Risk Management

UNIT 15 ASSET LIABILITY MANAGEMENT

Objectives
After reading this unit you should be able to:
l understand the scope, role and functioning of Asset-liability Management (ALM)
in a bank;
l identify the various approaches to ALM;
l appreciate crucial ALM decisions which have a bearing on the performance of
the bank under different environments; and
l describe the linkage of ALM to other areas of risk management.

Structure
15.1 Introduction
15.2 Nature of ALM Risks and its Organisation
15.3 Balance Sheet Structure: Implications for ALM
15.4 Liquidity Risk
15.5 Interest Rate Risk
15.6 Market Risk
15.7 Summary
15.8 Self Assessment Questions
15.9 Further Readings

15.1 INTRODUCTION
As indicated in the previous chapter on risk management, risks can have an impact on
either the accounting earnings which are periodically reported and or Value of equity
which is relatively a new dimension. The Asset Liability Management (ALM)
function involves planning, directing, and controlling the flow, level, mix and rates on
the bank assets and liabilities. The ALM responsibilities are fully aligned to the
overall objectives at the bank level. There was no need for an elaborate ALM
function till the interest rates were guided by the regulator and the business of banking
was purely volume driven. Deregulation of interest rates, interest rate volatility and
increasing competition in the financial market place has made the ALM function a
significantly important function in today’s environment.

Categorisation of Bank Balance Sheet

At this juncture, it is important to understand how the assets & liabilities in the
balance sheet of a bank are classified into Banking Book and Trading Book. The
following are the points distinguishing one from the other:
Held-till-maturity vs. Short-term holding period
The intention of the bank in case of banking books is to hold the assets and liabilities
till maturity whereas in case of trading book the holding period is extremely short and
may vary between a few hours (or minutes in some cases) to a maximum of 90 days
(as per the RBI’s stipulation of holding period).
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Accrual Income vs. Price Change Asset Liability Management

The assets & liabilities in the banking book accrue income and expenses respectively
over time. The target variable in case of the banking book is the net accrual income.
In case of the trading book, price appreciation (or depreciation) due to fluctuation in
market price is the main target variable as the holding period is very short

Historical cost vs. Mark-to-market Value

The assets & liabilities in the banking book are valued at historical cost. Change in
the values of assets and liabilities are not recognized in the P&L account. The norm
in case of trading book is periodic valuation (mark-to-market) and reflection of the
market value of the assets and liabilities in the balance sheet. Any appreciation or
depreciation with reference to the value prior to valuation would pass through the
P&L account as profit or loss.

Examples
Banking Book includes; Deposits, Borrowings, Loans and Advances
Trading Book comprises of securities such as bonds and equity, various currency
positions and commodity positions specifically identified by the bank as part of the
trading book. Derivative contracts which are used as a hedge for the trading book or
forming part of proprietary trading position would also be part of trading book

Scope of ALM
ALM is a part of overall risk management of a bank which addresses the following
risks:
l Liquidity Risk: Risk arising out of unexpected fluctuation in cash flows from
the assets and liabilities – both in banking and trading books.
l Interest Rate Risk: Risk arising out of fluctuations in the interest rates on assets
and liabilities in the banking book.
l Market Risk: Risk of price fluctuations due to market factors causing changes
in the value of the trading portfolio.

15.2 NATURE OF ALM RISKS AND ITS ORGANISATION

The nature of risks addressed by ALM is the ones which need to be and are
centralized at the bank treasury level for efficient management. In other words,
interest rate and liquidity risks may be created by branches of a bank in the process of
their intermediation between depositors and borrowers, but these risks need to be
pooled at the highest level and managed. This is because these risks arising at a
branch is not relevant as they need to be offset by exactly opposite positions in some
other branch of the same bank. Hence, what is significant to be managed is the net
position arising at the bank treasury level rather than individual positions arising at a
number of branches. In other words, branch heads do not have anything to with the
management of interest rate and liquidity risks at their own level. Their job at present
is restricted to providing accurate and timely data for the assessment of the risks
which are centralized. By its very nature, as the trading portfolio is managed at the
treasury level, no further centralization is warranted.
Like in many countries, the RBI has entrusted the job of ALM in each bank to the
Asset-Liability Committee (ALCO) to be set up in each bank. ALCO, consisting of
senior executives of a bank, is the apex decision making unit responsible for managing
all the three risks that come under the purview of ALM in an integrated manner.
As per RBI requirements, the ALCO is required to meet periodically to assess the 101
Risk Management bank’s position in terms of the risks and provide strategic guidance to achieve the
overall targets and objectives set. With the above introduction, the concentration of the
following section is on the three risks that the ALCO is supposed to address.
The typical organizational structure for Risk Management with specific reference to
ALM defined by the RBI is as under:

Figure 15.1: Typical Organisational Structure for Risk Management

Board of Directors
(Decide overall risk management policy and strategy)
s
Risk Management Committee
Board Subcommittee including CEO and Heads of Credit, Market and Operational
Risk Mangement Committees
(Policy and Strategy for integrated Risk Management)
s s s

Credit Risk Asset Liability Committee (ALCO) Operational

Management Headed by CEO/CMD/ED, including Chief Risk Management
Committee of Investment, Credit, Resource/Funds Committee
s s Ensure adherence to the limits, monitoring
and control, articulating interest rate view/
Credit Risk funding/transfer pricing policy, etc. and submit
Management to RMC.
Department s s
(CRMD)

CREDIT
Administration
Department (CAD)

ALM Support Group/Risk Middle Office

Management Group:
Consisting of operating staff. Responsible
for analyzing. monitoring and reporting the
risk profiles to ALCO, prepare forecasts/
simulations on possible changes in market
conditions and recommend action on
bank’s limits.
Consisting of experts in market risk management,
economists, statisticias and general bankers.
Responsible for independent risk assessment which is
critical to ALCO’s key-function of controlling and
managing market risks in accordance with the mandate
established by the Board/Risk Management
Committee. Track the magnifude of market risk on a
real time basis, aggregate total market risk exposure
assumed by bank at any point of time.

Source: Guidance Note on Market Risk Management, Reserve Bank of India, October 2002, Page. 8

15.3 BALANCE SHEET STRUCTURE: IMPLICATIONS

FOR ALM
As the entire subject of ALM is about balance sheet and its management, it is useful
at this stage to understand the typical structure of an Indian commercial bank in terms
of both rate earning assets and rate paying liability products. Other assets and
liabilities, which are not very significant, are excluded.
Balance Sheet Structure: Assets
l Advances
- A significant portion linked to Prime Lending Rate (PLR) in the form of
CC/OD, Demand loan & term loans
- PLR linked loans – Absence of reset dates (future dates on which the rates
102 would be reset is unknown)
 - Pattern of repayment based on behavioural studies Asset Liability Management

- Unavailed portion of CC/OD – Uncertainty of utilisation

- Borrower Option to prepay in case of Fixed Rate Term loans
l Investments
- Major portion Fixed Rate
- Medium to long duration portfolio
- Illiquidity of a significant portion of the portfolio – no or very low flexibility
for reshuffling (altering the structure)

Balance Sheet Structure: Liabilities

l Deposits – Savings and Current
- Non-maturity – No date of maturity
- High volatility of balances in case of current account
- Customer Option to freely introduce or withdraw money at any time
- Administered interest rates unrelated to market interest rates
l Term Deposits: Cumulative, Non-Cumulative and Recurring
- Overwhelming majority in Fixed Rates
- Customer Option (put option valuable when interest rates go above the
contractual fixed rate)
- The reinvestment risk in case of cumulative deposits
- Uncertain installment payments in case of recurring deposits
- Floating Rate ( a recent development)
l Borrowings
- Fixed or Floating Rate
- Various tenor
- Usually no options, hence no uncertainty about the term
It can be understood from the above structure that a significant portion of liabilities in
the form of term deposits have a fixed-rate meaning that the rates would remain
unchanged till the maturity or till the deposit remains with the bank. ‘Borrowings’
which is a smaller portfolio in the liabilities are at market related rates.
A significant portion of loans and advances portfolio is linked to PLR, which is a
floating rate. The meaning of floating rate here is an asset or liability rate linked to a
reference or index such as the Treasury bill rate, Government of India security yield,
bank rate, money market rate, etc., are the rates reset at predetermined frequencies
with reference to the reference rate. The problem that the PLR of banks suffer from is
the uncertainty caused by the absence of any predetermined reset dates for the loans
and advances linked to PLR. This implies that whenever PLR changes, the rate on the
loans & advances would change instantly without any time lag. Contrast this with a
hypothetical asset linked to a reference rate, say treasury bill rate with a 3-month
reset, we know very clearly that the rate once set for the asset can change only after
3 months and not before that.
An overwhelming majority of the investment portfolio is in the form of fixed-rate
Government and other securities.
Having discussed the balance sheet structure which determines the exposure of a bank
to ALM risks, the risks can be taken up for a detailed discussion
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Risk Management Activity 1
Pick up annual reports of any two banks and study the composition of various assets
& liabilities and compare them.
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15.4 LIQUIDITY RISK

Liquidity risk is defined as the possibility that the bank would not be able meet the
commitments in the form of cash outflows with the available cash inflows. This risk
arises as a result of inadequacy of cash available and near cash item including
drawing rights to meet current and potential liabilities. Liquidity risk is categorized
into two types; Trading Liquidity Risk and Funding Liquidity Risk.
Trading liquidity risk arises as a result of illiquidity of securities in the trading
portfolio of the bank. Trading liquidity risk is common to all the institutions having
exposure to same set of securities which may turn illiquid or less liquid. Liquidity or
otherwise can be measured security-wise on the basis of statistics generated from
market trades such as volume traded, no. of trades, percentage of volume traded to the
total outstanding volume of a security etc. on a day-to-day basis. This can be used to
ascertain the extent of liquid securities in the trading portfolio to the total size of the
portfolio. As liquidity and return are negatively related, i.e., higher returns can be
expected by accepting an illiquid security over a liquid one, strict policy measures to
contain the extent of illiquidity in the portfolio need to be set up and monitored on a
frequent basis. In fact, one of the important considerations for the inclusion of
securities in the trading portfolio is on the basis of its liquidity status. As the trading
portfolio is short-term in nature with the regulator-constrained maximum holding
period of 90 days, it is logical to include only those securities which are not only
liquid at the time of creation, but are expected to be liquid over the holding period of
the portfolio
Unlike the trading liquidity risk, which has similar impact on all the institutions
having exposure to the securities, the funding liquidity risk arises as a result of
mismatch between the timing of cash flow of the assets from that of the liabilities in
the balance sheet can be drastically different even for institutions having similar
balance sheet structure, such as commercial banks. Hence, funding liquidity risk that
arises as a result of the cash flow mismatch pointed out above is very much an
outcome of difference in balance sheet strategies pursued by different institutions in
the same industry. It is perfectly possible for a few banks to have excess funding
liquidity while other banks may suffer shortage of liquidity. Of course, the presence
of surplus and deficit is the precondition for an active money market to exist to move
the funds from surplus segment to deficit segment in the form of lending and
borrowing. An example of funding liquidity risk at this stage is appropriate.
Let us assume a single asset and a single liability in the balance sheet of a bank for the
sake of simplicity. The asset is a three-year loan and the liability is a six-month term
deposit. The bank would face funding liquidity risk six-months from today when the
six-month term deposit matures for payment since the liability in the form of
six-month deposit would require a cash out flow while the asset would not return any
cash flow (ignoring possible interest flows from the loan) six-months from today.
104
This is typically the funding mismatch that the bank has to manage either by Asset Liability Management
rolling-over the maturing deposit or acquiring a fresh deposit or sourcing money in
any other way suitable for the bank.

Tools of Liquidity Risk Measurement:

There are two approaches to measure liquidity risk at balance sheet level. They are:
1. Liquidity Gap Analysis, and
2. Structural Balance Sheet Ratios

Liquidity Gap Analysis

Liquidity gap report which is useful for measuring short-term liquidity risk is
prepared by placing assets and liabilities into various time buckets on the basis of
timing of cash inflows from the assets and the timing of cash outflows from the
liabilities. The cash flows from assets and liabilities include both principal and
interest cash flows. For the purpose of regulatory reporting of liquidity mismatches,
the RBI has prescribed a liquidity gap report with the following time buckets:
1 – 14 days
15 – 28 days
29 – 3 months
3 – 6 months
6 – 12 months
1 – 3 years
3 – 5 years
Above 5 years
The following Table 15.1, is the summary of a real-life liquidity gap report of a
commercial bank which would be used for our discussion this point onwards.
Table 15.1: Liquidity Gap Summary
(Amount in Rs. Crores)
PARTICULARS 1-14 D 15-28 D 29D-3M 3-6 M 6-12 M 1-3 Y 3-5 Y OVER 5Y TOTAL

Term Deposits 851 613 1835 1858 2372 6601 3729 1172 19030

A. Total Outflows 3414 849 2806 3099 2799 18798 4092 4903 40758

B. Total Inflows 3440 752 2105 2636 2630 8036 4481 16501 40581

C. Net Gap (B-A) 26 -96 -702 -462 -170 -10761 389 11598 -177

D. Cumulative Gap 26 -70 -772 -1234 -1404 -12165 -11776 -177

As reflected in the gap summary, total outflows (A) denotes expected cash outflows
from liabilities including term deposits, and the total inflows (B) denotes expected
cash inflows from assets as on a particular reporting date. The net gap (C) is the
difference between outflows and inflows, i.e., (B)-(A). The net gap figure reflects the
net liquidity mismatch, i.e., either the excess of cash outflows over inflows or the
excess of cash inflows over outflows for each time bucket. It can be seen from the
summary report above that while the bank has a little surplus liquidity in the shortest
bucket (1 -14 days), the other buckets up to 1 -3 years show significant shortage of
liquidity. The cumulative gap which is a successive summation of net gaps in each
bucket can be used to ascertain the mismatch for a period longer than reflected in the
short-term buckets. If the bank intends to ascertain its liquidity position for the next
three month period, then from the summary above, it can be said that there would be
shortage of liquidity to the extent of Rs. 772 crores which is the cumulative gap upto
105
the 3-month bucket.
Risk Management Issues in using the Gap Approach to Measurement of Liquidity Risk
While the concept of liquidity gap is extremely simple to understand and use, there are
a few issues which need to be addressed to be able to use the gap approach.
The issues are:
1) Non-maturity Items in the Balance Sheet: A sizeable portion of deposits of the
Indian banking industry is in the form of current and savings deposits which do
not have any specific maturity. Similarly, advances in the form of cash credit &
over draft do not have any specific maturity. These items can result in a cash
flow at any time. Absence of specific maturity dates in case of these ‘non-
maturity’ items makes it difficult to place them in a definite bucket on the basis
of cash flows. As prescribed by the RBI, as these items do not have contractual
maturity, their behavioural maturity need to be ascertained on the basis of
statistical analysis for placing them in appropriate buckets. In the absence of
such analysis, the approach suggested by the RBI for non-maturity deposits may
be used as an alternative
2) Renewal Assumptions in Case of Maturing Term Deposits: Though the term
deposits are expected to result in cash out flow on maturity, it has been observed
that a sizeable chunk of the maturing term deposits are actually renewed in the
same branch. Such renewals prevent the outflow of cash thereby reducing the
net gap. While the renewal behaviour is positive, it is difficult to predict
perfectly the percentage of maturing deposits renewed period after period as the
depositor behaviour may vary from time to time depending on a number of
factors. If a certain percent of renewal of deposits, say 60% is assumed for the
preparation of the gap reports and the actual renewal is only say 40% for a
period, this would create an unexpected deficit of liquidity which is serious given
the nature of banking business which is heavily dependent upon public
confidence. The public confidence in a bank is the function of its ability to meet
all its commitments to the depositors. Surplus of liquidity would be the result
when the actual renewal is higher than the expected renewal of deposits. While
surplus is viewed favourably from the point of view of the bank’s ability to meet
the cash out flows, expected return may suffer as deploying unexpected surplus
may diminish expected return.
3) Assumptions Relating to Unavailed Portion of Cash Credit, Overdraft: A
sizeable portion of the advances portfolio of the Indian banking industry is in the
form of cash credit, overdraft etc. In case of CC/OD etc., a limit is sanctioned
for each borrower and the right to borrow upto the limit is vested with the
borrower. While this has given a lot of flexibility to the borrowers to utilize the
limit sanctioned to the extent it is required for meeting business commitments,
banks pay a price in the form of uncertainty of timing of utilization by the
borrowers of the unutilized limits as they may be utilized at any time without
prior notice. As a result of the uncertainty, banks can neither keep the unutilized
portion idle as returns may suffer, nor can deploy it in other assets as the
requirement may arise at any time unexpectedly. This problem of banks has
been exacerbated by the behaviour of a few large corporates who maintain an
unutilized limit and borrow from the money or capital market as the rate would
be cheaper than the lending rate of banks. These corporates return to the
unutilized portion when the market turns tight or the market as a source of
borrowing by corporate dry up. The assumptions relating to unavailed portion
need to be thoroughly validated on the basis of behavioural analysis and
experience of the bank over a period of time for proper handling of the same.
4) Assumptions Relating to off-balance Sheet Items: Guarantees provided in
favour of customers by banks in various forms, Letters of Credit etc. are off-
106 balance sheet in nature as the nature of liabilities are contingent upon events.
 For example a financial or performance guarantee is a non-funded commitment Asset Liability Management
till the time it is invoked by the party in whose favour the guarantee was issued
by the bank. Analysis of the timing and magnitude of crystallization of a non-
funded commitment into a funded commitment is extremely important to assess
the impact of such crystallization on the liquidity position of the bank.
5) Embedded Options: As indicated earlier, a number of asset and liability
products offered by banks to customers have options embedded in them. In the
terminology of derivatives, an options contract gives its buyer the right to buy
(call option) or right to sell (put option) at a price determined at the time of
entering into the options contract (called the strike or exercise price). The
simplest example is the fixed rate term deposit in the deposits portfolio. The
term deposit holder has the right but not an obligation to prematurely terminate
the term deposit at any time during the currency of the deposit. This behaviour
of the depositors increases whenever interest rate applicable for the deposit goes
up in the market and the new rate happens to be higher than original rate
contacted at the time of opening of the deposit. This leads to flight of deposits
from a bank to its competitor causing an impact on the liquidity position of the
bank. This option of the term deposit holder is the put option. Similarly, the
term loan borrowers may exercise their call option to prepay the loan fully or
partially when interest rates go down as they would be in a position to get the
advantage of lower rates elsewhere. It is important to understand here that the
customer exercising options either on the liability side or the asset side need not
necessarily have an impact on the existing liquidity position when the liability or
asset is rebooked with the same institution at new rates. To continue with our
term deposit holder example, if the deposit is prematurely withdrawn and taken
out, then it would have an impact on liquidity. But if the deposit is withdrawn
prematurely but rebooked in the same bank at a higher rate, then there is impact
on liquidity. A careful analysis of the embedded options and their impact on the
liquidity position need to be analysed as they display appreciable variations in
terms of geographic region, the socio-economic profile of the customer,
remaining life of the asset or liability, size of the asset or liability, the extent of
change in the market interest rates, etc.
6) Static Nature of the Gap Report: The time taken to compile the report
determines whether it is useful for decision making or not. If time taken is fairly
long, then the first few buckets of information would be useless as the period for
which the gaps are calculated would have simply elapsed. Even if the time delay
is considerably reduced, the dynamic nature of the business of banking in which
a lot of assets and liabilities are contracted on an ongoing basis would make the
figures less relevant in the light of new business, changing behaviour of
customers, etc. These call for the consideration of new business in the form of
expected assets and liabilities in future and the behavioural pattern of customers
to take into account the dynamic nature of the balance sheet. Unless the dynamic
nature of positions and behavioural analysis as indicated in the previous points
are incorporated into the analysis of gaps, preparation of a meaningful liquidity
report would not be possible.

Structural Balance Sheet Ratios

A part from the gap analyses, structural balance sheet ratios are also used to assess
the liquidity position taking into consideration the structure of the assets and liabilities
in the balance sheet. A few of them are indicated below:
l Call borrowing to total borrowing: Extent of dependence on call money market
for funding the assets.
107
Risk Management l Purchased funds to liquid assets: As purchased funds are volatile to market
conditions, the extent to which they are matched by liquid assets.
l Core Deposits to Core Assets: Extent to which retail deposits are used to fund
core assets such as Loans and approved securities.
l Liquid assets to total assets: To ascertain asset liquidity.
l Liquid assets to deposits: Extent of liquid assets available to meet deposit
outflows in an abnormal environment.
l Liquid securities to total investments: To estimate the extent of liquid securities
in the investment portfolio which is otherwise illiquid.

Liquidity Risk Management

The logical step that follows after liquidity analyses is liquidity risk management. The
issues that are relevant in managing the liquidity risk are:
l Whether the liquidity mismatch (surplus or deficit) for the period under
consideration is within tolerable limits as per the policy of the bank?
l If not, what are the strategies to be employed to ensure that the mismatch is
within tolerance levels set?
Sometimes, even if the liquidity mismatch is within tolerance levels set, the ALCO
may still implement strategies to get the maximum benefit in a given market
environment subject to adhering to the limits set at all points of time. This is
sometimes referred to as active management of liquidity risk in contrast to passively
keeping the liquidity mismatch within limits at all points in time without taking any
active position. There are a number of strategies to managing the mismatch. Typical
strategies involve the use of trading portfolio; refinance facilities and lines of credit
available from various sources, market borrowing, wholesale deposits, securitization,
loan sales etc. Each one of the strategies has to be analyzed in terms of cost and the
intended benefit before a strategy is implemented for managing the mismatch. This is
an ongoing process for the ALCO.
Apart from managing liquidity on a day-to-day basis, as per RBI requirements, all
banks are required to produce a Contingency Funding Plan (CFP) to manage stress
scenarios and to withstand a prolonged adverse liquidity crisis. Action plans based on
the CFP must be established by the ALCO to address the situation arising out of the
stress situation.

Activity 2
Go through & interpret the maturity profile of assets and liabilities in the annual
report of any two banks. What types of gaps are found?
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15.5 INTEREST RATE RISK

Interest Rate Risk (IRR) arises as a result of change in interest rates on rate earning
assets and rate paying liabilities of a bank. The scope of IRR management is to cover
the measurement, control and management of IRR in the banking book. As indicated
elsewhere, with the deregulation of interest rates, the volatility of the interest rates
108 have risen considerably. This has transformed the business of banking forever in our
country from a mere volume driven business (as volume would take care of Asset Liability Management
profitability in a regulated environment) to a business of careful planning and to
achieve targets of profitability by choosing the appropriate assets and liabilities to be
employed.
To take an example at this stage, a bank funding a three year fixed rate loan with a six
month fixed rate deposit is exposed to interest rate risk as the timing of repricing of
assets and liabilities is different. The asset has a repricing period of three years while
the repricing period of the liability is six months. The concept of repricing is
extremely important in IRR management which reflects the time remaining for interest
rate to change on assets and liabilities. This concept would be expanded further to
cover finer aspects of repricing in a subsequent section. If the interest rates go up in
six months from now, the impact of the interest rate would hit the bank in the form of
reduction in the spread, where the spread is the difference between the yield on assets
and the cost of liabilities. This is because the asset rate would remain the same as it is
a fixed rate and the liability rate has gone up at a time when existing liability matured
and a fresh liability is taken to continue the funding of the assets in the balance sheet.
Any fall in the interest rate would have led to positive impact on the spread as liability
rate falls while the asset rate remaining the same. This is typically how the interest
rate exposure of an institution is arrived at and analysed. As indicated in case of the
liquidity risk, the analysis for IRR is carried out at the bank level as branches and
business units have nothing to do with the management of IRR.

Approaches to IRR
The two basic approaches to IRR are:
1. Earnings Approach, and
2. Economic Value Approach

Earnings Approach to IRR

The earnings approach is otherwise known as accounting approach. The main focus
of the approach is on the impact of interest rate changes on assets and liabilities on the
Net Interest Income (NII). NII is an important top-line performance indicator of a
bank and is computed as under:
NII = Interest Income – Interest Expenses .............................................1
The interest income includes income from advances and investment portfolios
excluding the fee, commission, exchange, brokerage etc. which form part of other
income. The profit or loss from trading operations is also a part of other income. The
term ‘interest’ for the purpose of interest income has a wider connotation in the sense
that it includes dividend received from equity portfolio, portfolio of mutual fund
investments etc. The interest expense includes interest paid on deposits, borrowings
and debt capital (Tier – 2 bonds) of banks
NII in monetary terms can be expressed as a percentage in the form of Net Interest
Margin (NIM) and impact of interest rate change can be analysed on NIM. There are
a number of definitions for NIM, prominent among them are:
NIM = NII / Total Assets ........................................ 2
NIM = NII / Earning Assets ........................................ 3
In equations 2 and 3, in the denominator, total assets and earning assets can be
replaced by average total assets and average earning assets respectively to consider
the average annual figure instead of the year end figure. Moreover, there is also a
debate whether the non-performing assets (both in advances investments) should be
part of the denominator or not. There is no end to this debate but what is important 109
Risk Management here is consistency of the definition both for inter-firm and intra-firm comparison for
the evaluation of performance.
The earnings approach which concentrates on accrual income proxies of NII / NIM
has a short-term focus as the analysis of interest rate impact is restricted to maximum
of a year as the accounting cycle has a period of one year. In fact, the interest rate
impact can be analysed on the proxies for a period as short as a few days. But
typically, the impact is analysed for a quarter or a month or for a shorter period
depending on the periodicity of the updation of data at the bank level. The impact of
interest rate changes on other accrual accounting income proxies such as operating
profit, net profit, Return on Assets (ROA), Return on Equity (ROE), Earnings Per
Share (EPS) can also be analysed but such analysis should carefully remove the
impact of non-interest income and non-interest expense on the other proxies for
meaningful conclusions to be drawn. This is simply because, the other proxies are
impacted by not only the NII, they are impacted by non-interest expenses such as
salaries, rent, other administrative expenses and non-interest income such as fee,
commission, exchange, brokerage, profit or loss from trading operations etc.

Activity 3
Compute NII, NIM, ROA, ROE, EPS for any two banks from the data available in
their annual reports and compare them.
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Tools of Earnings Approach

The gap analysis we discussed in case of liquidity report is an important tool for the
earnings approach of IRR. The major difference between the gap approach for
liquidity and the rate sensitivity is the treatment of assets and liabilities. In the gap
report for interest rate sensitivity, the assets and liabilities are placed in the buckets
(called repricing buckets) on the basis of timing of change or expected change in the
interest rates for the assets and liabilities not on the basis of cash inflows and outflows
as in the case of liquidity gap report. The RBI has prescribed a statement of interest
rate sensitivity with the following time buckets for regulatory reporting:
1 – 28 days
29 – 3 months
3 – 6 months
6 – 12 months
1 – 3 years
3 – 5 years
Above 5 years
Non-sensitive
Apart from the clubbing of the first two liquidity buckets in case of interest rate
sensitivity which does not have any other impact, the inclusion of a column for ‘non-
sensitive’ assets and liabilities in the balance sheet is a major difference in the
statement of interest rate sensitivity. An example of a non-sensitive asset is cash in
hand, which is non-sensitive as it does not earn any interest at present. Any change in
the interest rates would not have any impact on cash. Similarly on the liability side of
110 the balance sheet, equity capital is non-sensitive. This is because the entire analysis of
IRR ultimately boils down to impact of interest rate changes in assets and liabilities on Asset Liability Management
the equity of the bank. In other words, the impact on equity would be the net of
impact on assets and liabilities. Given this, equity itself is not directly sensitive to
interest rate changes; its sensitivity is through asset and liability sensitivities.
The following rules would guide us on what determines the rate sensitivity of assets
and liabilities. In other words, how to place different types of assets and liabilities
such as fixed rate, floating rate, etc. in the rate sensitive gap report for IRR.
Asset and liability are rate sensitive if and only if:
l The cash flows from them are on their maturity
l The cash flows represent an interim, or part principal repayment
l The interest rate applied to the outstanding principal changes contractually
during the period under consideration
l The outstanding principal can be repriced when some base rate or index changes
and management expects the base rate or index to change during the period
An example of two term deposits first with a fixed rate and the other with a floating
rate would help clarify the rules above:
Term Deposit– 1: Fixed Rate
Current Date: 1-April-2004
Date of maturity: 31-March-2007
Term-to-maturity: 3 years
Principal: Rs.10, 000
Outstanding Balance: Rs.10, 000
Rate of Interest: 5.5% per annum
Type of interest: Fixed Rate
Periodicity of interest payment: Quarter ends of March, June, September and December
As the deposit is a fixed rate deposit, the repricing would take place on maturity. It is
to be interpreted that the rate applicable on the deposit can undergo a change only on
the maturity of the deposit, not before. Hence the deposit with a three-year repricing
period would be placed in the 3-year repricing bucket in gap report:
Term Deposit– 2: Floating Rate
Current Date: 1-April-2004
Date of maturity: 31-March-2007
Term-to-maturity: 3 years
Principal: Rs.10000
Outstanding Balance: Rs.10000
Reference Rate = 364-day Treasury Bill Rate
Rate of Interest: Treasury Bill Rate + 0.75%
Current Interest Rate: 5.75%
Type of interest: Floating Rate
Periodicity of interest payment: Quarter ends of March, June, September amd December
Periodicity of reset of interest rates: Same as the periodicity of interest payment
Though the deposit has 3 years to mature, as the interest rates are likely to change on
the next reset from today, i.e., end of June, the repricing period in case of the floating
rate deposit is 3 months from today and it will be placed in the 3-month repricing
bucket in the gap report.
111
Risk Management The example illustrated how term deposits similar in all respects but differing only in
terms of type of interest payment – fixed rate or floating rate has to be treated in the
rate sensitive gap report.
Further discussion of the earnings approach would be enabled with the help of a real-
life interest rate sensitivity summary report as under:
Table 15.2: Rate Sensitive Gap Summary
(Amount Rs. in Crores)

Particulars 0-1M 1-3M 3-6M 6-12M 1–3Y 3–5Y Over 5 Y Non- Total
Sensitive
Term Deposits 1464 1835 1858 2372 6601 3729 1172 19030
A. Total Liabilities 2099 2593 10930 2730 6601 3792 1172 10342 40258
B. Total Assets 2162 1480 10651 1425 2986 3893 12378 5605 40581
C. Net Gap
(B-A) 63 -1113 -280 -1305 -3614 102 11206 -4737 323

D. Cumulative Gap 63 -1049 -1329 -2634 -6248 -6146 5060 323

As seen above, the gap is positive in the first repricing bucket and is negative in all
other buckets except the last two repricing buckets of 3-5 years and over 5 years.
What is the impact of the gaps on the NII of the bank? The formula for NII impact
analysis is as under:
Impact on NII = Gap × Interest Rate Change ............................ 4
The above formula assumes the impact is for a one year period and the interest rate
change is per annum. Computation of impact for shorter periods can be carried out
by suitably adjusting both the period of impact and the rate to reflect the period. To
illustrate, what is the annual impact of the positive gap in the first repricing bucket
when interest rate is expected to go up by 1%? To answer this, we need to make an
assumption of timing of rate change within the first bucket as assets and liabilities
having different repricing periods upto 1 month are clubbed together for the sake of
convenience. The usual assumption is that the rate change takes place at the mid-
point of the bucket, i.e., 15 days from today, i.e., 0.5 month. Observe the following
arising from the above:
Timing of change in rate = mid-point of the first bucket = (0+1)/2 = 0.5 month
Annual impact would be for a period of = 11.5 months (i.e., 12 – 0.5)
Rate change per annum = 1%
Gap in the first bucket = Rs. 63 crores
NII impact for the first bucket = Gap × Periodicity of annual impact × Rate Change
= 63 × 11.5 × (1%/12) = 0.60375
Hence, the annual impact of interest rate going up in case of the first repricing bucket
is Rs.0.6037 crores. As the impact is positive, the NII would go up. What is the
annual impact for the second repricing bucket for the same interest rate change?
Timing of change in rate = (1+3)/2 = 2 months
Annual impact would be for a period of = 10 months (i.e. 12 – 2)
Rate change per annum = 1%
Gap in the second bucket = -1113 crores
NII impact for the second bucket = -1113 × 10 × (1%/12) = -9.275
While the NII impact of the gap in the first bucket was positive, the impact of the
negative gap in the second bucket is negative to the extent of 9.275 crores. This gives
112
an indication that the NII would suffer to an extent of 9.275 crores for the second Asset Liability Management
bucket. The approach described above can be used to arrive at the impact for each
bucket and then aggregate bucket-wise impact to arrive at quarterly, semi-annual and
annual impact on NII. In the numerical analysis above, the reason for difference in
impact between the first and second buckets is simple. The gap in the first bucket is
an asset sensitive gap as more assets are repricing than the liabilities. An asset
sensitive gap with an increase in interest rates would produce positive impact on NII.
That is what we observed in case of the first bucket. The gap in the second bucket is
liability sensitive as more liabilities are repricing than assets in the bucket. A liability
sensitive position with an increase in interest rates would produce a negative impact
that we observed in case of the second bucket. The following table summarises the
NII impact given the sign of the gaps and the sign of change in interest rates

Activity 4
For the given summary gap report above, compute the quarterly, semi-annual and
annual impact on NII for increase in interest rate by 1% p.a. for both assets and
liabilities.
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NII Impact Analysis

Repricing Gap Interest Rate view

(assets and liab.) Impact on NII
Positive Up Positive
(RSA>RSL)
Positive Down Negative
(RSA>RSL)
Negative Up Negative
(RSA<RSL)
Negative Down Positive
(RSA<RSL)
Zero (RSA=RSL) Up or Down Zero

Legend: RSA = Rate Sensitive Assets, RSL = Rate Sensitive Liabilities

The NII sensitivity analysis as explained above is used after the preparation of the rate
sensitive gap report to asses the impact of interest rate changes on the NII for various
periods. As in the case of liquidity, limits on the NII impact need to be set for various
interest rate changes ranging from -1% to +4% in steps of 1% each at a time as per
the requirement of the regulators as no bank can absorb undefined negative impact
arising out of exposures and adverse movement in interest rates. ALCO is entrusted
with the job of managing the gaps within the limits prescribed to the best advantage of
the bank

Economic Value Approach of IRR

Earnings approach of IRR has a short-term focus and covers only an initial part of the
life of assets & liabilities in the balance sheet. It does not cover the long-term impact
of the exposure to the changes in interest rates. The Economic Value Approach,
which is known by many names such as Market Value Approach, Net Portfolio Value
Approach etc. considers the long-term impact of interest rate changes by covering the 113
Risk Management entire life of all the assets and liabilities. A number of banks worldwide prefer to limit
their IRR exercise to earnings approach alone but the regulators worldwide have made
it mandatory to use economic value as long-term implications of current strategies
would be reflected by the economic value approach rather than by the earnings
approach. Moreover, the current accounting earnings based measures have ceased to
be performance measures as they are not adjusted for risk. A higher accounting profit
does not necessarily mean better performance unless the risk taken in achieving the
performance is taken into consideration. This gives rise to a piquant situation where a
number of different strategies followed by different banks may produce to similar
current performance in terms of accounting profits, but the success or otherwise of
today’s strategies would be felt in the long-term earnings performance which is the
essence of the economic value approach
Under the economic value approach, the impact of interest rate changes are studied on
an important variable called Economic Value of Equity (EVE). It is known by many
names such as Net Portfolio Value, Market Value of Equity, Market Value of Portfolio
Equity etc. The term economic value is preferred to the term market value as a
number of assets and liabilities in the balance sheet of a bank do not yet have a ready
market for buying and selling though the use of the term market value is technically
correct. In this material, the term EVE would be used consistently. The EVE is:
EVE = Economic Value of Assets – Economic Value of Outsider Liabilities ............ 5
The economic value of assets and economic value of outsider liabilities represent the
fair value of assets and the fair value of liabilities except equity respectively. The
essence of the equation reflects the residuary nature of the claims of the equity
shareholders who are the owners. This approach recognises the fact that changes in
interest rates not only change the NII but also the economic value of assets and
liabilities, which in turn is reflected in the value of equity. The difficulty in
understanding this simple truth lies in our accounting policies which recognize change
in value of only a few items in the balance sheet (example: trading portfolio) while
other assets and liabilities are reflected at historical cost despite change in value. The
economic value approach overcomes the difficulty and makes us understand the
impact of current strategies on the long-term earning capacity of a bank which is
reflected in the valuation of assets and liabilities
The economic value approach calls for the valuation of each rate sensitive asset and
liability to arrive at EVE. The approach to the valuation is the well known ‘present
value of future cash flows’, which is a basic foundation for the subject of finance.
Before proceeding further, it is necessary to recall the well known inverse relationship
between interest rate changes and asset and liability values. When the interest rate on
an asset goes up from the current level to a higher level, the value of the asset would
fall and vice versa. The same is the case with a liability but we need to quickly
recognize that the value of an asset going up has a positive impact on EVE while the
value of a liability going up has a negative impact on EVE from equation 5 above.
The equation clearly shows that any increase in economic value of an asset or any
decrease in the economic value of a liability is positive for EVE and any decrease in
economic value of an asset and increase in economic value of liability is negative for
EVE. Why should bank managements bother about EVE at all? As indicated earlier,
EVE reflects future earning potential of a bank. Moreover EVE is considered to be a
proxy for ‘market capitalization’ which is computed by multiplying the most recent
market value of a stock with the number of stocks outstanding. It is difficult to study
the impact of internal decisions taken on market capitalization in the short-term as it is
influenced by a number of factors. Hence the proxy in the form of EVE is used by the
bank managements to study the impact of their decisions on the EVE, which is
expected to be reflected in the bank’s market capitalization in the long-run. There is
114 also a regulatory angle to the importance of EVE. As the EVE reflects the fair value
of equity capital of a bank, the bank regulators are keen to use it as a proxy for capital Asset Liability Management
adequacy in market value terms. Hence, the regulators would not allow a more than
acceptable volatility in EVE for change in interest rates.
Apart from the above, the economic value approach has gained prominence as the NII
impact and EVE impact for a given change in interest rates on assets and liabilities
need not have to be in the same direction. It is perfectly possible for a bank to
substantially gain in NII terms when interest rates go up, but end up with a reduction
in EVE and vice versa. The most difficult question to answer in such a conflicting
situation is which impact to be managed immediately. Should the NII be allowed to be
impacted positively when the EVE is negatively impacted by the same interest rate
change or not? There is no simple answer to this question as the bank managements
are required to set-up limits for both NII and EVE and manage them to ensure that the
actual impact are within the limits prescribed.

Activity 5
Identify the situations under which the earnings and economic value approaches would
experience different impacts for a specified change in interest rate for assets and
liabilities.
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Sensitivity of Economic Value: Duration as a Measure of Elasticity of Value

Apart from the valuation of assets and liabilities using the principle of valuation, there
is also a need to use well known measures of interest rate sensitivity to understand the
interest rate elasticity of each asset & liability in the balance sheet and for arriving at
the net sensitivity, which would ultimately impact the EVE as per equation 5. The
well known measures of interest rate sensitivity are the duration family measures
which are used extensively in IRR in the current environment. The following
illustration would be used to explain the concept of valuation and measures of interest
rate sensitivity
Table 15.3: Valuation and Computation of Duration Measures for a Term Deposit

Principal and outstanding balance 10000

Opening Date of Deposit 01/01/03
Current Date 01/01/04
Date of Maturity of Deposit 31/12/08
Contractual Rate of Interest 9.00%
Freq. of int. payment per annum 1
Current Rate of Interest 8.00%
Residual Maturity (Years) 5.00
Time Period (t) in years Cash flow PVCF Duration Segment
1 900 833.3333 0.0801
2 900 771.6049 0.1484
3 900 714.4490 0.2061
4 900 661.5269 0.2545
5 10,900 7418.357 3.5668
Value of the Deposit ————————> 10399.27 4.2559 Duration of Deposit
3.9406 Modified
Duration of Deposit
115
Risk Management Steps in Valuation and Computation of Duration Measures
1. Cash Flow = (rate of interest × principal)/Frequency of Int.Payment
2. PV of Cash Flow (PVCF) = Cash flow (each time period) / (1+current interest
rate) time period
3. Value of Deposit = sum of all PVCFs
4. Duration Segment = (PVCF (each time period)/Value of Deposit) × time period
5. Duration of Deposit = Sum of all duration segments
6. Modified Duration of Deposit = Duration of Deposit /(1 + Current Interest Rate/
Frequency of Int.Payment))

Activity 6
Compute duration and modified duration of a cumulative deposit (cash certificate or
reinvestment deposit) using the same figures as given in the example above.
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The valuation carried out for the term deposit reveals that the economic value of the
deposit is Rs.10399.27 while the book value of the same is Rs.10000. As explained
elsewhere, a higher economic value than book value for a liability is a negative impact
on EVE. This can be interpreted as hinting at deterioration in the future earning
potential for the bank, which is reflected by a reduction in EVE. This explanation
would be crystal clear if the contractual interest rate and the current interest rate are
compared to draw conclusions on future earning potential. The comparison of interest
rates show that the bank has been incurring and will continue to incur till the deposit
matures a cost of 9% while the current interest rate on similar deposit has fallen to
8%. The bank is not able to reduce the interest rate on the deposit as the deposit
carries a fixed rate. The EVE reduction to the tune of Rs.399.27 (i.e., the current
book value of Rs.10000 – the economic value of Rs. 13399.27) is nothing but the
present value of future losses that the bank is going to suffer in the next 5 years of the
life of deposit as it is compelled to pay a rate 1% higher than current interest rate on
similar deposits. This interpretation is as of the current date, which may change in
future depending on interest rate on the deposit. One more observation worth making
here is that as the contractual rate is higher than the current rate, the depositor
exercising put option to prematurely withdraw his deposit is highly remote as the
benefit of higher rate would be lost then.
Both the duration, family measures of duration and modified duration, need to be
interpreted to assess the volatility of the value of the deposit for a change in interest
rate. The traditional meaning of duration is the pay back period by which the investor
would be able to get back the original amount invested along with the expected return.
The duration number of 4.2559 for the deposit is the pay back period in years for the
depositor. This concept has got a number of applications which are beyond the scope
of this discussion. Technically, duration is a measure of interest rate sensitivity
applicable in the continuous compounded form of interest rates. The modified
duration is an adjustment to duration to reflect the discrete compounding followed in
many situations. As discrete compounding is followed in the case of deposit in our
example, modified duration is the applicable measure of interest rate sensitivity.
Hence, the modified duration number of 3.9406 can be interpreted as a measure of
interest rate sensitivity. This interpretation suggests that for 1% change in the interest
rate on the deposit, the value of the deposit would change in the opposite direction of
116
the interest rate change by 3.9406%. This is the direct measure of interest rate Asset Liability Management
sensitivity of the deposit. Subject to the limitations of the duration family measures,
this measure of sensitivity can be used both in case of assets and liabilities.
The process explained above has to be followed for each asset & liability in the
balance sheet to arrive at aggregate duration at asset and liability level. The
aggregation process is simple as the duration of the asset side of the balance sheet is
the weighted average of individual asset durations where the weights are market value
of each asset to total value of the assets portfolio. Having estimated the asset and
liability durations, they can be compared with each other to assess the net sensitivity
which would impact the equity.
Consider the following example:
Duration of Assets = 5
Value of Asset = 100
Duration of Liabilities = 3.5
Value of Liabilities = 90
Economic Value of Equity = 10 (100 – 90)
A comparison of asset and liability durations reveals that the assets are more interest
rate sensitive than the liabilities of the bank. If interest rate goes up by 1% for both
the asset and liability, there would be a greater fall in the value of assets than the
liabilities. As a result of higher fall in asset value than liability value, the economic
value of equity would fall from its present level of Rs.10. The economic value of
equity would increase to the same extent when the interest rate falls. In the simple
example that we considered above, an adjustment for leverage, i.e. the extent of assets
funded by outside liabilities, has to be carried out to balance the asset side with the
liability side to arrive at the leverage adjusted duration gap which reflects the net
sensitivity of the EVE to interest rate changes. The following table describes the
sensitivity of EVE to interest rate change
EVE Sensitivity Analysis

LDGAP Interest Rate View EVE Impact =

(Assets and Liabilities) (LDGAP × MV of Assets×
Interest Rate Shock)
Positive Up Negative
Positive Down Positive
Negative Up Positive
Negative Down Negative
Zero Up or Down Zero

LDGAP = Leverage Adjusted Duration Gap = DA – (DL × K) where

DA = Duration of Assets; DL = Duration of Liabilities
K = Leverage = Market Value of Outsider Liabilities/
Market Value of Assets

To continue with the same example as above to estimate the leverage adjusted duration
gap
Duration of Assets = 5
Value of Asset = 100
Duration of Liabilities = 3.5
Value of Liabilities = 90
Economic Value of Equity = 10 (100 – 90)
Leverage = 90/100 = 0.90
Leverage Adjusted Duration Gap = 5 – (3.5 × 0.90) = 1.85
117
Risk Management Since the leverage adjusted duration gap is positive, as described in the Table, there
will be reduction in EVE when interest rate goes up and increase in the EVE when
interest rate falls
Computation of EVE impact with the Duration Gap
The computation of EVE impact for the entire balance sheet can be accomplished with
the help of the following equation:
Impact on EVE = -LDGAP × A × Interest Rate Shock ................. 6
Where:
-LDGAP = Leverage Adjusted Duration Gap (a minus sign is inserted to signify the
negative relationship between interest rate change and asset and liability values)
A = Economic Value of Assets
Interest Rate Shock = Rate of change in interest rate = Change in interest rate/
(1+New interest rate, i.e. interest rate after the change)
To continue with the same example to illustrate the impact on EVE:
Duration of Assets = 5
Value of Asset = 100
Duration of Liabilities = 3.5
Value of Liabilities = 90
Economic Value of Equity = 10 (100 – 90)
Leverage = 90/100 = 0.90
Leverage Adjusted Duration Gap = 5 – (3.5 × 0.90) = 1.85
Change in Interest Rate for assets & liabilities = 1%
New interest rate = 10% (old interest rate of 9% + current increase in interest rate of 1%)
Impact on EVE = -1.85 × 100 × (1%/(1+10%)) = -1.68182
EVE after interest rate shock = 8.3181
Percentage impact on EVE for 1% change in interest rates =
(EVE after shock – EVE prior to shock) / EVE Prior to shock
(8.3181 – 10) / 10 = -16.8182%
The impact of 1% increase in the interest rate for assets & liabilities is a negative
impact on EVE to the extent of 16.8182% opposite would be the case when interest
rate goes down. It has to be realized here that a lower LDGAP would always lead to
lower EVE sensitivity compared to higher LDGAP

Management of IRR under Economic Value Approach

It has to be realized that equation 6 is the ultimate balance sheet equation that can be
used by the bank management to control the sensitivity of EVE for change in interest
rates. Out of the three components in the equation, Leverage Adjusted Duration Gap
(LDGAP) and the market value of assets (A) are within the control of bank
management as they can be altered by the policies and strategies followed by a bank.
The LDGAP can be increased by increasing asset duration and / or reducing the
liability duration or vice versa for reducing the LDGAP. The last component, interest
rate shock is beyond the control. Had it been controllable, there is no need for IRR
management process at all! By adjusting the controllable factors suitably, the interest
rate sensitivity of EVE can be maintained at an acceptable level.

118
Activity 7 Asset Liability Management

Identify the strategies to increase and increase LDGAP.

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Special Concerns in Managing IRR

Apart from the issues pointed out in case of management of liquidity risk, the
following items need to be carefully considered:
Yield Curve Risk: Arises as a result of non-uniform changes in interest rates for
various term-to-maturities. For example, 3-year deposit rate may go up by 1%,while
1-year deposit rate may go up by 0.5%.
Basis Risk: Arises as a result of imperfect correlation among asset and liability rates.
It is not necessary for the asset & liability rates to change by the same quantum.
There may also be lags in change of one rate for a change in the other.
Embedded Options Risk: It has already been explained in the section on
liquidity risk. The options risk arises as a result of put and call options present in
many of the liability and asset products of the bank. The implication is non-linear
change in NII and EVE for a change in interest rates. This means that same
change in interest rates on either side (increase by 1% and decrease by 1% from the
same base) would produce dissimilar impact on NII and EVE as a result of
customer options.
It is to be observed that in the examples used for NII sensitivity analysis, duration gap
analysis etc., only the repricing gap arising out of timing differences between the
repricing of assets and liabilities was considered. It is extremely important to consider
yield curve, options and basis risk dimensions of IRR before a meaningful decision is
taken. To highlight the importance, even if the repricing gap in a bucket is zero, the
existence of basis risk between asset and liability rate changes would definitely impact
NII. Similarly, the gaps arrived at on the basis of repricing without the consideration
of options risk can be highly misleading in a volatile interest rate environment. The
presence of yield curve risk would challenge the basic assumption of similar interest
rate changes across the maturity segments of an asset or liability. The analysis of
yield curve, basis and options risks require high quality data from both within and
outside the bank. The data need to be subjected to a number of relevant statistical
tests to arrive at a bank’s exposure to these dimensions of IRR. The sum and
substance of the discussion is the significance of graduating from a mere
concentration on repricing alone to higher dimensions of IRR. In this sense, the
current practice of a number of banks restricting the analysis to repricing
gap alone in their interest rate risk analysis and management framework is highly
inadequate in the current environment .

15.6 MARKET RISK

Market Risk arises as a result of volatility in price of assets (and liabilities) due to
changes in:
l Interest Rates
l Currency Prices
l Commodity Prices, and
l Equity Prices 119
Risk Management Price risk of the assets in the trading book is the prime decision point in market risk
management. Of the above, the most significant exposure is to the interest rates in the
form of a sizeable portfolio of Government and other securities. Hence the major
concentration would be on interest rates.

Tools for Measurement of Market Risk

Measures for market risk are broadly categorized as under:
l Factor Sensitivity Measures
l Volatility Based Measures
Factor Sensitivity Measures: Factor sensitivity measures assess the impact of change
in the major factors (which determine the market value of the positions) on the market
value of the portfolio. The most prominent factor sensitivity measure is the modified
duration explained in the previous section. Modified duration is the direct measure of
sensitivity in value of a security or a portfolio of bonds for a change in interest rates.
The modified duration concept rests on a number of assumptions which are unrealistic
in today’s environment. Though a number of refinements to the original concept have
been suggested to make it applicable in the current environment, a number of issues
remain unattended. Important among them are the relevance of the tool in an
environment of non-parallel shifts in the yield curve and adequacy of the concept for
bonds embedded options in the form of calls, puts, caps, floors etc.
The most significant application of the factor sensitivity measures is to use them for
setting limits at portfolio level. For example, a bank may set the maximum modified
duration of its bond portfolio as (say) 7. This means that the price sensitivity that the
bank is willing to accept in case of the bond portfolio is maximum 7% of the value of
the portfolio for 1% change in the interest rates. Any loss higher than 7% would not
be tolerated by the bank. This is extremely important as the traders in their zeal to
make more and more profits (as their remuneration is linked to their trading profits in
many private & foreign banks) may go out of control to expose the bank to unlimited
amount of risk. The moral hazard problem involved in this is that when excessive
risk taking leads to profits in some periods, everybody would be happy as all are
better off. If the excessive risk taking leads to catastrophic losses as it can, the loss to
the trader is limited to losing the income and job. But such catastrophic losses can
wipe out banks instantaneously. There have been number of such instances in many
markets; the most important among them is the collapse of the Barings Bank in the
UK due to losses hidden by its star trader Nick Leeson, who was making tonnes of
profits for the benefit of all. This is precisely the reason why many banks have not set
up treasury mid-office with a specific mandate of ensuring adherence to policy limits.
The mid-office should be completely independent of any risk taking positions and
enjoy direct reporting to risk management committee.
Volatility Based Measures: While factor sensitivity measures are still very popular in
our country and are practiced widely, in the recent past, volatility based measure
popularly known as Value-at-Risk (VAR) has gained a lot of prominence among the
trading and risk management communities. The greatest advantage of VAR is its
uniformity in measuring trading risk across various positions such as interest rates,
currency, equity and commodity, which is the weakest thing as far as factor sensitivity
measures are concerned. As a result of this uniformity of measurement, it is possible
to aggregate risk across completely different positions, compare and contrast among
various positions to assess the relative riskiness and so on. Apart from this, VAR has
revolutionized the risk communication from trading desk to top management as the
measure is extremely simple to understand unlike the factor sensitivity measures
which make sense only to the respective trading and risk management community that
120 uses them. For others, especially the top management with little exposure to such
concepts, it would be only Greek and Latin. VAR has tremendously overcome such Asset Liability Management
communication barriers. It is important to recognize here that unless the risk reports
are understood and acted upon by the top management, there would always be a
possibility of a misalignment between what is perceived as acceptable risk by the top
management and others who are in operating lines. Detailed discussion of the
technique of VAR is beyond the scope of the material as it requires a reasonable
knowledge of mathematics and statistics since VAR is an application of standard
mathematical and statistical principles for financial risk management. An example of
VAR is as under:
Type of the portfolio: GOI Bond Trading Portfolio
Market Value: Rs. 200 crores
VAR = Rs. 5 crores
Confidence Level used for VAR computation: 99%
Holding Period used for VAR computation (days): 1
The above information can be interpreted easily with a little knowledge of probability.
The exact interpretation of VAR of Rs. 5 crores for a Rs.200 crore GOI Bond
portfolio is: the maximum loss that the bank will suffer on a single trading day (as
holding period used is 1 day) would not exceed Rs.5 crores on 99% of the trading
days (as the confidence level used for VAR computation is 99%). Only on 1% of the
trading days, the loss would exceed the VAR of Rs. 5 crores. If we assume 100
trading days in a period, the above interpretation means that 99 trading days out of
100 days would have losses less than Rs. 5 crores. Only on 1 day out of 100 days,
the losses would exceed the VAR number computed. Please note that the concept of
VAR concentrates on only the possible losses.

Activity 8
Interpret the VAR at 95% in the above example.
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There are at least three broad methods to computing VAR:

l Historical Simulation: The approach relies heavily on past data of prices to
estimate VAR. The basic assumption of the method is that the past trends and
volatilities in prices would repeat in future also. This method does not require
the use of any statistical distribution and tools, hence it is non-parametric.
l Analytical or Variance Covariance VAR: This is the most accepted and
practiced method at present popularized by the investment bank J.P.Morgan in
the 90s. This approach is parametric as it assumes the prices to follow normal
distribution and uses statistical concepts such as standard deviation, correlation,
covariance etc. for the estimation of VAR.
l Monte Carlo VAR: The term monte carlo denotes a popular approach to
simulating random numbers based on a specified statistical distribution. This
approach does not make any assumption of distributional properties of asset
prices but involves empirical estimation of the statistical distribution from the
prices which is then used to simulate the prices leading to the estimation of VAR.
There are a number of variants to the above broad methods of VAR each may require
specific data for implementation.
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Risk Management Wherever the factor sensitivity measures are used at present by banks, VAR can be
used. In fact, the basis for computation of capital for market is VAR. This was
suggested by the Basle committee on Bank Supervision in 1996 and has been accepted
worldwide by the bank regulators. India is not an exception to this. The standard
limitation of VAR is that its computation rests on a number of assumptions relating to
the statistical properties of market prices and price returns, which are not realistic.
This is the precise reason why the selection of an appropriate VAR model must be
based on ‘backtesting’. Backtesting compares the output of a model with actual
outcome to decide whether the model is performing as per expectation or not.
Increasingly it has been found out that the VAR as a method for market risk
measurement is suitable for only normal market environment. Stress testing
should be used to complement the computed VAR to assess the performance of the
portfolio in an environment of abnormal market movements which remain outside the
standard VAR models as of date. This is attempted to be accomplished by modeling
extreme price movements using Extreme Value Theory and other similar approaches.

15.7 SUMMARY
All the three risks under the umbrella of ALM are highly interrelated with each other.
The interrelationship must be kept in mind when risk measures are chosen and used.
Care must be exercised when assumptions relating to risks falling under a different
domain, especially credit risk, are made as they may be inappropriate unless otherwise
validated. An important development that can enhance the capability to handle risks
in general is the introduction of the derivative products in the market. Derivative
products offer an off-balance sheet alternative to managing risks in an accurate,
instantaneous and the least costly way. It is not surprising that they have occupied the
centre-stage now in our country. A number of banks are in the process of finalizing
their policies and beefing-up their systems to be able to use the products. No doubt,
derivatives can alter the landscape of banking in the next few years to come, as it had
happened in a number of countries in the developed world

15.8 SELF ASSESSMENT QUESTIONS

1. Explain the role, scope & objectives of ALM function in a bank.
2. How does liquidity risk arise and what are its components?
3. Explain the assumptions made for the preparation of liquidity gap report.
4. What are the broad approaches to measuring the interest rate risk? Are they in
agreement with each other always? Why or why not?
5. How are the non-maturity deposits treated for ALM?
6. How do yield curve, basis & options risks impact NII?
7. Compute Leverage adjusted duration gap and EVE sensitivity given the
following:
Duration of Assets = 6.5
Value of Assets = 230
Duration of Liabilities = 3.75
Value of outsider liabilities = 200
The interest rates on assets & liabilities are expected to increase by 1% p.a.
immediately.
8. Do you expect the impact on EVE to be same as in the previous question if the
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interest rates decrease by 1% p.a immediately? Why?
 Asset Liability Management
15.9 FURTHER READINGS
Asset Liability Management (ALM) System in Banks, Reserve Bank of India, 1999.
Guidance Note on Market Risk Management, Reserve Bank of India, 2002.
Risk Management Systems in Banks, Reserve Bank of India, 1999.
Gardner and Mills, Managing Financial Institutions: An Asset Liability Approach.
New York, Dryden Press.
Saunders Anthony and Cornett Marcia Millon, 2003, Financial Institutions
Management – A Risk Management Approach, McGraw Hill, New York.
Bessis Joel, 2003, Risk Management in Banking, John Wiley & Sons,
New York.
Crouchy Michel, Galai Dan and Mark Robert, 2001, Risk Management, McGraw
Hill, New York.
Bitner, 1992, Successful Bank Asset-Liability Management: A Guide to the Future
Beyond Gap, John Wiley, New York.
Jorion Philippe, 2001, Value at Risk-The New Benchmark for Managing Financial
Risk, McGraw Hill, New York.
Best Philip, Implementing Value at Risk, New York, John Wiley & Sons, 1998
Dowd Kevin, 1998, Beyond Value at Risk- The New Science of Risk Management,
John Wiley & Sons, New York.

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