Banking

Module 3
Asset Liability Management
• Asset Liability can be defined as a mechanism to address the risk faced by a bank
due to mismatch between assets and liabilities either due to liquidity or change in
interest rates.
• ALM policy framework focuses on bank profitability and long term viability.
• Maturity matching of assets and liabilities across various time horizons.
• ALM aims to manage the volume, mix, maturity, rate sensitivity, quality and
liquidity of assets and liabilities as a whole so as to attain predetermined
acceptable risk/reward ratio.
• It is aimed to stabilize short-term profits, long-term earnings and long-term
substance of the bank
Asset Liability Management
• The parameters for stabilizing ALM system are:
• Net Interest Income (NII)
• Net Interest Margin (NIM)
• Economic Equity Ratio
Asset Liability Management - Need
• Globalization of financial markets
• Deregulation of interest rates
• Diversification of ALM products’
• Healthy competition in banking sector
• Multi-currency Balance Sheet
• Integration of markets
• Narrowing of NIM/NII
Asset Liability Management – Objective
• Liquidity Risk Management.
• Interest Rate Risk Management.
• Currency Risks Management.
• Profit Planning and Growth - Projection.
Asset Liability Management – Tools
Asset Liability Management – Information
System
• 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 :
• Analyzing the Behaviour of asset and liability products
• Making rational assumptions
• The data and assumptions can then be refined
Asset Liability Management – Organisation
• 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
• The role of ALCO includes product pricing for both deposits and advances,
desired maturity profile of the incremental assets and liabilities,
• It should review the results of and progress in implementation of the decisions
made in the previous meetings
Asset Liability Management – Process
Asset Liability Management – Risk Types
Asset Liability Management – Risk Types
• Risk that are managed
Asset Liability Management – Risk Types
• Liquidity Risk - The risk that the institution might not be able to generate
sufficient cash flow to meet its financial obligations
Effects of Liquidity Crunch
• Risk to bank’s earnings
• Reputational risk
• Contagion effect
• Liquidity crisis can lead to runs on institutions
Asset Liability Management
RBI Guidelines on Structural Liquidity Statement
• Main focus should be on the short-term mismatches viz., 1day,2-7 days,7-14 days
and 15-28 days.
• Maturing Liability: Cash Outflow
• Maturing Assets : Cash Inflow
• The negative gap during 1day,2-7 days,7-14 days and 15-28 days time-buckets
should not exceed 5%,10%,15% and 20 %
• The SSL may be reported to RBI, once a month, as on the third Wednesday of
every month.
Asset Liability Management
Liability mismatch
• Outflows are more than inflows.
• Managing the situation is based on time availability. Short term borrowing
• Availing finances and discounting facilities from other banks, RBI etc.
• Sell securities, shares etc
Asset mismatch
• It occurs when inflows are more than outflows.
• The excess money should be deployed in profit generating avenues like:
• Government bonds and securities
• Shares of good companies
• Any other legal investments
Asset Liability Management
Analysis of liquidity risk position
• Gap =Inflow-Outflow Value of Gap
• Mismatch = (Negative gap/Outflow)x100
Decision Rule
• Mismatch in the time buckets 1day,2-7ddays,8- 14days greater than 5%,10% and
20% implies liquidity risk is higher
• Mismatch in any time buckets is greater than bank’s internal tolerance limit in the
corresponding time buckets implies existence of liquidity risk in those time
buckets.
Asset Liability Management - Interest Rate
Risk (IRR)
• The risk where changes in market interest rates might adversely affect a bank's
financial condition.
• Excessive interest rate risk can pose a significant threat to a bank’s earnings and
capital base
• 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
Asset Liability Management - Interest Rate
Risk (IRR)
Interest rate risk Analysis
• Traditional Gap analysis is considered to be a suitable method to measure the
Interest Rate Risk.
• Gap analysis measures mismatches between rate sensitive liabilities and rate
sensitive assets (including off-balance sheet positions).
• An asset or liability is normally classified as rate sensitive if:
• within the time interval under consideration, there is a cash flow;
• the interest rate resets/reprices contractually during the interval;
• it is contractually pre-payable or withdrawable before the stated maturities;
• It is dependent on the changes in the Bank Rate by RBI
Asset Liability Management - Interest Rate
Risk (IRR)
• Impact on Net Interest Income (NII)
Asset Liability Management - Suggestions
If assets are more,
• Repay high cost call money and creditors
• Government bonds and securities
• Shares of good companies
• Any other legal investments
If liabilities are more,
• Short term borrowing
• Diminish excess cash balance at the branches
• Availing finances and discounting facilities from other banks, RBI etc.
• Sell securities, shares etc
Liquidity Management
• Liquidity is a bank’s capacity to fund increase in assets and meet both expected
and unexpected cash and collateral obligations at reasonable cost and without
incurring unacceptable losses.
• Liquidity risk is the inability of a bank to meet such obligations as they become
due, without adversely affecting the bank’s financial condition.
• Effective liquidity risk management helps ensure a bank’s ability to meet its
obligations as they fall due and reduces the probability of an adverse situation
developing.
• This assumes significance on account of the fact that liquidity crisis, even at a
single institution, can have systemic implications..
Liquidity Management
• Liquidity problems arise on account of the mismatches in the timing of inflows
and outflows.
• Per se, the liabilities being the sources of funds are inflows while the assets being
application of funds are outflows.
• However, in the context of Liquidity Risk Management, we need to look at this
issue from the point of maturing liabilities and maturing assets; a maturing
liability is an outflow while a maturing asset is an inflow.
Liquidity Management
• A bank is said to be solvent if it's net worth is not negative.
• To put it differently, a bank is solvent if the total realizable value of its assets is
more than its outside liabilities (i.e. other than it's equity/owned funds).
• As such, at any point in time, a bank could be
I. Both solvent and liquid
II. Liquid but not solvent
III. Solvent but not liquid
IV. Neither solvent nor liquid.
• The need to stay both solvent and liquid therefore, makes effective liquidity
management crucial for increasing the profitability as also the long-term
viability/solvency of a bank.
Liquidity Management – Considerations
• Availability of liquid assets,
• Extent of volatility of the deposits,
• Degree of reliance on volatile sources of funding,
• Level of diversification of funding sources,
• Historical trend of stability of deposits,
• Quality of maturing assets,
• Market reputation,
• Availability of undrawn standbys,
• Impact of off balance sheet exposures on the balance sheet, and
• Contingency plans.
Liquidity Management – Types
Banks face the following types of liquidity risk:
• Funding Liquidity Risk – the risk that a bank will not be able to meet efficiently
the expected and unexpected current and future cash flows and collateral needs
without affecting either its daily operations or its financial condition.
• Market Liquidity Risk – the risk that a bank cannot easily offset or eliminate a
position at the prevailing market price because of inadequate market depth or
market disruption.
Liquidity Management – Issues to be
Considered
• The extent of operational liquidity, reserve liquidity and contingency liquidity that
are required
• The impact of changes in the market or economic condition on the liquidity needs
• The availability, accessibility and cost of liquidity
• The existence of early warning systems to facilitate prompt action prior to
surfacing of the problem and
• The efficacy of the processes in place to ensure successful execution of the
solutions in times of need.
Liquidity Management – Factors

Internal Banking Factors External Banking Factors

High off-balance sheet exposures. Very sensitive financial markets depositors.
The banks rely heavily on the short-term corporate External and internal economic shocks.
deposits.
A gap in the maturity dates of assets and liabilities. Low/slow economic performances.

The banks’ rapid asset expansions exceed the available Decreasing depositors’ trust on the banking sector.
funds on the liability side
Concentration of deposits in the short term Tenor Non-economic factors

Less allocation in the liquid government instruments. Sudden and massive liquidity withdrawals from
depositors.
Fewer placements of funds in long-term deposits. Unplanned termination of government
deposits.
Liquidity Management - Principles
• A bank should establish a robust liquidity risk management framework that
ensures it maintains sufficient liquidity, including a cushion of unencumbered,
high quality liquid assets, to withstand a range of stress events, including those
involving the loss or impairment of both unsecured and secured funding
• A bank should clearly articulate a liquidity risk tolerance that is appropriate for its
business strategy and its role in the financial system.
• Develop a strategy, policies and practices to manage liquidity risk in accordance
with the risk tolerance and to ensure that the bank maintains sufficient liquidity.
Senior management should continuously.
• Incorporate liquidity costs, benefits and risks in the internal pricing, performance
measurement and new product approval process for all significant business
activities (both on- and off-balance sheet).
Liquidity Management - Principles
• Process should include a robust framework for comprehensively projecting cash
flows arising from assets, liabilities and off-balance sheet items over an
appropriate set of time horizons.
• A bank should establish a funding strategy that provides effective diversification
in the sources and tenor of funding.
• A bank should actively manage its collateral positions, differentiating between
encumbered and unencumbered assets
• A bank should have a formal contingency funding plan (CFP) that clearly sets out
the strategies for addressing liquidity shortfalls in emergency situations.
Cash Management – Concept
Cash Management – Services Offered
Cash Management – Need
Cash Management is a new product off the block , which facilitates the banks to
source cheaper funds and serve its clients more efficiently
Cash Management – Forecasting
• Steps in any market forecast undertaken by an organisation
Cash Management – CRR
• At present with effect from the fortnight beginning from February 9, 2013, the
CRR prescribed by the Reserve Bank is 4.0 per cent of a bank's total of demand
and time liabilities adjusted for the exemptions.
• During maintenance of CRR on a daily basis, In order to provide flexibility to
banks and enable them to choose an optimum strategy of holding reserves
depending upon their intra period cash flow, scheduled UCBs are presently
required to maintain on average daily balance, a minimum of 70 per cent of the
prescribed CRR balance based on their Net Demand and Time Liabilities (NDTL),
as on the last Friday of the second preceding fortnight.
Treasury – Domestic and Global
• The basic function of a treasury is to arrange for funds whenever needed and to
deploy the surplus funds profitably.
• But the treasury division of a- modern bank functions as an independent profit
center and, hence, engages itself in the business of raising funds by issuing several
liability instruments, and investing them by taking up different items of asset
products.
Treasury – Domestic and Global – Objective
I. Ensuring strict compliance with the statutory requirements of maintaining the
stipulated Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
II. Management of bank’s liquidity by:
• Optimum profitable investment of surplus resources;
• Raising additional funds required to meet credit demands at optimal cost; and
• Managing the market and liquidity risks in the transactions undertaken by the
treasury.
Treasury – Domestic and Global – Functions
• Domestic Operations:
1. Maintenance of statutory reserves, viz., CRR and SLR.
2. Managing liquidity.
3. Profitable deployment of surplus resources.
4. Arbitrage operation and making profit.
5. Hedge and cover operations.
• Foreign Exchange Operations:
1. Funding and managing foreign currency assets and liabilities.
2. Extending cover to foreign exchange trade transactions.
3. Arbitrage operations in foreign currency.
4. Providing hedge and other cover to mitigate the forex risks undertaken by the
bank’s customers.
Treasury – Domestic and Global – Products
(A) Domestic Treasury:
1. Asset Products:
(a) Call/Notice Money Lending
(b) Term Money Lending/Inter-Bank Deposits
(c) Investment in Certificate of Deposits (CDs)
(d) Investment in Commercial Papers
(e) Inter-bank Participation Certificates
(f) Dealing in Derivatives of Asset Nature
(g) Deployment of funds in Reverse Repos
(h) Investment in various SLR Bonds issued or guaranteed by the Central/State
Government
Treasury – Domestic and Global – Products
(i) Investment in non-SLR Bonds
(j) Private Placements and
(k) Investment in Floating Rate Bonds, Tax-free Bonds, Preference Shares,
Listed/Unlisted Equity Shares, Mutual Funds, etc.
Treasury – Domestic and Global – Products
2. Liability Products:
(a) Call/Notice Money Borrowing.
(b) Term Money Borrowing.
(c) Acceptance of funds by issuing Certificate of Deposits (CDs).
(d) Inter-bank Participation Certificates.
(e) Borrowing under Repos.
(f) Borrowing under Refinance from different financial institutions and the
Central Bank of the country.
(g) Borrowing under Tier-II bonds issued by the bank.
Treasury – Domestic and Global – Products
(B) Foreign Exchange Operations:
1. Inter-bank:
(a) Buying and selling of currencies on Cash, Tom, Spot and Forward basis
(b) Forward SWAPS (simultaneous purchase and sale of a currency for two
different forward maturities) and
(c) Foreign currency placements, investments and borrowings
2. Cover for various merchant transactions undertaken by the branches:
(a)These transactions include pre-shipment foreign credit, foreign currency bills
purchased, foreign currency loans, post-shipment foreign credit, retirement of
import bills, etc.
(b)The treasury also manages the foreign exchange transactions emanating from
foreign currency loan (FCL) business, remittances handled by the branches for
their customers.
Interbank deals
• Interbank deals refer to purchase and sale of foreign exchange between the banks.
• In other words it refers to the foreign exchange dealings of a bank in the interbank
market.
• Purchase and sale of foreign currency in the market undertaken to acquire or
dispose of foreign exchange required or acquired as a consequence of the dealings
with its customers is known as the ‘cover deal’. The purpose of cover deal is to
insure the bank against fluctuation in the exchange rates.
Interbank deals
• There are three exchange rate regimes:
• Fixed (or pegged) exchange rate system – the government chooses an
exchange rate and offers to buy and sell currencies to keep the exchange rate
within a narrow band. The “official rate” is call the par value.
• Flexible (floating) exchange rate system – determination of exchange rates is
left totally up to the market, and is determined entirely by supply and demand.
The major trading countries have been on this system since 1973.
• Partially flexible (dirty or managed float) exchange rate system– the
government sometimes affects the exchange rate and sometimes leaves it to
the market.
Interbank deals – Activities
• Arbitrage is the process of buying and selling to take advantage of such
discrepancies.
• It is nearly riskless.
• It ensures that rates in different locations are essentially the same.
• It ensures that rates and cross-rates are consistent.
• A forward exchange contract is an agreement to exchange one currency for
another at some specified future date at an exchange rate set now (the forward
exchange rate).
• The exchange rate that actually eventuates is called the future spot rate.
Interbank deals – Activities
• Hedging involves acquiring an asset in the foreign currency to offset a net liability
in another, or vice versa. It effectively sets the exchange rate for a future exchange
transaction now, removing the exchange rate risk. If 100% of the risk is removed,
it is called a perfect hedge.
• Speculating is the act of taking a long position or a short position in some
currency or related asset in hopes of making a short-term profit. It is purely a
gamble, and is not motivated by any import/export activity.
• Currency futures are contracts traded on organized exchanges, like the Chicago
Mercantile Exchange or the NY Futures Exchange (NYFE).The futures contract is
a standardized contract, and is a tradable security.
Interbank deals – Activities
• A currency option gives the buyer or holder of the option the right, but not the
obligation, to buy (a call option) or sell (a put option) foreign currency at some
time in the future at a price set today. The price at which the buyer has the right to
buy or sell is called the strike price or exercise price. For this right, the buyer pays
the seller a premium.
• In a currency swap, two parties agree to exchange flows of different currencies
during a specified period of time. It is basically a set of spot and forward
exchanges packaged together in a single contract. It generates lower transactions
costs than an array of equivalent spot and forward contracts, and also may lower
risk.
Anti Money Laundering
• 'Money Laundering' is the process by which illegal funds and assets are converted
into legitimate funds and assets.
Anti Money Laundering - Sources
Money Laundering generally refers to ‘washing’ of the proceeds or profits generated
from:
Anti Money Laundering – Cycle
Anti Money Laundering – Risk, Types
• Reputational risk
• Legal risk
• Operational risk (failed internal processes, people and systems & technology)
• Concentration risk (either side of balance sheet).
All risks are inter-related and together have the potential of causing serious threat to
the survival of the bank
Anti Money Laundering – Punishment
• Imprisonment up to seven years.
• In addition, the tainted property is also confiscated by the Central Government.
Anti Money Laundering – Steps
• Board and management oversight of AML risks.
• Appointment a senior executive as principal officer with adequate authority and resources at his
command.
• Systems and controls to identify, assess & manage the money laundering risks.
• Make a report to the Board on the operation and effectiveness of systems and control.
• Appropriate documentation of risk management policies, their application and risk profiles
• Appropriate measures to ensure that ML risks are taken into account in daily operations,
development of new financial products, establishing new business relationships and changes in
the customer profile.
• Screening of employees before hiring and of those who have access to sensitive information.
• Appropriate quality training to staff.
• Quick and timely reporting of suspicious transactions
Anti Money Laundering – Risk
High risk countries:
• Drug producing countries
• Countries with high levels of corruption
• Countries linked to terrorist financing
High risk customers:
• Private money transmitters
• Money changers
• Real estate dealers
• Casinos, gambling outfits
• Non profit organizations –charities
Anti Money Laundering – Risk
High risk services:
• Wire transfers
• Private banking
• Correspondent banking
• Electronic banking services-internet, debit/credit cards
KYC – Know Your Customer
Customer?
• One who maintains an account, establishes business relationship, on who’s
behalf account is maintained, beneficiary of accounts maintained by
intermediaries, and one who carries potential risk through one off transaction.

Your? Who should know?

• Branch manager, audit officer, monitoring officials, PO.

Know? What you should know?

• True identity and beneficial ownership of the accounts.
• Permanent address, registered & administrative address.
KYC – Advantage
• They help to protect banks’ reputation and the integrity of banking systems by
reducing the likelihood of banks becoming a vehicle for or a victim of
financial crime and suffering consequential reputational damage;
• They provide an essential part of sound risk management system (basis for
identifying, limiting and controlling risk exposures in assets & liabilities).
• Customer Acceptance Policy.
• Customer Identification Procedure- Customer Profile.
• Risk classification of accounts - risk based approach.
• Ongoing monitoring of account activity.
• Reporting of cash and suspicious transactions