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PROJECT REPORT ON
Asset Liability Management of Commercial Bank
BY
Ashish Chaurasia
UNDER THE GUIDANCE OF
Prof. Trupti Naik
A PROJECT SUBMITTED IN FULFILMENT OF MMS TO
VIDYALANKAR INSTITUTE OF TECHNOLOGY
Wadala (East), Mumbai 400 037
March 2015
PROJECT REPORT ON
1
Asset Liability Management of Commercial Bank
BY
Ashish Chaurasia
UNDER THE GUIDANCE OF
Prof. Trupti Naik
A PROJECT SUBMITTED IN FULFILMENT OF MMS TO
VIDYALANKAR INSTITUTE OF TECHNOLOGY
Wadala (East), Mumbai 400 037
March 2015
Signature of Faculty Guide Head of Department
DECLARATION
2
This is to declare that the study presented by me to Vidyalankar Institute of
Technology, in completion of the Master in Management Studies (MMS)
under the “Asset Liability Management of Commercial Bank” has been
accomplished under the guidance of prof. Trupti Naik.
Ashish Chaurasia
Place:
Date:
ACKNOWLEDGEMENT
3
My project on “Asset Liability Management of Commercial Bank’’ has been a
great learning experience. I was exposed to the different areas of research in
finance and gained valuable experience, which I will always recall with a
sense of satisfaction and pride.
This is to acknowledge Prof. Trupti Naik under whose guidance I have been able to successfully complete this project and effectively come to a very successful conclusion.
To all my colleagues who have helped me either directly or indirectly, I am grateful
for their valuable inputs. This project would not have been possible without their help.
Ashish Chaurasia
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CONTENT
1. Objective 5
2. Literatture review 6
3 INTRODUCTION OF THE TOPIC 9
4. Research Methodology 12
5. Risks associated with ALM 13
6. Strategies and Techniques used for ALM 16
7. Trends in Liquidity Risk Management 26
8. Roles of ALCO 35
9. Process of ALCO 37
10. Organisational Structure of ALCO 38
11. Trend analysis of Asset and liability component of Public sector,
Private sector and Foreign bankS 39
12 TREND OF Assets COMPONENTS IN PUBLIC SECTOR 41
13TREND OF LIABILITY COMPONENTS IN PUBLIC
SECTOR43
14 TREND OF ASSET COMPONENTS IN PRIVATE SECTOR 45
15TREND OF LIABLITY COMPONENTS IN PRIVATE
SECTOR47
16 TREND OF ASSETS COMPONENTS IN FOREIGN BANKS 49
17 TREND OF LIABILITY COMPONENTS IN FOREIGN
BANKS:51
18 Findings and Conclusion 55
19 BIBLIOGRAPHY 57
OBJECTIVE OF STUDY
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1. To understand risk associated with asset liability management in Indian
commercial banks.
2. To study strategies and techniques used for Asset liability management in
Indian commercial banks
3. Role of ALCO(Asset Liability committee) in asset liability management.
6
Literature Review:
Kanjana.E.N (2007), “Efficiency, Profitability and Growth of Scheduled Commercial Banks
in India” tested (1) whether the establishment expense was a major expense, and (2) out of total expense which is met by scheduled commercial banks is more due to more number of employees. In her empirical study, the earning factor and expense factor which are controllable and non-controllable by the bank.
Ashok Kumar.M (2009) in his study examines how the financial performance of
SBI group, Nationalized banks group, private banks group and foreign banks
group has been affected by the financial deregulation of the economy. The
main objective of the empirical study is to assess the financial performance of
Scheduled Commercial Banks through CRAMEL Analysis.
Recently, there has been much discussion regarding the concept of enterprise risk
management (ERM). ERM is a broader concept than asset liability management.
ERM can be viewed as a comprehensive and integral process of identifying,
assessing, monitoring and managing the risk exposure of an organization, ideally
through a formal organizational structure and a quality approach. The goal of
ERM is to minimize the effects of risk on an organization‟s capital and earnings,
and to better allocate its risk capital. Thus, ERM considers the broad range of risks
associated with operating a business, including financial, strategic, and operational
and hazard risks. Because financial institutions thrive on the business of risk, they
are good examples of companies that can benefit from effective ERM. Asset
liability Management is a significant component of ERM because it is an
important process in addressing financial risk since all risk cannot be eliminated
but it is the responsibility of risk managers to identify their risk levels and know
which level can be controlled or accept.
A number of authors (Hester & Zoellner, 1966; Kwast & Rose, 1982; Vasiliou, 1996; Kosmidou et al, 2004; and Asiri, 2007) have studies about the influence of the composition of assets and liabilities on the profitability of bank. Hester & Zoellner (1966) employed statistical cost accounting (SCA) method on US
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banks and found statistically significant coefficients for most of the categories of assets and liabilities and rejected the null hypothesis that there is no relationship between them. Vasiliou (1996), by employing SCA method, suggest that asset management rather than liability management play more prominent role in explaining inter-bank differences in profitability. However, these findings contrast with the findings of Kosmidou et al (2004) who find that liability management contributes more in creating the profitability differences among the banks.
These authors did not incorporate the variables relating to macro economic and market structure in their model. In fact, a number of bank specific or macroeconomic factors such as market structure, Inflation, gross domestic product (GDP) growth rate, etc do impact bank’s net earnings which were ignored by these authors. With this view, Kwast & Rose (1982) expanded the traditional SCA model by including market structure and macro economic variables. Nonetheless, their model found no evidence that differential returns and costs on different categories of assets and liabilities exist between high and low profit banks. In a recent study, Asiri (2007) has applied SCA method and finds that assets are positively and liabilities are negatively related to the profitability of the Kuwaiti banks.
The ALM area of finance has been widely studied for its use in pension funds, insurance companies, and other institutional investment portfolios (see Leibowitz and Henriksson 1988; Waring 2004a, 2004b; Fong and Guin 2007, among others). ALM has only recently begun to be examined in the context of individual investors. Numerous studies examine portfolio management of individual investors within an ALM framework. Stout (2008) presents a stochastic, Monte Carlo optimization of retirementportfolios that seeks to minimize the probability of exhausting the portfolio. He notes that the risk-minimizing allocation to equities decreases with retirement age and increases with the withdrawal rate from the portfolio. Ziemba (2003) presents an ALM methodology for managing multi-period investment horizons using a generalized stochastic program. In his article, individuals’ multi-period horizons are examined against a model that suggests an allocation for each horizon. Further, the EDHEC Risk and Asset Management Research Centre has published a number of general studies dealing with the topic of ALM for individual investors (for example, Amenc, Martellini, and Ziemann 2007).
The application of ALM for individual investors is also examined from a behavioral perspective in various studies. In these studies, liabilities are framed in terms of goals that investors wish to achieve using portfolio funds. Nevins (2004) examines goals-based investing using investor-specific liability goals and sub-portfolios (within the larger investment portfolio) that are managed to meet these goals. Chhabra (2005) also incorporates investor goals into the asset allocation decision and notes that risk allocation should precede asset allocation when managing portfolios for individual investors. Brunel (2006) examines goals-based investment techniques and compares the efficiency of these techniques to traditional allocation approaches; he
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discovers that the additional costs associated with goals-based investing are trivial.
Jones and Brown (2009) contend that private-wealth investors are challenged in ways: (1) asset allocation advice yielded from commonly applied techniques focuses on optimization, not risk management, and (2) shortfall funding risk analysis is not typically analyzed in terms of multi-period stochastic reality. They further contend that shortfall risk analysis does not typically provide asset-allocation advice. Their study argues that straightforward and readily implementable risk-management techniques that provide insight on asset allocation are in short supply for private wealth practitioners. Jones and Brown (2009) also contend that the absence of ALM in the private wealth arena stems from two factors: (1) its perceived complexity, and (2) prior attempts to implement ALM across larger firms tended to fail because of the actual complexity of the specific implementation techniques and the associated software, among other reasons. As a result, they present a straightforward interest rate immunization technique in which low-risk assets can ultimately be used to immunize liabilities over a specified period. Further, the net present value of liabilities over the specified immunization horizon is used as a constraint within a mean-variance optimization (MVO). This approach allows an individual’s portfolio to provide short-term cash flow, as needed, while also considering the longer-term demands on the portfolio. Another interpretation of this approach is as a form of liability-driven investing with surplus optimization (Taylor and Earney 2008), which itself falls within the ALM arena. Ultimately, ALM protects against shortfall funding risks and provides perspective on the basic mix of low-risk (immunizing) assets and riskier assets, whereas widely used asset-allocation techniques such as mean-variance optimization (MVO) focus primarily on optimizing assets. In this regard, the Jones and Brown (2009) approach allows for both liability risk managment and efficient portfolio construction.
INTRODUCTION OF THE TOPIC
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As financial intermediaries banks are known to accept deposit to lend money
to entrepreneurs to make profit. They essentially intermediate between the opposing
liquidity needs of depositors and borrowers. In the process, they function with an
embedded mismatch between highly liquid liabilities on the one side and less liquid
and long term assets on the other side of their balance sheets. Over and above this
balance sheet conflict, they also stand exposed to a wide array of risk such as market
risk, transformation risk, credit risk, liquidity risk, forex risk, legal risk, operation
risk, reputational risk, interest rate risk, etc. The recognition of three main risk i.e.
Interest Rate Risk, Liquidity Risk and Credit Risk gave rise to the concept of Asset
Liability Management.
Asset-Liability Management (ALM) can be termed as a risk management technique
designed to earn an adequate return while maintaining a comfortable surplus of assets
beyond liabilities. Banks are exposed to several risks which are multi-dimensional.
The main direct financial risks are interest rate risk, liquidity risk, credit risk and
market risk. The initial focus of the ALM function would be to enforce the risk
management discipline viz, managing business after assessing the risks involved. The
objective of good risk management programmes should be that these programmes will
evolve into a strategic tool for bank management. The asset-liability management
function would involve planning, directing and controlling the flow, level, mix, cost
and yield of the consolidated funds of the Bank. It takes into consideration interest
rates, earning power, and degree of willingness to take on debt and hence is also
known as Surplus Management. It enables banks to sustain their required growth rate
by systematically managing market risk, liquidity risk, capital risk, etc.
The objective of ALM is to manage risk and not eliminate it. Risks and rewards go
hand in hand. One cannot expect to make huge profits without taking huge amount of
risk. The objectives do not limit the scope of the ALM functionality to mere risk
assessment, but expanded the process to the taking of risks that might conceivably
result in an increase in economic value of the balance sheet.
Apart from managing the risks ALM should enhance the net worth of the institution
through opportunistic positioning of the balance sheet. The more leveraged an
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institution, the more critical is the ALM function with enterprise.
The objectives of Asset-Liability Management are as follows:
To protect and enhance the net worth of the institution.
Formulation of critical business policies and efficient allocation of Capital.
To increase the Net Interest Income (NII)
It is a quantification of the various risks in the balance sheet and optimizing of
profit by ensuring acceptable balance between profitability, growth and risks.
ALM should provide liquidity management within the institution and choose a
model that yields a stable net interest income consistently while ensuring
liquidity.
To actively and judiciously leverage the balance sheet to stream line the
management of regulatory capital.
Funding of banks operation through capital planning.
Product pricing and introduction of new products.
To control volatility of market value of capital from market risk.
Working out estimates of return and risk that might result from pursuing
alternative
programs.
Asset/ liability management (ALM) is a tool that enables bank managements’ to
take business decisions in a more informed framework. The ALM function informs
the manager what the current market risk profile of the bank is and the impact that
various alternative business decisions would have on the future risk profile. The
manager can then choose the best course of action depending on his board's risk
appetite.
Consider for example, a situation where the chief of a bank’s retail deposit
mobilization function wants to know the kind of deposits that the branches should
be told to encourage. To answer this question correctly he would need to know
inter alia the existing cash flow profile of the bank. Let us assume that the
structure of the existing assets and liabilities of the bank are such that at the
aggregate the maturity of assets is longer than maturity of liabilities. This would
expose the bank to interest rate risk (if interest rates were to increase it would
adversely affect the banks net interest income). In order to reduce the risk the bank
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would have to either reduce the average maturity of its assets perhaps by
decreasing its holding of Government securities or increase the average maturity of
its assets, perhaps by reducing its dependence on call/money market funds. Thus,
given the above information on the existing risk profile of the bank, the retail
deposits chief knows that the bank can reduce its future risk by marketing its long-
term deposit products more aggressively. If necessary he may offer increased rates
on long-term deposits and/or decreasing rates on the shorter term deposits.
The above example illustrates how correct business decision making can be added
by the interest rate risk related information. The real world of banking is of course
more complicated. The risk related information is just one of many pieces of
information required by a manager to take decisions. In the above example itself
the retail deposits chief would also have considered a host of other factors like
competitive pressures, demand and supply factors, impact of the decision on the
banks retail lending products, etc before taking a final decision. The important
thing, however, is that ALM is a tool that encourages business decision making in
a more disciplined framework with an eye on the risks that the bank is exposed to.
ALM is thus a comprehensive and dynamic framework for measuring, monitoring
and managing the market risks, i.e liquidity interest and exchange rate risks of a
bank. It has to be closely integrated with the bank’s business strategy as this affects
the future risk profile of the bank. This framework needs to be built around a
foundation of sound methodology and human and technological infrastructure. It
has to be supported by the board's risk philosophy, which clearly specifies the risk
policies and tolerance limits. ALM is a term whose meaning has evolved. It is
used in slightly different ways in different contexts. ALM was pioneered by
financial institutions, but corporations now also apply ALM techniques.
Traditionally, banks and insurance companies used accrual accounting for
essentially all their assets and liabilities. They would take on liabilities, such as
deposits, life insurance policies or annuities. They would invest the proceeds from
these liabilities in assets such as loans, bonds or real estate. All assets and liabilities
were held at book value. Doing so disguised possible risks arising from how the
assets and liabilities were structured.
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RESEARCH METHODOLOGY
MEANING OF RESEARCH:-
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Research is a scientific & systematic search for pertinent information on a
specific topic. The Advanced Learning Dictionary of Current English lays down the
meaning of research as “careful investigation or inquiry especially through search for
new facts in any branch of knowledge”. Some people consider research as a
movement, a movement from the known to unknown. It is actually a voyage of
discovery.
In short, the search for knowledge through objective & systematic method of finding
solutions
to a problem is research.
Data Collection:
For any study there must be data for analysis purpose. Without data there is
no means of study. Data collection plays an important role in any study. It can be
collected from various sources. I have collected the data from one source which are
given below:
Secondary Data
Published Sources such as Journals, Government Reports, Newspapers and
Magazines etc.
Unpublished Sources such as Company Internal reports.
Websites like RBI, IBA
To achieve the objective, information is collected through secondary data.
Secondary
data one those which have been already been collected.
Sampling As the study was primarily based on secondary data. No sampling
technique has been used for this purpose, no sample size is applicable and no tools
were used for collecting primary data.
Hypothesis:
Trends of asset liability components in private/public sector bank is different than
foreign bank
Limitation of the studies:
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The research work is mainly based on secondary data .
Less importance has been given to primary data which is actually the original
data and more reliable.
Risk associated with Asset Liability Management
Risk can be defined as the chance or the probability of loss or damage.
these include credit risk, capital risk, market risk, interest rate risk, liquidity risk,
operations risk and foreign exchange risks. These categories of financial risk require
focus, since financial institutions like banks do have complexities and rapid
changes in their operating environments.
1. Credit Risk: The risk of counter party failure in meeting the payment
obligation on the specific date is known as credit risk. Credit risk management
is an important challenge for financial institutions and failure on this front may
lead to failure of banks. Credit risk plays a vital role in the way banks perform.
It reflects the profitability, liquidity and reduced Non Performing Assets.
The other important issue is contract enforcement. Legal reforms are very
critical in order to have timely contract enforcement. Delays and loopholes in
the legal system significantly affect the ability of the lender to enforce the
contract. The legal system and its processes are notorious for delays showing
scant regard for time and money that is the
basis of sound functioning of the market system. Credit Risk Management is
the process that puts in place systems and procedures enabling banks to:
Identify and measure the risk involved in credit proposition, both at
individual transaction and portfolio level.
Evaluate the impact of exposure on bank's financial statements.
Access the capability of the risk mitigates to hedge/insure risks.
Design an appropriate risk management strategy to arrest risk mitigation.
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2.Capital Risk: Capital risk is the risk an investor faces that he or she may lose
all or part of the principal amount invested. It is the risk a company faces that it
may lose value on its capital. The capital of a company can include equipment,
factories and liquid securities. Capital adequacy focuses on the weighted average
risk of lending and to that extent, banks are in a position to realign their portfolios
between more risky and less risky assets.
3.Market Risk: Market risk refers to the risk to an institution resulting from
movements in market prices, in particular, changes in interest rates, foreign
exchange rates, and equity and commodity prices. Market risk is also referred
to as "systematic risk". This risk cannot be diversified. Market risk is related to
the financial condition, which results from adverse movement in market
prices. This will be more pronounced when financial information has to be
provided on a marked-to-market basis since significant fluctuations in asset
holdings could adversely affect the balance sheet of banks. The problem is
accentuated because many financial institutions acquire bonds and hold it till
maturity. When there is a significant increase in the term structure of interest
rates, or violent fluctuations in the rate structure, one finds substantial erosion
of the value of the securities held. Market risk is often propagated by other
forms of financial risk such as credit and market-liquidity risks. For example,
a downgrading of the credit standing of an issuer could lead to a drop in the
market value of securities issued by that issuer. Likewise, a major sale of a
relatively illiquid security by another holder of the same security could depress
the price of the security.
4.Interest Rate Risk: Banks in the past were primarily concerned about adhering to
statutory liquidity ratio norms and to that extent they were acquiring government
securities and holding it till maturity. But in the changed situation, namely moving
away from administered interest rate structure to market determined rates, it
becomes important for banks to equip themselves with some of these techniques, in
order to immunize banks against interest rate risk.
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Interest risk is the change in prices of bonds that could occur as a result of change
ininterest rates. In measuring its interest rate risk, an institution should
incorporate re-pricing
risk (arising from changing rate relationships across the spectrum of maturities), basis
risk
(arising from changing rate relationships among yield curves that affect the
institution's activities) and optionality risks (arising from interest rate related options
embedded in the institution's products).
There are certain measures available to measure interest rate risk. These include:
Maturity: Since it takes into account only the timing of the final principal
payment, maturity is considered as an approximate measure of risk and in
a sense does not quantify risk. Longer maturity bonds are generally subject
to more interest rate risk than shorter maturity bonds.
Duration: Is the weighted average time of all cash flows, with weights
being the present values of cash flows. Duration can again be used to
determine the sensitivity of prices to changes in interest rates. It represents
the percentage change in value in response to changes in interest rates.
Dollar duration: Represents the actual dollar change in the market value
of a holding of the bond in response to a percentage change in rates.
Convexity: Because of a change in market rates and because of passage of
time, duration may not remain constant. With each successive basis point
movement downward, bond prices increase at an increasing rate. Similarly
if rates increase, the rate of decline of bond prices declines. This property
is called convexity.
4.Liquidity Risk: Liquidity Risk is the risk stemming from the lack of
marketability of an investment that cannot be bought or sold quickly enough to
prevent or minimize a loss. It is usually reflected in a wide bid- ask spread or
large price movements. It arises from the potential inability of the Bank to
generate adequate cash to cope with a decline in deposits or increase in assets.
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To a large extent, it is an outcome of the mismatch in the maturity patterns of
assets and liabilities.
There are two types of liquidity i.e. market liquidity and funding liquidity.
Liquidity risk broadly comprises three sub-types:
Funding Risk: The need to replace net outflows of funds whether due to
withdrawal of retail deposits or non-renewal of wholesale funds.
Time Risk: The need to compensate for non-receipt of expected inflows of
funds, e.g. when a borrower fails to meet his repayment commitments.
Call Risk: The need to find fresh funds when contingent liabilities become
due. Call risk also includes the need to be able to undertake new
transactions when desirable.
STRATEGIES AND TECHNIQUES USED FOR
ASSET LIABILITY MANAGEMENT
ASSET MANAGEMENT STRATEGY
Some banks had the traditional deposit base and were also capable of achieving
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substantial growth rates in deposits by active deposit mobilization drive using their
extensive branch network. For such banks the major concern was how to expand the
assets securely and profitably. Credit was thus the major key decision area and the
investment activity was based on maintaining a statutory liquidity ratio or as a
function of liquidity management. The management strategy in such banks was thus
more biased towards asset management.
LIABILITY MANAGEMENT STRATEGY
Some banks on the other hand were unable to achieve retail deposit growth rates since
they did not have a wide branch network. But these banks possessed superior asset
management skills and hence could fund assets by relying on the wholesale markets
using Call money, CD’s Bill Rediscounting etc. Deregulation of interest rates coupled
with reforms in the money market introduced by the reserve bank provided these
banks with the opportunity to compete with funds from the wholesale market using
the pricing strategy to achieve the desired volume, mix and cost. So under the
Liability management approach, banks primarily sought to achieve maturities and
volumes of funds by flexibly changing their bid rates for funds.
ALM STRATEGY
As interest rated in both the liability and the asset side were deregulated, interest rates
in various market segments such as call money, CD’s and the retail deposit rates
turned out to be variable over a period of time due to competition and the need to
keep the bank interest rates in alignment with market rates. Consequently the need to
adopt a comprehensive Asset- liability strategy emerged, the key objectives of which
were as under.
The volume, mix and cost/return of both liabilities and assets need to be planned
and monitored in order to achieve the bank’s short and long term goals.
Management control would comprehensively embrace all the business segments
like deposits, borrowing, credit, investments, and foreign exchange. It should be
coordinated and internally consistent so that the spread between the bank’s
earnings from assets and the costs of issuing liabilities can be maximized.
Suitable pricing mechanism covering all products like credit, payments, custodial
financial advisory services should be put in place to cover all costs and risks.
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STRATEGIC APPROACHES TO ALM
Spread Management: This focuses on maintaining an adequate spread between a
bank’s interest expense on liabilities and its interest income on assets.
Gap Management: This focuses on identifying and matching rate sensitive assets
and liabilities to achieve maximum profits over the course of interest rate cycles.
Interest Sensitivity Analysis : This focuses on improving interest spread by testing
the effects of possible changes in the rates, volume, and mix of assets and
liabilities, given alternative movements in interest rates.
These strategies attempt to closely co-ordinate bank assets and liability management
so that bank’s earnings are less vulnerable to changes in interest rates. We will now
look at each of these strategies in a more detailed fashion.
Spread Management
This focuses on maintaining an adequate spread between a bank’s interest rate
exposure on liabilities and its interest rate income on assets to ensure an acceptable
profit margin regardless of interest rate fluctuations. Thus spread management aims to
reduce the bank’s exposure to cyclical rates and to stabilize earnings over the long
term and in order to achieve this banks must manage the maturity, rate structure and
risks in its portfolios so that assets and liabilities are more or less affected equally by
interest rate cycles.
Maturities on assets and liabilities are either matched or unmatched. If they are
matched then the bank knows what it must pay for deposits and borrowed funds and
what it will earn on loans and investments. If maturities are unmatched then assets
and liabilities will mature at different times and in this case management cannot lock
in a spread because funds must be reinvested as assets mature and funds must be
borrowed as liabilities mature at rates that may differ from current market rates.
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Co-ordinating rate structure among assets and liabilities is a second most important
aspect of spread management because rate structure and maturity combined determine
interest sensitivity in assets and liabilities. For rate structure, the rates paid and earned
on fixed- rate assets and liabilities are not sensitive to changes in market rates because
their rates are fixed for the term of the instrument’s maturity. Variable rate assets and
liabilities are interest sensitive because their earnings fluctuate with changing market
conditions.
Risk of default is the third aspect of assets and liabilities that must be coordinated in
spread management. A bank assumes greater risk of default in its asset portfolios than
it can in its liability portfolios since the depositor’s funds need to be protected.
Therefore balancing the default risk against the benefit of probable returns by
assuming some risk to maintain a profitable spread is vital.Because it is difficult to
forecast future rate and yield changes accurately, many banks try to match their rate
sensitive assets to their rate sensitive liabilities. This approach will lead to controlled
but steady growth and a gradual increase in average profitability.
Gap Management
Gap management is based on the following rate mix classifications:
Variable: Interest bearing assets and liabilities whose rates fluctuate with general
money market conditions.
Fixed: Interest bearing assets and liabilities with a relatively fixed rate over an
extended period of time.
Matched: Specific sources and uses of funds in equal amounts that have
predetermined maturities.
By definition, gap is the amount by which the rate sensitive assets exceed the rate
sensitive liabilities. The gap indicates the dollar amount of funds available to fund the
variable rate assets with variable rate liabilities. Gap measurement allows the
management to evaluate the impact the various interest rate changes will have on
earnings.
The objective of gap management is to identify fund imbalances. For example, If rates
are declining and the banks have an excess of variable rate assets over fixed rate
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liabilities the bank’s rate will narrow and interest rate margin will be reduced. On the
other hand if rates are increasing and variable rate assets exceed fixed rate liabilities
the bank’s rate will widen and interest margin will increase.
The gap is really a measurement of the bank’s balance sheet sensitivity to changes in
the interest rates ,expressed as a ratio of the rate sensitive assets to rate sensitive
liabilities. The greatest stability occurs when rate sensitive assets equal rate sensitive
liabilities or a ratio of 1
In general, with this ratio the bank’s earnings should remain the same
regardless of the interest rate changes because equal amount of assets and liabilities
will be reprised.
Then the sensitivity ratio is greater than 1, the bank has a positive gap, or is asset
sensitive. This position is illustrated by the second gap in exhibit. If interest rates rise,
the bank will benefit as more assets than liabilities are reprised at higher rates.
Conversely, if rates fall the bank’s margin will be negatively affected as more assets
than liabilities will be reprised at lower rates.
When the sensitivity ratio is less than 1, the bank has a negative gap or is
liability sensitive. This position is illustrated in the figure’s final gap illustration. If
interest rates fall the bank will be benefited as more assets than liabilities will be
reprised at lower rates. Conversely, if interest rates rise the bank’s margin will be
negatively affected as more assets than liabilities will be reprised at lower rates. The
impact on earnings from a rate change with a particular sensitivity position are
generalizations and that a change in asset/liability mix and interest spread may affect
the bank’s margin either positively or negatively, regardless of the gap position and
the change in interest rates.
For example, assume that the bank is in matched position holding variable rate assets
(90 day prime rate loans) and variable rate liabilities (90 day CDs) with an interest
spread of 2%. Now assume that the general level of rates rise by 1%. But because
business credit demand is up, banks are borrowing more money to finance loan
growth. Due to this the CD rates have risen to 9.5% thereby reducing the interest
spread to 1.5%. Although the bank is in matched position and identical amounts of
assets and liabilities are reprised the interest-spread narrows resulting in lower
earnings.
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In gap management, the absolute size of the gap must be controlled to optimize the
fixed and variable asset/liability relationships throughout a complete interest rate
cycle. Similarly stated, the gap position must be managed to expand and contract with
rate cycle phases.
INTEREST SENSITIVITY ANALYSIS
There are certain asset and liability whose interest costs vary with interest
rate changes over some time horizon are referred to as Rate Sensitive Assets
(RSA) or RateSensitive Liabilities (RSL). Those assets or liabilities whose
interest costs do not vary with interest rate changes over some time horizon are
referred to as Non Rate Sensitive Assets (NRSA) or Non Rate Sensitive Liabilities
(RSL). It is very important to note that the critical factor in the classification of
time horizon chosen. An asset or liability that is time sensitive in a certain time
horizon may not be sensitive in shorter time horizon and vice versa. However,
over a significantly long time horizon, virtually all assets and liabilities are
interest rate sensitive. As the time horizon is shortened, the rate of rate sensitive to
non rate sensitive assets and liabilities falls.
The table below shows the classification of the assets and liabilities of the bank
according to their interest rate sensitivity.
LLiabilities Type Assets Type
DDemand Deposits NRSL Cash N RSA
CCurrent Accounts NRSL Short Term Securities RSA
Money Market Deposits RSL Long Term Securities N RSA
Short Term Deposits RSL Variable Rate Loans RSA
Short Term Savings NRSL Short Term Loans RSA
RRepo Transactions RSL Long Term Loans N RSA
E Equity NRSL Other Assets N RSA
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This is an extension of gap management. It attempts to improve the interest
spread by testing the effects of changes in rates, volume, and mix of assets and
liabilities given alternative movements in interest rates. In this analysis, the bank
plans from a given point in time and
projects possible changes in its income statement that might result if changes are
made in the balance sheet. Such changes are then tested against scenarios of rising
rates and falling rates for periods ranging from two weeks to one year.
The analysis begins by separating the bank’s balance sheet into fixed rate and
variable rate components. The interest rate and margin are identified in the current
year. The next step lists the various assumptions that involve the rate, mix, and
volume of the bank’s portfolios- for example, projected increases in the volume of
loans, consumer time deposits, and larger CD’s, as well the current rates on these
instruments. The remaining key assumptions reflect the possible alternative directions
in which the rates may move. The bank then tests the effect of assumed changes in the
volume and composition of its portfolios against both interest rate scenarios (rising
and falling rates) to determine their impact on interest spread and margin.
However if the bank’s assets and liabilities are unmatched, the bank’s earnings can be
protected or improved by planning courses of action in advance for periods of rising
and falling rates.
Hedging with futures trading is a final strategy that can be used to protect against
exposure to interest rate risk if the bank’s interest sensitive assets and liabilities are
unmatched. Banks can use futures contracts as tools of ALM by selling futures ( a
short hedge) or buying futures (a long hedge). If the bank is in an unmatched position
in which the interest sensitive assets are funded by fixed rate liabilities, it makes a
long hedge. If the position is one of fixed rate assets funded by interest sensitive
liabilities the bank makes a short hedge. The ability to use hedging effectively to
offset risk in an unmatched position require that the future course of interest rate
levels be predicted accurately.
Liquidity (or Marketability) :
It is the ease with which you can turn your investment quickly into cash, at or near the
current market price. Some securities, such as mutual funds, offer liquidity by
24
allowing investors to redeem their securities (return them to the issuer) on short
notice. For non-redeemable securities, liquidity will depend on the owner's ability to
sell the securities to other investors in the open market. Listing on a stock exchange
may help, but does not guarantee liquidity. With some securities, law or contract from
reselling the securities for months or even years may restrict investors, or they may
find that there is no market for the securities when they want to sell.
Liquidity risk management techniques are constantly evolving. Customers today
increasingly use banks as a means to access the payments system and, consequently,
maintain minimal transaction balances. This has resulted in a situation where all
banks are facing high loan demand while their core deposits continue to erode. Most
multinational and regional banks turned to wholesale funding sources to fund asset
growth years ago; we are now seeing small banks being forced to turn to alternative
funding sources, such as subordinated debt, Government Home Loan, Bank loans, and
purchased fed funds to meet their needs.
Liquidity Risk
Liquidity risk is the potential that an institution will be unable to meet its obligations
as they come due. This is generally because the bank cannot liquidate assets or obtain
adequate funding (funding liquidity risk) or that it cannot easily unwind or offset large
exposures without significantly lowering market prices because of thinly traded
securities markets or market disruptions (market liquidity risk). While the following is
not all inclusive, it does present several criteria can serve as a guide to determine the
level of inherent liquidity risk in an institution: The composition, size, and availability
of asset-based liquidity sources in relation to the institution’s liquidity structure and
liquidity needs should be gauged. Factors to consider include the levels of money
market assets (Eurodollar placements, Govt funds, etc.); unpledged, marketable
securities; and securitization and asset sales activities. Thus, a bank that utilizes
predominantly short-term liabilities for funding will generally require more asset-
based liquidity. Conversely, a bank utilizing predominantly long-term liabilities, such
as core deposits, for funding generally will require lower asset-based liquidity. The
nature, volatility, and maturity structure of funding liabilities given the institution’s
core business (for example, whether it is predominantly a wholesale bank) must be
25
considered. Factors to review include level of dependence on credit sensitive funding
sources, the relationship of wholesale versus retail funding sources, and large funding
concentrations, both by type of instrument and by funding source. Bank management
must make sure that the liability structure makes sense given the nature of the assets
generated by the core business. Community banks are predominantly retail banks
characterized by long-term asset structures supported by a stable and long-term
liability structure. Conversely, a wholesale bank is characterized by a short-term asset
structure supported by a short-term liability structure. This arrangement is considered
adequate, since the asset and liability roll-off are closely matched. Funding
diversification is extremely important in determining the level of inherent liquidity
risk in an institution. Factors to assess include:
The proportion of funding from various types of relationships, such as
brokers,
professional money managers, out of market sources, and foreign.
Sources of funds providers, for possible over-reliance on specific types of
funds
providers, funding instruments, and maturities.
The portion of funding sources with common exposures. Bankers should look
at their
funds providers to ensure that they do not have common exposures.
Many bankers have learned the hard way over the years that their funds providers
were not as diversified as they thought. It is entirely possible to utilize funds providers
located all over the country that have a common exposure in such areas as sub prime
lending or real estate. Deterioration in these areas of concentration can result in an
unexpected drying up of funding from traditional providers, which can cause large-
scale funding problems. Funding gap assessment is very important, especially the
institution’s short-term exposures. Factors to assess include projected funding needs,
assessment of bank’s ability to cover any potential funding gaps at reasonable pricing,
and trends in asset quality. All funding analysis techniques assume that assets pay
when due. Banks experiencing asset quality problems must revise their funding
analysis to embody a more realistic set of assumptions about asset roll- off. The
composition of the off-balance sheet portfolio and its probable impact on funding
26
must be evaluated. Factors that must be assessed include off-balance sheet liability
levels, composition of the off-balance sheet liabilities, and the off-balance sheet
monitoring program. The institution’s funding strategies should be evaluated to
ensure that they remain valid.
Factors to consider include cash flows, secondary liquidity of the securities portfolio,
monitoring and metrics program, policies and procedures, an assessment of
institutional funding costs compared to its competitors, and an assessment of
management’s ability to effectively control liquidity risk
A factor that is increasingly important is the rating services view of the institution.
The two factors to assess are current ratings and rating agency perspective on the
condition of the institution and rating trends. A detailed assessment of the institution’s
contingency funding program should be made.
Factors to evaluate include the monitoring and metrics program, a viability
assessment of the contingency plan in light of the abilities of management, an
assessment of policy and strategic goals, and a review of the structure and
responsibilities of the crisis management team.
LIQUIDITY RISK MANAGEMENT
Liquidity risk management techniques must continue to improve in response to the
increasing volatility of these funding sources. Managers who fail to develop an
effective strategy for maintaining adequate liquidity may find that, at best, their
business plans are adversely affected by funding difficulties, and at worst, their bank’s
ongoing viability is threatened. Recent volatility in the wholesale funding markets has
highlighted both the importance of sound liquidity risk management practices and the
fact that financial institutions can and have experienced liquidity problems even
during good economic times. As a result, bank management’s ability to adequately
meet daily and emergency liquidity needs while controlling liquidity risk through risk
identification, monitoring, and controls is receiving increasingly intense regulatory
scrutiny. To meet the new demands of liquidity risk management, banks have evolved
new techniques.
27
TRENDS IN LIQUIDITY RISK MANAGEMENT
Funding pools
Many multinational banks are moving away from back up lines of credit as their
principle source of liquidity in a funding crisis. Disadvantages to lines of credit
28
include commitment fee costs, material adverse change clauses, and a potentially
adverse reaction by the funding markets should these backup lines be utilized.
While many banks still maintain these lines, they no longer rely on them as their
principle source of back up liquidity (merely to meet the rating agencies’
requirements). These banks now rely principally on segregated pools of liquid assets,
generally, marketable securities, to provide a secondary source of liquidity. To be
effective, these segregated pools, sometimes known as liquidity warehouses, should
contain readily marketable securities. Two keys to making this approach work include
are to fill them with investment grade securities to preclude the possibility that they
could not be readily sold in adverse markets and to avoid the use of securities from
thinly traded markets that could preclude rapid liquidation without incurring a
substantial discount.
Funding strategies
Banks are revising their funding strategies to avoid funding concentrations. Most
banking experts agree that excessive funding concentrations severely reduce the
bank’s ability to survive a liquidity crisis. Many banks are taking advantage of the
good economic times to diversify their funding sources. While most banks have
developed a contingency funding plan, the vast majority require some level of
enhancement, including triggering guidelines, metrics development, better
quantification of funding sources, adequacy of projected funding sources, and
development of common contingency scenarios. Many banks do not have predefined
triggers to automatically implement their contingency plan, and management should
develop critical warning signals that would be used as a benchmark during periodic
liquidity reviews. In some cases, banks increasingly are stress testing their funding
plans, using various interest rate shocks and adverse economic and competitive
scenarios to ascertain their impact on both the funding portfolio and
market access. At a minimum, the funding plans are generally tested with an interest
rate shock simulation incorporating a drop or gain of at least 200 basis points. On the
horizon, banks are seeking ways to link their liquidity risk models with their market
risk models. The goal is to stress test their portfolios, load the resulting data into their
liquidity models, and see what will happen to their funding positions.
29
Communication
Some banks are working to improve the communication lines between the treasury
function and back-office operational areas. At present, the treasury area relies on
informal lines of communication to keep it updated on operational events that could
affect funding. As a result, the treasury area is frequently unaware of a disruptive
event, such as a wire transfer failure or the need to fund a large loan commitment
draw down, until it is either too late or very costly to cover the resulting funding
shortfall. Bank management is paying more attention to investor relations than ever
before. This is because dependence on wholesale funding sources has resulted in the
growing importance of credit risk in the placement decisions of funds providers.
Funds providers are increasingly sensitive to credit risk and will terminate a funding
relationship at the slightest hint of developing credit problems at an institution. This
has forced institutions to increase their attention to managing both funding
relationships and rating agency relations.
Reporting systems
Reporting systems are not as effective as they could be in determining the funding
implications of off-balance sheet commitments. Many banks perform a historical
survey and then develop a guideline for a level of funding to be held against off-
balance sheet commitments. Unfortunately, they seldom, it ever look at the guideline
again. As the bank’s strategic objectives change and new products are offered, the
level of off-balance sheet liabilities tends to grow while the level of funding does not,
since the bank’s reporting process is not measuring the true level of liabilities. This
lack of review, coupled with the informal lines of communication between treasury
and the operating areas of the bank, has frequently resulted in costly funding
mistakes. Many banks have realized this and are developing better off-balance sheet
reporting systems. In addition, many institutions have a tendency to ratchet down their
report generation during good economic times,
either reducing the level of information contained in the report or discontinuing some
reports altogether. This practice appears acceptable as long as the remaining reports
provide management with adequate information to properly manage risk. Banks
should realize, however, that to manage liquidity risk during adverse economic
conditions, a greater information flow embodying greater detail would be needed.
30
Therefore, policies should be in place to ratchet up the reporting process during
periods of deteriorating conditions.
TECHNIQUES OF ALM
1.GAP Analysis Model: Under the Gap analysis method, the various assets and
liabilities are grouped under various time buckets based on the residual maturity of
each item or the next repricing date, if on floating rate, whichever is earlier. Then the
gap between the assets and liabilities under each time bucket is worked out. Since the
objective is to maximize the NIT, it will be sufficient if this is done only with respect
to rate sensitive assets and liabilities. If the rate sensitive assets equal the rate
31
sensitive liabilities, it is known as the Zero Gap or matched book position. If the rate
sensitive assets are more than the rate sensitive liabilities, it is referred to as positive
gap position and if the rate sensitive assets are less than the rate sensitive liabilities, it
is known as negative gap position. The decision to hold a positive gap or a negative
will depend on the expectation on the movement of interest rates. The effect of an
upward movement or a downward movement in the interest rate on the Nil will also
depend on the position taken.
These effects are given in the table below:
GAP
Position
Changes in
Interest
Rates
Changes in
Interest
Income
Changes in
Interest
Expense
Change in
N I I
Positive Increase Increase Increase Increase
Positive Decrease Decrease Decrease Decrease
Negative Increase Increase Increase Decrease
Negative Decrease Decrease Decrease Increase
Zero Increase Increase Increase None
Zero Decrease Decrease Decrease None
Positive gap indicates a bank has more sensitive assets than liabilities and the
NII will generally rise (fall) when interest rate rises (fall)
Negative gap indicates a bank has more sensitive liabilities than assets and the
NII will generally fall (rise) when interest rates rise (fall)
It measures the direction and extent of asset-liability mismatch through either
funding or maturity gap. It is computed for assets and liabilities of differing
32
maturities and is calculated for a set time horizon. This model looks at the reprising
gap that exists between the interest revenue earned and the bank's assets and the
interest paid on its liabilities over a particular period of time. It is sometimes referred
to as periodic gap because banks use gap analysis report to measure the interest rate
sensitivity of RSA and RSL for different periods. These periods are known as
maturity buckets which vary across banks, depending on the operating strategy.
Positive Gap Negative Gap
Rate Sensitive Assets are more than Rate
Sensitive Liabilities
Rate Sensitive Liabilities are more
than Rate Sensitive Assets
Assets mature before Liabilities Liabilities mature before Assets
Short-term assets funded with long-
term liabilities
Long-term assets funded with short-
term liabilities
If interest rate increase, NII also
Increase
If interest rate increase, NII also
Decrease
Assumptions
Contractual Repayment Schedule i.e. no early repayment or option like
feature
On Schedule Payments i.e. there is no early repayments or defaults
Advantages
Simple to analyze
Easy to implement
Helps in future analysis of Interest Rate Risk
Helps in projecting the NII for further analysis
33
Limitations
It does not incorporate future growth or changes in the mix of assets and
liabilities.
It in not take time value of money or initial net worth into account.
The periods used in the analysis are arbitrary and reprising is assumed to
occur at the midpoint of the period.
It does not provide a single reliable index of interest rate.
2.Duration Analysis: The Gap method ignores time value of money. Under the
duration method, the effect of a change in the interest rate on Nil is studied by
working out the duration gap and not the gap based on residual maturity.
a. Timing and the magnitude of the cash flows is ascertained and calculated
b. By using appropriate discounting factor, the present value of each of the cash
flows needs to be worked out.
c. The time weighted value of the present value of the cash flows is calculates.
d. The sum of the time weighted value of the cash flows divided by the sum
of the present values will give the duration of a particular asset.
Duration analysis is useful in assessing the impact of the interest rate changes on
the market
value of equity i.e. asset-liability structure.
DGAP
Position
Changes in
Interest
Change in Market value
Assets Liabilities Equity
Positive Increase Decrease Decrease Decrease
Positive Decrease Increase Increase Increase
Negative Increase Decrease Decrease Increase
Negative Decrease Increase Increase Decrease
Zero Increase Decrease Decrease None
Zero Decrease Increase Increase None
Advantages
34
Duration Gap analysis serves as a strategic tool for evaluating and
controlling interest rate risk.
It improves the maturity gap and cumulative gap models by taking into
account the timing and market value of cash flows rather them time
maturity.
It offers flexibility in spread management.
Instead of changing the maturity structure of assets and liabilities,
Duration Gap analysis puts emphasis on change of mix of assets or
liabilities whichever is feasible.
Limitations
It requires extensive data on specific characteristics and current market
pricing schedules of financial instruments.
It requires high degree of analytical expertise regarding issues such as term
structure of interest rates and yield curve dynamics.
Simulation Analysis : It analyzes the interest-rate risk arising from both current
and planned business. Gap analysis and duration analysis as standalone tool for
asset-liability management suffer from their inability to move beyond the static
analysis of current interest rate risk exposures. Basically simulation models
utilize computer power to provide what if scenarios.
What if:
The absolute level of interest rate shift
There are non parallel yield curve changes
Marketing plans are under-or-over achieved
Margins achieved in the past are not sustained/improved
Bad Debts and prepayment levels change in the different interest rate
scenarios
There are changes in the funding mix e.g. an increasing reliance on short-
term funds for balance sheet growth.
35
Accurate evaluation of current exposures of asset and liability portfolios to
interest rate risk.
Changes in multiple target variables such as NII, Capital adequacy and
liquidity.
There are certain criteria for the simulation model to succeed. These pertain to
accuracy of data and reliability of the assumptions made. In other words, one
should be in a position to look at alternatives pertaining to prices, growth rates,
reinvestments, etc., under various interest rate scenarios. This could be difficult
and sometimes contentious. it is also to be noted that the managers might not want
to document their assumptions and data is not easily
available for differential impacts of interest rates on several variables. Hence,
simulation models need to be used with the caution. The use of simulation model
calls for commitment of substantial amount of time and resources.
Assumptions
Expected changes and the levels of interest rates and the shape of yield curve
Pricing strategies for assets and liabilities
The growth, volume and mix of assets and liabilities
Advantages
It is easy to approximate very complex and discounted payoff
It is very flexible
It can incorporate multiple time periods
It captures majority of the option risk
Limitations
It is computationally intensive
36
It requires maintenance of pricing models
Value at Risk (VAR) Model: Under VAR credit rating is given to each of the
borrowers and its migration over the years form a part of the calculation of the
credit value at risk over a given time horizon. This is due to credit risk, which
emanates not only from counter party default, but also from slippage in credit
quality. Thus, the volatility of value due to changes in the quality of the credit
needs to be estimated to calculate VAR. In general; banks review financial
statements of borrowers once a year and allot credit ratings. But there is no
explicit theory to guide time horizon on risk assessment. Any risk assessment
model shall normally
predict relative risk than absolute risk. The objective of any risk assessment model
is to initiate risk mitigating actions, irrespective of the time horizons. Hence, any
risk measurement model can be tailored to suit different time horizons based on
actual need.
Advantages
Translates portfolio exposures into potential profit and loss
Aggregates and reports multi-product, multi-market exposures into one
number
Uses risk factors and correlations to create a risk weighted index
Monitors VAR limits
Meets external risk management disclosures and expectations.
Limitations
This study is useful only for normal operative accounts to predict their
probability of default.
This model does not take already defaulted customers into account.
Macro level changes in an industry, changes in government policies, etc.,
may result in distorted results.
In this methodology if the VAR measurement is for shorter duration, the
risk assessment is more accurate.
37
ROLE OF ALCO
The Asset-Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the limits set by the
Board as well as for deciding the business strategy of the bank (on the assets and
liabilities sides) in line with the bank's budget and decided risk management
objectives.
The ALM desk consisting of operating staff should be responsible for analyzing,
monitoring and reporting the risk profiles to the ALCO. The staff should also prepare
forecasts (simulations) showing the effects of various possible changes in market
38
conditions related to the balance sheet and recommend the action needed to adhere to
bank's internal limits.
The ALCO is a decision making unit responsible for balance sheet planning
from risk-return perspective including the strategic management of interest rate and
liquidity risks. Each bank will have to decide on the role of its ALCO, its
responsibility as also the decisions to be taken by it. The business and risk
management strategy of the bank should ensure that the bank operates within the
limits/parameters set by the Board. The business issues that an ALCO would consider,
inter alia, will include product pricing for both deposits and advances, desired
maturity profile of the incremental assets and liabilities, etc. In addition to monitoring
the risk levels of the bank, the ALCO should review the results of and progress in
implementation of the decisions made in the previous meetings. The ALCO would
also articulate the current interest rate view of the bank and base its decisions for
future business strategy on this view. In respect of the funding policy, for instance, its
responsibility would be to decide on source and mix of liabilities or sale of assets.
Towards this end, 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 v/s capital market funding, domestic vs
foreign currency funding, etc. Individual banks will have to decide the frequency for
holding their ALCO meetings.
Top Management, the CEO/CMD or ED should head the Committee. The
Chiefs of Investment, Credit, Funds Management/Treasury (forex and domestic),
International banking and Economic Research can be members of the Committee. In
addition the Head of Information
Technology Division should also be an invitee for building up of MIS and related
computerization. Some banks may even have sub-committees.
The size (number of members) of ALCO would depend on the size of each institution,
business mix and organizational complexity.
Committee composition
Permanent members:
Chairman Treasury Manager
39
Managing Director/CEO ALCO officerFinancial Director Divisional ManagersRisk Manager
By invitation:
Economist
Risk Consultants
Purposes and Tasks of ALCO:
Formation of an optimal structure of the Bank's balance sheet to provide
the maximum profitability, limiting the possible risk level;
Control over the capital adequacy and risk diversification;
Execution of the uniform interest policy
Determination of the Bank's liquidity management policy;
Control over the state of the current liquidity ratio and resources of the
Bank;
Formation of the Bank's capital markets policy;
Control over dynamics of size and yield of trading transactions
(purchase/sale of currency, state and corporate securities, shares,
derivatives for such instruments) as well as extent of diversification
thereof;
Control over dynamics of the basic performance indicators (ROE, ROA,
etc.) as prescribed in the Bank's policy.
PROCESS OF ALCO
40
H Meet monthly weekly and determine if current strategy is appropriate
H Meet monthly weekly and determine if current strategy is appropriate
ReviewPrevious month
result
ReviewPrevious month
result Access current Balance sheet options
Access current Balance sheet options
Project Exogenous factors
Project Exogenous factors
Develop asset liability strategies
Develop asset liability strategies
Stimulate asset liability strategies
Stimulate asset liability strategies
Determine most appropriate strategy
Determine most appropriate strategy
Set measurable targets
Set measurable targets
Communicate targets to appropriate manager
Communicate targets to appropriate manager
Monitor action regularly and evaluate
Monitor action regularly and evaluate
Organization Structure Of ALCO
41
Board of Director
Management Committee
Asset liability committee(ALCO)
Asset liability management cell
Financial planning department
Credit risk managementDepartment
Credit analysis department
Treasury
Investment and loan department
Trend analysis of Asset and liability component of Public sector,
Private sector and Foreign banks
Public Sector
2010 2011 2012 2013 2014
Asset accounts
Liquid asset 9.98% 9.94% 9.255% 9.215% 8.365%
investments 28.535% 27.16% 28.07% 28.12% 26.345%
Advances 57.995% 59.385% 59.39% 60.2% 62.275%
Fixed asset 0.97% 1.105% 1.08% 0.9% 0.785%
other asset 2.65% 2.41% 2.18% 1.89% 2.17%
Liability account
Capital 0.98% 0.775% 0.67% 0.52% 0.645%
Reserves 4.685% 4.725% 4.705% 4.595% 4.93%
Deposits 84.07% 84.13% 85.475% 86.035% 85.365%
Borrowings 3.88% 4.2% 3.225% 5.635% 6.08%
Other liability 6.385% 6.15% 5.91% 3.19% 2.8%
Private Sector
2010 2011 2012 2013 2014
Asset accounts
Liquid asset 13.715
%
13.77
%
12.245
%
10.59
%
10.5%
Investments 27.94% 27.06
%
28.895
%
30.79
%
29.33
%
Advances 53.01% 55.03
%
54.63% 55.61
%
55.63
%
Fixed asset 1.26% 1.32% 1.24% 1.23% 1.09%
other asset 3.03% 2.82% 2.99% 1.78% 2.53%
42
Liability
account
Capital 1.93% 1.67% 1.54% 1.55% 1.51%
Reserves 5.495% 7.21% 6.97% 7.45% 7.99%
Deposits 81.68% 81.41
%
81.3% 80.86
%
79.98
%
Borrowings 4.18% 3.42% 4.44% 5.7% 6.31%
Other liability 6.68% 6.29% 5.75% 4.44% 3.73%
Foreign Bank
2010 2011 2012 2013 2014
Asset accounts
Liquid asset 27.12
%
23.57
%
25.83
%
24.7% 23.45%
Investments 26.5% 26.75
%
25.65
%
31.79
%
30.37%
Advances 35.16
%
37.44
%
36.66
%
32.92
%
34.95%
Fixed asset 1.21% 0.93% 1.22% 1.032
%
1.82%
other asset 10% 11.5% 11.18
%
9.45% 9.43%
Liability
account
Capital 19.57
%
19.5% 25.67
%
24.07
%
28.55%
Reserves 7.74% 7.11% 7.58% 7.62% 7.93%
Deposits 44.91
%
44.87
%
42.41
%
41.54
%
36.088
%
Borrowings 20.58 20.71 17.31 19.94 20.54%
43
% % % %
Other liability 7.3% 7.12% 6.99% 6.49% 6.3%
44
TREND OF ASSET COMPONENTS IN PUBLIC
SECTOR:
45
46
TREND OF LIABILITY COMPONENTS IN PUBLIC
SECTOR:
47
TREND OF ASSET COMPONENTS IN PRIVATE
SECTOR:
48
49
50
TREND OF LIABILITY COMPONENTS IN PRIVATE
SECTOR:
51
52
TREND OF ASSET COMPONENTS IN FOREIGN
BANKS:
53
54
TREND OF LIABILITY COMPONENTS IN FOREIGN
BANKS:
55
Public/Private bank Foreign bank
56
Comparison of asset liability components of
Public/Private banks and foreign banks:
Asset accounts Public/Private bank Foreign bank
Liquidity of assets Less more
Investment Difference No significant difference
Advances More Less
Fixed assets Difference No significant difference
Other assets Less More
Liability accountsPublic/Private bank Foreign bank
Capital Less More
Reserves Difference No significant difference
Deposits More Less
Borrowings Less More
Others Not significant Significant
Liabilities Difference No significant difference
Each of the asset and liability accounts defined have different trend over time,
showing the impact of change of prudential regulations of RBI, enhancement of
technology, global integration, liberalization ,etc.
As u can see In case of public sector banks and private sector banks, major item on
liability side is deposits ,and on asset side are advances. These accounts have around
80 per cent share in total assets/liabilities. While in case of foreign banks major items
on asset side are Liquid assets, Other assets and on liability side Capital and
borrowings. In case of public sector banks and private sector banks the share of liquid
asset accounts including cash, balances with RBI and banks, and money at call and
short notice declined over time. while in case of foreign banks liquid assets are more
and almost constant over period of time.
Bank's capital, is the margin by which creditors are covered if the bank's assets
were liquidated. Capital serves as a cushion for depositors and creditors, and
57
considered as a long-term source for bank. In case of public sector banks and private
sector banks ratio of capital to total assets, i.e. share of capital in total liabilities
declined, whereas the share of ratio of reserves and surplus to total assets increased.
Foreign banks have higher proportion of capital, reserves, borrowings and liquid asset
as compared to public and private sector banks. High share of equity may be due to
higher regulatory capital. Public sector banks have highest share in deposits than other
bank groups. This may be due to the foundation structure of public sectors banks.
58
Findings & conclusion:
Asset liability management is an integral part of financial management process
of any bank. It is concerned with strategic balance sheet management involving risk
caused by changes in the interest rates, exchange rates and liquidity position of the
banks.It also focuses on managing credit risk , contingency risk .It can termed as risk
management technique design to earn an adequate return while maintaining a
comfortable surplus of assets beyond liabilities.
It takes into consideration interest rates, earning power and degree of willingness
to take on debt and is also known as Surplus Management .It is nothing but efficient
management of balance sheet dynamics with regard to its size, constituents and
quality. It is a process of managing Net Interest Margin(NIM) within the overall risk
bearing ability of banks.ALM process depends on understanding balance sheet ;the
availability, accuracy , adequacy and expediency of the data and the MIS system. In
simple words ALM is nothing but “An attempt to match asset and liability” in terms
of maturities and interest rates sensitivities and also to minimize Interest rates risk and
Liquidity risk.
From the name it’s clear that it has two parts Asset management and Liability
management
Asset Management is “ How liquid are the asset of the banks”.
Liability Management is “How easy the bank can generate loans from market”
There are certain risks involved in ALM like Interest rate risk: which focuses on
understanding negative impact on bank’s future earnings and market value due to
changes in interest rates.
Liquidity risk: It is risk of having inefficient liquid assets to meet liability at given
time.
59
Forex risk: It is risk of having losses in foreign exchange asset and liability due to
exchange in exchange rates among multi-currencies under consideration.
There are different types of strategies to manage different types of risks like for
interest rate risk there are various models like GAP analysis, Duration Gap analysis,
and value at risk. There are certain assets and liabilities which are interest sensitive
and some are non interest sensitive so depending on that NIM also changes. so there is
connection between this two. To manage this there is “Asset Liability Committee”.
This committee responsible for managing asset liability, forming various policies,
taking some important decision.
Asset liability composition of public sector banks, private sector banks is
different than foreign banks. Trend analysis had proved this hypothesis true. So
overall ALM is “Process of decision making to control risk of existence, stability and
growth of the system through the dynamic balances of its asset and liability.
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BIBLIOGRAPHY:
www.rbi.com
www.iba.org.in
Research paper on Relationship between asset and liability of
Indian Commercial bank By Seema Jaiswal.
Book on Asset Liability Management 2nd Edition by T Ravi
Kumar
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