next day, 2-7, 8-14 and 15-28 days not
to exceed 5, 10, 15 and 20 % respectively of
cash flow
• Format of Statement of Structural Liquidity has
been revised accordingly
• Guidance instructions have been furnished
• Banks given time to fine-tune MIS by 1 Jan’08
• Reporting frequency to continue as monthly
• Supervision will be fortnightly – April 01,2008
• Financing of gaps above norms to be indicated

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