Asset Liability Management in Banks

Components of a Bank Balance Sheet Liabilities

1. 2. 3. 4. 5. Capital Reserve & Surplus Deposits Borrowings Other Liabilities

Assets
1. Cash & Balances with RBI 2. Bal. With Banks & Money at Call and Short Notices 3. Investments 4. Advances 5. Fixed Assets 6. Other Assets

Banks profit and loss account

A banks profit & Loss Account has the following components:
I.

II.

Income: This includes Interest Income and Other Income. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

Evolution

In the 1940s and the 1950s, there was an abundance of funds in banks in the form of demand and savings deposits. Hence, the focus then was mainly on asset management But as the availability of low cost funds started to decline, liability management became the focus of bank management efforts Banks started to concentrate more on the management of both sides of the balance sheet

What is Asset Liability Management??

It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII. The process by which an institution manages its balance sheet in order to allow for alternative interest rate and liquidity scenarios

Banks and other financial institutions provide services which expose them to various kinds of risks like credit risk, interest risk, and liquidity risk
Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management.

An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio

It is aimed to stabilize short-term profits, long-term earnings and longterm substance of the bank. The parameters for stabilizing ALM system are:

1.
2. 3.

Net Interest Income (NII) Net Interest Margin (NIM) Economic Equity Ratio

3 tools used by banks for ALM

ALM information systems

ALM Organization
ALM Process

ALM Information Systems

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 : analysing the behaviour of asset and liability products in the top branches as they account for significant business then making rational assumptions about the way in which assets and liabilities would behave in other branches The data and assumptions can then be refined over time as the bank management gain experience

The spread of computerisation will also help banks in accessing data.

ALM Organization

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 Is responsible for balance sheet planning from risk - return perspective including the strategic management of interest rate and liquidity risks The role of ALCO includes product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities, It will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs foreign currency funding It should review the results of and progress in implementation of the decisions made in the previous meetings

ALM Process
Risk Parameters

Risk Identification

Risk Measurement

Risk Management Risk Policies and Tolerance Level

Under ALM, risks that are typically managed are.

Currency Risk

Liquidity Risk

Interest Rate Risk

Will now be discussed in detail

Liquidity Risk

Liquidity risk arises from funding of long term assets by short term liabilities, thus making the liabilities subject to refinancing

Funding risk
Time risk Call Risk

Arises due to unanticipated withdrawals of the deposits from wholesale or retail clients

It arises when an asset turns into a NPA. So, the expected cash flows are no longer available to the bank.

Due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when available.

Liquidity Risk Management

Banks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times Liquidity Management is the ability of bank to ensure that its liabilities are met as they become due Liquidity positions of bank should be measured on an ongoing basis A standard tool for measuring and managing net funding requirements, is the use of maturity ladder and calculation of cumulative surplus or deficit of funds as selected maturity dates is adopted

Statement of Structural Liquidity

All Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:
i. 1 to 14 days ii. 15 to 28 days iii. 29 days and up to 3 months iv. Over 3 months and up to 6 months v. Over 6 months and up to 1 year

vi. Over 1 year and up to 3 years

vii. Over 3 years and up to 5 years viii. Over 5 years

Statement of structural liquidity

Places all cash inflows and outflows in the maturity ladder as per residual maturity
Maturing Liability: cash outflow Maturing Assets : Cash Inflow Classified in to 10 time buckets at present. Shows the structure as of a particular date Banks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement

15-28 1-14Days Days 30 Days- 3 Mths - 6 Mths - 1Year - 3 3 Years - Over 5 3 Month 6 Mths 1Year Years 5 Years Years Total

300 200 350 400 50 50 700 650 200 150 50 50 200 150 Loans BPLR Linked 100 150 Others 50 50 Total Inflow 600 550 Gap -100 -100 Cumulative Gap -100 -200 Gap % to Total Outflow -14.29 -15.38

Capital Liab-fixed Int Liab-floating Int Others Total outflow Investments Loans-fixed Int Loans - floating

200 600 600 300 200 350 450 500 450 450 0 550 1050 1100 750 650 250 250 300 100 350 0 100 150 50 100 200 150 150 150 50 200 500 350 500 100 0 0 0 0 0 650 1000 950 800 600 100 -50 -150 50 -50 -100 -150 -300 -250 -300
18.18 -4.76 -13.64 6.67 -7.69

200 200 450 200 1050 900 100 50 100 200 1350 300 0
28.57

200 2600 3400 300 6500 2500 600 1100 2000 300 6500 0 0

Addressing the mismatches

Mismatches can be positive or negative Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A. In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. For ve mismatch, it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

Currency Risk

The increased capital flows from different nations have contributed to increase in the volume of transactions Dealing in different currencies brings opportunities as well as risk To prevent this banks have been setting up overnight limits and undertaking active day time trading Value at Risk approach to be used to measure the risk associated with forward exposures. Value at Risk estimates probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.

Interest Rate Risk

Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM) Interest Rate risk is the exposure of a banks financial conditions to adverse movements of interest rates Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a banks earnings and capital base

Changes in interest rates also affect the underlying value of the banks assets, liabilities and off-balance-sheet item
NIM= diff. In interest paid and interest received.

Risk Measurement Techniques

Various techniques for measuring exposure of banks to interest rate risks

Maturity Gap Analysis Duration Simulation Value at Risk

Maturity gap method (IRS)

THREE OPTIONS: A) Rate Sensitive Assets>Rate Liabilities= Positive Gap B) Rate Sensitive Assets<Rate Liabilities = Negative Gap C) Rate Sensitive Assets=Rate Liabilities = Zero Gap Sensitive Sensitive Sensitive

Gap Analysis

Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates - If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII

- conversely, a positive gap (RSA>RSL) in a given time band, an decrease in market interest rates could cause a decline in NII

The basic weakness with this model is that this method takes into account only the book value of assets and liabilities and hence ignores their market value.

Analysis
Change in inst. rate Change in NII

RSA = RSL
RSA = RSL RSA > RSL RSA > RSL RSA < RSL

Increase
Decrease Increase Decrease Increase

NO CHANGE
NO CHANGE INCREASE DECREASE DECREASE

RSA < RSL

Decrease

INCREASE

Duration Analysis

It basically refers to the average life of the asset or the liability

It is the weighted average time to maturity of all the preset values of cash flows

The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero.

As

Simulation

Basically simulation models utilize computer power to provide what if scenarios, for example: What if:

The absolute level of interest rates shift Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad debt and prepayment levels change in different interest rate scenarios There are changes in the funding mix e.g.: an increasing reliance on short-term funds for balance sheet growth

This dynamic capability adds value to this method and improves the quality of information available to the management

Value at Risk (VaR)

Refers to the maximum expected loss that a bank can suffer in market value or income: Over a given time horizon, Under normal market conditions, At a given level or certainty

It enables the calculation of market risk of a portfolio for which no historical data exists. VaR serves as Information Reporting to stakeholders It enables one to calculate the net worth of the organization at any particular point of time so that it is possible to focus on long-term risk implications of decisions that have already been taken or that are going to be taken

SUCCESS OF ALM IN BANKS: PRE CONDITIONS

Awareness for ALM in the Bank staff at all levelssupportive Management & dedicated Teams. Method of reporting data from Branches/ other Departments. (Strong MIS). Computerization-Full computerization, networking. Insight into the banking operations, economic forecasting, computerization, investment, credit. Linking up ALM to future Risk Management Strategies.

CONCLUSION
Asset-Liability Management has evolved as a vital activity of all financial institutions and to some extent other industries too. It has become the prime focus in the banking industry, with every bank trying to maximize yield and reduce their risk exposure. The Reserve Bank of India has issued guidelines to banks operating in the Indian environment to regulate their asset-liability

positions in order to maintain stability of the financial system.

Maturity-gap analysis has a wide range of focus, not only as a situation analysis tool, but also as a planning tool. Banks need to maintain the maturity gap as low as possible in order to

avoid any liquidity exposure. This would necessarily mean that the outflows in different maturity
buckets need to be funded from the inflows in the same bucket.

Thankyou!!!