ASSET LIABILITY MANAGEMENT

• The collection of managerial techniques that we call asset – liability management provides financial institutions with defensive weapons to handle such challenging events as business cycle and seasonal pressures and with offensive weapons to shape portfolios of assets and liabilities in ways that promote each institutions goals.

• Asset Management strategy• Bankers tend to take their source of funds i.e. liabilities

and equity largely for granted. This so called asset management view held that the amount and kinds of deposits a bank held would largely depend on the public determined source . With the change in the scenario of the deregulation banks can reshape the source of funds and use these funds to create asset .

Contd.

• Liability Management strategy• The bankers could excise control over their landings . Confronted

with the soaring interest rates and intense competition for funds bankers began to devote greater attention to new sources of funding and monitoring the mix and cost of their deposits and non deposit liabilities. This new strategy was called liability management.

• Here the key is to control over fund sources. The Key control was

the price, the interest rate and other terms .• Funds Management approach• The maturing of liability management techniques, coupled with more

volatile interest rates and greater risk eventually gave to the concept of funds management approach, which dominates Banking and the activities of many competitors today. This view is much more balanced approach to the Asset – Liability Management that stresses several key objectives.

Contd.

• 1. Management should exercise as much control as possible over the volume, mix and return or cost of both assets and liabilities in order to achieve the financial institutions goals.

• 2. Management control over assets must be coordinated with its control over the liabilities so that asset management and liability management are internally consistent and do not pull against each other. Effective coordination in managing them will help maximize the spread between revenues and costs and control risk exposure.

• 3. Revenues and cost arise from both sides of the balance sheet . Managements policies should be to maximize revenues and minimize costs

Managing the Banks response to changing market interest rates

Interest revenuesInterest costs

Market value of assetsMarket value of liabilities

Net Interest Margin Net worth

(Equity)

Banks investment value , profitabilityAnd risk

Asset Liability Management In Banking

This figure is for Concept check

Interest Rates Risk:Greatest ALM Challenges

• What is interest rate Risk?• Any change in the interest rate in the market changing

the interest income on loan and the interest cost on deposit causes this risk.

• Also this changes the market value of the assets and liabilities , thereby changing the Net worth.

• Thus change in the market interest rates impacts the balance sheet and the statement of income and expense.

• So we have to analyse the forces determining the interest rates.

Contd.

PRICEOFCREDIT

Quantity of loanable funds

Affects the rateOf return on Loans and

Securities and The borrowing cost

From selling depositsAnd issuing

Non depositsIOUs

DS

Rate of interest

Volume of credit

contd

• The rate of interest of any particular loan or security is ultimately determined by the financial market place where suppliers of loanable funds ( credit ) interact with demanders of loanable funds (credit) and the interest rate ( price of credit) tends to settle at a point where the quantitites of loanable funds ( credit) demanded and supplied are equal as shown in the previous slide.

• As market rates move bankers and competitors face two kinds of interest rate risks i.e. Price risk and reinvestment risk.

• Price risk arises when market interest rate rise, causing the market values of most bonds and fixed loan rate loans to fall. If a financial institution wishes to sell instruments in the raising rate period they must be prepared to accept capital losses.

contd

• Reinvestment risk rears its head when market interest fall, forcing a firm to invest incoming funds in lower yielding earning assets, lowering its expected future income.

• Thus a big part of managing Assets and liabilities consists of finding ways to deal effectively with these two forms of changing market interest rates.

• The Measurement of Interest rates • One of the popular rate measures is the YTM ( yield to

maturity) which is the discount rate that equalizes the current market value of a loan or security with the expected stream of future income payments that the loan will generate.

Contd.

• The formula • Current Market price of a loan =• Expected Cash flow in period 1 Ex Cash flow in P2

---------------------------------------- + -----------------------+ -----------------------------

(1 + YTM) ^1 (1+YTM)^2

- - - - - - ExCFPn Sale or redemption price of security

in period n

------------- + -------------------------------------------

(1+YTM)^n (1+ YTM) ^n

Another popular measure is the bank discount rate which is often quoted on short term loans and money market securities . The formula is :

DR = (100 – Purchase price o n loan/100) x 360 / Number of days to maturity

contd

• For example : Suppose a Money market loan can be purchased for a price of Rs. 96 and has a face value of Rs. 100 to be paid at maturity. If the loan matures 90 days , its interest rate measured by the Bank DR must be

• DR= (100 -96)/100 x 360/90 = 0.16 or 16 %• We can combine the two formulas above to take care of

the DR and YTM and arrive at the formula as follows:• YTM equivalent yield = (100 – Purchase price)/Purchase price x 365/ Days to

maturity

• Taking the above example itself• YTM equivalent = (100-96)/96 x 365/90 = 0.1690 = 16.90%

contd

• Goals of Interest rate hedging• One important goal in dealing with interest rate risk is to

insulate profits i.e. Net income after taxes and other expenses from the damaging effects of fluctuating interest rates.

• To Manage this concentrate on Manage Interest sensitive Assets and Liabilities.

• Normally these include loans and investment on Asset side and earning assets i.e. interest bearing deposits and money market borrowing on liability side.

• To do that we have to hold the NIM ( Net interest margin)• So what is NIM

Contd.

• NIM = Interest Income from loans and investments minus Interest expense on deposits and other borrowed funds divided by Total earning assets

• i.e. NIM = NII after expenses / Total earning assets • Example : Suppose a bank records Rs.4 billion in

interest revenues from loans and securities and Rs. 2.6 billion in interest expenses paid out to attract deposits and borrowed funds. If the bank holds Rs. 40 billion in earning assets then NIM is

• NIM = [(Rs. 4-2.6) / 40 billion] x100 = 3.5 %• We have not taken into account the non interest

expenses such as overhead, salary etc. which may further reduce the margin of the bank

contd

• Interest sensitive GAP management • It requires to perform an analysis of the maturities and

repricing opportunities associated with the interest bearing assets with deposits and other borrowings

• i.e. ISA = ISL• What is repricable asset ? What is repricable liability?• Deposits which are coming up for renewal are repricable

liability and loans which are coming up for renewal are repricable assets.

• If repricable assets does not equal to repricable liabilities there exists a GAP which is

• Interest Sensitive GAP = ISA- ISL

Contd.

• Let us see examples of

• Repricable Assets :

– Short term securities issued by Go vt. And private borrowers (about to mature) .

– Short term loans made to borrowing customers (about to mature)

– Variable rate loans and securities

Repricable Liabilities

-Borrowings from the money market

-Short term saving accounts

-Money market deposits ( whose interest rates are adjustable every few days)

Contd.

• Examples of :• Non Repricable assets• -Cash in the vault and deposits with the central banking

authority (legal reserves)• Long term loans made at a fixed interest rate• Long term securities carrying fixed rates • Buildings and equipment

• Non Repricable Liabilities• Demand Deposits ( which pay no rate or a fixed interest

rate)• Long term savings and retirement accounts• Equity capital provided by the owners.

Contd.

• If the interest sensitive assets in each planning period exceeds the volume of interest sensitive liabilities subject to repricing , the firm is said to have a positive Gap and to he Asset Sensitive .

• i.e. ASG = ISA – ISL > 0• Similarly LSG = ISA – ISL < 0 i.e. the firm is having a

Negative Gap and Liability sensitive .• We can form a relative Interest sensitive GAP ratio.

Which can be put as :• Relative ISG= ISG / Size of institution (measured by total

assets ) • If Relative ISG is >0 the institution is Asset sensitive and

vice versa.

Contd

• We can also simply compare ratio of ISA and ISL which is called Interest sensitive Ratio (ISR) which is

• ISA / ISL = ISR• If ISR is > 1 then institution is Asset sensitive and vice

versa • We can also form the relative ISGap Ratio which is

obtained by dividing the IS Gap by the size of the financial institution .( Size of financial institution is for example measured by the total assets).

• Accordingly a Relative IS Gap is > 0 then it is asset sensitive and a negative relative IS Gap describes a Liability sensitive firm.

• Gapping methods are used vary greatly in complexity and form.

Contd.

• All methods used require financial managers to make some important decisions.

• 1. Management must choose time period during which NIM is to be managed ( say 6 months, 1 year) to achieve some desired value and the length of subperiod ( maturity buckets) into which the planning period is to be divided.

• 2. Must choose a target level for NIM i.e. whether to freeze the margin roughly where it is or perhaps increase the NIM.

• 3. If management wishes to increase the NIM , it must either develop a correct interest rate forecast or find ways to reallocate earning assets and liabilities to increase the spread between interest revenues and interest expenses.

• 4. Management must determine the dollar ( currency) Volume of interest sensitive assets and interest sensitive liabilities it wants the firm to hold.

contd

• Let us take an example:• Asset & 1week 8-30days 31-90days 91-360days >1yr Total• Liabilities• Assets 1700 310 440 480 1700 4100• Liabilities 1800 600 450 150 1100

4100• (All are total repricable (interest sensitive)A&L and total is NW)• IS GAP -100 -290 -10 +330 +70• Cumulative -100 -390 -400 -70 -0• Ratio of ISAL 94.4 % 51.7 % 97.8% 320% 106.4 %• Banks is LS LS LS AS AS• {Banks NIM IRR IRR IRR IRF IRF• {Will be squeezed if• Note LS –Liability sensitive AS – Asset Sensitive• IRR – Interest rate raise IRF – Interest rate fall

contd• Banks NII can be derived from the following formula• NII = Total Int. Income –Total Int. cost • = Average Int. Yield on RSA x Volume of RSA + Average Int.

Yield on fixed ( NRSA) assets x Volume of fixed Assets – Average Interest cost on RSL x Volume of RSL – Average int. cost on fixed liabilities x Volume of fixed liabilities

• Example : Taking the previous example. Suppose the Yield on RSA and Fixed Assets are 10 and 11 % while RSL and fixed liabilities are 8 and 9 % and in the 1st week the Bank hold 1700 in RSA and 1800 in RSL. . Suppose that these annualized interest rate remains steady . Then the banks NII on an annualized basis will be :

• 0.10 x 1700 + 0.11x (4100-1700) – 0.08x1800-0.9x(4100-1800)=83• Suppose increase the rate of RSA and RSl by 2 % then• 0.12x1700 +0.11x(4100-1700) -0.10x1800 -0.9x(4100-1800) = 81 • Therefore, we see that bank is exposed to interest risk in the coming

week and decide whether to accept the risk or to use hedging strategies or tools to mitigate the risk.

contd

• The overall measure of interest rate risk exposure is the cumulative gap, which is the total difference between those assets and liabilities that can be re -priced over a designated period of time.

• Example: Suppose a Bank has Rs. 100 million in earning assets and Rs. 200 million in liabilities subject to an interest rate change each month over the next six months .

• Then the cumulative Gap must be -600 i.e. • (Rs. 100 million x 6)-(Rs.200 million x 6) = -600 million • The relationship can be explained as • Change in NII = Overall change in Size of the cumulative• in Int. rates(in % points) x Gap ( in currency )• Suppose market interest rate rise by 1 % . Then effect on the Bank NII

will be (+0.01 ) x(-600 ) = Rs. -6 million.

• Generally Banks with a negative Cumulative Gap will benefit in falling rate but loose NII when interest rate rises. In case of Banks with a positive cumulative Gap will benefit if interest rate rises and loose NII if interest rate decline .

contd

• The Management have to necessarily manage the interest rate GAP.

• Aggressive interest sensitive GAP management

• An aggressive strategy is more risky .

• Mostly Management have learnt to rely on hedging against risks in managing Interest rate risk management

• So they adopt a defensive Gap management strategy.

Expected

Changes in Int.Rate

Management forecast

Best Int. sensitive GAP position to be in

AggressiveManagement most likely action

Rising Market Interest Rates

Possitive Interest sensitive GAP

Increase RSA

Decrease RSL

Falling market Interest Rates

Negative Interest sensitive GAP

Decrease RSA

Increase

RSL

Aggressive ISG Management

contd

• Eliminating Interest Sensitive Gap

Type of Gap The Risk Possible Management Responses

With Positive GAP

ISA>ISL

(Asset Sensitive)

Looses Interest rates fall because the NIM will be reduced

1. Do nothing

2. Extend Asset Maturities or shorten liability maturities

3. Increase ISL or reduce ISA

With Negative GAP

ISA< ISL

(Liability sensitive)

Looses if interest rates rise because the net interest Margin will be reduced

1. Do nothing

2. Shorten asset maturities or lengthen liability maturities

3. Decrease ISL or increase ISA

Contd.

• What is Defensive GAP management strategy: - Set IS gap as close to Zero as possible to reduce the expected volatility of NII.

• It is difficult to practically apply the ISG management though easily understood in theory.

• Some Banks have developed a weighted IS Gap approach which takes into account the tendency of Interest rates to vary in speed and magnitude relative to each other and with the ups and downs of business activity.

• The Interest rates attached to assets of various kinds often change by different amount and by different speeds than many of the interest rates attached to liabilities – a phenomenon called the Basis Risk .

• Interest Sensitive GAP management does not consider the impact of changing interest rates on Owners ( stock holders) position.

• An effective ALM demands that managers must work to achieve desirable levels of both NII and net worth.

Duration Gap Management

• Duration is a value and time weighted measure of maturity that considers the timing of all cash flows from earning assets and cash outflows associated with liabilities.

• It measures the average maturity of a promised stream of future cash payment .i.e. payments expected to receive and payment to depositors.

• In effect, duration measures the average time needed to recover the funds committed to an investment.

• The standard formula for calculating the duration of a financial institution is

• nΣ Expected CF in period t x period t /(1+YTM)^t

t=1 D = ------------------------------------------------------------------ n

Σ Expected CF in period t /(1+YTM)^tt=1

Contd.

• In the above formula :• D stands for instruments duration in years

t represents the period of time in which cash flow is received

CF indicates the volume of expected cash flow in each time period t

YTM is current yield to maturity. • If we see the formula the denominator is equivalent to the

instruments – current market value. So we can rewrite the formula :

n

Σ Expected CF x period t /(1+YTM)^t

t=1

D = ------------------------------------------------------

Current market value or price

Contd.

• Example:• Suppose a bank grants a loan to a customer for 5 years at 10 % i.e.

Rs. 100 per year. The face value (Par) of the loan is Rs. 1000 which is also the current market value (price) because the current YTM is 10 %. What is the loan’s duration ?

• Applying the above formula we have

5

Σ Rs. 100 x t /(1+ 0.10)t +Rs. 1000 x 5/(1+0.10)^5

t=1

D of loan =----------------------------------------------------------------------

Rs. 1000

= Rs. 41269.87 / 1000

= 4.17 years

Contd. • Alternatively we can tabulate and find out

Period of Expected PV of Time period PV

Expected cash flow Exp. Cash is to Expected

Cash flow from loan Cash flows be recd.(t) Cash flow

(@10%YTM) x t

----------- ------------ ------------------ ------------ -------------

1 100 90.91 1 90.91

2 100 82.64 2 165.29

3 100 75.13 3 225.39

4 100 68.30 4 273.21

5 100 62.09 5 310.46

Principal 5 1000 620.92 5 3104.61

Total 4169.87

Price of denominator Rs.1000 .Therefore, 4169.87/1000 = 4.16987 say

=4.17 years

USING DURATION TO HEDGE AGAINST INTEREST RATE RISK

• A Bank interested in fully hedging against interest rate fluctuations wants to chose assets and liabilities such that

The weighted duration of asset = weighted duration of Liabilities so that the Duration Gap is as close to Zero as possible.

Duration Gap = WDA – WDL (Weighted Duration assets & Liabilities) Because the volume of assets usually exceeds the volume of

liabilities (otherwise the firm would be insolvent) , a Bank seeking to minimize the effect of interest fluctuation would need to adjust for leverage: Therefore,

Leverage adjusted = WDA - WDL x Total Liabilities

duration Gap Total Assets

This equation tells us that the value of liabilities must change by slightly more than value of assets to eliminate the overall interest rate exposure.

The larger the leverage adjusted duration gap , the more sensitive will be the net worth of the bank to a change in the market interest rates.

contd

• We can calculate the change in the market value of a Bank’s equity , if we know the WADA and WADL , the original rate of discount applied to the cash flows and how interest rates have changed during the period we are concerned about. To do that we can use the following formula :

• Δ NW = [- DA x {Δi / (1+i)} x A] - [- DL x {Δi / (1+i)} x L]

• For example: A Bank has an average duration in its assets of 3 years and an average duration of liability of 2 years , the total liabilities of Rs. 100 million and total assets of Rs. 120 million. Interest rates were originally 10 % and suddenly rises to 12 %.

• Δ NW =[-3 x {+0.02/(1+0.10)}x 120 ] - [-2x{+0.02/(1+0.10)}x100]

= 2.91 million.

Clearly the bank faces a decline in Net worth and has to hedge.

Contd.

The impact of changing market interest rates on Net worth can be summarized as follows :

If the Banks leverage and if interest The Banks

adjusted duration Gap is rates Net worth will

Positive (DA>DLx L/A) Rise Decrease

Fall Increase

Negative ( DA< DLx L/A) Rise Increase

Fall Decrease

Zero (DA = DL x L/A) Rise No change

Fall No change Many of the aggressive managers would not like a strategy of

Portfolio immunization

Contd.

• Those type of managers would be willing to take some chances to maximize shareholder’ s position.

• Expected change Management Possible

in interest rates Action Outcome

Rates will rise Reduce DA and Increase DL NW increases

(moving closer to a negative (if rate forecast is

duration gap) correct)

Rates will fall Increase DA and reduce DL NW increases

(moving closer to positive ( if rate forecast is

duration gap) correct)