Asset Liability Management in Banks

Group 1

Components of a Bank Balance Sheet

Liabilities Assets

1. Capital2. Reserve & Surplus3. Deposits4. Borrowings5. Other Liabilities

1. Cash & Balances with RBI

2. Bal. With Banks & Money at Call and Short Notices

3. Investments4. Advances5. Fixed Assets6. Other Assets

Banks profit and loss account

A bank’s profit & Loss Account has the following components:

I. Income: This includes Interest Income and Other Income.

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

Evolution In the 1940s and the 1950s, there was an abundance of

funds in banks in the form of demand and savings deposits. Hence, the focus then was mainly on asset management

But as the availability of low cost funds started to decline, liability management became the focus of bank management efforts

In the 1980s, volatility of interest rates in USA and Europe caused the focus to broaden to include the issue of interest rate risk. ALM began to extend beyond the bank treasury to cover the loan and deposit functions

Banks started to concentrate more on the management of both sides of the balance sheet

What is Asset Liability Management??

The process by which an institution manages its balance sheet in order to allow for alternative interest rate and liquidity scenarios

Banks and other financial institutions provide services which expose them to various kinds of risks like credit risk, interest risk, and liquidity risk

Asset-liability management models enable institutions to measure and monitor risk, and provide suitable strategies for their management.

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

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

1. Net Interest Income (NII)

2. Net Interest Margin (NIM)

3. Economic Equity Ratio

3 tools used by banks for ALMALM information systems

ALM Organization

ALM Process

ALM Information Systems Usage of Real Time information system to gather the

information about the maturity and behavior of loans and advances made by all other branches of a bank

ABC Approach : analysing the behaviour of asset and liability products in

the top branches as they account for significant business then making rational assumptions about the way in which

assets and liabilities would behave in other branches The data and assumptions can then be refined over time

as the bank management gain experience

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

ALM Organization

The board should have overall responsibilities and should set the limit for liquidity, interest rate, foreign exchange and equity price risk

The Asset - Liability Committee (ALCO) ALCO, consisting of the bank's senior management (including CEO)

should be responsible for ensuring adherence to the limits set by the Board

Is responsible for balance sheet planning from risk - return perspective including the strategic management of interest rate and liquidity risks

The role of ALCO includes product pricing for both deposits and advances, desired maturity profile of the incremental assets and liabilities,

It will have to develop a view on future direction of interest rate movements and decide on a funding mix between fixed vs floating rate funds, wholesale vs retail deposits, money market vs capital market funding, domestic vs foreign currency funding

It should review the results of and progress in implementation of the decisions made in the previous meetings

ALM Process

Risk Parameters

Risk Identification

Risk Measurement

Risk Management

Risk Policies and Tolerance Level

Categories of Risk Risk is the chance or probability of loss or

damageCredit Risk Market Risk Operational Risk

Transaction Risk /default risk /counterparty risk

Commodity risk Process risk

Portfolio risk /Concentration risk

Interest Rate risk Infrastructure risk

Settlement risk Forex rate risk Model risk

Equity price risk Human risk

Liquidity risk

But under ALM risks that are typically managed are….

Will now be discussed in detail

Interest Rate Risk

Currency Risk

Liquidity Risk

Liquidity Risk Liquidity risk arises from funding of long term assets by

short term liabilities, thus making the liabilities subject to refinancing

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

Funding risk

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

Time risk

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

Call Risk

Liquidity Risk Management

Bank’s liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times

Liquidity Management is the ability of bank to ensure that its liabilities are met as they become due

Liquidity positions of bank should be measured on an ongoing basis

A standard tool for measuring and managing net funding requirements, is the use of maturity ladder and calculation of cumulative surplus or deficit of funds as selected maturity dates is adopted

Statement of Structural LiquidityAll Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:i. 1 to 14 days

ii. 15 to 28 days

iii. 29 days and up to 3 months

iv. Over 3 months and up to 6 months

v. Over 6 months and up to 1 year

vi. Over 1 year and up to 3 years

vii. Over 3 years and up to 5 years

viii. Over 5 years

Statement of structural liquidity

Places all cash inflows and outflows in the maturity ladder as per residual maturity

Maturing Liability: cash outflow

Maturing Assets : Cash Inflow

Classified in to 8 time buckets

Mismatches in the first two buckets not to exceed 20% of outflows

Shows the structure as of a particular date

Banks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement

1-14Days15-28 Days

30 Days-3 Month

3 Mths - 6 Mths

6 Mths - 1Year

1Year - 3 Years

3 Years - 5 Years

Over 5 Years Total

Capital 200 200Liab-fixed Int 300 200 200 600 600 300 200 200 2600Liab-floating Int 350 400 350 450 500 450 450 450 3400Others 50 50 0 200 300Total outflow 700 650 550 1050 1100 750 650 1050 6500Investments 200 150 250 250 300 100 350 900 2500Loans-fixed Int 50 50 0 100 150 50 100 100 600Loans - floating 200 150 200 150 150 150 50 50 1100Loans BPLR Linked 100 150 200 500 350 500 100 100 2000Others 50 50 0 0 0 0 0 200 300Total Inflow 600 550 650 1000 950 800 600 1350 6500Gap -100 -100 100 -50 -150 50 -50 300 0Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0Gap % to Total Outflow-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57

Addressing the mismatches

Mismatches can be positive or negative

Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.

In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.

For –ve mismatch, it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

Currency Risk

The increased capital flows from different nations following deregulation have contributed to increase in the volume of transactions

Dealing in different currencies brings opportunities as well as risk

To prevent this banks have been setting up overnight limits and undertaking active day time trading

Value at Risk approach to be used to measure the risk associated with forward exposures. Value at Risk estimates probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.

Interest Rate Risk

Interest Rate risk is the exposure of a bank’s financial conditions to adverse movements of interest rates

Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base

Changes in interest rates also affect the underlying value of the bank’s assets, liabilities and off-balance-sheet item

Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM)

NIM = (Interest income – Interest expense) / Earning assets

Sources of Interest Rate Risk

Re-pricing Risk: The assets and liabilities could re-price at different dates and might be of different time period. For example, a loan on the asset side could re-price at three-monthly intervals whereas the deposit could be at a fixed interest rate or a variable rate, but re-pricing half-yearly

Basis Risk: The assets could be based on LIBOR rates whereas the liabilities could be based on Treasury rates or a Swap market rate

Yield Curve Risk: The changes are not always parallel but it could be a twist around a particular tenor and thereby affecting different maturities differently

Option Risk: Exercise of options impacts the financial institutions by giving rise to premature release of funds that have to be deployed in unfavourable market conditions and loss of profit on account of foreclosure of loans that earned a good spread.

Risk Measurement Techniques

Various techniques for measuring exposure of banks to interest rate risks

Maturity Gap Analysis Duration Simulation Value at Risk

Maturity gap method (IRS)

THREE OPTIONS: A) Rate Sensitive Assets>Rate Sensitive

Liabilities= Positive Gap B) Rate Sensitive Assets<Rate Sensitive

Liabilities = Negative Gap C) Rate Sensitive Assets=Rate Sensitive

Liabilities = Zero Gap

Gap Analysis Simple maturity/re-pricing Schedules can be used to

generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates

- If a negative gap occurs (RSA<RSL) in given time band, an increase in market interest rates could cause a decline in NII

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

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

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

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

The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates

As per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero.

Duration Analysis

Simulation Basically simulation models utilize computer power

to provide what if scenarios, for example: What if:

The absolute level of interest rates shift Marketing plans are under-or-over achieved Margins achieved in the past are not sustained/improved Bad debt and prepayment levels change in different

interest rate scenarios There are changes in the funding mix e.g.: an increasing

reliance on short-term funds for balance sheet growth

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

Value at Risk (VaR)

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

It enables the calculation of market risk of a portfolio for which no historical data exists. VaR serves as Information Reporting to stakeholders

It enables one to calculate the net worth of the organization at any particular point of time so that it is possible to focus on long-term risk implications of decisions that have already been taken or that are going to be taken

Thank You!!!

Group 1 :

Nandita Sadhwani – 11020241089

Mayank Chandola -

11020241087

Priyanka Hirwani - 11020241097