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ASSET LIABILITY MANAGEMENT Areas covered for Banking Entities
Interest rate risk Foreign exchange rate risk Liquidity risk Linkages between credit risk and market risks ALM organization (e.g., ALCO, i.e., Asset Liability Management Committee) Tools and systems for ALM
Banking Sector in India: Asset Management to Liability Management
In the 1940s and the 1950s, there was an abundance of funds in banks in the form of demand and savings deposits. Because of the low cost of deposits, banks had to develop mechanisms by which they could make efficient use of these funds. 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.
Source: R. Vaidyanathan, “Asset-liability management: Issues and trends in Indian context”, ASCI (Administrative Staff College of India) JOURNAL OF MANAGEMENT 29(1). 39-48 (1999). (Available on: http://www.iimb.ernet.in/~vaidya/Asset-liability.pdf
ernet. (Available on: http://www. 39-48 (1999). Source: R.Banking Sector in India: Asset Management to Liability Management and shift towards ALM Approach Liability management essentially refers to the practice of buying money through cumulative deposits. “Asset-liability management: Issues and trends in Indian context”.in/~vaidya/Asset-liability. ASCI (Administrative Staff College of India) JOURNAL OF MANAGEMENT 29(1).iimb.pdf . banks started to concentrate more on the management of both sides of the balance sheet. federal funds and commercial paper in order to fund profitable loan opportunities. But with an increase in volatility in interest rates and with a severe recession damaging several economies. Vaidyanathan.
the FW. 10. 2006 . As a measure to raise long-term capital funds. 21. IDFC Chairman Deepak Parekh to head the Committee and submission of a quick report within six weeks in a run-up to the budget. India Infrastructure Finance Company Ltd.000 crore.Asset/Liability Management 11th Plan Approach Paper: The target of finding and investing $320 billion in Infrastructure development in the next five years. Long-pending proposal of the Planning Commission to use the country’s booming forex reserves for infrastructure. Source: “Parekh to Head Panel on Infrastructure Funding”. FM Chidambaram to push pension and insurance reforms. Dec. (IIFCL) to tap the debt market to raise funds to the tune of Rs.
A principal source of earnings for depository institutions and NBFCs: The difference between interest received and interest paid.Asset/Liability Management Applicability to depository institutions (commercial banks. savings and loan associations. Maxim: Never borrow short to lend long! . pension funds. mutual savings banks. and credit unions). mortgage banks. and the source of the risk is primarily the volatility of these same interest rates. non-bank financial corporations (insurance companies. finance companies. Depository institutions and NBFCs primarily concerned with the return on their portfolios and the risk associated with holding these portfolios. brokerage firms. and investment banks) and MNCs.
(Even otherwise some residual translation exposure associated with financial statement consolidation) ALM as a treasury function of a commercial bank – Asset allocation issues – ALM and hedging as closely related activities (complementary to one another) – ALM techniques include techniques for managing interest-rate risk and exchange-rate risk.Asset/Liability Management For MNCs: The additional problem of exchangerate risk from holding assets denominated in one currency that are funded by liabilities denominated in another currency. .
primarily. and equity. long-term debt. . (So little art or science involved in liability management and the principal focus was on asset management). And the outcome: An Institution’s short-term funding mix was determined. by decisions made by the institution’s depositors. (Little control over deposits) Institutions could not attract depositors from outside their immediate geographic region by offering higher rates.Asset/Liability Management The Evolution of Asset/Liability Management Early 1960s: Depository institutions derived the bulk of their funding from customer deposits. The terms on the deposit accounts (demand and/or time deposits) were fixed.
(Citibank experiment with 14 days negotiable certificate of deposit) CD as a tool to manipulate the mix of liabilities that supported asset portfolios (stage was set for active management of asset and liability portfolios as against management of the asset portfolio alone) . Highly regulated deposit taking industries – limited competition – stable interest rates Early 1960s USA: Demand for funds by corporate customers outstripped banks’ traditional funding sources. Alternatives: A portion to be set aside as non interest earning reserves (deposits with Central Banker) or invest in loan/securities portfolio.Asset/Liability Management Role of the treasury department: Use the funds provided by depositors to structure an asset portfolio that was appropriate for the given liability portfolio.
to gap management (The term. between Oct. 139 times in 1970s. PLR changed – 16 times in 1950s and the 1960s. “Spread” in banking) Aggressiveness and complexity in ALM: Contributory factors such as Volatile interest rates.Asset/Liability Management The first Asset/Liability strategy…….management of interest margin (interest received on earning assets and the interest paid on liabilities) Interest margin management led to the concept of the gap and subsequently. the introduction of money market mutual funds (MMMFs). the development of overseas markets as both funding and lending sources. In US alone. Rung the death knell for the old way of doing the business. 1980. . 1979 and Dec. about 50 times. deregulation of financial services.
Disintermediation – The process by which the traditional customers of depository institutions. MMMF (first in US in 1973) as the main driving force behind the disintermediation process – investment pattern of MMMFs – Cheque writing facility as another innovation – Shift of funds from banks and thrifts to MMMFs. pull their funds out in order to earn higher returns elsewhere.Asset/Liability Management Traditional source of low-cost financing – the demand and time deposits – dried up as savers gradually turned to more lucrative. equally liquid. . unregulated alternatives. small savers.
A banker: We would prefer to have bulk deposits for at least one year as it allows for deployment of funds in longer dated assets. .65 per cent for almost five weeks in a row. (NIM in excess of three per cent) Large PSBs and private sector banks tweaked their deposit rates for raising medium term funds instead of short-term funds. Hence effective returns from such investments were negative. Many banks contained acceptance of bulk deposits. to avert possible liquidity mismatches. Yields on T-bills ranged 6.Asset/Liability Management December 16. Bulk deposits cost 8 per cent – No longer seen as profitable in view of the short tenure – Mostly deployed in 91-day T-Bills. 2006 (Business Line) Improved net interest margins (NIM) despite the hike in the CRR.
The industry average yield on assets was upwards of 8.5 per cent. 2006 . Increased costs largely neutralized by increased yields on credit that moved up to over 11 per cent from about 10 per cent in Q2. Dec. Source: “Banks’ profits for Q3 may remain buoyant”.Asset/Liability Management At least. neutralizing the increased cost of liabilities. 16. Weighted average cost of funds remained under control and allowed for parking in long-term assets. including credit. BL. 50 per cent of the banks deposits’ mix came from savings accounts.
Source: “More leeway for banks in capital market exposure”. convertible bonds. BL. bridge loans against expected equity flows or issues and all exposure to Venture Capital funds. loans to corporates against bonds/debentures. bonds. . advances against shares. 2006. convertible debentures. 17. secured and unsecured advances to stock brokers and guarantees issued on behalf of stockbrokers. Dec.Asset/Liability Management RBI notification on Dec. including IPOs or ESOPs or for other purposes. 14: More leeway for banks in capital market exposure and guidelines to come into effect from April 1 Aggregate capital market exposure to 40 per cent of its net worth on a solo and consolidated basis and the direct capital market exposure to 20 per cent of its consolidated net worth. debentures or other securities to individuals for investment in shares. Aggregate exposure would include direct investment in equity shares. units of equity-oriented mutual funds.
Asset/Liability Management Foundation concepts (Applicable to all asset/liability management strategies) (a) (b) (c) (d) (e) Liquidity Term Structure Interest Rate Sensitivity Maturity Composition Default Risk .
now CBoP and ICICI) Cash required to meet any such liquidity demands.Foundation Concept: LIQUIDITY Liquidity Ease in Conversion: The ease with which assets can be converted into cash.g. overnight repos and multi-year commercial loans as highly illiquid assets) and the second dimension is marketability (An asset is liquid if it can be easily sold in the secondary market without a major price concession – Treasury Security vs. e. . Two dimensions of liquidity: The first one is maturity liquidity (maturity within a very short period of time. (Sudden withdrawal by depositors – News item regarding BoP. Junk Bond) Trade-off between liquidity and profitability..
.Foundation Concept: TERM STRUCTURE Term Structure Relationship between debt instrument yields and their maturities (depiction by the yield curve). Draw Relationship for securities having a similar credit rating. Expectations of the asset/liability manager about the future shape of the curve and its’ role in his/her strategy. The shape of the yield curve.
Often the one-year spot rate is less than the two-year spot rate. Flat. would enable the investor to obtain all the payments promised by the security in question. Downward Sloping Yield curve provides an estimate of the current term structure of interest rates. which in turn is less than the three-year spot rate and so on. and will change daily as yields-to-maturity change. . Yield Curve: A graph that shows the yields-to-maturity (on the vertical axis) for Treasury securities of various maturities (on the horizontal axis) as of a particular date. Typical Yield Curve Shapes: Upward Sloping.Foundation Concept: TERM STRUCTURE The Yield-to-maturity: On any fixed-income security is the single interest rate (with interest compounded at some specified interval) that. if paid by a bank on the amount invested.
Foundation Concept: TERM STRUCTURE (a) (b) (c) (d) Term Structure Theories The Unbiased Expectations Theory The Liquidity Preference Theory The Market Segmentation Theory The Preferred Habitat Theory Source: “Fundamentals of Investments” by Alexander. 2003 . Sharpe and Bailey.
10 x 1.10 x 1. What if the expected future spot rate is 6% instead of 10% and an option to invest for one year and two years? Two strategies: Maturity strategy vs. Roll over strategy (1 x 1. Naive Strategy: Two-year security could be purchased now and sold after one year. An investor does not know what the one-year spot rate will be one year from now.Foundation Concept: TERM STRUCTURE (a) The Unbiased Expectations Theory (or Pure Expectations Theory) The forward rate represents the average opinion regarding the level of the expected future spot rate for the period in question. the investor has an expectation about what it will be. (1 x 1.10) vs.06). .
Flat Yield curve to mean that the marketplace expected interest rates to remain at the same level.Foundation Concept: TERM STRUCTURE (b) The Liquidity Preference Theory The notion that investors are primarily interested in purchasing short-term securities. Investors will agree to follow a maturity strategy only if the expected return from doing so is higher than the expected return from following the rollover strategy. The difference between the forward rate and the expected future spot rate is known as the liquidity premium. Investors realize that they may need their funds sooner than anticipated and recognize that they face less “price risk” (interest rate risk) if they invest in shorter term securities. . Downward-sloping yield curve will be observed only when the marketplace believes that interest rates are going to decline substantially.
spot rates are determined by supply and demand conditions in each market. (Investment in China by residents and foreigners – H-Shares vs. or custom in certain maturities. A-shares) There is a market for short-term securities. preference. Investors and borrowers will not leave their market and enter a different one even when the current rates suggest to them that there is a substantially higher expected return available if they make such a move. Various investors and borrowers are thought to be restricted by law.Foundation Concept: TERM STRUCTURE © The Market Segmentation Theory A third explanation for the determination of the term structure rests on the assumption that there is market segmentation. As per the theory. another for intermediate-term securities. . and a third for long-term securities.
.Foundation Concept: TERM STRUCTURE An upward-sloping term structure exists when the intersection of the supply and demand curves for shorter term funds is at a lower interest rate than the intersection for longer tem funds Reason: Either a relatively greater demand for longer term funds by borrowers or a relatively greater supply of shorter term funds by investors. or some combination of the two) A downward-sloping term structure would exist when the intersection for shorter term funds was at a higher interest rate than the intersection for longer term funds.
Investors and borrowers have segments of the market in which they prefer to operate. However. similar to the market segmentation theory. they are willing to leave their desired maturity segments if there are significant differences in yields between the various segments.Foundation Concept: TERM STRUCTURE (d) The Preferred Habitat Theory A more moderate and realistic version of the market segmentation theory is the preferred habitat theory. Risk premium does not necessarily rise directly with maturity and is a function of the extra yield required to induce borrowers and investors to shift out of their preferred habitat. Yield differences are determined by the supply and demand for funds within the segments The term structure reflects both expectations of future spot rates and a risk premium. .
(Being Interest rate sensitive instruments and if market rates rise then the return on int. To focus on the variable or floating-rate assets and liabilities. . The degree to which an instrument’s interest rate adjusts and the speed of this adjustment.Foundation Concept: Interest Rate Sensitivity Interest Rate Sensitivity The degree to which an instrument’s price will change when the instrument’s yield (a reflection of the current market rate) changes. rate sensitive assets and the cost of the interest-sensitive liabilities will also rise).
re-present non-sensitive liabilities e.Gap or Mismatch Risk A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts. Reserves. maturity dates or repricing dates.1900 1000 0 2500 2500 5500 600 (Note: the difference of Rs 600 cr between assets and liabilities. Current deposits etc). thereby creating exposure to unexpected changes in the level of market interest rates. Capital. .g. 0-6 Assets 100 6M-1Y 1000 >1Y 5000 Total 6100 Liabilities 2000 Gap .
Gap or Mismatch Risk: Implications As the bank has negative mismatch in the first year (i. Relationship between a bank’s net interest income. its net interest margin or earnings will decline in a rising rate scenario.e. The reverse will happen in a falling interest rate scenario. its maturing liabilities are more than assets). gap and direction of interest rate movements Direction of Interest Rates Position of Gaps Impact on Net Interest Income (NII) Increasing Decreasing Increasing Decreasing Positive Positive Negative Negative Positive Negative Negative Positive .
Foundation Concept: Maturity Composition Maturity Composition The maturities of assets and liabilities can be matched or unmatched. If the maturity and the interest-rate sensitivity of an asset and a liability are matched. Maturity composition and term structure interact to determine interest-rate sensitivity. then the institution has a spread lock on that portion of the principals that are also matched. .
. the bank would lose money.Foundation Concept: Maturity Composition and Asset-Liability Mismatch An asset-liability mismatch occurs when the financial terms of the assets and liabilities do not correspond. such movements in the value of the assets and liabilities could lead to bankruptcy or liquidity problems. Example: A bank that chose to borrow entirely in U. dollars and lend in Indian Rupee would have a significant mismatch if the value of the Indian Rupee were to fall dramatically (depreciation as well as devaluation).S. In extreme cases.
longermaturity. payrolls for commercial accounts. the institution could reduce its holding of lowreturn cash equivalents in favour of higher-return. less liquid assets). (so as to liquidate assets to meet the liquidity needs) – Holding of cash equivalent assets. harvest cycle for agriculturalists) Depositor behaviors of such types had to be planned for through asset management. CDs allowed FIs a tool by which to manage their liquidity on the liability side.Asset/Liability Management The Changing Face of Liquidity Management Unpredictable element in deposits and withdrawals: Depositors could withdraw funds on relatively short notice in case of depository institutions (Festival season for individuals. . (By managing liquidity on the liability side of the B/S.
CD Approach to manage depository institution liquidity replicated on the corporate side with the introduction of commercial paper.Asset/Liability Management Decline in holding of cash and cash equivalents Holding composition of banks and NBFCs Ability to manage liquidity on the liability side of the balance sheet: Enhanced by repo/reverse repo market. .
. Overnight borrowings to total assets etc. Further. Inter bank borrowings to total assets. may be valid good for a point of time only as balance sheet profile constantly changes. as it does not factor market liquidity aspect of assets and liabilities. However. presence of some short-term investments may show the improved liquidity risk of the bank whereas the investment itself may be highly illiquid.Liquidity Risk Management (a) (b) Approaches to Measure Liquidity risk Stock Approach Flow Approach Stock Approach Certain standard ratios are computed. Some of the ratios widely used in banks are Liquid assets to short-term liabilities. For example. management of liquidity through ratios suffers from some drawbacks. Core assets to core liabilities. though good indicator of liquidity. the ratio.
.Liquidity Risk Management Flow Approach The alternative model for measuring and managing liquidity has been accepted by most of the banks. cash flows are segregated into different maturity ladders and net funding requirement for a given time horizon is estimated. The net funding requirement over a given time horizon gives a fair idea of liquidity risk faced by an institution. Under flow approach.
Pramod. “ALM in Indian Banks”.ac. and Arvind Shahi. www.in/archives/events/spandan/Spandan (Nov 20.iimk. The mismatches as percentage to outflows should not exceed negative 20% in the time buckets of 1-14 days and 15-28 days. PERFORMA LIQUIDITY RISK PROFILE OF A BANK Source: Vaidya. 2005) . There are limits for liquidity mismatches in the first two buckets prescribed by RBI.Flow Approach: RBI has prescribed some statutory returns for submission of data on liquidity risk and interest rate risk by banks.
Asset/Liability Management Spread-lock Strategy Lock-in spread by matching both the type and the maturity of its assets and liabilities. All fixed-rate assets would be funded by fixed-rate liabilities and all floating-rate assets would be funded by floating-rate liabilities. but this exposes the institution to greater default risk. Pros and Cons: Relatively safe strategy. . barring loan and securities defaults – Not necessarily produce spreads sufficient to cover the institution’s overhead expenses. The spread can be increased by holding higher-risk assets.
To increase the gap when interest rates are expected to rise and to decrease the gap (negative gaps included) when interest rates are expected to fall. (The reverse argument applies when rates fall) . An increase in the gap will increase the spread when rates rise since the return on the variable-rate assets will rise but the cost of the fixed-rate liabilities used to fund the assets will not rise.Asset/Liability Management Gap Management as aggressive strategy The institution varies the gap in response to its expectations about the future course of interest rates and the shape of the yield curve.
Spread: Expectation of rising rate market Upper Limit to spread from Unexpected but favourable Interest rate movements Spread Expected Spread Lower Limit to spread From unexpected unfavourable Interest rate movements Gap .Gap vs.
NHB on ALM for Housing Finance Companies ALM Information System TRIAD OF ALM PROCESS ALM Organization ALM Process .
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